Emerging Markets

Highlights The basic conditions that the U.S. Treasury utilizes to evaluate its major trade partners do not justify labeling China as a currency manipulator. Even if China were officially declared as a manipulator, the remedial measures that the Treasury must follow under the existing legal framework are materially insignificant for a country like China. Trade friction between the U.S. and China may increase with product-specific tariffs, but that a broader escalation in protectionism is unlikely, at least in the near term. The changing correlation between the RMB and Chinese stocks suggests that investors may be becoming less worried about the RMB and China's foreign exchange policy. Over the long run, the "normal" negative correlation between the performance of exchange rate and that of the stock market should also emerge with regards to the RMB and Chinese stocks. Feature Financial markets will continue to grapple with what U.S. President-elect Donald Trump will bring to the global economy as we head into the final trading weeks of 2016. His signature policy proposals - fiscal stimulus, a more restrictive immigration policy, and trade protectionism - have already led to a significant repricing of risk asset, and will continue to unsettle investors. As far as China is concerned, the upshot is that more fiscal stimulus under President Trump will generate stronger American demand, which could spill over to China. The downside risk is undoubtedly protectionism, which will cast a long shadow on an economy that is still heavily dependent on overseas markets.1 President-elect Trump declared on the campaign trail that he would name China a currency manipulator on his first day in office, accompanied by punitive tariffs on Chinese imports that could reach 45%. This adds a major uncertainty to the growth outlook for China next year. Conditions And Remedies For A Currency Manipulator For now, it is impossible to predict what President Trump will do. He has become notably more pragmatic since his election victory. In his first policy statement, he declared his intentions to withdraw the U.S. from the Trans-Pacific Partnership (TPP) negotiations as his top priority on trade, while avoiding further China-bashing. However, the true color of his trade policy remains unclear. What is more certain is that the basic conditions that the U.S. Treasury utilizes to evaluate its major trade partners do not justify labeling China as a currency manipulator. The existing Treasury review process of foreign exchange practices is a formal process laid out in statutory law that governs the reporting process, the need for negotiations in cases of manipulation, and the recommended trade remedies if negotiations fail. Specifically, there are three conditions a nation must meet to be labeled a currency manipulator: It runs a significant bilateral trade surplus with the U.S.; It has a material current account surplus; and It has engaged in persistent one-sided intervention in the foreign exchange market. In China's case, the country does run a significant bilateral trade surplus with the U.S., but its current account surplus as a share of GDP has declined from a peak of 10% in 2007 to 2.5% currently (Chart 1). More importantly, while China's foreign exchange market intervention has indeed been one-sided since 2014, the effort has been to prop up the RMB against the dollar. Without the PBoC's intervention, the RMB would have fallen further, potentially substantially. The RMB may have met all three criteria for currency manipulation before the global financial crisis, but the case is a lot harder to make at the moment. Chart 1Conditions For A Currency Manipulator Conditions For A Currency Manipulator Conditions For A Currency Manipulator Moreover, even if China were officially declared as a manipulator, the remedial measures that the Treasury must follow under the existing legal framework are materially insignificant for a country like China. The U.S. Treasury is required to negotiate with alleged currency manipulators, utilizing several "sticks" if negotiations fail: Prohibit the Overseas Private Investment Corporation from financing (including providing insurance to) new projects in that country; Prohibit the federal government from procuring from that country; Seek additional surveillance of the macroeconomic and exchange rate policies of that country through the International Monetary Fund; Take into account the currency practices in negotiating new bilateral or regional trade agreements with that country. While these "sticks" may be intimidating enough for small open economies, for a country like China, they are largely irrelevant. There is no ongoing negotiation for bilateral trade agreement between the two countries, and on a federal level the U.S. government rarely procures in China, if at all. Therefore, labeling China a currency manipulator may be a highly symbolic move aimed at satisfying Trump supporters, but the real economic consequences are rather small. To be sure, the U.S. president has enough administrative authority to bypass existing legal constraints and take unilateral action on trade issues. However, that would require extraordinary political capital. Barring this rather "extreme" scenario, we expect trade frictions between the U.S. and China to increase in the form of product-specific tariffs. A broader escalation in protectionism is unlikely, at least in the near term. The Impact On Investment Flows From a balance-of-payment point of view, a country running a trade deficit should not be viewed as a sign that it is losing in bilateral trade. Rather, it reflects capital flows from a surplus country to a deficit country in the form of exported domestic savings. In this vein, China running a chronic current account surplus with the U.S. implies that the country as a whole has been accumulating U.S. assets. By the same token, so long as China runs a current account surplus, it means it is still a net creditor to the rest of the world, and the nation's foreign asset holdings, official and private sector combined, continue to increase. In previous years, it was the Chinese central bank that had increased its holdings of foreign assets, primarily in the form of U.S. Treasurys and other low-risk liquid assets. More recently, as the RMB has been depreciating against the dollar, the Chinese domestic private sector been accumulating foreign assets, particularly denominated in U.S. dollars. In fact, the private sector has taken over as the main source of demand for foreign assets, primarily in risker asset classes such as corporate equities, bonds and real estate. The official sector, on the other hand, has been selling foreign asset holdings, as reflected in China's declining official reserves. In other words, rather than experiencing an exodus of capital, there has been a gigantic "swap" of foreign assets between private and public sector in China. Indeed, Chart 2 shows China's official reserves have dropped significantly in the past two years. Chinese official holdings of Treasurys currently stand at USD 1157 billion, down from USD 1315 billion in 2011. Meanwhile, anecdotal evidence suggests that buoyant demand among Chinese households for foreign assets, particularly real estate. For the corporate sector, there has been a dramatic increase in overseas mergers and acquisitions (M&A) and other investment activity by Chinese companies, particularly in the U.S. (Chart 3). So far this year, total announced M&A deals by Chinese firms in the U.S. have already tripled compared to last year, however, most are still in progress and pending. Chart 2The Official Sector Is##br## Shedding Foreign Assets... The Official Sector Is Shedding Foreign Assets... The Official Sector Is Shedding Foreign Assets... Chart 3... While The Private ##br##Sector Accumulates China As A Currency Manipulator? China As A Currency Manipulator? Looking forward, if the business environment in the U.S. under President Trump becomes less foreign-friendly, it may impact Chinese enterprises' confidence in acquiring U.S. assets, and complicate Chinese companies' M&A deals. At a minimum, the massive increase in Chinese M&A interest in the U.S. will pause until policy visibility improves, while the outlook for many already announced pending deals will remain murky. This may deter further capital flows to the U.S. by the Chinese private sector. Changing Correlation Between The RMB And Stocks? The RMB has continued to drift lower against the dollar in the past week in both the onshore and offshore markets. Interestingly, Chinese stocks have appeared to have largely ignored the RMB's slide and have continued to move higher. This is in stark contrast to last year's panic selloffs that happened whenever RMB appreciation against the dollar appeared to quicken (Chart 4). In August 2015 and January 2016, the RMB's outsized moves against the dollar caused major disruptions in both A shares and H shares, sending shockwaves across the globe. It is too soon to draw definitive conclusions from very short-term moves. However, the changing correlation between the RMB and Chinese stocks suggests that investors may have become less worried about the RMB and China's foreign exchange policy. First, investors may be getting more accustomed to the RMB's rising volatility. The trade-weighted RMB in recent days has been stable, a sign that the RMB's weakness against the dollar is mainly a reflection of the strong dollar. The People's Bank of China and other relevant authorities have also been paying more attention when communicating to market participants, which may also help anchor investors' expectations. Second, in previous episodes of "sharper" RMB depreciation, the Chinese economy was clearly decelerating, and the RMB weakness further amplified investors' anxiety on China's macro conditions. Currently the Chinese economy is showing notable signs of improvement, particularly in the industrial sector, which also lessens investors' concerns. Chart 4The RMB Is Less Troubling ##br##To Market bca.cis_wr_2016_11_24_c4 bca.cis_wr_2016_11_24_c4 Chart 5The Mirror Image Between Yen ##br##And Japanese Stocks The Mirror Image Between Yen And Japanese Stocks The Mirror Image Between Yen And Japanese Stocks Finally, the market may be starting to reflect the reflationary impact of a weaker currency rather than the negative consequences of RMB depreciation. China's growth improvement is in no small part attributable to the falling exchange rate. This in and of itself limits the RMB's downside, rather than leading to an endless downward spiral. It remains to be seen whether Chinese stocks will stay calm as the RMB continues to depreciate against a surging dollar. Our hunch is that global equity markets, particularly in the U.S., have become complacent with a strong dollar and rising U.S. interest rates, both of which tighten global liquidity conditions. Therefore, global equities are vulnerable to downside risk, which could spill over to the Chinese market. For now, we are staying on the sidelines and do not suggest investors chase the rally in Chinese equities. However, over the long run, we expect investors will eventually come to terms with the "new normal" for the RMB as it becomes an important macro factor for the economy and stock market. Chart 5 shows that the performance of Japanese stocks has almost been a mirror image of the yen/dollar exchange rate, in which a weaker yen boosts Japan's growth profile as well as stock prices, and vice versa. Barring a crisis scenario, such a correlation will also emerge between the RMB and Chinese stocks over the long run. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "China-U.S. Trade Relations: The Big Picture", dated November 17, 2016, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights A central bank cannot control/target the quantity and price of money simultaneously. For the past few years, China's central bank has silently moved away from controlling money growth toward targeting interest rates. As such, the reserve requirements imposed on banks have not and will not be a constraint on Chinese commercial banks' ability to lend and create money if the PBoC continues to supply banks with reserves "on demand." China's banks have created too many RMBs (broad money/deposits) and the PBoC has accommodated them. Such enormous supply of RMBs and mainland households' and companies' desire to get rid of their RMBs will lead to further yuan depreciation. Continue shorting the RMB and Asian currencies versus the U.S. dollar. Re-instate a short Colombian peso trade; this time against an equal-weighted basket of the U.S. dollar and the Russian ruble. Feature Following our October 26 Special Report titled, "Misconceptions About China's Credit Excesses",1 some clients have asked us how our analysis squares with fact that the People's Bank of China (PBoC) conducts its monetary policy using a reserve requirement ratio. The relevant question being, why would the PBoC's reserve requirements not limit commercial banks' ability to create money/credit? In that Special Report, we wrote: "A commercial bank is not constrained in loan origination by its reserves at the central bank if the latter supplies liquidity (reserves) to commercial banks "on demand." Given PBoC lending to banks has surged 5.5-fold over last three years (Chart I-1), we concluded that the reserve requirement ratio had, for all intents and purposes, lost its meaning in China. In this week's report we elaborate on this issue in detail. The main implication of our analysis today reinforces our conclusion from the previous report: namely, China's commercial banks have expanded credit enormously, and the PBoC has accommodated it. With respect to financial market implications, there are simply too many RMBs (broad money/deposits) in the system (Chart I-2). Chinese households and companies can instinctively sense this, and are opting to move their wealth into real assets, such as real estate, or foreign currencies. Hence, the oversupply of RMBs will continue to weigh on China's exchange rate, which will depreciate much further. We expect the US$/CNY to reach 7.8-8 over the next 12 months. Chart I-1The PBoC Has Provided Banks With Liquidity 'On Demand' bca.ems_sr_2016_11_23_s1_c1 bca.ems_sr_2016_11_23_s1_c1 Chart I-2There Are Too Many RMBs Floating Around bca.ems_sr_2016_11_23_s1_c2 bca.ems_sr_2016_11_23_s1_c2 Targeting Either The Quantity Or The Price Of Money Any central bank can target and control either the quantity of money or the price of money, but not both simultaneously. This holds true for any monopolist supplier of any good/service that does not have control over the demand curve. A demand curve for money is the function that ties the quantity demanded at various price points (the price being interest rates). Central banks - being monopolist suppliers of money, but unable to control money demand - must choose between controlling either the quantity of money or the price of money. The system of required reserves (RR) is a tool to control money supply (the quantity of money). When central banks reinforce the RR ratio, interbank interest rates typically swing enormously and often deviate considerably from the target policy rate (Chart 1). For example, when commercial banks expand loans too much and lack sufficient reserves at the central bank, they must borrow from the interbank market and thereby bid up interbank rates- i.e., short-term interest rates rise. This in turn restrains credit demand or the willingness to lend, and eventually reduces money growth. The opposite also holds true. When a central bank wants to target interest rates (the price of money), it cannot control money supply. To ensure that interbank/money market rates stay close to the policy rate - i.e., to reinforce its interest rate target - a central bank should provide the banking system with reserves "on demand." In other words, when interbank rates rise above the target policy rate, a central bank should inject sufficient liquidity into the system to bring interest rates down. Similarly, when interbank rates fall below the target policy rate, a central bank should withdraw enough liquidity from the banking system to assure interbank rates rise converging to its target policy rate. By supplying commercial banks with reserves (high powered money) "on demand" - i.e., providing as much reserves as they need - a central bank is de facto failing to enforce reserve requirements. As such, the central bank is giving up control over money creation. By and large, RRs lose their effectiveness if a central bank provides commercial banks with as much reserves as they request. In short, when a central bank opts for targeting interest rates, it cannot steer monetary aggregates - i.e., RRs and RR ratios lose their meaning. In the 1970s and 1980s, most central banks in advanced countries targeted money supply to achieve their policy goals such as inflation and sustainable economic growth. However, starting in the early 1990s, developed nations' central banks (the Federal Reserve, the Bank of England, the Bank of Canada, the Swiss National Bank and others) began to move away from controlling money supply (monetary aggregates) and toward targeting interest rates. Individual banks' limitations to borrow from the central bank often rests with the availability of collateral. So long as a commercial bank has eligible collateral (often government bonds), it can access central bank funding. This is true for Chinese commercial banks too. Bottom Line: Monetary authorities cannot control/target the quantity and price of money simultaneously. The Money Multiplier In An Interest Rate Targeting System When a central bank opts for targeting interest rates, commercial banks can originate an unlimited amount of loans and demand the central bank provide additional reserves, as long as they have eligible collateral. This corroborates our point from our previous report that a commercial bank's loan origination is not constrained by its reserves at the central bank if the latter supplies liquidity (reserves) "on demand." In a fractional reserve system, the ability of commercial banks to create loans/money is defined by a money multiplier. A potential ceiling for a money multiplier (MM) is calculated as: MM = (1 / RR ratio) For example, when the RR ratio is 10%: The money multiplier MM = (1 / 0.1) = 10 In effect, the banking system can create up to 10 times more money/loans/deposits per one dollar of reserves. Under the current system of interest rate targeting – which has prevailed among most developed countries since the early 1990s and more recently in China (more on China below) – we can think of the RR ratio as heading towards zero because central banks provide banks with almost unlimited liquidity (reserves). The RR ratio is not zero because there are still limitations on banks' ability to borrow from central banks due the availability (or lack thereof) of eligible collateral or compliance with Basel III requirements. Yet as the RR ratio gets smaller in size, its reciprocal (1 / RR ratio) becomes very large (not infinite, but a plausibly very large number). Overall, when a central bank targets interest rates, the ceiling of the money multiplier is not set by the central bank. Rather, the money multiplier is de facto determined by commercial banks' willingness to originate loans. Thus, the money multiplier can potentially be very high when animal spirits among bankers and borrowers run wild. Consequently, the points discussed in our Special Report titled, "Misconceptions About China's Credit Excesses"2 - namely that commercial banks create loans/money/deposits out of thin air - holds, and is relevant in a system where central banks target/control interest rates. Bottom Line: When central banks opt to control short-term interest rates, they must provide commercial banks with as much liquidity as the latter demands. In such a case, RRs and the RR ratio become almost irrelevant. Therefore, in an interest rate targeting system, banks' ability to originate loans/create money and deposits is not contingent on their reserves at the central bank. This point is greatly relevant to China. The PBoC: Shifting From Money To Interest Rate Targeting For the past few years, China’s central bank has silently moved away from controlling money growth to targeting interest rates. As a result, nowadays the PBoC has very little quantitative control over money/credit creation by commercial banks or the money multiplier. It is Chinese commercial banks that effectively drive money/credit/deposit creation. Chart I-3SHIBOR Crises In 2013 Forced PBoC ##br##To Start Targeting Interest Rates bca.ems_sr_2016_11_23_s1_c3 bca.ems_sr_2016_11_23_s1_c3 We suspect this shift in China's monetary policy management has been occurring since early 2014 on the heels of the so-called SHIBOR crisis, which erupted in June 2013 when interbank rates surged and was followed by another spike in interbank rates in December 2013 (Chart I-3). During these episodes, the PBoC enforced reserve requirements and thus did not provide liquidity to banks that were running short on it. In essence, it did whatever a central bank targeting money growth via control over RR would do. However, as interbank rates surged and banks complained, policymakers backed off, and provided banks with as much liquidity as they demanded. This stabilized interbank rates and, importantly, appears to have marked the PBoC's shift toward interest rate targeting. Thus, by de facto moving to a monetary system of targeting interest rates, the PBoC cannot effectively reinforce reserve requirements because it must supply any amount of reserves that commercial banks require to preclude a major spike in interbank rates. A few points illustrate that in fact the PBoC has been targeting short-term money market rates, and banks have expanded loans enormously despite their excess reserves being flat: Volatility in interbank rates has dropped substantially (Chart I-4), as the PBoC's claims on commercial banks has exploded 5.5-fold since the early 2014. Even though commercial banks' excess reserves have been flat, their lending has been booming - i.e., the money/credit multiplier has been rising (Chart I-5). This is only possible when the PBoC has been supplying reserves "on demand" or when it cuts the RR ratio. Since the RR ratio has not been cut over the past two years, it means that the former is true. Chart I-4Interbank Rate Volatility Has Fallen As ##br##PBoC Injected A Lot Of Liquidity bca.ems_sr_2016_11_23_s1_c4 bca.ems_sr_2016_11_23_s1_c4 Chart I-5China's Money/Credit Multiplier##br## Has Been Rising bca.ems_sr_2016_11_23_s1_c5 bca.ems_sr_2016_11_23_s1_c5 Just like central banks in advanced economies, the only way the PBoC can alter money/credit growth is if it lifts or cuts its interest rate target. Barring any changes to its policy rate, commercial banks, not the PBoC, determine money/loan/deposit creation in China. As to other factors that determine the amount of credit/money creation by commercial banks in China, we elaborated on these in the above-mentioned report. Bottom Line: It appears the PBoC has shifted toward targeting interest rates. Consequently, the PBoC cannot pretend to control money/credit origination unless it changes its interest rate target. Moreover, we reiterate that China's abnormal credit growth has been the result of speculative behavior among Chinese banks and borrowers, and not the natural result of the country's high savings rate. Oversupply Of RMBs = A Lower Currency As China's central bank has been printing RMBs and commercial banks have been "multiplying" them at a high rate (by originating loans), the supply of RMBs has continued to explode. Such an oversupply of local currency will continue to depress the value of the nation's exchange rate. The