Energy

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

Dear Client, This week, we are sending you a piece written by my colleague Robert Ryan, Senior Vice-President for our Commodity & Energy sister service. This piece analyses dynamics in the oil markets and concludes that even if the U.S. dollar is indeed experiencing a cyclical bull market, oil prices could buck this trend. This gives us comfort on our more positive stance on the petro currencies within the commodity currency complex. Also, this week the Fed increased rates as was expected by the market. However, the tone of this hike was perceived as dovish, especially by the dollar: Four participants forecasted four hikes in 2017; one Fed president voted to keep rates unchanged, and the natural rate of unemployment estimate was downgraded to 4.7%, suggesting that the Fed perceives that the labor market is not as tight as it thought in December. Do these dynamics signal the end of the U.S. dollar cyclical bull market? No. The U.S. economy remains fundamentally strong. Various new orders surveys continue to hit record highs and capex should recover further. As a corollary, so will employment. Most crucially, the U-6 unemployment rate is now at 9.2%, a level at which wage growth significantly accelerated in 1997 and 2005. Thus, even if the U.S. economy tracks the now much-poorer Q1 GDP growth forecast of the Atlanta Fed, this soft patch will ultimately prove temporary. However, the U.S. dollar may continue to experience some short-term weakness against European currencies and the yen while forming a bottom against EM and commodity currencies. As we have argued in recent weeks, the global economy is very strong right now and it may prove difficult to sustain such a pace of growth in the industrial sector. As such, plays highly levered to the global industrial sector may experience a correction, a process that will boost the USD against EM and commodity currencies, but that will support the euro and the yen. Mathieu Savary, Vice President Mathieu@bcaresearch.com Highlights Global fundamentals - supply, demand and inventories - will support oil prices generally, and will remain bullish for the evolution toward backwardated forward curves, even as the Fed's interest-rate normalization policy supports the USD's broad trade-weighted index (TWI). This will cause the oil-USD divergence noted in earlier research to persist.1 Energy: Overweight. We are once again long Dec/17 WTI vs. short Dec/18 WTI, after the resting order placed on March 9/17 was elected on March 13/17 at -$0.12/bbl. Our oil-balances modeling indicates storage will draw throughout the rest of this year and next. Base Metals: Neutral. Spot copper prices remain subdued despite strikes at Peru's Cerro Verde and Chile's Escondida mines. Meanwhile, export-license talks continue in Indonesia at the Grasberg mine. When a market fails to rally on supportive news, it normally is a bearish indicator. An unexpected surge in LME copper stocks partly offset supply-side concerns. Precious Metals: Neutral. Gold will remain weak, as markets discount the timing and size of further rate hikes. We remain long volatility, with our long-put/long-call spread combination in June, recommended on February 23/17, up 29.5%. Ags/Softs: Underweight. Indications of higher output of corn and beans in South America from the USDA, and a well-supported USD keep us bearish. Lower planting intentions - to be reported at month-end - could support corn. Feature Markets got a rare "two-fer" yesterday. The first, a long-anticipated bullish oil inventory report from the U.S. Energy Information Administration (EIA). The second, a fully priced follow-through on the Fed's recent forward guidance in the form of a 25bp hike in overnight rates, which, while important to oil markets, will continue to be secondary to the fundamental adjustments that will be reflected in subsequent EIA reports. Not unexpectedly, U.S. commercial oil inventories drew hard last week - more than 8mm bbl (including SPR), with crude stocks accounting for 1.1 mm bbl - following weeks of builds, which forced many a long from the market. The balance of the draws will shift to crude within the next month, as U.S. refiners come back off performing routine maintenance. With the year-end surge from OPEC's Gulf producers now fully absorbed, we expect to see a sustained draw in OECD storage this year. This will force inventories toward the five-year average levels sought by OPEC and non-OPEC producers in their production-cutting agreement last year (Chart of the Week). Chart of the WeekOil Markets Will Tighten This Year And Next Oil Markets Will Tighten This Year And Next Oil Markets Will Tighten This Year And Next Chart 2OECD Inventories Will Draw Sharply OECD Inventories Will Draw Sharply OECD Inventories Will Draw Sharply In our balances model, we have global supply up 0.5 mm b/d in 2017 yoy and demand up 1.5 mm b/d on average. For 2018, we have supply up 1.5 mm b/d on average vs. 2017, and demand up 1.6 mm b/d. This will produce the draws in OECD inventories anticipated by the Kingdom of Saudi Arabia (KSA) and Russia when they led the negotiations between OPEC and non-OPEC oil-producing states that will produce these supply deficits (Chart 2). The Fed - And The USD - Still Matter, But Not As Much The 25bp hike in overnight rates was perhaps the most strongly telegraphed messaging from FOMC members in post-GFC history. If nothing else, the Fed is unambiguously signaling its intent to normalize interest-rate policy, which, all else equal, will be supportive of the USD's TWI. We do not believe the Fed is intent on raising real rates, which will somewhat temper the rates normalization policy of the Fed. This will allow the synchronized global growth we now see - along with a synchronized increase in global inflation rates - to continue, and will prevent an overly strong USD from crimping demand ex-U.S. - particularly in the EM markets. Indeed, we continue to expect strong growth in EM oil demand, which we proxy by non-OECD oil consumption (Chart 3). Chart 3EM Growth Will Drive Oil Demand EM Growth Will Drive Oil Demand EM Growth Will Drive Oil Demand Chart 4USD Will Not Dominate Oil-Price Evolution USD Will Not Dominate Oil-Price Evolution USD Will Not Dominate Oil-Price Evolution Therefore, while the evolution of the USD will remain important to the evolution of oil prices, we do not expect it to dominate that evolution as it has post-GFC to the end of 1Q16. As can be seen in Chart 4, which shows Brent prices as a function of the USD TWI, this relationship has weakened some, after fundamentals - chiefly supply destruction and demand growth - reacted to the lower prices brought on by the market-share war declared by OPEC in November 2014. However, we do not expect this relationship to break down entirely: Indeed, it has been remarkably durable since 2000, when oil prices - like the USD - became random-walking economic variables (Chart 5).2 We do think the market is in a transition phase - chiefly from being over-supplied to tighter, given the physical deficits we expect - with price levels capable of following a more stable path with less volatility. This will translate into even greater volatility in the forward curves for oil prices, which we believe will become more backwardated as markets finally get evidence storage is drawing (Chart 6). We continue to expect WTI prices to trade between $45 and $65/bbl, with a central tendency of $55/bbl this year and next. Chart 5Expect The USD To Be Less##br## Determinant For Oil Prices Expect The USD To Be Less Determinant For Oil Prices Expect The USD To Be Less Determinant For Oil Prices Chart 6We Continue to Expect Backwardation##br## in Oil Forwards We Continue To Expect Backwardation In Oil Forwards We Continue To Expect Backwardation In Oil Forwards Back In The Backwardation Trade We are once again long Dec/17 WTI vs. short Dec/18 WTI, after the resting order placed on March 9/17 was elected on March 13/17 at -$0.12/bbl. We are including a stop-loss on this recommendation of -$0.36/bbl (i.e., the Dec/17 vs. Dec/18 spread goes into a -$0.48/bbl contango), given this is a strategic recommendation and we are willing to incur larger losses given our high-conviction view of the evolution of the WTI forward curve. As the above analysis indicates, we strongly expect storage to draw throughout the rest of this year and next. This will produce backwardated markets - prompt-delivery prices exceed deferred-delivery prices - and tighten markets globally. We recently exited the exact same trade on February 23/17, when we entered it at -$0.11/bbl (in contango), and exited at +$0.96/bbl, for a gain of +$1.07/bbl (972.7%). This is evidence of the volatility we continue to expect as the forward curve transitions to a backwardated structure. Bottom Line: The oil market is performing as we expect, with supply cuts in the face of strong demand growth producing a physical deficit. This will lead to a backwardation in the forward curves for WTI and Brent, which we are capitalizing on by re-establishing our long Dec/17 WTI vs. short Dec/18 WTI position. While the USD will continue to exert an influence on oil prices, we continue to believe this will be secondary to the evolution of prices. Fundamentals will drive price discovery going forward. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Days Of Oil Future's Past: Mean-Reversion," dated March 2, 2017, and "Fed's Pre-Emptive Hike Will Hit Gold, Not Oil," dated March 9, 2017, available at ces.bcaresearch.com. 2 Please see "Days Of Oil Future's Past: Mean-Reversion," published March 2, 2017, referenced above. In that article we examine the evolution of oil prices from a mean-reverting series to a difference-stationary series. We considered the possibility the KSA - Russia production agreement could deepen, allowing these states to exert more control over the evolution of prices. This is not foregone, by any means, but it is useful to consider the implications of supply contracting as a result of their detente, and the return of a more inelastic supply curve. In such a market, small adjustments to the supply side can have profound effects on prices - assuming demand remains inelastic - and allow these states to regain a measure of control over oil market fundamentals. Currencies U.S. Dollar Chart II-1 USD Technicals 1 USD Technicals 1 Chart II-2 USD Technicals 2 USD Technicals 2 The greenback had an interesting reaction to the Fed rate hike. The FOMC's statement and forecasts disappointed markets and the DXY pared back most of its February gains, depreciating more than 1% following the hike. The Summary of Economic Projections confirmed two more hikes this year, for which the dates are uncertain, decreasing the perceived risk of four hikes in 2017. Moreover, the downgrade of the estimate for the structural unemployment rate suggests the Fed sees more labor market pressures than in December. Furthermore, FOMC board member, Neel Kashkari, voted against the hike, preferring instead to maintain the target rate at 0.5%-0.75%. February CPI numbers slowed slightly with core CPI falling to 2.2% from 2.3%, however, this was expected by the market. Additionally, headline CPI picked up to 2.7% from 2.5%, also as expected. The timing of the next up-leg in the dollar may now rest on the next clarifications of Trump's recent budget proposals. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 The Euro Chart II-3 EUR Technicals 1 EUR Technicals 1 Chart II-4 EUR Technicals 2 EUR Technicals 2 The euro minimally reacted to the Dutch elections, as its appreciation reflected the weak dollar. Regardless, the outcome for the elections was mainly market-positive as Euroskeptic Geert Wilders was defeated by Europhile party VVD. Also, Comments by ECB board member Nowotny gave the euro a further filip. Economic data, however, was not too strong: German CPI and HICP remained steady at 2.2%; ZEW Survey measures for the German Current Situation and the Economic Sentiment both underperformed expectations; Euro area industrial production declined annually; Euro area headline inflation held at 2%, and core also remained at 0.9%. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 The French Revolution - February 3, 2017 The Yen Chart II-5 JPY Technicals 1 JPY Technicals 1 Chart II-6 JPY Technicals 2 JPY Technicals 2 In its monetary policy statement yesterday the BoJ reiterated its commitment to maintain its policy rate at -0.1% and to keep its yield curve control program, which leaves the rate of 10-year JGBs around 0%. Furthermore, the BoJ also recognized one theme that we have highlighted before: Japanese economic activity is improving and inflation, although still very weak, is improving. Evidence can be found in recent data: Industrial production yearly growth increased by 3.7% in January relative to a 3.2% growth in December Labor cash earnings grew by 0.5% from a year ago, outperforming expectations. Given that rates are anchored and inflation continues to improve, real rates Japanese rates should fall vis-à-vis the rest of the world, putting downward pressure on the yen on a cyclical basis. Report Links: Et Tu, Janet? - March 3, 2017 JPY: Climbing To The Springboard Before The Dive - February 24, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 British Pound Chart II-7 GBP Technicals 1 GBP Technicals 1 Chart II-8 GBP Technicals 2 GBP Technicals 2 The pound rallied following the monetary policy statement of the BoE justifying why policy rate was left unchanged. In fact, the hawkish tone was enhanced by the dissent of one member who favored hiking. Furthermore the BoE also stated that "if aggregate demand stays resilient, monetary policy may need to be tightened sooner and to a greater degree". How likely is it that aggregate demand will stay resilient (and consequently that the pound gains)? Recent data paints a mixed picture in the short term: Industrial production growth and manufacturing production growth came in at 3.2% and 2.7%, underperforming expectations. However unemployment decreased to 4.7% and the goods trade balance continued to improve, beating expectations. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Australian Dollar Chart II-9 AUD Technicals 1 AUD Technicals 1 Chart II-10 AUD Technicals 2 AUD Technicals 2 AUD/USD gained more than 1.5% this week on the back of a weak greenback and strong Chinese data. Industrial production in China increased by 6.3% in January, more than expected. We think this strength is temporary and will pass shortly: Inflation expectations released by the Melbourne Institute decreased to 4%; Unemployment rate increased by 0.2% to 5.9%, underperforming expectations; Employment decreased by 6,400. Part-time employment decreased by 33,500, while full-time employment increased by 27,100. Although this is an overall net decrease in employment, this may imply a tightening labor market as the full-time market strengthens relative to the part-time one. However, it is still too soon to tell. Monitoring labor market developments is important as they provide an important outlook for wage, and thus inflation, developments. Report Links: AUD And CAD: Risky Business - March 10, 2017 Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 New Zealand Dollar Chart II-11 NZD Technicals 1 NZD Technicals 1 Chart II-12 NZD Technicals 2 NZD Technicals 2 The NZD has been the worst performer amongst the commodity currencies so far in 2017. This has been in part due to disappointing economic data such as the recent GDP numbers which came below expectations at 2.7% yearly growth. However the central bank has also been responsible for the poor performance of the NZD as it has been much less hawkish than anticipated. The RBNZ blamed low tradable-goods inflation and a worsening current account caused by a strong NZD as the main reasons behind its neutral bias. However the central bank may be falling behind the curve. Food inflation now stands at 2.2%, while the current account continues to close faster than expectations. This means that inflation might reach its target much before the RBNZ late 2018 projection, which could lift kiwi rates and the NZD as markets begin doubting the RBNZ's resolve. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Canadian Dollar Chart II-13 CAD Technicals 1 CAD Technicals 1 Chart II-14 CAD Technicals 2 CAD Technicals 2 After a period of weakness due to a dovish rhetoric by the BoC and the recent surprise surge in oil inventories, CAD has rebounded against the greenback on the back of the USD's broad weakness. Within Canada, upbeat data has also contributed to this strength as the labor market has shown some improvements recently: The net change in employment was recorded at 15,300, beating expectations of 2,500; Unemployment came in at 6.6%. These developments took place despite a mild decrease in participation rate, suggesting the decrease in the unemployment rate was mostly driven by a stronger employment sector. The improvement in employment has manifested across the board, with employment among prime-age women increasing by 1.7% and among men aged 55 and above also increasing. Importantly, part-time employment actually fell by 90,000 while full-time employment rose by 105,000, potentially indicating a tightening in the labor market. Report Links: AUD And CAD: Risky Business - March 10, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 Swiss Franc Chart II-15 CHF Technicals 1 CHF Technicals 1 Chart II-16 CHF Technicals 2 CHF Technicals 2 Yesterday, the SNB left its policy rate unchanged at -0.75%. Furthermore, as we expected, it stood by its commitment to intervene in the franc as the central bank still consider that the franc is "significantly overvalued". At the moment, EUR/CHF has risen from the implied floor of 1.065 set by the SNB, thanks to the overwhelming victory by the Europhile green party in the Dutch elections. This will take some pressure off the SNB, which last week was accumulating reserves at the fastest pace since December 2014. On the inflation front, the SNB upgraded its short term forecast and downgraded their long term forecast. We will continue to monitor how inflation develops in comparison to the SNB's forecast, as here lies the key to judging whether a break from the peg is possible or not. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Norwegian Krone Chart II-17 NOK Technicals 1 NOK Technicals 1 Chart II-18 NOK Technicals 2 NOK Technicals 2 After skyrocketing following the surprising increase in oil inventories last week, USD/NOK has come down to earth, thanks to this week's draw in oil stocks. Additionally, the fall in the U.S. dollar following the "dovish Fed hike" has also put downward pressure on USD/NOK. Overall, oil prices should provide a tailwind, for the NOK, particularly against other commodity currencies, as oil is set to outperform base metals given that supply cuts by OPEC will ultimately results in draws in inventory. The domestic situation paints a more bearish picture. Core inflation plummeted from 2.1% to 1.6% from last month. Moreover, Norway continues to have an output gap of -2.5% and a negative credit impulse. All of these factors should support the Norges Bank dovish bias in an environment of rising U.S. rates, lifting USD/NOK in the process. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swedish Krona Chart II-19 SEK Technicals 1 SEK Technicals 1 Chart II-20 SEK Technicals 2 SEK Technicals 2 The Krona strengthened across the board as inflation numbers came in stronger than previously: monthly CPI came in at 0.7%, up from -0.7%; and yearly CPI was recorded at 1.8%, close to the Riksbank's 2% target. With capacity utilization above its historical average and the Riksbank's Resource Utilization indicator being at pre-crisis levels, this indicates that the economy could soon hit its inflation target. The labor market's tightness is apparent due to the low supply of workers relative to demand. Mismatch in terms of the supply and demand of labor are likely to put upward pressure on a substantial share of wage earners as firms find it difficult to fulfill vacancies. While both short-term and long-term dynamics paint an inflationary picture, the Riksbank is likely to lean to the dovish side for the remainder of the year: The Swedish central bank wants to prevent any build-up of a deflationary mindset and wants to mitigate any external risks to the economy. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Global fundamentals - supply, demand and inventories - will support oil prices generally, and will remain bullish for the evolution toward backwardated forward curves, even as the Fed's interest-rate normalization policy supports the USD's broad trade-weighted index (TWI). This will cause the oil-USD divergence noted in earlier research to persist.1 Energy: Overweight. We are once again long Dec/17 WTI vs. short Dec/18 WTI, after the resting order placed on March 9/17 was elected on March 13/17 at -$0.12/bbl. Our oil-balances modeling indicates storage will draw throughout the rest of this year and next. Base Metals: Neutral. Spot copper prices remain subdued despite strikes at Peru's Cerro Verde and Chile's Escondida mines. Meanwhile, export-license talks continue in Indonesia at the Grasberg mine. When a market fails to rally on supportive news, it normally is a bearish indicator. An unexpected surge in LME copper stocks partly offset supply-side concerns. Precious Metals: Neutral. Gold will remain weak, as markets discount the timing and size of further rate hikes. We remain long volatility, with our long-put/long-call spread combination in June, recommended on February 23/17, up 29.5%. Ags/Softs: Underweight. Indications of higher output of corn and beans in South America from the USDA, and a well-supported USD keep us bearish. Lower planting intentions - to be reported at month-end - could support corn. Feature Markets got a rare "two-fer" yesterday. The first, a long-anticipated bullish oil inventory report from the U.S. Energy Information Administration (EIA). The second, a fully priced follow-through on the Fed's recent forward guidance in the form of a 25bp hike in overnight rates, which, while important to oil markets, will continue to be secondary to the fundamental adjustments that will be reflected in subsequent EIA reports. Not unexpectedly, U.S. commercial oil inventories drew hard last week - more than 8mm bbl (including SPR), with crude stocks accounting for 1.1 mm bbl - following weeks of