PBoC's liquidity injections have exploded in recent years (Chart I-6). The central bank has not only been offsetting the liquidity withdrawal due to its currency foreign exchange market interventions, but it has also been providing banks with as much liquidity as they require. The objective seems to have been to avoid a rise in interbank rates when corporate leverage is extremely high and banks are overextended. Since February 2015, the PBoC's international reserves have dropped by US$0.9 trillion, or 4.2 trillion RMB (Chart I-7). This means that the PBoC has withdrawn 4.2 trillion RMBs from the system. If the central bank did not re-inject these RMBs into the financial system, interbank rates would have skyrocketed. As the PBoC has injected RMBs into the system, it has effectively undone its RMB defense. The whole point of defending the exchange rate from falling or depreciating too fast is to shrink local currency liquidity. Yet, naturally, that would also lead to higher interbank rates. If the central bank chooses not to tolerate higher interest rates and continues to inject local currency into circulation, the RMB's depreciation will likely continue and accelerate. By injecting RMBs into the system, the monetary authorities have allowed banks to continue to lend, thereby creating enormous amounts of money and deposits. Banks create deposits when they lend. The Chinese banking system has a lot of deposits partially because commercial banks have lent too much. In short, the supply or quantity of money (RMBs) has continued to explode, despite massive capital outflows. Notably, if the PBoC did not lend RMBs to commercial banks, the latter's excess reserves would have plunged by 4 trillion RMB (Chart I-8) and banks would have been forced to pull-back their lending. Chart I-6PBoC's Liquidity Injections Have ##br##Exploded Since Early 2014 bca.ems_sr_2016_11_23_s1_c6 bca.ems_sr_2016_11_23_s1_c6 Chart I-7China: Foreign Exchange##br## Reserve Depletion bca.ems_sr_2016_11_23_s1_c7 bca.ems_sr_2016_11_23_s1_c7 Chart I-8China: What Would Have Banks' Excess Reserves##br## Been Without Borrowing From PBoC? bca.ems_sr_2016_11_23_s1_c8 bca.ems_sr_2016_11_23_s1_c8 Overall, in the current fiat money system, when a central bank targets interest rates, the monetary authorities can print unlimited high-powered money (bank reserves) and commercial banks can multiply it by creating enormous amounts of loans/deposits.3 However, there is no free lunch - no country can print its way to prosperity (otherwise all countries would have been very rich already). The negative ramifications of unlimited money creation are numerous, but this report focuses on the exchange rate implications. The growing supply of RMBs will lead to a much further drop in China's exchange rate. It seems Chinese retail investors and companies intuitively sense this, and are eager to get rid of their RMBs. This also explains Chinese investors' desire to overpay for any real or financial asset, domestically or abroad. We expect growing downward pressure on the RMB as capital outflows accelerate anew. Although China’s foreign exchange reserves are enormous in absolute U.S. dollar terms, they are low relative to money supply (Chart 9). The ratio of the central bank’s international reserves-to-broad money is 15% in China and it is relatively low compared with other countries (Chart 10). Chart I-9China: International Reserves Are Not##br## High Relative To Broad Money bca.ems_sr_2016_11_23_s1_c9 bca.ems_sr_2016_11_23_s1_c9 Chart I-10International Reserves-To-Broad##br## Money Ratio China's Money Creation Redux And The RMB China's Money Creation Redux And The RMB As a final note, the oversupply of local currency has not created inflation in the real economy because of massive overcapacity following years of booming capital spending. However, continued money creation will eventually lead to higher inflation. This does not seem imminent but we will be monitoring these dynamics carefully going forward. Bottom Line: China's banks have created too much RMBs and the PBoC has accommodated them. Such enormous supply of RMBs and mainland households' and companies' desire to get rid of their RMBs will lead to further yuan depreciation. Investment Implications: A Free-Fall For RMB And Asian Currencies The RMB's value versus the U.S. dollar will drop much further. Our new target range for US$/CNY is 7.8-8 over the next 12 months, or 11-14% below today's level. The forward market is discounting only 2.8% depreciation in the next 12 months (Chart I-11). We maintain our short RMB / long U.S. dollar trade (via 12-month NDF). A persistent relapse in the RMB's value will drag down other Asian currencies. In particular, the Korean won and the Taiwanese dollar have failed to break above important technical levels (their long-term moving averages), and have lately relapsed (Chart I-12). Chart I-11RMB Will Depreciate Much More##br## Than Priced In By Forwards RMB Will Depreciate Much More Than Priced In By Forwards RMB Will Depreciate Much More Than Priced In By Forwards Chart I-12Asian Currencies:##br##More Downside Ahead bca.ems_sr_2016_11_23_s1_c12 bca.ems_sr_2016_11_23_s1_c12 For the Korean won, we believe there is considerable downside from current levels. Consistently, we recommended shorting the KRW versus the THB trade on October 19.4 Chart I-13EM ex-China Currencies Total Return##br## (Including Carry): Is The Rally Over? bca.ems_sr_2016_11_23_s1_c13 bca.ems_sr_2016_11_23_s1_c13 Traders who believe in continued U.S. dollar strength, like we do, should consider shorting the KRW versus the U.S. dollar outright. For DM currencies, this means that the drop in the JPY has further to go. In emerging Asia, we are also shorting the MYR and the IDR versus the U.S. dollar and also versus Eastern European currencies such as the ruble and the HUF, respectively. As emerging Asian currencies depreciate versus the U.S. dollar, other EM currencies will likely follow. It is hard to see the RMB and other Asian currencies plunging and the rest of EM doing well. The total return (including the carry) of the aggregate EM ex-China exchange rate versus the U.S. dollar (equity market-cap weighted index) has failed to break above a critical long-term technical resistance, and has rolled over (Chart I-13). This is a bearish technical signal, implying considerable downside from these levels. As such, we maintain our core short positions in the following EM currencies outside Asia: TRY, ZAR, BRL and CLP and add COP to this list today. This is based on an assumption of diminished foreign inflows to EM and lower commodities prices. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy & Frontier Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Assistant andrijav@bcaresearch.com Colombia: Headed Toward Recession In our May 4 Special Report on Colombia,5 we argued that despite a bright structural backdrop this Andean economy was headed for a growth recession (i.e. very weak but still positive growth). Domestic demand has buckled and now we believe the nation could be on the verge of its first genuine recession in two decades (Chart II-1). Colombia's Achilles heel is its low domestic savings rate, reflected by a still large current account deficit financed by FDI and portfolio capital inflows (Chart II-2). As a result, low oil prices and rising global interest rates have exposed the nation's main cyclical vulnerability. Given the trade deficit is still large (Chart II-3) and our bias is that oil prices will be flat-to-down, a further retrenchment in domestic demand is unavoidable. Chart II-1Colombia's First Recession##br## In 20 Years? bca.ems_sr_2016_11_23_s2_c1 bca.ems_sr_2016_11_23_s2_c1 Chart II-2Colombia's Lingering Balance Of ##br##Payments Vulnerability bca.ems_sr_2016_11_23_s2_c2 bca.ems_sr_2016_11_23_s2_c2 Chart II-3A Weaker COP Will Force The ##br##Necessary Adjustment bca.ems_sr_2016_11_23_s2_c3 bca.ems_sr_2016_11_23_s2_c3 Going forward, the external funding constraint will continue to bite. Moreover, policymakers are trapped and will be unable to prevent growth from contracting. The central bank is stuck between the proverbial rock and hard place. Cutting interest rates will undermine the appeal of the peso to foreign investors. Raising rates to prop up the currency, however, will exacerbate the economy's downward momentum. In the end, downward pressure on the exchange rate and still high inflation mean the central bank will not cut rates soon (Chart II-4). Tight monetary policy in turn means that private sector credit will decelerate much more (Chart II-5). Chart II-4High (Well Above Target) Inflation Limits##br## Central Bank's Ability To Ease bca.ems_sr_2016_11_23_s2_c4 bca.ems_sr_2016_11_23_s2_c4 Chart II-5Colombia: Credit Growth Is ##br##Headed Much Lower bca.ems_sr_2016_11_23_s2_c5 bca.ems_sr_2016_11_23_s2_c5 Our marginal propensity to consume proxy, an excellent leading indicator for household spending, signals consumption is set to weaken even further (Chart II-6). Facing weakening demand, investment is set to continue contracting (Chart II-7) and, ultimately, unemployment will be much higher, reinforcing the downtrend in consumer expenditures. Chart II-6Colombian Domestic Demand##br## To Retrench Further bca.ems_sr_2016_11_23_s2_c6 bca.ems_sr_2016_11_23_s2_c6 Chart II-7Contracting Investment Bodes ##br##Poorly For Employment bca.ems_sr_2016_11_23_s2_c7 bca.ems_sr_2016_11_23_s2_c7 Meanwhile, fiscal policy will remain tight as Colombia's orthodox policymakers struggle to adjust the fiscal accounts to the structurally negative terms-of-trade shock in this oil-dependent economy. The current fiscal reform effort is very positive for sustainable long-run dynamics, as influential central bank board members have highlighted.6 Yet particular parts of the reform, such as raising VAT taxes from 16% to 19%, will almost inevitably lead to a drop in consumer demand. Furthermore, nominal government revenues are already contracting and a slumping economy means that the total fiscal effort will need to be greater than currently envisioned. Overall, with monetary and fiscal policy stimulus hamstrung by the nation's low domestic savings rate (i.e. large current account deficit), a mild recession seems very likely. And while a lot of weakness has already been priced into the nation's financial markets, we think there is still more downside ahead. For instance, the Colombian peso may be cheap in real (inflation-adjusted) terms, but it is highly vulnerable due to the nation's still wide current account deficit. This week we recommend re-instating a short position in the peso; this time against an equal-weighted basket of the U.S. dollar and the Russian ruble.7 Turning to equities, Colombian stocks have fallen sharply since 2014, mostly a reflection of the collapse of the nation's energy plays. At present bank stocks account for 60% this nation's MSCI market cap, and though we believe they will fare better than many other EM banking systems,8 they will not go unscathed by a recession. Still, orthodox policymaking should limit the downside in the performance of this bourse and sovereign credit (U.S. dollar bonds) relative to their respective EM benchmarks. Meanwhile, fixed-income investors should continue to bet on yield curve flattening by paying 1-year/ receiving 10-year interest rate swaps, a trade we have recommended since September 16, 2015.9 The recent steepening in the yield curve will prove unsustainable as the economy tanks. Bottom Line: Colombia is probably headed toward recession and policymakers are straightjacketed and cannot ease monetary and fiscal policies to prevent it. As such, the currency will be the main release valve and it will depreciate further. Go short the COP versus an equal-weighted basket the U.S. dollar and the Russian ruble. Dedicated EM equity and credit investors should maintain a neutral allocation to Colombia within their respective EM benchmarks. Continue to bet on flattening in the yield curve by paying 1-year/ receiving 10-year interest rate swaps. Santiago E. Gomez Associate Vice President santiago@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Report, titled "Misconceptions About China's Credit Excesses", dated October 26, 2016. 2 Please refer to the Emerging Markets Strategy Special Report, titled "Misconceptions About China's Credit Excesses," dated October 26, 2016. 3 As we argued in Emerging Markets Strategy Special Report, titled "Misconceptions About China's Credit Excesses", dated October 26, 2016, it is new loans that create new deposits and vice versa. 4 Please refer to the section on Thailand in our Emerging Markets Strategy Weekly Report, titled " The EM Rally: Running Out Of Steam?" dated October 19, 2016. 5 Please refer to the Emerging Markets Special Report titled, "Colombia: A Cyclical Downturn Amid Structural Strength," dated May 4, 2016, available at ems.bcaresearch.com 6 Please see Cano, Carlos Gustavo "Monetary Policy in Colombia: Main Challenges 2016 -2017" Bank of America Merrill Lynch, Small Talks Symposium, October 7, 2016, Washington DC http://www.banrep.gov.co/sites/default/files/publicaciones/archivos/cgc_oct_2016.pdf 7 For more on the ruble please refer to the section on Russia in our Emerging Markets Weekly Report, dated November 16, 2016, titled, "Russia: Overweight Equities; Reinstate Long RUB / Short MYR Trade". 8 Please refer to the Emerging Markets Special Report titled, "Colombia: A Cyclical Downturn Amid Structural Strength" dated May 4, 2016, available at ems.bcaresearch.com 9 Please refer to the section on Colombia in our Emerging Markets Weekly Report, dated September 15, 2015, titled "Colombia: An Incomplete Adjustment", available at ems.bcareseach.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Sweden Yield Curve: The drivers behind our Sweden 5-year/10-year curve flattener trade - a Riksbank stance that appeared too dovish, a cautious global risk landscape and the strength of Sweden's economic expansion - have become less compelling. We advocate closing that trade, at a profit of +84bps. Swedish Rates: The Riksbank rate liftoff will start earlier than priced in the market. We recommend entering a new trade, paying the 18-month Sweden Overnight Index Swap rate. NZ Rates: New Zealand's inflation will surprise to the upside in 2017 and put upward pressure on short-term interest rates. To position for this, pay 12-month rates on the New Zealand Overnight Index Swap curve. Korea vs. Japan: The rationale behind our recommended trade favoring 5-year Korean government debt versus 5-year Japanese government bonds has changed. We are closing the trade at a profit of +260bps. Feature The surprising U.S. election victory of President-elect Trump, on a policy platform that is both reflationary and protectionist, has shaken up the global macro landscape. The shock has been even more acute for small, open and export-oriented economies like Sweden, New Zealand and Korea. This triggers a necessary re-assessment of our positions. In this Weekly Report, we revisit three previously recommended trades included in our "Overlay Trades Portfolio" that are most exposed to the changing global backdrop. Sweden: Closing Our Flattener Trade... Last year, we were of the view that the Riksbank would shift to a more hawkish policy stance during 2016.1 Fast forward to today, and this has not panned out as we expected with the Riksbank persistently sticking with its dovish bias. We are no longer comfortable facing the stiff resolve of the Riksbank and, therefore, we are closing our recommended Swedish 5-year/10-year yield curve flattener trade (Chart 1). Chart 1Closing Our Sweden Flattener Closing Our Sweden Flattener Closing Our Sweden Flattener Chart 2The Dovish Rhetoric Is Paying Off The Dovish Rhetoric Is Paying Off The Dovish Rhetoric Is Paying Off The message has been clear - Sweden's central bank will stay accommodative as long as it takes to get inflation back on a sustainable upward trajectory. In a unified fashion, the most senior Riksbank officials have communicated the following: 2 Monetary policy is set to escape low inflation as fast as possible. Currency intervention to weaken the Krona cannot be ruled out. There is no problem in extending the Riksbank's asset purchase program, since it has worked well so far in keeping government bond yields at accommodative levels and helping depress the Krona. The exchange rate is now notably weaker throughout the entire Riksbank forecast period than previously assumed, but this has not been sufficient to counteract the lower underlying inflationary pressures in Sweden.3 In a nutshell, the Riksbank wants to bring about higher inflation through a depreciation of the currency. The strategy has started to work of late (Chart 2). A very accommodative monetary policy, combined with rising inflation pressures from a cheapening Krona, now points to a prolonged period of low real policy rates that will keep the Swedish yield curve under steepening pressure. Aside from the monetary policy rhetoric, the global political landscape is no longer favorable for a yield curve flattening trade either, even in Sweden. In June, when Brexit surprised the planet, our Sweden flattener trade performed well, as global uncertainty spiked and a risk-off environment supported lower longer-term bond yields. Donald Trump's upset election earlier this month had the exact opposite effect, however, triggering a massive curve steepening in most bond markets, including Sweden (Chart 3).4 Going forward, if the effects of Trump's proposed policies - such as a decent fiscal impulse and protectionist trade measures - linger, as we expect, a Swedish flattener will likely underperform. Global bond markets will continue to be heavily influenced by a steepening U.S. Treasury curve. Moreover, our optimism on Swedish growth has dimmed recently, with certain parts of the economy slowing down. At the business level, weakening new orders data signal lower industrial production growth ahead. In addition, exporter order books have rolled over, resulting in a build-up of inventories (Chart 4). Chart 3Same Populism, Different Outcome A Post-Trump Update Of Our Overlay Trades A Post-Trump Update Of Our Overlay Trades Chart 4Dimming Optimism Dimming Optimism Dimming Optimism In turn, Swedish households are feeling the pinch. Slower wages and employment growth are reducing consumption. Growth in retail sales and car registrations has decelerated and private bankruptcies have started to rise (Chart 5). Since household consumption is a vital part of Sweden's economy, the recent robust expansion will moderate in the next few quarters. Consequently, the gap between the Riksbank's dovish monetary stance and the economic backdrop can no longer be deemed unsustainable, as we have described it in the past. This reality has been well depicted in the latest Riksbank Monetary Policy Report (MPR), where 2016 GDP growth is now forecasted to be only 1.8%. This seems reasonable considering the decline in actual demand - observable through the slowing growth of Swedish imports - and the Riksbank's own forward-looking economic activity index (Chart 6). The Riksbank is now projecting only a modest growth rebound to 2.5% in 2017, but this implies a meaningful reacceleration in growth to an above-trend pace later on in the year. Chart 5Swedish Households: Feeling The Pinch Swedish Households: Feeling The Pinch Swedish Households: Feeling The Pinch Chart 6Swedish GDP Growth Will Slow Further Swedish GDP Growth Will Slow Further Swedish GDP Growth Will Slow Further Bottom Line: The drivers behind our Sweden 5-year/10-year curve flattener trade - a Riksbank stance that appeared too dovish, a cautious global risk landscape and the strength of Sweden's economic expansion - have become less compelling. We advocate closing that trade, at a profit of +84bps. ...And Placing A New Bet On Rising Swedish Inflation Currently, the Swedish Overnight Index Swap (OIS) curve is expecting monetary policy stability in the first half of next year, pricing in only a 10% probability of a rate cut and a mere 2% chance of a rate hike by July 2017. Of the two, a rate hike is most likely, in our view, given the growing risks of upside inflation surprises stemming from a weaker Krona and rising energy prices. With such a low probability of a hike currently priced into the curve, the risk/reward potential for a trade is compelling. Today, we enter into a new position: paying 18-month Swedish OIS rates (Chart 7). Chart 7Pay 18-Month Sweden OIS Rates Pay 18-Month Sweden OIS Rates Pay 18-Month Sweden OIS Rates Chart 8Energy Prices Are Crucial For Swedish Inflation A Post-Trump Update Of Our Overlay Trades A Post-Trump Update Of Our Overlay Trades In the Riksbank's October MPR, the first rate increase was pushed forward from the second quarter of 2017 to the first quarter of 2018.5 At that point, the central bank's forecast becomes slightly lower than the interest rate expectation now priced in the OIS market. Even with our more sober view of the Swedish economy, the next rate hike is now expected to occur too far into the future. It will likely happen beforehand as upside surprises on inflation will force the Riksbank to begin tightening sooner than planned. Sweden's inflation path is mainly influenced by two factors: the Krona and energy prices. If the Krona's weakness accelerates and energy prices resume their uptrend, inflation will jump. In turn, if inflation reaches its target earlier, the central bank will start normalizing rates sooner than expected. Chart 9Can Sweden Still Overheat? Can Sweden Still Overheat? Can Sweden Still Overheat? As stated above, the Riksbank members' dovish rhetoric has been successful in pushing the Krona lower. Much to our astonishment, they seem ready to continue moving in that direction, despite the potential negative spillovers. The bubbly Swedish housing market - fueled by low interest rates and lacking the macro-prudential measures to stop its expansion - does not appear to be a major concern of the Riskbank for the time being. In addition to the exchange rate, the path of energy prices is crucial for inflation; it represents the bulk of the deflationary pressure over the last few years (Chart 8). Although this situation has changed recently, with a positive contribution to inflation in the last four months, energy prices will need to appreciate again to keep consumer price advances on track. This is likely to happen. Our Commodity strategists believe that the markets are understating the odds of Brent exceeding $50/bbl by the end of this year, given their expectation that Saudi Arabia and Russia will announce production cuts of 500k b/d each at the OPEC meeting scheduled for November 30th in Vienna.6 If such meaningful production cuts come to fruition, energy prices will rise and add to Sweden's inflationary pressure. Moreover, the bigger structural picture in Sweden remains very inflationary, despite the short term cyclical weakness stated earlier. GDP, employment and hours worked are all expanding faster than the Riksbank's assessment of the long-run trend growth rates. Plus, according to the Economic Tendency Survey, companies are reporting labor shortages in all major business sectors.7 In sum, with resource utilization already stretched, keeping real interest rates low for longer can only prolong the steadfast Swedish credit expansion, potentially overheating the economy and creating additional inflation surprises (Chart 9). This will set the stage for an eventual shift by the Riksbank to a more hawkish posture. Bottom Line: The Riksbank rate liftoff will start earlier than priced in the market. We recommend entering a new trade, paying the 18-month Sweden Overnight Index Swap rate. New Zealand: Inflation To Re-Surface Here, As Well Chart 10Global Output Gaps Have Narrowed Global Output Gaps Have Narrowed Global Output Gaps Have Narrowed On November 9th, the Reserve Bank of New Zealand (RBNZ) cut its overnight rate to 1.75% and signaled that it would probably be on hold for the foreseeable future. From here, things could go both ways; another rate cut is not inconceivable in 2017. Yet the market is expecting a stable rate backdrop, pricing in only a 5% chance of a rate cut and a 6% probability of a rate hike by June 2017. Such an "undecided" market is not surprising. On one hand, inflation remains below target. On the other hand, the economy has been humming along with no signs of any major slowdown on the horizon. In our view, monetary policy risks are tilted towards rate hikes. Similar to Sweden's case, inflation has the potential to surprise on the upside in 2017. Several factors have contributed to the current stubbornly low inflation environment. However, going forward, those forces will abate and push inflation and, eventually, short term interest rates higher. 