builds, which forced many a long from the market. The balance of the draws will shift to crude within the next month, as U.S. refiners come back off performing routine maintenance. With the year-end surge from OPEC's Gulf producers now fully absorbed, we expect to see a sustained draw in OECD storage this year. This will force inventories toward the five-year average levels sought by OPEC and non-OPEC producers in their production-cutting agreement last year (Chart of the Week). In our balances model, we have global supply up 0.5 mm b/d in 2017 yoy and demand up 1.5 mm b/d on average. For 2018, we have supply up 1.5 mm b/d on average vs. 2017, and demand up 1.6 mm b/d. This will produce the draws in OECD inventories anticipated by the Kingdom of Saudi Arabia (KSA) and Russia when they led the negotiations between OPEC and non-OPEC oil-producing states that will produce these supply deficits (Chart 2). Chart of the WeekOil Markets Will Tighten This Year And Next Oil Markets Will Tighten This Year And Next Oil Markets Will Tighten This Year And Next Chart 2OECD Inventories Will Draw Sharply OECD Inventories Will Draw Sharply OECD Inventories Will Draw Sharply The Fed - And The USD - Still Matter, But Not As Much The 25bp hike in overnight rates was perhaps the most strongly telegraphed messaging from FOMC members in post-GFC history. If nothing else, the Fed is unambiguously signaling its intent to normalize interest-rate policy, which, all else equal, will be supportive of the USD's TWI. We do not believe the Fed is intent on raising real rates, which will somewhat temper the rates normalization policy of the Fed. This will allow the synchronized global growth we now see - along with a synchronized increase in global inflation rates - to continue, and will prevent an overly strong USD from crimping demand ex-U.S. - particularly in the EM markets. Indeed, we continue to expect strong growth in EM oil demand, which we proxy by non-OECD oil consumption (Chart 3). Therefore, while the evolution of the USD will remain important to the evolution of oil prices, we do not expect it to dominate that evolution as it has post-GFC to the end of 1Q16. As can be seen in Chart 4, which shows Brent prices as a function of the USD TWI, this relationship has weakened some, after fundamentals - chiefly supply destruction and demand growth - reacted to the lower prices brought on by the market-share war declared by OPEC in November 2014. Chart 3EM Growth Will Drive Oil Demand EM Growth Will Drive Oil Demand EM Growth Will Drive Oil Demand Chart 4USD Will Not Dominate Oil-Price Evolution USD Will Not Dominate Oil-Price Evolution USD Will Not Dominate Oil-Price Evolution However, we do not expect this relationship to break down entirely: Indeed, it has been remarkably durable since 2000, when oil prices - like the USD - became random-walking economic variables (Chart 5).2 We do think the market is in a transition phase - chiefly from being over-supplied to tighter, given the physical deficits we expect - with price levels capable of following a more stable path with less volatility. This will translate into even greater volatility in the forward curves for oil prices, which we believe will become more backwardated as markets finally get evidence storage is drawing (Charts 6). We continue to expect WTI prices to trade between $45 and $65/bbl, with a central tendency of $55/bbl this year and next. Chart 5Expect The USD To Be Less Determinant ##br##For Oil Prices Expect The USD To Be Less Determinant For Oil Prices Expect The USD To Be Less Determinant For Oil Prices Chart 6We Continue To Expect Backwardation ##br##In Oil Forwards We Continue To Expect Backwardation In Oil Forwards We Continue To Expect Backwardation In Oil Forwards Back In The Backwardation Trade We are once again long Dec/17 WTI vs. short Dec/18 WTI, after the resting order placed on March 9/17 was elected on March 13/17 at -$0.12/bbl. We are including a stop-loss on this recommendation of -$0.36/bbl (i.e., the Dec/17 vs. Dec/18 spread goes into a -$0.48/bbl contango), given this is a strategic recommendation and we are willing to incur larger losses given our high-conviction view of the evolution of the WTI forward curve. As the above analysis indicates, we strongly expect storage to draw throughout the rest of this year and next. This will produce backwardated markets - prompt-delivery prices exceed deferred-delivery prices - and tighten markets globally. We recently exited the exact same trade on February 