1.A more inflationary global backdrop New Zealand's low inflation problem comes from the tradable components. Simply put, because of the global deflationary environment of the last few years, and because of the Kiwi's strength, New Zealand has imported lower prices from abroad. But this phenomenon will move in the other direction going forward. The global inflationary backdrop has slowly changed. As noted by our Chief Global Investment Strategist, Peter Berezin, spare capacity within the developed economies has shrunk substantially over the last few years (Chart 10).8 Unemployment rates are lower than the non-accelerating inflation rates of unemployment (NAIRU) in most major countries, with the exception of France and Italy. Looking ahead, the current cyclical upswing in global growth, coming at a time of narrowing output gaps and increasing supply-side constraints, will put upward pressure on global inflation. This will eventually trigger a rise in New Zealand's import price inflation, although the impact might not be felt in the very short term. 2.A continued boost from China Closer to home for New Zealand, China's backdrop has become less deflationary. As we pointed out in a recent Special Report, China has turned into a cyclical tailwind for the global economy, putting upward pressure on inflation and bond yields in the near-term.9 Our "GFIS China Check List", composed of our favored indicators, highlights that China is in the expansionary phase of its economic cycle (Table 1). Table 1The GFIS China Checklist A Post-Trump Update Of Our Overlay Trades A Post-Trump Update Of Our Overlay Trades Most striking is that Chinese final goods producer prices have turned positive. This could prove to be a major development for New Zealand tradable goods prices, if it lasts; the correlation between Chinese PPI inflation and the tradable goods contribution to New Zealand's headline CPI has historically been elevated (Chart 11). 3.A weaker kiwi dollar Donald Trump's U.S. election victory could help raise New Zealand inflation through the exchange rate. If his ambitious fiscal plan and protectionist inclinations gain traction, the Fed might have to raise rates more aggressively than expected, putting upward pressure on the U.S. dollar. Under such a scenario, the Kiwi will re-price lower, potentially reversing the prior dampening effect on import prices from a strengthening currency. This would relieve policymakers on the RBNZ, who have consistently pointed to the currency's strength as the main reason inflation has missed the target (Chart 12). Chart 11China: A New Tailwind For Prices China: A New Tailwind For Prices China: A New Tailwind For Prices Chart 12The Kiwi Is Problematic The Kiwi Is Problematic The Kiwi Is Problematic 4.A stronger dairy sector Over the past couple of years, the Achilles heel for New Zealand has been its dairy sector, with plunging prices eroding confidence throughout the economy. Fortunately, this bad predicament is about to change as well. The exogenous factors depressing dairy prices are abating and prices are surging anew (Chart 13). The Global Dairy Trade price index has advanced in seven out of the last eight dairy auctions.10 If this impulse is prolonged, both New Zealand's export prices and domestic wages will begin to reflate. 5.A reversal of migration inflows The massive flow of migration into New Zealand since 2013 has been the main factor capping wage growth by increasing the supply of labor (Chart 14). The bulk of this inflow has been composed of young workers, aged between 15 & 29 years old.11 It is unclear if this migration will become permanent or prove to be transitory. Chart 13NZ Dairy Prices Have Rebounded NZ Dairy Prices Have Rebounded NZ Dairy Prices Have Rebounded Chart 14NZ Inward Migration To Stabilize... NZ Inward Migration To Stabilize... NZ Inward Migration To Stabilize... Much of this inflow can be explained by the weakness in the Australian economy, which has triggered migration back into New Zealand from those who left for work in Australia. As such, if the Aussie economy improves, the migration flow could conceivably reverse, at least to some extent. As a result, the domestic supply of workers would recede and the invisible ceiling on New Zealand wages would progressively disappear. This scenario is highly plausible. The latest surge in Australia's terms of trade could be an early signal of a commodity sector revival. Much of this is due to China's growth upturn this year. However, the wave of optimism towards a potential fiscal stimulus in the U.S. - especially through longer-term infrastructure projects - is a possible boost to demand that could support higher global commodity prices higher over the next few years.12 If this proves correct, New Zealand migration towards Australia could be renewed, shrinking the domestic pool of skilled labor, and pushing wages higher (Chart 15). An unwind of these disinflationary forces would coincide with improving cyclical growth prospects. A mix of strong credit growth, decent construction sector activity and robust corporate earnings should support job creation and wages in the short term (Chart 16). In this environment, consumption will accelerate. Since the output gap is already closed, faster spending will cause inflationary pressures to build (Chart 17). Chart 15...If Australian Mining Revives ...If Australian Mining Revives ...If Australian Mining Revives Chart 16An Inflationary Backdrop An Inflationary Backdrop An Inflationary Backdrop Chart 17Inflation Surprises Ahead Inflation Surprises Ahead Inflation Surprises Ahead Traders can benefit from a turnaround in New Zealand inflation prospects by playing the Overnight Index Swap market. Since April 12th of this year, we have recommended payer positions in 6-month New Zealand Overnight Index Swap (OIS) rates.13 This trade has not worked as planned, due to the stubbornly low trend of New Zealand inflation, and today we are closing that trade recommendation at a loss of -30bps. The market is currently pricing in a 23% chance of a rate hike by the September 28, 2017 RBNZ meeting. Due to the inflation risks cited above, the probability should be higher than that, in our view. As such, we are entering a 12-month OIS payer. This trade offers modest downside risk versus for a decent potential gain, i.e. a risk/reward ratio of about 3:1. Bottom Line: New Zealand's inflation will surprise to the upside in 2017 and put upward pressure on short-term interest rates. To position for this, pay 12-month rates on the New Zealand Overnight Index Swap curve. Closing Our Japan/Korea Relative Value Trade This week, we are unwinding our Japan/Korea relative value trade, where we were long 5-year Korean government bonds versus 5-year Japanese Government Bonds (JGBs) on a currency-unhedged basis. While the currency leg did allow for a profitable trade, the Korea/Japan yield differential widened by +52bps. Several unpredictable events have negatively impacted Korean bonds since the trade was initiated. Chart 18Political Scandal = Higher Risk Premium Political Scandal = Higher Risk Premium Political Scandal = Higher Risk Premium Chart 19Trump: Catastrophic For Korean Bonds Too Trump: Catastrophic For Korean Bonds Too Trump: Catastrophic For Korean Bonds Too First, a scandal surrounding the Korean president, a.k.a. Choi-Gate, has erupted. As more details of the affair have been revealed, the president's approval rating has plunged - standing now at 5% - and the Government has become dysfunctional (Chart 18). In the near future, the geopolitical risks surrounding Korean assets should remain elevated as the prosecutors will continue the process of investigating the president and her associates; the risk premium on Korean bond yields might increase further. Chart 20The Korea 5-Year Bond Model The Korea 5-Year Bond Model The Korea 5-Year Bond Model Second, Trump's victory has been catastrophic for bond markets across the globe, including those related to open and export-oriented economies linked to the emerging markets, like Korea (Chart 19). Yet the impact on JGBs has been more contained since the Bank of Japan (BoJ) moved to a yield curve targeting framework back in September. The BoJ surprised many by adopting that policy of anchoring longer-term JGB yields. This has substantially reduced the volatility of JGBs, even during the recent backup in global yields. In turn, this has lowered the payoff potential of shorting JGBs, both in absolute terms and versus Korean bonds. Finally, the appeal of our Korea vs Japan trade has decreased from a valuation perspective. A simple model that we have developed for the Korean 5-year government bond yield now points towards rising yields in 2017 (Chart 20).14 With all of these factors now working against our trade, we are choosing to close it out. The trade has generated a profit from the currency exposure, which we decided not to hedge. However, when events move against the original reasons for putting on a trade, the prudent strategy is to unwind that position and look for other opportunities. Bottom Line: The rationale behind our recommended trade favoring 5-year Korean government debt versus 5-year Japanese government bonds has changed. We are closing the trade at a profit of +260bps. Jean-Laurent Gagnon, Editor/Strategist jeang@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Special Report, "Riksbank: Close To An Inflection Point", dated September 22, 2015, available at gfis.bcaresearch.com 2 Source: Bloomberg Finance L.P. NSN OG2NHA6JIJUO GO. NSN OGD9GRSYF01S GO. NSN OGFQO26S972O GO 3 http://www.riksbank.se/Documents/Protokoll/Penningpolitiskt/2016/pro_penningpolitiskt_161026_eng.pdf 4 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes & Investment Implications", dated November 9, 2016, available at gps.bcaresearch.com 5 For details, please see http://www.riksbank.se/en/Press-and-published/Published-from-the-Riksbank/Monetary-policy/Monetary-Policy-Report/ 6 Please see BCA Commodity & Energy Strategy Weekly Report, "Raising The Odds Of A KSA-Russia Oil-Production Cut", dated November 3, 2016, available at ces.bcaresearch.com 7 Private services, retail trade, construction and manufacturing 8 Please see BCA Global Investment Strategy Weekly Report, "Slack Around The World", dated November 4, 2016, available at gis.bcaresearch.com 9 Please see BCA Global Fixed Income Strategy Special Report, "How To Assess The 'China Factor' For Global Bonds", dated November 8, 2016, available at gfis.bcaresearch.com 10 https://www.globaldairytrade.info/en/product-results/ 11 For details, please see "Understanding low inflation in New Zealand", Dr, John McDermott, October 11, 2016 available at http://www.rbnz.govt.nz/news/2016/10/understanding-low-inflation-in-new-zealand 12 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes & Investment Implications", dated November 9, 2017, available at gps.bcaresearch.com 13 Please see BCA Global Fixed Income Strategy Special Report, "New Zealand: More Than Just Dairy", dated April 12, 2016, available at gfis.bcaresearch.com 14 This model is based upon a regression of Korean yields on U.S. 5-year treasury yield, Korean Trade-weighted currency, Brent crude price in USD, and Korea's headline CPI. Forecasts are based on financial market futures data and the ministry of finance's inflation forecast. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The blistering dollar rally has mimicked the selloff in U.S. and global bonds. The dollar and bonds may have gotten ahead of themselves. A short-term reversal or a pause in the recent trend is becoming our base-case scenario for the rest of the year. If a dollar correction materializes, USD/CNY will also retreat, temporarily diminishing pressures on EM currencies. The yen weakness illustrates the importance of the September policy change by the BoJ. AUD/SEK is a short. We are re-introducing our back sections, but now covering all the G10 currencies. Feature In recent weeks, we have developed the view that a Trump victory would embolden our cyclically bullish stance on the dollar. We re-iterated this sentiment last week.1 Since then, we have received many questions about the very short-term outlook for FX markets. Our view is that from now to the end of the year, the dollar is likely to stabilize and may even weaken somewhat. This should create a buying opportunity for investors that have missed the dollar rocket. It's All About Bonds The dollar rally since Trump's election has been so torrid that the broad trade-weighted dollar has made new highs. DXY is now flirting with the top of the trading range established since March 2015 (Chart I-1). If the dollar can significantly punch above this resistance, or EUR/USD falls below 1.055, another violent dollar rally could ensue. While we do ultimately expect such a move to materialize, we do not expect it to happen just yet. The main reason for our skepticism is the bond market. Much of the appreciation in the dollar has been explained by the sharp rally in U.S. bonds, which has caused interest rates differentials to move massively in favor of the greenback (Chart I-2). For DXY to meaningfully punch above 100, bonds have to sell-off further. Chart I-1The Return Of The King The Return Of The King The Return Of The King Chart I-2Dollar And Bond Yields: Same Fight Dollar And Bond Yields: Same Fight Dollar And Bond Yields: Same Fight Our U.S. Bond Strategy service remains cyclically underweight duration, but the short-term outlook is murky. The move in bonds has been extremely one-sided. The bond market's behavior displays the hallmark of groupthink, where long-term and short-term traders have uniformly been selling Treasurys. The fractal dimension for bonds, a measure of groupthink developed by Dhaval Joshi, our European Chief Strategist, rests at 1.25, a level at which a trend reversal - even if a temporary one - tends to emerge (Chart I-3).2 Chart I-3Groupthink In The Bond Market Groupthink In The Bond Market Groupthink In The Bond Market Additionally, our composite sentiment indicator, based on the 13-week rate of change of prices, investor sentiment, and net speculative positions, is deeply oversold, highlighting the risk of a backup in prices (Chart I-4). Fundamentals also warrant a careful stance. A December Fed hike is fully priced in, and the expected Fed funds rates 12-months from now is already near the levels hit before the Fed raised rates in 2015 (Chart I-5). A catalyst is now needed to push rate expectations materially higher. Chart I-4Bond Sentimen##br##t Is Depressed Bond Sentiment Is Depressed Bond Sentiment Is Depressed Chart I-5Interest Rates Priced In A Lot##br## In A Short Time Span Interest Rates Priced In A Lot In A Short Time Span Interest Rates Priced In A Lot In A Short Time Span However, the recent backup in yields and the dollar has massively hit EM currencies (Chart I-6). EM currencies are falling because investors are taking funds out of these economies. Consequently, EM liquidity and financial conditions are tightening, a dark omen for economic activity in that space (Chart I-7). The more than 10% fall in gold prices since July 8, also paints a picture of deteriorating global liquidity conditions. Chart I-6Bond Yields Are Hurting##br## EM Financial Conditions Bond Yields Are Hurting EM Financial Conditions Bond Yields Are Hurting EM Financial Conditions Chart I-7A Dark ##br##Omen A Dark Omen A Dark Omen An EM correction may compel the Fed to worry about the short-term outlook. This development, along with the tightening in U.S. financial conditions resulting from the 7% back up in the broad trade-weighted dollar and 77 basis points in bond yields since mid-August, heighten the risk of a correction in risk assets. The Fed is aware of this and the market knows it. Chart I-8CPI Swaps Can Rebound More bca.fes_wr_2016_11_18_s1_c8 bca.fes_wr_2016_11_18_s1_c8 Additionally, U.S. 5y/5y forward CPI swaps have backed up 60 basis points from their lows to 2.4%, but they still remain below their historical norm of 2.5% to 3.3% (Chart I-8). The Fed probably wants to see them closer to these levels before aggressively ramping up its rhetoric and "dot-plot" forecasts. A Trump presidency will result in a large dose of fiscal stimulus, but we still have little clarity regarding the size of any packages, their composition, or their timing. Neither does the Fed. If there was any clarity, the Fed would likely be in a position to increase its "dot-plot" even without inflation expectations being in their normal range. Additionally, this week, the Bank of Japan put actions behind its words and announced an unlimited bond buying program at fixed prices, a process that should cap the upside on this anchor for global yields. Thus, in the very near term, the burden of proof is now elevated for rates to rise higher without the Fed's rhetoric becoming clearly more hawkish. While we expect this outcome to ultimately materialize, the next few weeks are not when we see it happening. This implies that the dollar's rip-roaring rally is likely to take a pause and even retrace some of its exceptional gains. However, a key risk remains, and that is China. Since Trump's victory, the Chinese RMB has accelerated its downward path, depreciating 1.7% in nine days. This move reflects the fear that Trump will impose large tariffs on Chinese-made goods. In the process, the fall in the yuan has dragged Asian currencies lower than the DXY appreciation would have warranted (Chart I-9). If these moves were to continue, EM currencies, the yen, and the AUD would fall further even without U.S. bond yields rising much. In the short-term this remains more a risk rather than a base-line scenario. While USD/CNY has rallied, the yuan has been stable relative to the currency basket targeted by the PBoC (Chart I-10). Therefore, if our view that the U.S. bond sell-off pauses temporarily is correct, the USD/CNY rally will also take a breather. Chart I-9Tariff Risk Weighing On Asian Forex bca.fes_wr_2016_11_18_s1_c9 bca.fes_wr_2016_11_18_s1_c9 Chart I-10Mind The Gap! Mind The Gap! Mind The Gap! The currencies most likely to benefit from any dollar bull-market pause are JPY, SEK, and EUR as they have become hyper-sensitive to U.S. bond yields. EM currencies too could see a temporary rally, especially if USD/CNY stops appreciating in line with the DXY. Bottom Line: The dollar bull market is intact. However, the tactical outlook points toward a pause in the greenback's upswing. In light of the fast repricing of the market's expectations for Fed policy, and the lack of clarity regarding Trump's plans, bond yields and interest-rate expectations have gotten ahead of themselves. Even the rally in USD/CNY, which has contributed to devaluation pressures on other Asian currencies, could pause if DXY stops rallying for a period of time. Why is the Yen So Weak? We have articulated a very bearish view on the yen since September 23.3 To our way of thinking, the Bank of Japan pegging 10-year JGB yields to 0% until Japanese inflation significantly overshoots 2% was a sea-change. However, we have been surprised by the violence of the recent yen sell-off. After all, wouldn't a selloff in EM currencies support the yen? A few factors have been at play. First, Japanese preliminary Q3 GDP numbers have come in at 2.2% on a year-on-year basis, handily beating expectations of 0.9%. Moreover, industrial production has picked up, and our model forecasts further acceleration, despite the recent strength in the yen (Chart I-11). With the employment market being tight - the unemployment rate stands at 3.1% and the active-job-openings-to-applicants ratio is at a 25-year high - this raises the risk that inflation begins to emerge. With nominal bond yields pegged at zero, this would weigh on Japanese real rates, and thus the yen, which continues to closely correlate with Japanese real rates differentials. Second, the recent global sell off in bonds has been an additional weight on the yen. In our communications with clients, we are often reminded how USD/JPY and bond yields are essentially one and the same, a heuristic borne by the facts (Chart I-12). Chart I-11Japanese IP Is ##br##Picking Up Japanese IP Is Picking Up Japanese IP Is Picking Up Chart I-12USD/JPY And Bond Yields ##br##Are One And The Same USD/JPY And Bond Yields Are One And The Same USD/JPY And Bond Yields Are One And The Same But right now, there is more to the relationship with bond yields than in previous episodes. The September promise of a cap on 10-year JGB yields is causing Japanese yield differentials to stand at mid-2015 levels, despite global yields being lower than they were then (Chart I-13). Also, the sell-off in global bonds has caused 10-year JGB yields to move slightly above 0%. However, having announced unlimited bond purchases at capped yields, the BoJ is about to begin purchasing JGBs to prevent yields from punching above 0% meaningfully. This will result in growing Japanese liquidity, compounding already existing JPY weaknesses. Chart I-13The BoJ Policy In Action The BoJ Policy In Action The BoJ Policy In Action Finally, the government is talking up fiscal stimulus. The third revision of the second supplementary budget has been passed, and the executive is already pushing for a third supplementary budget. Additionally, both Abe and Kuroda are ramping up their rhetoric regarding next year's wage negotiations, highlighting the growing risk that the government will implement wage policies in 2017.4 Short-term risks are skewed toward a yen rebound. When the BoJ announced its new policy in September, USD/JPY was 7% undervalued according to our short-term model. This is not the case anymore. Also, if global bond yields stop their ascension until year end, the BoJ will not purchase any bonds. Moreover, falling global bond yields will push Japanese rate differentials in favor of the yen, supporting the currency further. Finally, a continuation of EM stresses could prompt Japanese investors to repatriate funds into the country, putting upward pressures on the yen. Bottom Line: The extraordinary weakness in the yen reflects the improvement in Japanese economic activity. Also, the change in monetary policy executed earlier this year is limiting the upside for JGB yields, and the BoJ is now setting up an unlimited purchase program to back its words. However, a short term pull-back in USD/JPY grows increasingly likely if the global bond implosion takes a breather. Going Short AUD/SEK Shorting AUD/SEK here makes sense. To begin with, AUD/SEK is trading 16% above its long-term fair value as well as 5.2% above its short-term equilibrium (Chart I-14). Additionally, the current account differential is 9.4% of GDP in favor of Sweden. In terms of the economy, the Swedish consumer is displaying stronger resilience than the Australian one, powered by an outperforming Swedish labor market (Chart I-15). Additionally, Swedish house prices are growing 5% faster than in Australia. With Swedish consumer confidence outperforming that of Australia, and Swedish household credit overtaking Australian household credit growth, inflationary forces could emerge, resulting in a tightening of Swedish policymakers' rhetoric relative to Australia. On this front, the recent pick up in Swedish inflation is telling. Having rebounded to 1.2% annually, Swedish headline CPI is at a four-and-a-half-year high, suggesting that the emergency measures put in place by the Riksbank are beginning to outlive their usefulness. Meanwhile, Australia is moving away from its easing bias. But a move toward less accommodation is still not in the cards, especially as employment growth underperformed and total hours worked contracted at a 1% annual pace. Financial market dynamics also favor a weaker AUD/SEK. This cross has moved much ahead of nominal interest rate differentials, and real-interest-rate differentials have moved in the opposite direction, pointing to a lower AUD/SEK. Additionally, the Swedish broad market as well as financial equities have been outperforming Australian stocks. This suggests that Swedish financial conditions are too easy relative to Australia. Finally, technicals point to a negative short-term outlook for this cross. AUD/SEK is massively overbought on a 52-week-rate-of-change measure. On a shorter-term basis, the MACD indicates an overbought condition and is forming a negative divergence with prices, exactly as the stochastic indicator has broken down (Chart I-16). Chart I-14Poor Risk/Reward Tradeoff ##br##For Holding AUD/SEK Poor Risk/Reward Tradeoff For Holding AUD/SEK Poor Risk/Reward Tradeoff For Holding AUD/SEK Chart I-15The Swedish Labor ##br##Market Is On Fire The Swedish Labor Market Is On Fire The Swedish Labor Market Is On Fire Chart I-16AUD/SEK:##br## Poised For A Shakeout AUD/SEK: Poised For A Shakeout AUD/SEK: Poised For A Shakeout Bottom Line: The outlook for AUD/SEK is problematic. This cross is pricey and the Swedish consumer is outperforming that of Australia. This is happening exactly as the Riksbank may begin moving away from its hyper-accommodative stance, as inflation is hitting four-and-a-half year highs. Finally, financial market dynamics and currency technicals are flagging a short in this cross. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "Raeganomics 2.0?", dated November 11, available at fes.bcaresearch.com 2 Please see European Investment Strategy Special Report, "Fractals, Liquidity & A Trading Model", dated December 11, 2014, available at eis.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, "How Do You Say "Whatever It Takes" In Japanese?", dated September 23, 2016 available at fes.bcaresearch.com 4 Ibid. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Last week, equities and the dollar rallied as Trump's unexpected victory was taken as a positive for the U.S. economy in the hopes of promised fiscal stimulus. Both the market and Fed officials therefore remain tenacious on the prospects of a 25bps hike in December, with a 98% probability currently priced in. In a speech on Thursday, Yellen confirmed the gradual normalization of policy and acknowledged the strength of the U.S. labor market. Initial jobless claims declined to 235,000 from 254,000 and continuing jobless claims declined to 1.977 million from 2.043 million. This has further solidified our bullish stance on the dollar. On a technical basis, the DXY Index has hit a key resistance level of 100, which suggests a temporary halt to last week's surge. However, longer-term momentum is indicating a possible break-out from the key 100 level in the near future. Report Links: Reaganomics 2.0? - November 11, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Euro Chart II-3EUR Technicals 1 bca.fes_wr_2016_11_18_s2_c3 bca.fes_wr_2016_11_18_s2_c3 Chart II-4EUR Technicals 2 bca.fes_wr_2016_11_18_s2_c4 bca.fes_wr_2016_11_18_s2_c4 The Euro continues to mirror the U.S. Dollar, losing more than 3% in a week since the U.S. Presidential Election. This move seems to be a function of the election only, as European data has come out reasonably strong this week: Economic sentiment from the ZEW Survey shot up to 15.8, beating expectations, while current conditions declined to 58.8 from 59.5. The trade balance increased by €8.2bn to €26.5bn. European GDP growth remains solid at 1.6%. Data points to EUR strength, so the Euro should remain somewhat neutral on a trade-weighted basis as its economy remains strong. Monetary policy divergence and technicals, however, should continue to weigh on EUR/USD in the short term, suggesting that cross-currency plays are the best way to capture any Euro strength. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Yen Chart II-5JPY Technicals 1 bca.fes_wr_2016_11_18_s2_c5 bca.fes_wr_2016_11_18_s2_c5 Chart II-6JPY Technicals 2 bca.fes_wr_2016_11_18_s2_c6 bca.fes_wr_2016_11_18_s2_c6 The yen has been one of the worst performing currencies in the G10 following Trump's election, with USD/JPY appreciating by about 5%. After this down-leg, we will not be surprised if the yen recovers some ground in the short-term. USD/JPY has already reached overbought technical levels and the sell-off in EM caused by the rising dollar may eventually trigger a risk-off period from which the yen will benefit. However, past the short term, we continue to be yen bears. Although the policies that the BoJ implemented in September did not seem as radical back then, a cap on Japanese 10-year rates takes a whole different meaning for the yen in the recent environment where interest rates are rising in the U.S, since it exerts considerable pressure on Japanese real rates vis-à-vis the rest of the world. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 British Pound Chart II-7GBP Technicals 1 bca.fes_wr_2016_11_18_s2_c7 bca.fes_wr_2016_11_18_s2_c7 Chart II-8GBP Technicals 2 bca.fes_wr_2016_11_18_s2_c8 bca.fes_wr_2016_11_18_s2_c8 An interesting trend has caught our attention: the British economy continues to be very resilient, beating not only market expectations but also projections by the BoE. Recent October data confirms this view: Retail sales and retail sales ex-fuel grew at an annual rate of 7.4% and 7.6% respectively, blowing past expectations. Additionally Markit Services PMI was 54.5, also beating expectations. This is particularly surprising given that the service sector is likely getting very little support from the weak pound. We are reticent to be bullish on the pound, at least on the short term, given that political risks continue to dominate the movements of this currency. Nevertheless, the cable is very cheap from a valuation standpoint, and if the British economy continues to beat expectations, the pound could become an attractive buy. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9AUD Technicals 1 bca.fes_wr_2016_11_18_s2_c9 bca.fes_wr_2016_11_18_s2_c9 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 The RBA left its cash rate unchanged at 1.5% at their November meeting, and clarified that their easing cycle has come to an end. Recent data, however, is showing signs of weakness in the Australian economy: the Westpac Consumer Confidence Index came in last week at -1.1%; wage pressures remain subdued at 1.9% yoy in Q3 from 2.1% in Q2; employment change was weaker than expected at 9,800 with the unemployment rate unchanged at 5.6% in October. Labor market slack remains a fundamental concern for the Australian economy, something the RBA also pointed out in their November statement. Inflationary pressures, if any, will likely emanate only from commodity prices, for which the outlook remains questionable due to a rising USD. Deteriorating consumer confidence and continued labor market slack will translate into deflationary tendencies, which will cap rates and add downward pressure on the AUD. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 In line with expectations, The RBNZ cut rates by 25 basis points to 1.75% at its latest policy meeting. Shortly after, a speech by Governor Wheeler lifted the NZD, as he appeared to signal that the RBNZ might be done easing by stating that "at this stage we think that we won't need another cut". We are unfazed by this change of rhetoric, and continue to be bearish on the kiwi. The NZD has formed a head-and-shoulders pattern which, along with fading momentum, foretells a downside leg for this antipodean currency. Moreover, a sell-off in Asian currencies and deteriorating financial conditions in Emerging markets following Trump's election should put further downward pressure on the kiwi, given that the NZD is the most sensitive currency to Asian spreads in the G10. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data points south for CAD: The merchandise trade deficit increased to CAD 4.1bn in September, with imports rising 4.7% to a record CAD 47.6 bn, and exports only up 0.1% to CAD 43.5 bn. The housing market continues to display warning signs as housing starts decreased in October to 192,900 and building permits declined by 7% in September from August, showing signs of supply decreases and rising prices. Although the labor market seems to be picking up, with net change in employment increasing by 43,900 and the participation rate at 65.8%, the setback in growth from the commodity slump and the Q2 Alberta wildfires will keep the BoC from raising rates. Nevertheless, we remain bullish on oil in the commodity space, and the CAD will likely display strength against the antipodeans. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 The rally in USD/CHF should subside, at least in the short term. Not only has the swissie reached technical overbought levels, but the continued tightening in EM financial conditions caused by the rising dollar increased the probability of a risk off period where the CHF would rally. EUR/CHF on the other hand is likely to have limited downside from here on. Since August 2015, this cross had traded within a tight range of 1.075 to 1.110, breaking down only after the Brexit vote, when all risk-off assets rallied. However it has recently broken down again, an unwelcomed development for the SNB, who will likely intervene in the currency market in order to keep a rising franc from adding additional deflationary pressures to the Swiss economy. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 The Krone was another victim of Trump's election, with USD/NOK rising by 4%. Although we expect that the dollar bull market will ultimately weigh on the krone, we remain positive on the outlook for this currency compared to its commodity peers. Inflation is currently at 3.7%, significantly above the Norges Bank target. Additionally house prices are rising at almost 20%, while household debt as a percentage of disposable income has surpassed the 200% mark. The Norges Bank has not overlooked this developments, as their rhetoric has recently become more hawkish. All these factors along with rebalancing energy markets, should provide strong tailwinds for the NOK, particularly against its crosses. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 The Swedish economy looks strong according to recent data: Manufacturing PMI ticked up last month from 54.9 to 58.4. Industrial production increased in September by 1.5% annually. Inflation in October came in at 1.2% yoy. Inflation in the near future also looks quite upbeat, as per the uptick in 1-, 2-, and 5-year Prospera inflation expectation numbers to 1.4%, 1.7%, and 1.9% respectively. The Riksbank has therefore lifted their easing bias, which is also reflected by an increase in the 12-month market expectations of the repo rate to -0.4%. All is not perfect though. New orders decreased by 16.4% annually, indicating possible fragility in the manufacturing sector. Additional medium-term risk to the SEK will be dictated by bullish moves in the USD, as SEK remains one of the currencies with the highest sensitivity to the dollar. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Dazed And Confused - July 1, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Tighter global oil markets resulting from the production cut we expect to be announced November 30 at OPEC's Vienna meeting, along with fiscal stimulus from the incoming Trump administration in the U.S., will continue to stoke inflation expectations. We believe gold is well suited for hedging investors' medium-term inflation exposure, given its sensitivity to 5-year/5-year CPI swaps in the U.S. and eurozone. If the Fed decides to get out ahead of this expected pick-up in inflation and inflation expectations by raising rates aggressively next year, we would expect any increase in gold prices - and oil prices, for that matter - to be challenged. For OPEC and non-OPEC producers, a larger production cut may be required to offset a stronger USD next year. Near term, we still like upside oil exposure, given our expectation that production will be cut. Energy: Overweight. We remain long Brent call spreads expiring at year-end, and long WTI front-to-back spreads in 2017H2, in anticipation of an oil-production cut. Base Metals: Neutral. We expect nickel to outperform zinc in 2017. Precious Metals: Neutral. We are long gold at $1,227/oz after our buy-stop was elected on November 11. We are including a 5% stop-loss for this position. Ags/Softs: Underweight. Our long Mar/17 wheat vs. beans order was filled on November 14. We still look to go long corn vs. sugar. Feature Chart of the WeekBrent, WTI Curves Will Flatten, ##br##Then Backwardate Following Oil-Production Cut bca.ces_wr_2016_11_17_c1 bca.ces_wr_2016_11_17_c1 Continuing production increases from sundry sources outside OPEC, which the International Energy Agency estimates will lift output almost 500k b/d in 2017, are turning the heat up on the Kingdom of Saudi Arabia (KSA) and Russia to agree a production cut at the Cartel's meeting in Vienna later this month. It's either that or risk another downdraft that takes prices closer to the bottom of our long-standing $40-to-$65/bbl price range that defines U.S. shale-oil economics. The unexpected strength in production growth outside OPEC likely will require KSA and Russia to come up with a production cut that exceeds the 1mm b/d we projected earlier this month would be required to lift prices into the mid-$50s/bbl range. On the back of the expected cuts, we recommended getting long a February 2017 Brent call spread - long the $50/bbl strike vs. short the $55/bbl strike at $1.21/bbl. As of Tuesday's close, when we mark our positions to market every week, the position was up 9.09%. Reduced output from KSA and Russia - and, most likely, Gulf allies of KSA - will force refiners globally to draw down crude in storage, and for refined product inventories to draw as well. This will lift the forward curves for Brent and WTI futures (Chart of the Week). We expect oil prices will increase by approximately $10/bbl, following the joint cuts of 500k b/d each we expect KSA and Russia, which will be announced November 30. This also will lift 3-year forward WTI futures prices, which, as we showed in previous research, share a common trend with 5y5y CPI swaps. As stocks continue to draw next year, we expect the forward Brent and WTI curves to flatten, and, in 2017H2, to backwardate - that is to say, prompt-delivery prices will trade above the price of oil delivered in the future. For this reason, we are long August 2017 WTI futures vs. short November 2017 WTI futures, expecting the price difference between the two, which favors the deferred contract at present (i.e., a contango curve), to flip in favor of the Aug/17 contract. Chart 2Longer-dated WTI Futures, ##br##Inflation Expectations Rising bca.ces_wr_2016_11_17_c2 bca.ces_wr_2016_11_17_c2 Fiscal Stimulus Expected in the U.S. The election of Donald J. Trump as the 45th president of the U.S. likely will usher in significant fiscal stimulus beginning next year, particularly as Republicans now control the Presidency and Congress for the first time since 2005 - 06, when George W. Bush was president. Trump campaigned on a promise of significant fiscal stimulus, which likely will, among other things, stoke inflation expectations as money starts to flow to infrastructure projects and tax cuts toward the end of next year. Even before Trump's election 5-year/5-year (5y5y) CPI swaps were ticking higher, as oil markets rebalanced and started to discount the drawdown in global inventories this year and next (Chart 2). As the outlines of the Trump administration's fiscal policy take shape and money starts to flow to infrastructure projects, we expect inflation expectations to continue to rise. In previous research, we showed 5y5y CPI swaps and 3-year forward WTI futures are cointegrated, meaning they follow the same long-term trend. Indeed, we can specify 5y5y CPI swaps in the U.S. and eurozone directly as a function of 3-year forward WTI futures.1 Gold Will Lift With Rising Inflation Expectations... In the post-Global Financial Crisis (GFC) markets, gold prices have shared a common trend with U.S. CPI 5y5y swaps and real interest rates, which we show in a new model (Chart 3A, top panel).2 Using this specification, we find a 1% increase in the U.S. 5y5y CPI swaps increases gold prices by slightly more than 9%. Similarly, we find a 1% increase in EMU 5y5y CPI swaps increases gold prices by slightly more than 10% (Chart 3B, top panel).3 Of course, investors always can go straight to Treasury Inflation Protected Securities (TIPS) for inflation protection, given the evolution of the respective CPIs in the U.S. and eurozone drives returns for these securities (Chart 4). However, we believe gold gives investors higher leverage to actual inflation and expected inflation. Chart 3AGold Prices Ticking Higher With ##br##U.S. CPI Inflation Expectations Gold Prices Ticking Higher With U.S. CPI Inflation Expectations Gold Prices Ticking Higher With U.S. CPI Inflation Expectations Chart 3BEMU Inflation Expectations ##br##Vs. 3-year Forward WTI bca.ces_wr_2016_11_17_c3b bca.ces_wr_2016_11_17_c3b Chart 4Inflation Expectations And TIPS ##br##Are Highly Correlated, As Well Inflation Expectations And TIPS Are Highly Correlated, As Well Inflation Expectations And TIPS Are Highly Correlated, As Well ...But The USD's Evolution Matters, Too The combination of tighter oil markets and fiscal stimulus in the U.S. will continue to push inflation and inflation expectations higher. The Fed will not sit idly by and just watch inflation expectations move higher next year. Indeed, prior to the election, we expected two rate hikes next year, following a likely rate increase at the FOMC's meeting next month. With expectations of a tightening oil market, and a fresh round of fiscal stimulus from the incoming Trump administration, the odds of an even stronger USD increase. We had been expecting the USD will appreciate 10% over the next year or so, as a result of the upcoming December rate hike and two additional hikes next year. This could change, since, as, our Foreign Exchange Strategy service noted, "Trump's electoral victory only re-enforces our bullish stance on the dollar."4 A stronger USD, all else equal, is bearish for commodities generally, since it raises the cost of dollar-denominated commodities ex-U.S., and lowers the costs of commodity producers in local-currency terms. The former effect depresses demand at the margin, while the latter raises supply at the margin. Both effects would combine to reduce oil prices at the margin (Chart 5). This would, in turn, lower inflation expectations, which would feed into lower gold prices (Chart 6). Chart 5A Stronger USD Would Be Bearish For Oil bca.ces_wr_2016_11_17_c5 bca.ces_wr_2016_11_17_c5 Chart 6And Gold Prices As It Would Lower Inflation Expectations bca.ces_wr_2016_11_17_c6 bca.ces_wr_2016_11_17_c6 Our FX view, is complicated by the possibility the Fed might want to run a "high-pressure economy" next year, and the potential for additional Chinese fiscal stimulus going into the 19th Communist Party Congress next fall. If both the U.S. and China deploy significant fiscal stimulus next year, the growth in these economies could overwhelm the negative effects of a stronger USD, and industrial commodities - chiefly base metals, iron ore and steel - could rally as demand picks up. Oil demand also would be expected to pick up as a result of the combined fiscal stimulus coming out of the U.S. and China, both from infrastructure build-outs and income growth. KSA - Russia Oil-Production Cut Gets Complicated These considerations will complicate the calculus of KSA and Russia and their respective oil-producing allies as the November 30 OPEC meeting in Vienna draws near. If the Fed moves to get out ahead of increasing inflation expectations by adding another rate hike or two next year, oil prices will encounter a significant headwind. OPEC and non-OPEC producers could very well find themselves back at the bargaining table negotiating additional cuts, as prices come under pressure next year from higher U.S. interest rates. It is too early to act on any speculation regarding fiscal policy in the U.S. or China next year. However, given our expectation for an oil-production cut announcement later this month at OPEC's Vienna meeting, we are confident staying long the Brent $50/$55 call spread, and the long Jul/17 vs. short Nov/17 WTI spread position we recommended earlier this month. As greater clarity emerges on U.S. and Chinese fiscal policy going into next year, we will update our assessments. Bottom Line: We expect global oil markets to tighten as KSA and Russia engineer a production cut, which will be announced at OPEC's Vienna meeting later this month. Fiscal stimulus from the incoming Trump administration in the U.S., and possible fiscal stimulus in China next year could put a bid under commodities. However, if the Fed gets out ahead of the expected pick-up in inflation and inflation expectations by raising rates aggressively next year, any increase in commodity prices - oil and gold, in particular - will be challenged. KSA and Russia could find themselves back at the bargaining table, negotiating yet another production cut to offset a stronger USD. That said, we are retaining our upside oil exposure via a Brent $50/$55 call spread expiring at the end of this year, and our long Jul/17 WTI vs. short Nov/17 WTI futures, which will go into the money as the forward curve flattens and then goes into a backwardation. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com BASE METALS China Commodity Focus: Base Metals Nickel: A Good Buy, Especially Versus Zinc Chart 7Nickel: More Upside Ahead Nickel: More Upside Ahead Nickel: More Upside Ahead We are bullish on nickel prices, both tactically and strategically. Its supply deficit is likely to widen on rising stainless steel demand and falling nickel ore supply in 2017. China will continue to increase its refined nickel imports to meet strong domestic stainless steel production growth. We remain strategically bearish zinc even though our short Dec/17 LME zinc position got stopped out at $2500/MT with a 4% loss. We expect nickel to outperform zinc considerably in 2017. We recommend buying Dec/17 LME nickel contract versus Dec/17 LME zinc contract at 4.3 (current level: 4.38). If the order gets filled, we suggest putting a stop-loss level for the ratio at 4.15. Nickel prices have gone up over 50% since bottoming in February (Chart 7, panel 1). The global nickel supply deficit reached a record high of 75 thousand metric tons (kt) for the first eight months of this year, based on the World Bureau of Metal Statistics (WBMS) data (Chart 7, panel 2). More upside for nickel in 2017 On the supply side, the outlook is not promising in 2017. Global nickel ore and refined nickel production fell 5.2% and 1.1% yoy for the first eight months of this year, respectively, according to the WBMS data (Chart 7, panel 3). The newly elected Philippine government is clearly aiming for "responsible mining," and has been highly restrictive on domestic nickel mining activities, actions that likely will reduce the country's nickel ore production in 2017. The Philippines became the world's biggest nickel ore producer and exporter after Indonesia banned nickel ore exports in January 2014. The Philippines has implemented a national audit on domestic mines from July to September and has halted 10 mines for their environmental violations since July. Eight of them are nickel producers, which account for about 10% of the country's total nickel output. In late September, the government further declared that 12 more mines (mostly nickel) were recommended for suspension, and 18 firms are also subject to a further review. Stringent policy oversight will be the on-going theme for Philippine mines. We expect more suspensions in the country next year. There is no sign the export ban will be removed by the Indonesian government. Since Indonesia banned nickel ore exports in January 2014, the country's nickel ore output has declined 84% from 2013 to 2015. This occurred even though smelters were built locally, which will allow more nickel ore output in Indonesia. However, the incremental Indonesian output is unlikely to make up for the global nickel ore shortage next year. Global nickel demand is on the rise again (Chart 7, panel 4). According to the International Stainless Steel Forum (ISSF), global stainless steel production grew by 11.5% in 2016Q2 from only 3.7% yoy in 2016Q1. Comparatively, in 2015, the growth was a negative 0.3%. Due to fiscal and monetary stimulus in China this year, we expect continued growth in global stainless steel production in 2017. Why China Is Important To Global Nickel Markets China is the world's biggest nickel producer, consumer and importer. Its primary effect on nickel prices is through refined nickel imports. It also influences global stainless steel prices through stainless steel exports. In comparison to the global supply deficit of 75 kt, the deficit in China widened to 346 kt for the first eight months of this year - the highest physical shortage ever (Chart 8, panel 1). China has driven the global growth of both refined nickel production and nickel consumption since 2010 (Chart 8, panels 2 and 3). During the first eight months of this year, Chinese nickel production dropped sharply to 40.5 kt, nearly three times the global nickel output loss of 13.6 kt. For the same period, China's nickel demand growth accounted for 67% of global growth. In addition, the country produces about 53% of global stainless steel and exports about 10% of domestic-made stainless steel products to the rest of world (Chart 8, panel 4). Clearly, China is extremely important to both the global stainless steel and nickel markets. China Needs To Import More Nickel in 2017 Looking forward, China is likely to continue increasing its nickel imports to meet a growing domestic supply deficit (Chart 9, panel 1). The country's ore imports have been declining because of Indonesia's ban since 2014, and further dropped this year on the Philippine's suspensions (Chart 9, panel 2). Scarcer ore supply drove down Chinese refined nickel and nickel pig iron (NPI) output every year for the past three consecutive years (including this year). Chart 8China: A Key Factor For Nickel Market China: A Key Factor For Nickel Market China: A Key Factor For Nickel Market Chart 9Chinese Nickel Imports Are Set To Rise bca.ces_wr_2016_11_17_c9 bca.ces_wr_2016_11_17_c9 Prior to 2014, China imported nickel ores from Indonesia to produce NPI, which is used in its domestic stainless steel production. In 2013, only 20% of domestic nickel demand was met by unwrought nickel imports. After 2014, China's higher nickel ore imports from the Philippines were not able to make up the import losses from Indonesia (Chart 9, panel 3). As a result, in 2015, the percentage of domestic nickel demand met by unwrought nickel imports jumped to 47%. Furthermore, for the first eight months of this year, imports accounted for 57% of Chinese demand. Before the Indonesian ban in 2014, Chinese stainless steel producers and NPI producers built up mammoth nickel ore inventories for their stainless steel ore NPI production (Chart 9, panel 4). Now, Chinese laterite ore inventories are much lower than three years ago. Plus, most of the inventories likely are low nickel-content Philippines ore. Besides the tight ore inventory, China's stainless-steel output is accelerating. According to Beijing Antaike Information Development Co., a state-backed research firm, for the first nine months of 2016, Chinese nickel-based stainless steel output grew 11.3% yoy, a much stronger growth rate than the 4% seen during the same period last year. Given falling domestic nickel output and increasing nickel demand from the stainless steel sector, China seems to have no other choice but to import more refined nickel or NPI from overseas. Downside Risks Nickel prices could fall sharply in the near term if massive LME inventories are released to the global market. After all, global nickel inventories currently are at a high level of more than 350 kt, which is more than enough to meet the supply deficit of 75 kt (Chart 10, panel 1). However, as prices are still at the very low end of the range over the past 13 years, we believe that the odds of a massive, sudden inventory release is small. Inventory holders will be hesitant to sell their precious inventory too quickly, therefore the inventory release will likely be gradual, especially given the continuing export ban in Indonesia and a likely increase in the suspension of mines in the Philippines. In the longer term, if Indonesian refined nickel output continues growing at the pace registered in the past two years, the global nickel supply deficit may be much less than the market expects (Chart 10, panel 2). In that scenario, nickel prices will also fall. Due to power supply shortages, poor infrastructure and funding problems, many of the smelters and stainless steel plants' development have got delayed, so we believe these problems will continue to be headwinds for Indonesian nickel output growth. A five-million capacity stainless steel project, funded by three Chinese companies, potentially making Indonesia the world's second biggest stainless steel producer, will only be in production by 2018. Therefore, we believe next year is still a good window for a further rally in nickel prices. In addition, global stainless steel output may weaken again after this year's stimulus from China runs out of steam, which will also weigh on nickel prices (Chart 10, panel 3). We will monitor these risks closely. Investment strategy We expect nickel to outperform zinc considerably in 2017. Nickel has underperformed zinc massively since 2010 with the nickel/zinc price ratio tumbling to a 17-year low (Chart 11, panel 1). Chart 10Downside Risks To Watch bca.ces_wr_2016_11_17_c10 bca.ces_wr_2016_11_17_c10 Chart 11Nickel Likely To Outperform Zinc In 2017 bca.ces_wr_2016_11_17_c11 bca.ces_wr_2016_11_17_c11 Even though our short Dec/17 LME zinc position was stopped out at $2500/MT with a 4% loss due to the short-term turbulence, we remain strategically bearish zinc, as we expect supply to rise in 2017 (Chart 11, panel 2).5 Given our assessments of the nickel and zinc markets, we recommend buying Dec/17 LME nickel contract versus Dec/17 LME zinc contract at 4.3 (current level: 4.38) (Chart 11, panel 3). If the order gets filled, we suggest putting a stop-loss level for the ratio at 4.15. Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com 1 Our updated estimates of the cointegrating regressions for U.S. and eurozone 5y5y CPI swaps indicate 3-year forward WTI futures explain close to 87% of the U.S. swap levels and 82% of the eurozone swaps, in the post-GFC period (January 2010 to present). Please see Commodity & Energy Strategy Weekly Report "Inflation Expectations Will Lift As Oil Rebalances," dated March 31, 2016, available at ces.bcaresearch.com. 2 We also found that, over a longer period encompassing pre-GFC markets, gold prices shared a common trend with U.S. 5y5y CPI swaps, as well. Indeed, the evolution of 5y5y CPI swaps explained 84% of gold's price from 2004, when the 5y5y CPI swap time series begins, to present. 3 Previously, we estimated a gold model using the Fed's core PCE and the St. Louis Fed's 5y5y U.S. TIPS inflation index and found a 1% increase in the core PCE translates to a 4% increase in gold prices. Please see Commodity & Energy Strategy Weekly Report "A 'High-Pressure Economy' Would Be Bullish For Gold," dated October 20, 2016, available at ces.bcaresearch.com. 4 Please see Foreign Exchange Strategy Weekly Report "Reaganomics 2.0?," dated November 11, 2016, available at fes.bcaresearch.com. 5 Please see Commodity & Energy Strategy Weekly Report for zinc section "The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market," dated October 27, 2016, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Closed Trades

Highlights The U.S. accounts for 18% of Chinese exports, while China accounts for only 8% of American overseas sales, which puts China at a disadvantage in a full-blown trade war. However, China has become an increasingly important export destination of American companies in recent years, while the significance of the U.S. in China's total trade peaked in the late 1990s. The case of China U.S. steel trade dispute suggests that unless the U.S. imposes punitive tariffs on imports from all countries, picking on China will only shift American demand to other more expensive alternatives, while the benefits to American domestic producers will be questionable, let alone American consumers. A more inward-looking U.S. administration certainly bodes poorly for international trade and globalization. However, the role of China should not be underestimated. Potential protectionist threats from the U.S. will likely generate a mutual desire among China and other economies to work more closely. Feature Global financial markets have gradually been coming to terms with the concept of President Donald Trump. Interestingly, U.S. equity market participants appear to be cheering on a potentially sizable fiscal spending package under the new administration, which has boosted industrial sector stocks over the past week. Markets in Asia, particularly Chinese H shares, however, have been less upbeat and have focused more on a possible protectionism backlash emanating from the U.S. under the new leadership. Tough talk on China has featured in every U.S. presidential campaign going back to Nixon reaching out to China in the early 1970s - from Jimmy Carter's strong condemnation of Nixon-Kissinger's "immoral" secret diplomacy of "ass kissing" the Chinese, to Bill Clinton's harsh warnings to the "butchers of Beijing", to repeated pledges by Obama in the 2008 campaign to label China as a "currency manipulator" - all of which signaled an immediate confrontation. Once in office, however, all candidates significantly softened their rhetoric, as government policies require much more realistic and thoughtful discussion, negotiation and compromise. Furthermore, given the huge importance of trade for both economies, a full-fledged trade war between the U.S. and China would risk the growth recession and enormous financial volatility around the globe, a lose-lose outcome hardly conceivable to anyone, no matter how much chest-thumping and aggrandizing is involved. To be sure, the threat of protectionism should not be downplayed. It appears clear that president-elect Trump will be less accommodative to free trade than his predecessors, which is confirmed by his choice of Mr. Dan Dimicco, a former CEO of an American steelmaker and an outspoken critic of U.S. trade policy, particularly with China, to head his trade transition team. However, it is unpredictable at the moment what specific measures he would take to be able to assess potential consequences. It is therefore more useful to take a step back and look at the big picture of trade relations between the two countries. China-U.S. Bilateral Trade Chinese sales to the U.S. far outnumber its purchases, leading to an ever-growing trade surplus in China's favor (Chart 1). In fact, the U.S. accounts for over half of China's total trade surplus - a key piece of evidence supporting some American politicians' accusation of China's purported currency manipulation and unfair trade practices. The U.S. accounts for 18% of Chinese exports, while China accounts for only 8% of American overseas sales, which puts China at a disadvantage in a full-blown trade war. Underneath, however, China has become an increasingly important export destination of American companies in recent years, while the significance of the U.S. as part of China's total trade peaked in the late 1990s (Chart 2). The share of U.S.-bound Chinese exports has remained roughly unchanged since the global financial crisis, and down significantly from pre-crisis levels. Chinese sales to the U.S. in recent years have been largely in line with overall export growth. On the contrary, American shipments to China have increased sharply as a share of total exports. Over the past five years, China has accounted for almost 20% of the net increase in U.S. exports, far outpacing any other American trade partner. Chart 1U.S.-China##br## Bilateral Trade U.S.-China Bilateral Trade U.S.-China Bilateral Trade Chart 2China Depends More ##br##On The U.S. Than Vice Versa China Depends More On The U.S. Than Vice Versa China Depends More On The U.S. Than Vice Versa Conventional wisdom holds that protectionist policies will be of more benefit to those countries running deficits in bilateral trade. However, a trade war with China would also remove the biggest source of marginal demand for American goods, which would be met with strong domestic resistance. Anti-Dumping And China's Trade Performance China is no stranger to anti-dumping measures in global trade. The country accounts for 30% of all anti-dumping actions initiated by World Trade Organization (WTO) members in recent years, even though Chinese products account for only about 14% of total global goods exports. China has not been regarded as a "market economy" by major developed countries, making it an easier target for punitive tariffs and other barriers under WTO rules. A case in point is steel products, which remain center stage in the ongoing trade dispute between China and the U.S. President George W. Bush in 2002 imposed tariffs of up to 30% on a broad range of Chinese steel products, while the Obama administration further upped the ante with various product-specific punitive measures during his tenor. These measures have dramatically changed steel trade for both countries: From the U.S. side, total American steel imports have remained largely range-bound in the past 20 years, but Chinese steel products have had a dramatic rollercoaster ride (Chart 3). Punitive tariffs led to a collapse of Chinese steel in the U.S. market, accounting for a mere 3% of total U.S. steel imports, down from a peak of almost 20% in 2008. However, the losses to Chinese steelmakers have simply been filled by other exporting countries. For example, U.S. steel imports from Brazil have roared back to historical high levels as Chinese products plummeted (Chart 3, bottom panel). On the Chinese side, Chinese steel products suffered huge market share losses in the U.S., but the country's total steel exports have continued to make new record highs, as it has dramatically expanded sales to other markets, particularly developing countries (Chart 4). The U.S. currently accounts for about 1% of total Chinese steel exports, down from about 10% at the peak, while Vietnam has rapidly replaced the U.S. as a key market for Chinese steelmakers to expand overseas sales. Chart 3China In U.S. Steel Imports China In U.S. Steel Imports China In U.S. Steel Imports Chart 4U.S. In Chinese Steel Exports U.S. In Chinese Steel Exports U.S. In Chinese Steel Exports Moreover, the punitive measures imposed by the U.S. have pushed Chinese steelmakers into higher value-added products. The top panel of Chart 5 shows the average price of American steel imports from China was roughly comparable to U.S. steel purchases from other developing countries in the late 1990s, while Germany and Japanese steelmakers traditionally occupied the higher-priced segments. The situation has shifted quickly in the past two decades: The unit price of Chinese steel sales in the U.S. has risen rapidly relatively to their peers, increasingly challenging producers in more advanced countries. Other emerging countries have filled the space left by China and remained at the lower end of the spectrum. Similarly, on the Chinese side, the average price of Chinese steel exports to the U.S. has increased sharply in recent years relative to other major markets, particularly developing countries (Chart 5, bottom panel). Currently, the average price of China's steel products exported to the U.S. is far higher than to other countries - almost triple that to other emerging countries. This confirms that Chinese steelmakers have been moving up the value-added ladder in the U.S. market, but have been "dumping" cheaper products to other developing countries. The important point here is that the punitive tariffs have indeed significantly reduced Chinese sales to the U.S., but other steel-producing countries have simply "stolen" China's lunch. By the same token, unless the U.S. imposes punitive tariffs on imports from all countries, picking on China will only shift American demand to other more expensive alternatives, while the benefits to American domestic producers will be questionable, let alone American consumers. Moreover, President Trump may still target Chinese steel products as a highly symbolic gesture to show his toughened stance on China and to keep his campaign trail promises of reviving rust-belt states - the relevance of which, however, has diminished dramatically, as steel products now account for only a tiny fraction of total trade between these two countries (Chart 6). Chart 5Chinese Steelmakers##br## Are Moving Up The Value Chain Chinese Steelmakers Are Moving Up The Value Chain Chinese Steelmakers Are Moving Up The Value Chain Chart 6Steel Is No Longer ##br##Relevant For China-U.S. Trade China-U.S. Trade Relations: The Big Picture China-U.S. Trade Relations: The Big Picture U.S. And China In Global Trade A more inward-looking U.S. administration certainly bodes poorly for international trade and globalization. However, the role of China should not be underestimated. For tradable goods, it is well known that China has long surpassed the U.S. as the world top exporter. For imports of goods, the U.S. is still bigger, but the gap has narrowed dramatically (Chart 7). China has already become a bigger market than the U.S. for a growing list of countries, particularly commodities producers and China's Asian neighbors. What is much less known is that Chinese imports of services just this year also surpassed that of the U.S., marking an important milestone in China's global reach and influence (Chart 8). Moreover, China's exports of services are much smaller, leaving a deficit almost as large as U.S. service surpluses with the rest of the world. Chart 7U.S. And China##br## In Global Trade Of Goods U.S. And China In Global Trade Of Goods U.S. And China In Global Trade Of Goods Chart 8China Surpassed##br##The U.S. In Service Imports China Surpassed The U.S. In Service Imports China Surpassed The U.S. In Service Imports In a world starving for growth, China remains a bright spot. Potential protectionist threats from the U.S. will likely generate a mutual desire among China and other economies to work more closely. China will inevitably continue to explore bilateral and multilateral free-trade agreements (FTA) with its main trade partners. China currently has 19 FTAs under construction, among which 14 agreements have been signed and implemented. Together, FTAs cover an increasingly bigger share of Chinese exports, higher than Chinese sales to the U.S. (Chart 9). Chart 9China Sells More To FTA##br## Countries Than To The U.S. China Sells More To FTA Countries Than To The U.S. China Sells More To FTA Countries Than To The U.S. Meanwhile, China will likely take a more active role in negotiating the "Regional Comprehensive Economic Partnership (RCEP)" - an ambitious multilateral agreement on trade and investments that covers almost half of the world population and output. On the other hand, the outlook of the Trans-Pacific Partnership (TPP) under President Trump has become more uncertain, which may also push other emerging countries to participate in China-initiated trade deals. If President Trump indeed turns more inward, the center of global trade will further shift toward China. A Word On The RMB And Industrial Stocks The RMB has continued to drift lower against the greenback in recent days, which still reflects the dollar's broad strength rather than RMB weakness. In fact, the trade-weighted RMB has strengthened notably (Chart 10). Conspiracy theories abound that China may engineer a flash-crash of the RMB before President Trump takes office to "preempt" any protectionist pressures. This scenario certainly cannot be ruled out, but it is highly unlikely in our view, as it may further intensify trade tensions between the two countries, making Trump's trade policy on China even less predictable. In short, we maintain the view that the near-term RMB outlook is entirely dictated by the movement of the dollar, and that the Chinese authorities should be able to maintain exchange rate stability, as discussed in recent reports.1 Turning to the stock market, Chinese industrial stocks have not joined the sharp post-Trump rally of their U.S. counterparts, likely a reflection of investors' conviction that protectionism in the U.S. may benefit domestic firms at the expense of foreign entities, particularly Chinese firms. (Chart 11). However, similar to almost all other major sectors, the profitability of Chinese industrial names is almost identical to their American peers, but they are trading at hefty discounts based on conventional valuation indicators, reflecting a much larger risk premium in Chinese stocks. For now, we remain on the sidelines with respect to Chinese stocks due to developing global uncertainty, as discussed in detail last week.2 Beyond near-term tactical consideration, we expect Chinese shares to resume their uptrend both in absolute terms and against EM and global benchmarks. Chart 10The RMB Remains Stable##br## In Trade-Weighted Terms The RMB Remains Stable In Trade-Weighted Terms The RMB Remains Stable In Trade-Weighted Terms Chart 11Industrial Stocks:##br## Spot The Differences Industrial Stocks: Spot The Differences Industrial Stocks: Spot The Differences Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "The RMB's Near-Term Dilemma And Long-Term Ambition", dated October 20, 2016, and "Greater China Currencies: An Overview", dated November 3, 2016, available at cis.bcaresearch.com 2 Please see China Investment Strategy Weekly Report, "Chinese Stocks: Between Domestic Improvement And External Uncertainty", dated November 10, 2016, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights EM risk assets will continue to plunge as U.S. bond yields and the U.S. dollar have more upside. Asset allocators should maintain an underweight allocation to EM within global equity and credit portfolios. Upgrade Russian stocks from neutral to overweight within an EM equity portfolio. Reinstate the long Russia ruble / short Malaysian ringgit trade. Feature The rout in emerging markets (EM) risk assets will persist, regardless of the direction of the U.S. equity market. While president-elect Donald Trump's potential fiscal stimulus will boost U.S. growth, it will not be sufficient to offset the negative impact on EM from rising U.S. Treasury yields and a stronger U.S. dollar. On a broader scale, risks of protectionist measures from the incoming U.S. administration are non-trivial, which will make investors even more jittery on EM. Notably, from a historical perspective, firm U.S. growth has not been a panacea for EM, particularly when the latter's domestic fundamentals were poor and commodities prices were falling. For example, EM in general and emerging Asia in particular collapsed in 1997- '98 when U.S. real GDP growth was averaging 4.5%, and European real GDP growth was 3.5%. In particular, U.S. import volumes were booming at double-digit rates, but this was insufficient to circumvent the crisis in Asia (Chart I-1). Importantly, U.S. bond yields were falling during the 1997-'98 period. Chart I-1Strong U.S. Growth Is No Panacea For EM Stocks bca.ems_wr_2016_11_16_s1_c1 bca.ems_wr_2016_11_16_s1_c1 It is hard to expect similar U.S. growth nowadays, even with Trump's potential fiscal impetus. Meanwhile, any fiscal boost in Europe so far remains a forecast. Besides, back in the 1990s, the U.S. and Europe were dominant sources of global demand - and China was not at all an economic power. Since the late 1990s, the significance of China and the rest of EM has grown enormously, while the importance of the U.S. and Europe with respect to global demand in general and EM in particular has fallen. In short, the outlook for stronger growth in the U.S. is not a reason to turn bullish on EM because the latter's fundamentals are poor. The U.S. dollar rally will persist. The greenback is close to being fairly valued, or only slightly expensive (Chart I-2). Typically, major cycles run until a market becomes considerably expensive or very cheap. It is not often that markets bottom or peak at their fair value. Odds are that the U.S. dollar will become more expensive before this bull market is over. In effect, the U.S. dollar rally is reflective of America sucking in capital. This will leave EM current account deficit countries exposed. As the currencies of these countries plummet and their local bond yields rise, their share prices will plunge and credit spreads will widen. Importantly, Trump's trade protectionist rhetoric could accelerate the depreciation in the Chinese RMB. If and when America imposes import tariffs on China, the latter will compensate via further yuan depreciation. In fact, Chinese residents will "assist" the People's Bank of China in devaluing the currency by converting their RMBs into U.S. dollars. As the RMB weakens further, probably at a faster speed, other Asian currencies will plummet (Chart I-3). In fact, odds are high that EM financial markets will once again become sensitive to the RMB. Chart I-2The U.S. Dollar Is Not Expensive bca.ems_wr_2016_11_16_s1_c2 bca.ems_wr_2016_11_16_s1_c2 Chart I-3RMB And Emerging Asian Currencies RMB And Emerging Asian Currencies RMB And Emerging Asian Currencies Apart from shorting the RMB versus the U.S. dollar, on October 19 we recommended shorting the KRW against the THB because the Korean won was one of most vulnerable EM currencies to continued RMB depreciation and renewed JPY weakness. We reiterate this trade today. Consistent with U.S. dollar appreciation, commodities prices will drop. One unsustainable post-U.S. presidential election move has been the rally in industrial metals in general, and copper in particular. Traders have bid up copper prices as the metal had lagged the rally in risk assets since February (Chart I-4). Nevertheless, expectations that U.S. infrastructure spending will considerably boost world demand for industrial metals are misplaced. The U.S. accounts for a very small portion of global industrial metals demand, including copper. Chart I-5 demonstrates that U.S. demand for copper is seven times smaller than that of China. On average, China accounts for about 50% of global demand for industrial metals, while the U.S. accounts for slightly less than 10%. Chart I-4The Rally In Copper ##br##Prices Is Unsustainable The Rally In Copper Prices Is Unsustainable The Rally In Copper Prices Is Unsustainable Chart I-5Industrial Metals ##br##Consumption: U.S. Versus China EM Got "Trumped" EM Got "Trumped" Hence, any reasonable rise in U.S. demand will not be sufficient to offset a single-digit percentage drop in China's intake of industrial metals, which we expect to occur in 2017. Finally, the Chilean mining firm Codelco - the largest copper producer in the world - in recent weeks has cut its premiums on copper shipped to Asia and Europe.1 This is a move to reduce prices - and a sign that demand is weak relative to supply. This leads us to believe that a rally driven by financial investors at a time of inferior demand-supply balance will prove short-lived. Investors should consider shorting copper on any further price strength. The selloff in U.S. and global bonds will likely persist well into December, which in turn will unravel the turmoil in bond proxies and high-multiples stocks (Chart I-6). In our July 13 Weekly Report,2 we argued that U.S. bond yields had bottomed and a selloff would prove painful as lower yields increases their duration. As a result, even a small rise in yields would lead to considerable bond price declines. Since then, while G7 bond yields initially grinded higher, they have surged over the past week. U.S. 10-year and 30-year bond yields have risen by 40 and 36 basis points, respectively since November 1. This translates into a 3.5% and 7.5% price decline for 10-year and 30-year bonds, accordingly. A similar scenario has also played out with EM bonds - both U.S. dollar and local-currency denominated. Accumulating considerable losses will force further bond liquidation. Our feeling is that many bond proxies and markets that benefited from lower yields will be seriously damaged in the coming weeks. Consistently, EM carry trades are at risk of further unraveling. Interestingly, Chart I-7 demonstrates that many high-yielding EM local bond markets are at a critical technical juncture. Odds are that their yields are heading considerably higher after troughing at their long-term moving averages. Chart I-6U.S. Bond Yields ##br##And Bond Proxies bca.ems_wr_2016_11_16_s1_c6 bca.ems_wr_2016_11_16_s1_c6 Chart I-7AEM Local-Currency Bonds Are ##br##At Critical Technical Resistance Levels bca.ems_wr_2016_11_16_s1_c7a bca.ems_wr_2016_11_16_s1_c7a Chart I-7BEM Local-Currency Bonds Are##br## At Critical Technical Resistance Levels bca.ems_wr_2016_11_16_s1_c7b bca.ems_wr_2016_11_16_s1_c7b Bottom Line: EM risk assets will continue to plunge. Stay put and remain defensive. Asset allocators should maintain an underweight allocation to EM within both global equity and credit portfolios. Currency traders who are not already short should consider shorting a basket of the following EM currencies: BRL, CLP, ZAR, TRY, IDR and MYR. In addition, we recommend maintaining our short RMB versus USD trade, as well as our short KRW / long THB position. Today, we are also reinstating the long RUB / short MYR trade (see section on Russia below). For more details on other currency, fixed-income, credit and equity positions, please refer to our Open Position Tables on pages 12-13. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy & Frontier Markets Strategy arthurb@bcaresearch.com 1 Please see: Codelco cuts 2017 China copper premium by 27% to $72/t.- sources (2016, November 14). Retrieved from https://www.metalbulletin.com/Article/3601613/Latest-news/Codelco-cuts-2017-China-copper-premium-by-27-to-72-sources.html 2 Please refer to the Emerging Markets Strategy Weekly Report, titled "Risks To Our Negative EM View," dated July 13, 2016; a link is available on page 14. Russia: Overweight Equities; Reinstate Long RUB / Short MYR Trade Chart II-1Overweight Russian Stocks ##br##Versus The EM Equity Benchmark Overweight Russian Stocks Versus The EM Equity Benchmark Overweight Russian Stocks Versus The EM Equity Benchmark Russia stands out as one of the few EM countries that will likely benefit from Trump's presidency. As such, we recommend dedicated EM investors overweight Russia within both EM equity and credit portfolios. The energy and financial equity sectors together account for 75% of the Russian MSCI equity index, and we think they will continue to outperform their EM peers for the following reasons: With the ruble serving as a shock absorber, Russia's oil and gas sector has been able to weather the volatility in energy prices. If it wasn't for the ruble's massive devaluation in 2014-15, Russian energy companies would have struggled to stay solvent. While we expect oil prices to drop toward $35 per barrell, Russian energy stocks will still perform better than their EM counterparts. Furthermore, going forward, oil prices will outpace industrial metals prices. This should help Russian stocks, credit, and the currency outperform their EM peers (Chart II-1). As we argued above (please refer to page 3), the latest rally in industrial metals prices - based on expectations of U.S. infrastructure spending - does not make sense to us. In fact, the U.S. is a much more important consumer of oil than industrial metals in total world aggregate demand. Hence, strong U.S. growth and weaker Chinese growth (our baseline assumption) should be associated with oil prices outperforming base metals prices. Russia is much more advanced in its deleveraging cycle than most other EM economies. This will help banks and consumer stocks outperform their EM peers. In March 2016 we highlighted our preference for Russia's banking system relative to Malaysia's, and initiated a relative equity trade: long Russian stocks / short Malaysian stocks. This trade has already returned 30% and we believe it still has further to go. Today, we extend this positive view on Russia's banking system vis-à-vis Malaysia, to one versus the entire EM bank universe. In contrast to other emerging markets, Russian banks have been recognizing NPLs and have increased their provisions significantly (Chart II-2). Russia has now been in recession for two years and its banks have increased their NPL provisions and their credit growth has already slowed down significantly. This stands in stark contrast to other emerging markets, where banks are failing to realize NPLs and increase provisions adequately, despite substantially slower economic growth and elevated debt levels. In fact, Russia's domestic credit impulse is already starting to head into positive territory (Chart II-3), while the same indicator for the overall EM aggregate will be negative over the next 12 months or so. Russia's financial market outperformance will be aided by orthodox macro policies. This stands in contrast to unorthodox measures in many other developing countries. In terms of monetary policy, the Central Bank of Russia has refrained from injecting excess liquidity into the system or intervening in the foreign exchange market. Moreover, the central bank has been canceling the licenses of smaller banks. This is bullish for listed banks, as their market share will increase (Chart II-4). Chart II-2Russian Banks Have Recognized ##br##NPLs And Raised Provisions Russian Banks Have Recognized NPLs And Raised Provisions Russian Banks Have Recognized NPLs And Raised Provisions Chart II-3Russia's Credit Impulse ##br##Is Turning Positive Russia's Credit Impulse Is Turning Positive Russia's Credit Impulse Is Turning Positive Chart iI-4Russia: Banking Sector Consolidation ##br##Is Bullish For Listed Banks Russia: Banking Sector Consolidation Is Bullish For Listed Banks Russia: Banking Sector Consolidation Is Bullish For Listed Banks With respect to fiscal policy, although the government has exceeded its planned budget deficit of 3% of GDP for 2016, we believe this is not an issue given that Russia's total government debt is very low at only 16.5% of GDP. Lastly, our bias is that the recent victory of President-elect Trump will be marginally positive for the Russian economy relative to other EM. While the U.S. is not a major importer of Russian exports, investors will begin to price in sanction relief. European sanctions are particularly important for Russia and a substantive improvement in U.S.-Russia relations could lead some relatively pro-Russia European governments (Italy, Hungary, Greece, etc.) to demand that EU sanctions be either rolled back fully or significantly modified. Therefore, since Russia does not export as many goods to the U.S. compared to other emerging markets and sanctions may be easing soon, the nation is much more insulated from potential U.S. protectionist measures than many other EM countries. Investment Recommendations The Russian economy is further along its necessary adjustment path compared to the rest of the EM world, and there is less downside at the moment. Furthermore, Russian monetary and fiscal policymakers have undertaken orthodox policy measures in the face of an economic crisis - which cannot be said of many other EM countries. As such, we recommend dedicated EM investors upgrade Russia from neutral to overweight within an EM equity portfolio. We reiterate an overweight stance on Russian sovereign and corporate credit and recommend holding the following trades: Short Russian CDS / long South African CDS Long Russian and Chilean corporate credit / Short Chinese offshore corporate credit. We also recommend currency traders reinstate the long RUB / short MYR trade (Chart II-5). The two currencies are sensitive to energy prices, but the Russian economy is likely to recover soon, while the Malaysian economy has much more downside ahead. Excessive liquidity injections in Malaysia relative to somewhat tighter monetary conditions in Russia will lead to ringgit depreciation versus the ruble (Chart II-6). Lastly, the ruble offers a higher carry than the ringgit. Consistent with the currency trade, we are maintaining our long Russian / short Malaysian equity trade. Chart II-5Reinstate Long RUB / ##br##Short MYR Trade bca.ems_wr_2016_11_16_s2_c5 bca.ems_wr_2016_11_16_s2_c5 Chart II-6Malaysia And Russia: ##br##Non-Orthodox Versus Orthodox bca.ems_wr_2016_11_16_s2_c6 bca.ems_wr_2016_11_16_s2_c6 Stephan Gabillard, Research Analyst stephang@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

BCA will be holding the Dubai session of the BCA Academy seminar on November 28 & 29. This two-day course teaches investment professionals how to examine the economy, policy, and markets; and also makes links between these important factors. Moreover, it represents a great networking opportunity for all attendees. I look forward to seeing you there. Best regards, Mathieu Savary Highlights Donald Trump's victory represents a sea-change for U.S. politics as well as the economy. His expansionary fiscal policy, to be implemented as the labor market's slack evaporates, will boost demand, wages, and will prove inflationary. The Fed will respond with higher rates, boosting the dollar. EM Asian currencies will bear the brunt of the pain. Commodity currencies, especially the AUD, will also be significant casualties. EUR/USD will weaken in the face of a strong greenback, but should outperform most currencies. Key risks involve gauging whether the Fed genuinely wants to create a "high-pressure", economy as well as the potential for Chinese fiscal stimulus. Feature Trump's electoral victory only re-enforces our bullish stance on the dollar. A Trump presidency implies much more fiscal stimulus than originally anticipated. Therefore, the Fed will not be the only game in town to support growth. This strengthens our view that, on a cyclical basis, the OIS curve still underprices the potential for higher U.S. interest rates. In a Mundell-Fleming world, this suggests a much higher exchange rate for the greenback. Additionally, Trump's protectionist views are likely to hit EM economies - China in particular - harder than DM economies. We continue to prefer expressing our bullish dollar view by shorting EM and commodity currencies. Is Trump Handcuffed? Trump's victory reflects a tidal wave of anger and dissatisfaction with the current state of the U.S. economy. Most profoundly, his candidacy was a rallying cry against an increasingly unequal distribution of economic opportunities and outcomes for the U.S. population. As we highlighted last week, since 1981, the top 1% of households have seen their share of income grow by 11%. In fact, while 90% of households have seen their real income contract by 1% since 1980, the top 0.01% of households have seen their real income increase more than five-fold (Chart I-1). Chart I-1The (Really) Rich Got Richer Reaganomics 2.0? Reaganomics 2.0? In this context, Trump's appeal, more than his often-distasteful racial or gender rhetoric, has been his talk of protecting the middle class. But, by losing the popular vote, are his hands tied? Marko Papic, BCA's Chief Geopolitical Strategist, surmises in a Special Report1 sent to all BCA's clients that it is not the case. First, Trump's victory speech emphasized infrastructure spending, indicating that this is likely to be his first priority. As Chart I-2 illustrates, there is a lot of room for the government to spend on this front. At 1.4% of GDP, government investment is at its lowest level since World War II. Furthermore, according to the Tax Policy Institute, Trump's current plan includes $6.2 trillion in tax cuts over the next 10 years. Second, the Republican Party now controls Congress as well as the White House. Not only has the GOP historically rallied around the president when all the levers of power are in the party's hands, but also, the Tea party has been one of Trump's most ardent supporters. Hence, Trump's program is unlikely to be completely squelched by Congress. Third, the GOP is most opposed to government spending when Democrats control the White House. When Republicans are in charge of the executive, the GOP is a much less ardent advocate of government stringency, having increased the deficit in the opening years of the Reagan, Bush I, and Bush II administrations (Chart I-3). Chart I-2Room To Increase##br## Infrastructure Spending Room To Increase Infrastructure Spending Room To Increase Infrastructure Spending Chart I-3Republicans Are Fiscally Responsible ##br##When It Suits them bca.fes_wr_2016_11_11_s1_c3 bca.fes_wr_2016_11_11_s1_c3 Finally, international relations are the president's prerogative. While there are legal hurdles to renegotiate treaties like NAFTA, Trump can slap tariffs easily, rendering previous arrangements quite impotent. Though protectionism has not been highlighted in Trump's victory speech, the topic's popularity with his core electorate highlights the risk that trade policies could be impacted. Bottom Line: Trump has a mandate to spend and got elected because of his policies that support the middle class. His surprise victory represents a sea-change, a move the rest of the Republican establishment will not ignore. Therefore, we expect Trump to be able to implement large-scale fiscal stimulus. Economic Implications To begin with, Trump is a populist politician. While populism ultimately ends badly, it can generate a growth dividend for many years. Nowhere was this clearer than in 1930s Germany, where Hitler's reign yielded a major economic outperformance of Germany relative to its regional competitors (Chart I-4).2 Government infrastructure spending played a large role in this phenomenon. Also, the Reagan era shows how fiscal stimulus can lead to a boost to growth. From the end of the 1981-82 recession to 1987, U.S. real GDP per capita outperformed that of Europe and Japan, despite the dollar's strength in the first half of the decade. Fascinatingly, the U.S. GDP per capita even outperformed that of the U.K., a country in the midst of the supply-side Thatcherite revolution (Chart I-5). This suggests that the U.S's economic outperformance was not just a reflection of Reagan's deregulatory instincts. Chart I-4Populism Can Boost Growth Populism Can Boost Growth Populism Can Boost Growth Chart I-5Reagan Deficits Boosted Growth Too bca.fes_wr_2016_11_11_s1_c5 bca.fes_wr_2016_11_11_s1_c5 Unemployment is close to its long-term equilibrium, and the hidden labor-market slack has greatly dissipated. Additionally, one of the biggest hurdles facing small businesses is finding qualified labor. In the context of a tight labor market, we anticipate that Trump's fiscal stimulus will not only boost aggregate demand directly, but will also exert significant pressures on already rising wages (Chart I-6). Compounding this effect, if Trump does indeed focus on infrastructure spending, work by BCA's U.S. Investment Strategy service shows that this type of stimulus offers the highest fiscal multiplier (Table I-1).3 Chart I-6Stimulating Now Will Feed Wage Growth Stimulating Now Will Feed Wage Growth Stimulating Now Will Feed Wage Growth Table I-1Ranges For U.S. Fiscal Multipliers Reaganomics 2.0? Reaganomics 2.0? Additionally, a retreat away from globalization, and a move toward slapping more tariffs and quotas on Asia and China would be inflationary. Historically, falling inflation has coincided with falling tariffs as competitive forces increase. This time, with the output gap closing, and the tightening labor market, decreasing the trade deficit could arithmetically push GDP above trend, accentuating wage and inflationary pressures. Finally, for households, a combination of rising wages, elevated consumer confidence, and low financial obligations relative to disposable income could prompt a period of re-leveraging (Chart I-7). Moreover, the median FICO score for new mortgages has fallen from more than 780 in 2013 to 756 today, an easing in lending standard for mortgages. All the factors above suggest that U.S. growth is likely to improve over the next two years, driven by the government and households. It also points towards rising inflationary pressures. As we have highlighted before, the more the economy can generate wage growth to support domestic consumption, the more it becomes resilient in the face of a stronger dollar. The tyranny of the feedback loop between the dollar and growth will loosen. This environment would be one propitious for the Fed to hike interest rates as the economy becomes less dependent on lower rates for support. In the long-run, the Trump growth dividend is likely to require a payback, but this discussion is for another day. Bottom Line: Trump is likely to boost U.S. economic activity through fiscal stimulus, especially infrastructure spending. Since the slack in the economy is now small, especially in the labor market, this increases the likelihood that the Fed will finally be able to durably push up interest rates (Chart I-8). Chart I-7Household Debt Load Can Grow Again Household Debt Load Can Grow Again Household Debt Load Can Grow Again Chart I-8Vanishing Slack = Higher Rates bca.fes_wr_2016_11_11_s1_c8 bca.fes_wr_2016_11_11_s1_c8 Currency Market Implications The one obvious effect from a Trump victory is that it re-enforces our core theme that the dollar will strengthen on a 12 to 18-months basis as the market reprices the Fed's path. However, we expect Asian currencies to be viciously hit by this new round of dollar strength. For one, compared to the drubbing LatAm currencies received, KRW, TWD, and SGD are only trading 13%, 9%, and 15% below their post 2010 highs. Most importantly though, EM Asia has been the main beneficiary of 35 years of expanding globalization. Countries like China or the Asian tigers have registered world-beating growth rates thanks to a growth strategy largely driven by exports (Chart I-9). Chart I-9Former Winners Become Losers Under Trump Reaganomics 2.0? Reaganomics 2.0? We expect these economies and currencies to suffer the most from Trump's retribution and from a continued structural underperformance of global trade. China, Korea, and co. are likely to be hit by tariffs under a Trump administration. Also, under a Trump administration, the likelihood of implementation of new international trade treaties is near zero. Therefore, the continuous expansion of globalization of the previous decades is over, and may even somewhat reverse. Furthermore, a move toward a more multipolar world, like the interwar period, tends to be associated with falling trade engagement. Trump's desire to diminish the global deployment of U.S. troops would only add to such worries. Regarding the RMB, the picture is murky. On the one hand, the RMB is trading 4% below fair value and does not need much devaluation from a competitiveness perspective. However, Chinese internal deflationary pressures, courtesy of much overcapacity, remain strong (Chart I-10). Easing these pressures requires a lower RMB. Moreover, the offshore yuan weakened substantially in the wake of Trump's victory, yet the onshore one did not, suggesting that the PBoC is depleting its reserves to support the currency. This tightens domestic liquidity conditions, exacerbating the deflationary forces in the country. Chart I-10Plenty Of Excess Capacity In China Reaganomics 2.0? Reaganomics 2.0? This means that China is in a bind as a depreciating currency will elicit the wrath of president Trump. The risk is currently growing that China will let the RMB fall substantially between now and January 20. Such a move would magnify any devaluating pressures on other Asian exchange rates. While it is difficult to be bullish MXN outright on a cyclical basis when expecting a broad dollar rally, the recent weakness in MXN is overdone. Mexico has not benefited nearly as much from globalization as Asian nations. Also, after a 60% appreciation in USD/MXN since June 2014, even after the imposition of tariffs, Mexico will still be competitive. Even then, the likelihood and severity of any tariffs enacted on Mexico might be exaggerated by markets. In fact, President Nieto's invitation to Trump last summer may prove to have been a particularly uncanny political move. Investors interested in buying the peso may want to consider doing it against the won, potentially one of the biggest losers from a Trump presidency. Outside of EM, the AUD is at risk. Australia sits in the middle of the pack in terms of economic and export growth during the globalization era, but it is very exposed to Asian economic activity. Historically, the AUD has been tightly correlated with Asian currencies (Chart I-11). Adding insult to injury, Australia is a large metals producer, which means that Australia's terms of trade are highly levered to the Chinese investment cycle, the main source of demand for iron ore, copper, etc. (Chart I-12). With China already swimming in over capacity, unless the government enacts a new infrastructure package, Chinese imports of raw materials will remain weak. Chart I-11AUD Will Suffer If Asian Currencies Fall bca.fes_wr_2016_11_11_s1_c11 bca.fes_wr_2016_11_11_s1_c11 Chart I-12China Is The Giant In The Room Reaganomics 2.0? Reaganomics 2.0? The NZD is also likely to suffer against the USD. The currency's sensitivity to the dollar strength and EM spreads is very high. However, we expect AUD/NZD to remain depressed. The outlook for relative terms of trades supports the kiwi as ag-prices will be less impacted by a slowdown in Chinese capex than metals. Additionally, on most metrics, the New Zealand economy is outperforming that of Australia (Chart I-13). The CAD should beat both antipodean currencies. First, it is less sensitive to the U.S. dollar or EM spreads than both the AUD and the NZD, reflecting its tighter economic link with the U.S. We also expect some softer rhetoric and actions from Trump when it comes to implementing trade restrictions with Canada than with Asia. Finally, while we are very concerned for the outlook for metals, the outlook for energy is superior. Yes, a strong greenback is a headwind for oil prices, but a Trump presidency is likely to result in strong household consumption. Vehicle-miles-driven growth would remain elevated, suggesting healthy oil demand from the U.S. Meanwhile, our Commodity & Energy Strategy service expects the drawdown in global oil inventories to accelerate, particularly if Saudi Arabia and Russia can agree on a 1mm b/d production cut at the upcoming OPEC meeting at the end of the month, which is bullish for oil (Chart I-14). Chart I-13Stronger Kiwi Domestic Fundamentals bca.fes_wr_2016_11_11_s1_c13 bca.fes_wr_2016_11_11_s1_c13 Chart I-14Better Supply/Demand Backdrop For Oil bca.fes_wr_2016_11_11_s1_c14 bca.fes_wr_2016_11_11_s1_c14 We also remain yen bears. The isolationist stance of Trump is likely to incentivize Abe to double down on fiscal stimulus, especially on the military. Japan is currently massively outspent on that front by China (Chart I-15). With the BoJ pegging policy rates at 0% for the foreseeable future, the yen will swoon on the back of falling real yields. Moreover, if our bearish stance on Asian currencies materializes itself, this will put competitive pressures on the yen, creating an additional negative. For the euro, the picture is less clear. The euro remains the mirror image of the dollar, so a strong greenback and a weak euro are synonymous. Additionally, Trump stimulus, if enacted, will ultimately result in higher nominal and real yields in the U.S. relative to Europe, especially as the euro area does not display any signs of being at full employment (Chart I-16). That being said, the euro is currently very cheap, supported by a current account surplus, and the ECB might begin tapering asset purchases in the second half of 2017. Combining these factors together, while we remain cyclically bearish on EUR/USD - a move below parity over the next 12-18 months is a growing possibility - the euro will outperform EM currencies, commodity currencies, and even the yen. We are looking to buy EUR/JPY, especially considering the skew in positioning (Chart I-17). Chart I-15Japan Will Spend More On Its ##br##Military With Or Without Trump bca.fes_wr_2016_11_11_s1_c15 bca.fes_wr_2016_11_11_s1_c15 Chart I-16European Labor Market##br## Slack Is Evident European Labor Market Slack Is Evident European Labor Market Slack Is Evident Chart I-17EUR/JPY Has##br## Room To Rally bca.fes_wr_2016_11_11_s1_c17 bca.fes_wr_2016_11_11_s1_c17 Finally, the outlook for the pound remains clouded until we get a better sense of the High Court's decision on the government's appeal regarding the need for a Parliamentary vote on Brexit. We expect the court's decision to re-inforce the previous ruling, which means that the pound could strengthen as the probability of a "soft Brexit" grows. The resilience of the pound in the face of the recent dollar's strength points to such an outcome. Risk To Our View And Short-Term Dynamics The biggest risk to our view is obviously that Trump's fiscal plans never pan out. However, since our bullish stance on the dollar predates Trump's electoral victory, we would therefore remain dollar bulls, albeit less so. Nonetheless, limited fiscal stimulus would likely cause a temporary pullback in the dollar. Chart I-18A Mispricing Or A Signal? bca.fes_wr_2016_11_11_s1_c18 bca.fes_wr_2016_11_11_s1_c18 Another short-term risk is the Fed. Currently, inflation expectations in the U.S. have shot up. If the Fed does not increase rates in December - this publication currently thinks the FOMC will increase rates then - the dollar will fall as this move will put downward pressures on U.S. real rates. This is especially relevant as the 5-year/5-year forward Treasury yield stands at 2.8%, in line with the Fed's estimate of the long-term equilibrium Fed funds rates as per the "dots". A big risk for our EM / commodity currency view is China. China may not respond to Trump by aggressively bidding down the CNY before January 20. Instead, to counteract the negative effect of Trump on Chinese export growth, China might instigate more fiscal stimulus, plans that always have a large infrastructure component. The recent parabolic move in copper needs monitoring (Chart I-18). Bottom Line: A Trump victory is a massive boon for the dollar. However, because Trump represents a move away from globalization, the main casualties of the Trump-dollar rally will be Asian currencies and the AUD. The CAD and the NZD will also undergo downward pressures, but less so. Finally, while EUR/USD is likely to fall, the euro will outperform EM currencies, commodity currencies, and the yen. As a risk, in the short-term, an absence of Fed hike in December would represent the biggest source of weakness for the dollar. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Geopolitical Strategy Special Report, "U.S. Election: Outcomes And Investment Implications", dated November 9, available at gps.bcaresearch.com 2 To be clear, while we do find some of Trump comments over the past year highly distasteful, we are not suggesting that he is a re-incarnation of Hitler or that his presidency is doomed to end in a massive global conflict. It is only an economic parallel. 3 Please see U.S. Investment Strategy Weekly Report, "Policy, Polls, Probability", dated November 7, available at usis.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 bca.fes_wr_2016_11_11_s2_c2 bca.fes_wr_2016_11_11_s2_c2 Policy Commentary: "We are going to fix our inner cities and rebuild our highways, bridges, tunnels, airports, schools, hospitals. We're going to rebuild our infrastructure, which will become, by the way, second to none. And we will put millions of our people to work as we rebuild it." - U.S. President Elect Donald Trump (November 9, 2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 bca.fes_wr_2016_11_11_s2_c4 bca.fes_wr_2016_11_11_s2_c4 Policy Commentary: "I'm very skeptical as far as further interest rate cuts or additional expansionary monetary policy measures are concerned -- over time, the benefits of these measures decrease, while the risks increase" - ECB Executive Board Member Sabine Lautenschlaeger (November 7,2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Yen Chart II-5JPY Technicals 1 bca.fes_wr_2016_11_11_s2_c5 bca.fes_wr_2016_11_11_s2_c5 Chart II-6JPY Technicals 2 bca.fes_wr_2016_11_11_s2_c6 bca.fes_wr_2016_11_11_s2_c6 Policy Commentary: "In order for long-term interest rate control to work effectively, it is important to maintain the credibility in the JGB market through the government's efforts toward establishing sustainable fiscal structures" - BoJ Minutes (November 10, 2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 British Pound Chart II-7GBP Technicals 1 bca.fes_wr_2016_11_11_s2_c7 bca.fes_wr_2016_11_11_s2_c7 Chart II-8GBP Technicals 2 bca.fes_wr_2016_11_11_s2_c8 bca.fes_wr_2016_11_11_s2_c8 Policy Commentary: "[The impact of a weak pound on inflation]... will ultimately prove temporary, and attempting to offset it fully with tighter monetary policy would be excessively costly in terms of foregone output and employment growth. However, there are limits to the extent to which above-target inflation can be tolerated" - BOE Monetary Policy Summary (November 3, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9AUD Technicals 1 bca.fes_wr_2016_11_11_s2_c9 bca.fes_wr_2016_11_11_s2_c9 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Policy Commentary: "Inflation remains quite low...Subdued growth in labor costs and very low cost pressures elsewhere in the world mean that inflation is expected to remain low for some time" - RBA Monetary Policy Statement (October 31, 2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Policy Commentary: "Weak global conditions and low interest rates relative to New Zealand are keeping upward pressure on the New Zealand dollar exchange rate. The exchange rate remains higher than is sustainable for balanced economic growth and, together with low global inflation, continues to generate negative inflation in the tradables sector. A decline in the exchange rate is needed" - RBNZ Governor Graeme Wheeler (November 10, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Policy Commentary: "We have studied the research and the theory behind frameworks such as price-level targeting and targeting the growth of nominal gross domestic product. But, to date, we have not seen convincing evidence that there is an approach that is better than our inflation targets" - BoC Governor Stephen Poloz (November 1, 2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Policy Commentary: "We don't have a fixed limit for growing the balance sheet; it's a corollary of our foreign exchange market interventions - which we conduct to fulfill our price stability mandate" - SNB Vice-President Fritz Zurbruegg (October 25, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Policy Commentary: "Banks' capital ratios have doubled since the financial crisis and liquidity has improved. At the same time, some aspects of the Norwegian economy make the financial system vulnerable. This primarily relates to high property price inflation combined with high household indebtedness" - Norges Bank Deputy Governor Jon Nicolaisen (November 2, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 bca.fes_wr_2016_11_11_s2_c20 bca.fes_wr_2016_11_11_s2_c20 Policy Commentary: "...the weak inflation outcomes in recent months illustrate the uncertainty over how quickly inflation will rise. The Riksbank now assesses that it will take longer for inflation to reach 2 per cent. The upturn in inflation therefore needs continued strong support" - Riksbank Minutes (November 9, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Dazed And Confused - July 1, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights We remain positive on Chinese stocks both from structural and cyclical point of view, especially on H shares. In the near term, stay on the sidelines due to developing global uncertainty. The Q3 earnings scorecard of listed companies confirms an upturn in the Chinese profit cycle. Earnings momentum will likely be carried forward to at least early next year. The Chinese economy has improved notably, especially in the industrial sector. We expect the economy will likely continue to surprise to the upside. Feature Tuesday's U.S. election surprise sent strong shockwaves to global risk assets, including Chinese stocks. We tactically downgraded our "bullishness" rating on Chinese H shares in early October,1 partly due to brewing global uncertainty, but were still caught off guard by the election result. World financial markets have yet to fully grasp the implication and consequences of a President Trump. Yesterday, we sent clients a Special Report titled "U.S. Election: Outcomes & Investment Implications" prepared by Marko Papic, our Chief Geopolitical Strategist, providing our initial assessment on these important issues. As far as China is concerned, the biggest threat is the harsh anti-China trade policies that dominantly featured Mr. Trump's election campaign. A full-blown protectionist backlash is undoubtedly bearish for China and the rest of the world; this is a disturbing uncertainty that has to be carefully monitored and assessed going forward. However, it is also worth noting that anti-China rhetoric has been regularly featured in all U.S. presidential election campaigns by candidates from both parties as soon as the diplomatic tie between these two countries was established in 1979, but the economic integration has continued to deepen. For now, we do not advocate any kneejerk adjustment to investment strategy, as it is utterly unpredictable how much of Mr. Trump's campaign rhetoric will become real policy. An easier bet over the near term is that the Chinese authorities will likely maintain policy support to boost domestic demand in the wake of rising external uncertainty. Strategically, China will likely press forward its ongoing long-term initiatives to expand its global influence, such as the "One Belt One Road" (OBOR) project and Asian Infrastructure Development Bank. Meanwhile, China will continue to explore bilateral and multi-lateral free trade deals with its major trade partners to foster a more predictable global trade environment. We will follow up on these issues in our future research. While Chinese stocks have suffered badly from global contagion this week, Chinese domestic factors have, ironically, continued to turn more positive of late, with an improving cyclical economic profile, a largely accommodative policy stance and a strong recovery in profits. In the near term we are staying on the sidelines, as the uncertainty unleashed by the U.S. presidential elections continues to play out. Nonetheless, barring a major protectionist backlash, we remain positive on Chinese H shares both from a structural and cyclical perspective, and expect this asset class to outperform both global and EM peers. A Strong Earnings Recovery From an investor's stand point, the most important development is the sharp recovery in earnings reported by Chinese domestically listed A-share companies in the third quarter. Specifically: A share-listed companies' average earnings increased by 22% in the third quarter from Q3 2015, or by 3% for the first three quarters compared with a year ago (Table 1). Excluding financials and petroleum firms, earnings jumped by almost 50% in Q3, according to our calculations, or 21% year-to-date. While the sharp earnings recovery in Q3 is partially attributable to last year's low base, our model suggests that earnings momentum will likely be carried forward to at least early next year (Chart 1). Table 1Earnings Scorecard Chinese Stocks: Between Domestic Improvement And External Uncertainty Chinese Stocks: Between Domestic Improvement And External Uncertainty The earnings recovery reflects both top-line growth and margin expansion. Improving producer prices have eased deflationary pressure in the economy, particularly for the corporate sector. Total sales of A share-listed firms have benefited from the pickup in nominal GDP growth, and profit margins have also continued to widen in the last quarter, both of which are conducive for earnings growth (Chart 2). Cash flow positions have also continued to improve, especially in select sectors. Overall cash and cash equivalents held by Chinese non-bank firms as a share of assets currently stand at elevated levels, underscoring an overall cautious stance on business expansion and liquid balance sheets (Chart 3).2 Specifically, real estate developers' operating cash flow continues to increase sharply, boosted by strong sales, but capital expenditures have been muted, leading to a significant hoarding of cash. This will likely reduce financial stress among developers, even if housing policies begin to be tightened. Chart 1Strong Earnings Grow... bca.cis_wr_2016_11_10_c1 bca.cis_wr_2016_11_10_c1 Chart 2... Due To Rising Sales And Improving Margin bca.cis_wr_2016_11_10_c2 bca.cis_wr_2016_11_10_c2 Chart 3Developers' Improving Cash Flow And Balance Sheet bca.cis_wr_2016_11_10_c3 bca.cis_wr_2016_11_10_c3 In short, the Q3 earnings scorecard confirms our long-held view of an upturn in the Chinese profit cycle.3 We expect bottom-up analysts will continue to upgrade earnings expectations, which will provide a positive cyclical backdrop for Chinese stocks (Chart 4). The Economy Will Remain Resilient China's recent macro numbers have largely come in stronger than expected, albeit modestly. Overall, the economy has maintained positive momentum, especially in the industrial sector. The Keqiang Index - a combination of bank loan growth, railway freight activity and electricity consumption - has strengthened sharply, underscoring significant improvement in industrial activity (Chart 5). Looking forward, we expect the economy will likely continue to surprise to the upside. Chart 4Net Earnings Revision Will Continue To Improve bca.cis_wr_2016_11_10_c4 bca.cis_wr_2016_11_10_c4 Chart 5Keqiang Index Versus GDP Growth bca.cis_wr_2016_11_10_c5 bca.cis_wr_2016_11_10_c5 Business managers have largely been cautious, and have been focused on inventory destocking instead of business expansion. Industrial production has so far been muted, despite improvement in some leading indicators (Chart 6). Meanwhile, slowing capital spending among private enterprises has been one of the key reasons for slower growth in recent years; this should turn around as profitability improves (Chart 7). At minimum, downward pressure on private sector investment should diminish going forward. This, together with government-sponsored infrastructure construction, should underpin overall capital spending. Chart 6Industrial Production Has Been Muted bca.cis_wr_2016_11_10_c6 bca.cis_wr_2016_11_10_c6 Chart 7Profit Recovery Helps Capex bca.cis_wr_2016_11_10_c7 bca.cis_wr_2016_11_10_c7 On the policy front, monetary conditions continue to be accommodative. The trade-weighted exchange rate has remained low, and real interest rates have continued to drift lower through nominal declines and rising producer prices. Furthermore, inflation is unlikely to become a meaningful policy constraint anytime soon. Headline CPI picked up slightly last month, driven by food prices (Chart 8). However, this was largely due to the base effect. Agricultural wholesale prices have been mostly flat in recent years, and there is no case for generalized food inflation. The risk of any near term policy tightening has further diminished in the wake of the global uncertainty. Meanwhile, previous stimulative policies should continue to allow the economy to build forward momentum. The housing tightening policies imposed last month have begun to have a negative impact on home sales, which introduces a new risk factor for the economy, as discussed in a previous report. Anecdotal evidence suggests that property transactions in some major cities have dropped notably, even though home sales nationwide appear to remain buoyant (Chart 9).4 In addition, new housing construction has rolled over in the past few months, as developers have also focused on destocking inventories despite rising sales. However, inventories were already headed lower, which will eventually support new construction. Already, developers' land purchases have turned positive in recent months. In short, the impact of tightened housing policies should continue to be closely monitored. For now, our base case remains that housing construction will likely remain sluggish, but will not go through another major downturn. This view is further reinforced by the strong earnings and cash positions of real estate developers in the last quarter. Chart 8No Case For Food Inflation bca.cis_wr_2016_11_10_c8 bca.cis_wr_2016_11_10_c8 Chart 9Housing: Another Major Downturn Is Unlikely bca.cis_wr_2016_11_10_c9 bca.cis_wr_2016_11_10_c9 Chinese Stocks And Global Risk Aversion As far as Chinese stocks are concerned, we are positive both from structural and cyclical point of view, especially on H shares. Structurally, this asset class has been deeply depressed in recent years with an unduly high risk premium, which will eventually be renormalized through multiples expansion. Cyclically, the economy's budding forward momentum, strong profit recovery and accommodative policy stance are all supportive for stock prices. At a minimum, Chinese H shares should continue to outperform their global and EM peers. Tactically, however, we remain cautious as knee-jerk reactions in the stock market following the U.S. election surprise will continue to dominate the broader market trends. Furthermore, even as the impact of the election shock begins to fade, investors' focus may shift back over to a possible December rate hike by the Federal Reserve and another up leg in the U.S. dollar - both of which are negative for global liquidity and risk assets. Chart 10 shows that our proxy of global dollar liquidity has deteriorated significantly of late, which historically has often been accompanied by an increase in volatility in stocks. This time around, however, the market appears to have so far been rather sanguine, and is vulnerable to negative surprises. This is especially true, as global bellwether U.S. stocks are not cheap. In addition, Chinese stocks are overbought in the near term, and a period of consolidation or even correction is overdue (Chart 11). Our technical models for both A shares and H shares remain elevated even after the recent correction, which heralded further near-term difficulties. A favorable cyclical profile and large valuation buffer, particularly for H shares, should limit the downside for Chinese stocks, but the risk-return tradeoff in the near term is not particularly attractive, and warrants a more cautious stance. Chart 10Dollar Liquidity And Equity Volatility bca.cis_wr_2016_11_10_c10 bca.cis_wr_2016_11_10_c10 Chart 11Chinese Stocks Remain Near Term Overbought Chinese Stocks Remain Near Term Overbought Chinese Stocks Remain Near Term Overbought The bottom line is that we downgraded our "bullish rating" on Chinese H shares last month, and for now remain on the sidelines. Beyond near-term volatility we reiterate our positive conviction for this asset class, and expect Chinese H shares to continue to advance both in absolute terms and against the EM and global benchmarks. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010" , dated October 13, 2016, available at cis.bcaresearch.com 2 Please see China Investment Strategy Special Report, "Rethinking Chinese Leverage", dated October 27, 2016, available at cis.bcaresearch.com 3 Please see China Investment Strategy Weekly Reports, "2016: A Choppy Bottoming" , dated January 6, 2016 and "China: Four Important Charts" , dated April 13, 2016 and "Chinese Growth, Profits And Stock Prices", dated July 20, 2016, available at cis.bcaresearch.com 4 Please see China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010" , dated October 13, 2016, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights The inexorable shift of refining eastward would be accelerated if the Kingdom of Saudi Arabia (KSA) and Russia fail to curb crude oil production as we expect. Prolonging the crude oil market-share war - particularly between opposing camps led by KSA and Iran within OPEC, and Russia's campaign outside the Cartel - will advantage Asian refiners in the short term. Over the longer term, the expansion of oil refining in Asia and the Middle East likely will accelerate, as these warring camps invest directly in refining capacity in Asia and expand their domestic and regional refining and trading capacity. The risk Asian product markets will become super-saturated over the next 3 - 5 years remains elevated, as local refining capacity outgrows local demand and export markets are used to dispose of product surpluses. Like their upstream counterparts, refiners can be expected to fight for market share, leading to a compression in margins. Energy: Overweight. We continue to expect a production cut by KSA and Russia to be announced at the OPEC meeting this month. Base Metals: Neutral. LME aluminum prices still have upside as the market will likely remain supply deficit in the short term. We look to buy aluminum on weakness. Precious Metals: Neutral. We remain on the sidelines ahead of the Fed's December meeting. Ags/Softs: Underweight. We still look to go long wheat versus soybeans. We also look to go long corn versus sugar. Feature We continue to expect an announcement from KSA and Russia of a net 1mm b/d production cut at this month's OPEC meeting in Vienna, after accounting for the 400k b/d or so of seasonal production declines in KSA. A failure to follow through on a cut will prolong the global market-share war among OPEC and Russian oil producers seeking long-term customers in Asian refining markets, particularly in China. China's so-called teapots, which refine 60k to 70k b/d, only started importing crude oil for their own accounts late last year. These refiners represent about one-third of China's 14.3 mm b/d refining capacity as of 2015. It's been a slow ramp - some of these teapots only got started on importing their own crude this year - but they're definitely on a growth trajectory and should catch up with KSA and India in the near future. Some of them already are using hedge markets and setting up their own trading operations, according to media reports. Also, we're expecting to see increased investment in refining in China by KSA and others in the very near future, which will bring state of the art technology to the sector. In and of itself, a failure of KSA and Russia to agree a production cut would be bullish for the growth potential of Asian refiners, as Middle Eastern and Russian crude oil supplies continue to be aggressively marketed to them, allowing them to build capacity and grow their share of global exports (Chart of the Week). Chart of the Week (A)Asia/Middle East Refining Inputs Continue to ##br##Grow As OPEC Market-Share War Drags On bca.ces_wr_2016_11_10_c1a bca.ces_wr_2016_11_10_c1a Chart of the Week (B)Asia/Middle East Refiners' Market Share Of ##br##Gasoline Exports Is Growing bca.ces_wr_2016_11_10_c1b bca.ces_wr_2016_11_10_c1b Chart of the Week (C)...As Are ##br##Diesel/Gasoil Exports bca.ces_wr_2016_11_10_c1c bca.ces_wr_2016_11_10_c1c Our expectation for crude production cuts by KSA and Russia, perhaps with sundry cuts from their allies in the market-share war, would accelerate the draws in crude and product inventories globally. Absent a cut, inventories will continue to draw slowly, based on an assessment of data provided by the Joint Oil Data Initiative (JODI), a transnational oil-data service (Chart 2). The current cycle of supply destruction is being prolonged by high global inventory levels. High inventories keep prices under pressure, which, as we have often noted, raise the odds of civil unrest in cash-strapped states. The odds of unplanned production outages and loss of exports thus remains elevated. A price spike in such a scenario cannot be ruled out. Chart 2Inventories Will Continue To Fall Slowly ##br##If KSA-Russia Don't Cut Crude Output bca.ces_wr_2016_11_10_c2 bca.ces_wr_2016_11_10_c2 Chart 3Asia/Middle East Diesel Output##br## Growth Will Continue bca.ces_wr_2016_11_10_c3 bca.ces_wr_2016_11_10_c3 Global Refining and Storage Markets Continue Transformation Longer term, we see an inexorable shift in refining eastward, as local refiners expand their capacity in China and India, and financially stronger crude and product exporters expand their refining and trading operations by investing in existing or new Asian refining capacity - e.g., KSA in China and South Korea, and Russia's Rosneft in India alongside a major trading company. This will keep high-valued-added exports growing in Asia (Chart 3 and Chart 4), and will take market share from traditional processing centers - e.g., northwest Europe, and Singapore's processing refineries (Chart 5). Chart 4Along With ##br##Gasoline Output bca.ces_wr_2016_11_10_c4 bca.ces_wr_2016_11_10_c4 Chart 5Asia/Middle East Refiners ##br##Displace Traditional Processors bca.ces_wr_2016_11_10_c5 bca.ces_wr_2016_11_10_c5 With or without a production cut by KSA and Russia, the incidence of crude-oil supply destruction will continue to fall on the poorer OPEC producers outside the Gulf Cooperation Council (GCC), which lack the wherewithal to invest in higher crude-oil output domestically, or in refining and trading capacity domestically or abroad. These cash-strapped states also will be unable to make direct investments in refining assets in end-use markets, depriving them of assured outlets for crude production enjoyed by exporters like KSA with substantial refining investments domestically and worldwide.1 This means that, unlike KSA, where refined-product sales and trading will constitute a greater share of revenues over the medium term (out to 10 years), these cash-strapped producers will continue to depend on crude oil sales alone. Chart 6U.S. Product Exports Hold Up Well bca.ces_wr_2016_11_10_c6 bca.ces_wr_2016_11_10_c6 Given its technological edge and nearby crude supplies - Canadian heavy shipped south via pipeline, conventional and light-tight oil (LTO) from shale fields, and increasing volumes of Mexican crude following the sale of deep-water acreage next month - we do not expect U.S. refiners to lose export-market share in the high-value-added light-product markets (diesel and gasoline/aviation fuels) (Chart 6). Indeed, on a 5-year seasonal basis, U.S. refined-product exports actually are increasing, as nearby refiners - e.g., Mexico - continue to find it difficult to maintain operations. Even as Asia and the Middle East refining and trading markets develop, we continue to expect a deepening of crude and product flows among North and South American producers and refiners.2 China Policy Put Could Spur Refining Output In our earlier research, we noted the implicit put provided to Chinese refiners, after the National Development and Reform Commission mandated products be sold at a minimum crude oil reference price of $40/bbl. This was done to encourage conservation and to support domestic refiners and producers.3 So, if crude oil prices go below $40/bbl for Chinese refiners, this regulation incentivizes them to refine as much as possible, then store or export output surplus to domestic needs. Unless the government steps in to tax away the refining windfall resulting from this put whenever the reference crude price falls below $40/bbl, this policy will, at the margin, pressure global refined-product prices, and keep refining margin growth potential limited as Chinese capacity increases. This pattern was seen in Chinese agricultural markets, where crop price supports resulted in a massive accumulation of corn in storage, as farmers bought cheap corn on the international market and sold it into the government storage market. The crop price supports are being unwound, but it does illustrate the Ironclad Law of Regulation - markets always find a way to game regulations to their advantage. Refining Margins Will Remain Under Pressure Chart 7Refining Margins Will Remain Under Pressure bca.ces_wr_2016_11_10_c7 bca.ces_wr_2016_11_10_c7 The rapid expansion of refining capacity in Asia and the Middle East - driven by increased domestic and foreign investment in refining and trading capacity - suggests to us refined-product markets could be in for an extended period of oversupply, which will limit refiner margins going forward. OPEC's market-share war, and the massive supplies produced by U.S. shale-oil producers made it abundantly clear that crude oil is a super-abundant resource, particularly with shale-oil production ready to come on line as soon as prices move above $50/bbl. The buildout in refining capacity by KSA and other OPEC members, along with plans to expand Asian and Middle East refining capacity and, critically, to supply that capacity with aggressively priced crude charging stock, will keep refining margins under pressure going into 2017 (Chart 7). The risk of super-saturating Asian markets in the near future with unsold refined products as crude supplies and production are ramped up in the near future, therefore, poses a risk for refiners generally, since, at the right prices, crude and product can be moved anywhere on the globe. This poses a particular risk for KSA as it readies the IPO of is state-owned oil company Aramco. KSA is simultaneously attempting to grow its own refining capacity worldwide - from a current level of ~ 6mm b/d to as much as 10mm b/d - and retain and secure long-term customers for its crude. In effect, as a refiner it will be competing with the very customers to which it provides crude oil. This doubly compounds the difficulty of IPOing Aramco, as well, since investors will want to be assured the refining side of the enterprise is not being disadvantaged by the crude-oil supply side of the enterprise. However, for KSA as a sovereign state, this expansion of revenues earned from a massive refining presence worldwide is clearly a boon. KSA could, at the end of the day, refine, export and trade product volumes that equal or surpass its current crude export volumes, as it continues to invest and build out its global refining presence. This will further distance it from its OPEC brethren and other crude oil producers worldwide, making it less a crude exporter and more a global vertically integrated portfolio manager. Bottom Line: We see an inexorable shift of refining eastward, with or without a production cut by KSA and Russia. Failure to agree and implement a production cut would prolong the crude oil market-share and provide a tailwind to Asian refiners in the short term. With or without a production cut, we see the expansion of oil refining in Asia and the Middle East continuing apace, as direct investment flows to refining and trading. The risk that Asian product markets will become super-saturated over the next 3 - 5 years remains elevated, as local refining capacity outgrows local demand and exports from Asian and Middle East refineries grow. Like their upstream counterparts, refiners can be expected to fight for market share, leading to a compression in margins. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com BASE METALS China Commodity Focus: Base Metals Aluminum: Buy On Weakness Tactically, we are bullish on LME aluminum prices and neutral on SHFE aluminum prices.4 Supply shortages will likely persist in the ex-China world over next three to six months. Strategically, we are neutral on LME aluminum prices and bearish on SHFE aluminum prices. Profitable Chinese smelters will continue boosting their aluminum production, which will eventually spill over into the global market. We recommend buying Mar/17 LME aluminum contract if it falls to $1,580/MT (current: $1,727/MT). We expect the contract price to rise to $1,900/MT over next three to five months. If the order gets filled, we suggest putting a stop-loss at $1,500/MT. Aluminum prices have gone up considerably this year (Chart 8, panel 1). Global aluminum producers cut their production sharply while global consumption only contracted slightly, reversing a deep supply-surplus market in 2015 to a significant supply-deficit market in 2016 (Chart 8, panel 2). Moreover, aluminum inventories in both LME and SHFE markets also have fallen to multi-year lows (Chart 8, panel 3). However, aluminum prices went nearly vertical in China with a 48% rally since late last November, while LME prices have been only up 21% during the same period of time (Chart 8, panel 1). Why have prices in China gone up much more than the global LME prices? Will the rallies in aluminum prices in both LME and SHFE markets continue? The answer is mainly in China. China: The Most Important Factor In The Global Aluminum Market As the world's largest aluminum producer and consumer, China accounts more than 50% of global aluminum production and consumption (Chart 9, panel 1). The country has also been the major contributor to the growth of both global supply and demand for at least the past 10 years (Chart 9, panels 2 and 3). Chart 8Aluminum: Still More ##br##Upside Ahead? bca.ces_wr_2016_11_10_c8 bca.ces_wr_2016_11_10_c8 Chart 9China: The Most Important Factor ##br##In Aluminum Market China: The Most Important Factor In Aluminum Market China: The Most Important Factor In Aluminum Market China And The Price Collapse In 2015 In November 2015, while LME aluminum prices plunged to their lowest levels since February 2009, aluminum prices in China (SHEF) collapsed to their lowest levels since at least 1994. There were four main factors driving for the price drop. Chinese aluminum output increased more than 3 million metric tons (Mn MT), which accounted 87% of global supply growth, and resulted in excessive global supply. At the same time, global aluminum demand growth experienced a sharp slowdown -- yoy growth was 6% in 2015, versus 16.1% in 2014. This was mainly led by China, where, last year, aluminum demand growth slowed from 27.5% in 2014 to 10.9% in 2015. Inventories at SHFE were boosted by about 68% in 2015, while inventories at LME remained elevated. With China producing much more than it consumed, the country started to encourage exports of semi-manufactured aluminum products last year to reduce the domestic supply surplus (Chart 9, panel 4). In April 2015, the country removed the export tariff on several major aluminum semi-manufactured products. In November 2015, the country implemented a policy of giving a 13-15% value-added tax rebate to exporters of semi-manufactured products. As a result, last year net Chinese unwrought aluminum exports increased 16.7% yoy, which have weighed on global LME aluminum prices. China And The Price Rally In 2016 Chart 10Positive Factors To Aluminum Prices Positive Factors To Aluminum Prices Positive Factors To Aluminum Prices Similarly, China was the major driving factor behind this year's rally as well. Global supply was cut massively for the last two months of 2015 and the first eight months of 2016, as extremely low aluminum prices resulted in huge losses for most global aluminum producers. According to the World Bureau of Metal Statistics (WBMS), for the first eight months of this year, China accounted for 55% of the global aluminum supply cuts, as the country suspended its high-cost producing capacity and started industry-wide coordinated production cutbacks in last December (Chart 10, panel 1). Extremely low inventory levels also spurred the price rally. Inventories at SHFE warehouses fell 76.5% from mid-March to late-September (Chart 10, panel 2). In addition, the social inventory at major cities (Wuxi, Shanghai, Hangzhou, Gongyi and Foshan) also fell to record lows. Surging coal prices and rising alumina prices have also pushed up domestic aluminum production costs (Chart 10, panel 3). In addition, China implemented its newly promulgated Road Traffic Management Regulations regarding overloaded and oversized trucks, and unsafe vehicles on September 21. It was common before these regulations were implemented for drivers to overload shipments of commodities in order to increase profits. This raised road transportation costs for commodities like steel, coal, aluminum, aluminum products and other metals. It also created a bottleneck for timely transporting of coal to aluminum smelters, which own self-generated power plants, and transporting primary aluminum from major producing provinces Xinjiang, Inner Mongolia and Ningxia to some inner-land provinces like Henan for further manufacturing. As China cut its aluminum production this year, the country's exports of semi-manufactured aluminum products also fell 1.9% yoy for the first nine months of this year. As for Chinese aluminum demand, the data are confusing: The WBMS data showed a contraction for the first eight months of 2016, but the domestic industry association reported a decent increase in Chinese aluminum demand so far this year. Based on domestic auto output and construction activity data, we are inclined to believe Chinese aluminum demand rose moderately on the back of this year's fiscal stimulus. Other Factors For The Price Rally In 2016 There are two factors besides China for this year's aluminum rally. U.S. aluminum output fell nearly 50% yoy this year as Alcoa and Century Aluminum massively cut capacity late last year in response to lower prices (Chart 10, panel 4). For the ex-China world, while its supply fell 1.2%, consumption actually grew 0.4% for the first eight months of this year. This increased the supply deficit for the world excluding China, which is positive for LME aluminum prices (Chart 10, panel 5). So, What's Next? Tactically, we are bullish on LME aluminum prices and neutral on SHFE aluminum prices. Chart 11Aluminum: Buy On Weakness bca.ces_wr_2016_11_10_c11 bca.ces_wr_2016_11_10_c11 Most of the aforementioned positive factors are still in place. Even though China has enough capacity to oversupply both its domestic market and global markets again, the key factor will be how fast China boosts its aluminum output. With new added capacity and idled capacity returned to service, China's operating capacity for aluminum has been rising every month so far this year. According to the data provided by Sublime China Information Group, as of the end of October, China's aluminum operating capacity was 35.1 MMt/y (million metric tons per year), a rise of 0.575 MMt/y from the previous month, and an increase of 2.034 mtpy from the end of 2015. Based on our calculations, so far, total aluminum output from January to September is still much lower than the same period last year. In addition, considering the possible output loss due to the Spring Festival in late January, we believe it will take another three to six months for China to meet its own domestic demand and inventory restocking. Therefore, as domestic supply becomes more ample, China's domestic prices - including SHFE aluminum prices - should have limited upside. At the same time, the downside also should be limited by low inventory and rebounding demand. We expect more upside for LME aluminum prices as the supply shortage will likely persist in the ex-China world over next three to six months. Currently, Chinese aluminum prices are about 20% higher than the LME prices (both are in USD terms), which will likely limit the supply coming from China's exports to the rest of the world. Strategically, we are neutral on LME aluminum prices and bearish on SHFE aluminum prices. Currently, about 85% of the China's aluminum operating capacity is profitable. With new low-cost capacity and more idled capacity coming back line, profitable Chinese smelters will continue boosting their aluminum production to maximize profits. This, over a longer term such as nine months to one year, should eventually spill over into the global market. Risks China has imposed stricter environmental regulations on the domestic metal smelting and refining process since 2014 to control domestic pollution. The government currently is sending environmental inspection teams to major aluminum producing provinces to check how well the smelters and refiners comply with state environment rules. Some unqualified factories may be ordered to close. If this occurs, domestic SHFE aluminum prices may go up further in the near term. On the other side, if unprofitable aluminum producers in China also increase their output quickly, in order to creating jobs and revenue for local governments, prices at both SHFE and LME may face a big drop. We will monitor these risks closely. Investment Strategy We probably will see increasing Chinese aluminum production in 2016Q4, which may induce price corrections in both LME and SHFE prices. We prefer to buy LME aluminum on weakness. We recommend buying the Mar/17 LME aluminum contract if it falls to $1,580/MT (current: $1,727/MT) (Chart 11). We expect the contract price to rise to $1,900/MT over next three to five months. If the order gets filled, we suggest putting a stop-loss level at $1,500/MT. Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report for an extended discussion of increasing Asian and Middle Eastern refining capacity "KSA, China, India Ramping Oil Product Exports," dated July 28, 2016, available at ces.bcaresearch.com. 2 We will be exploring inter-American crude and product flows - and the potential for expanding this trade - in future research. 3 Please see Commodity & Energy Strategy Weekly Report p. 6 of the earlier-referenced "KSA, China, India Ramping Oil Product Exports," dated July 28, 2016, available at ces.bcaresearch.com. 4 LME denotes London Metals Exchange and SHFE denotes Shanghai Futures Exchange. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Closed Trades