23/17, when we entered it at -$0.11/bbl (in contango), and exited at +$0.96/bbl, for a gain of +$1.07/bbl (972.7%). This is evidence of the volatility we continue to expect as the forward curve transitions to a backwardated structure. Bottom Line: The oil market is performing as we expect, with supply cuts in the face of strong demand growth producing a physical deficit. This will lead to a backwardation in the forward curves for WTI and Brent, which we are capitalizing on by re-establishing our long Dec/17 WTI vs. short Dec/18 WTI position. While the USD will continue to exert an influence on oil prices, we continue to believe this will be secondary to the evolution of prices. Fundamentals will drive price discovery going forward. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Days Of Oil Future's Past: Mean-Reversion," dated March 2, 2017, and "Fed's Pre-Emptive Hike Will Hit Gold, Not Oil," dated March 9, 2017, available at ces.bcaresearch.com. 2 Please see "Days Of Oil Future's Past: Mean-Reversion," published March 2, 2017, referenced above. In that article we examine the evolution of oil prices from a mean-reverting series to a difference-stationary series. We considered the possibility the KSA - Russia production agreement could deepen, allowing these states to exert more control over the evolution of prices. This is not foregone, by any means, but it is useful to consider the implications of supply contracting as a result of their detente, and the return of a more inelastic supply curve. In such a market, small adjustments to the supply side can have profound effects on prices - assuming demand remains inelastic - and allow these states to regain a measure of control over oil market fundamentals. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016

Feature Dear Client, Instead of our usual weekly report, we are sending you a report written by my colleague Matt Gertken, Associate Editor of BCA's Geopolitical Strategy service. In this piece, Matt argues that there is more than a 50% chance that the Border Adjustment Tax (BAT) will pass and Donald Trump's support will be the decisive factor. There are also high chances that trade retaliation would unfold likely detracting from the trade benefits of the proposed tax. In addition, given the likelihood of the BAT implementation, we are highlighting U.S. equity sector investment implications and ranking industries on three variables: taxes, margins and foreign sales exposure. We trust that you will find this Special Report useful and insightful. Best Regards, Anastasios Avgeriou There are good chances that the border adjustment tax (BAT) will pass as the House GOP has a governing trifecta. Trump has not yet endorsed the BAT, which will be critical, and carve-outs will likely be made to reduce the impact on low- and middle-income households. Still, we can draw some sectoral implications from the known GOP proposal. While a lot of ink has been spilled on potential direct winners and losers from the BAT and what is priced in by the markets, we focus our sector analysis on the sweet spot of tax rates, profit margins and international sales exposure. Chart 1 shows a Venn diagram of these three factors, with the overlap representing the optimally positioned sector. We deem that industries with a combination of high tax rates, high profit margins and low or no foreign sales exposure will be prime beneficiaries of the BAT. Chart 1Sweet Spot Sector Ranking By BAT-ting Average Sector Ranking By BAT-ting Average At first glance this backdrop may appear counterintuitive, especially the international revenue exposure angle, given the preferential treatment that exporters would receive with the BAT implementation. Almost immediately upon Trump's election and news of BAT the market bought companies/industries with negative net import share and discarded sectors with high net import content (Chart 2A & Chart 2B). Chart 2AInvestors Have Been... Sector Ranking By BAT-ting Average Sector Ranking By BAT-ting Average Chart 2B... Preferring Exporters To Importers ... Preferring Exporters To Importers ... Preferring Exporters To Importers Watch The U.S. Dollar And Emerging Markets Nevertheless, what is worrisome is the market's neglect of a U.S. dollar knee jerk appreciation as our sister Global Investment Strategy service outlined in the January 20th Special Report titled: "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017." Chart 3U.S. Dollar And EM Risks U.S. Dollar And EM Risks U.S. Dollar And EM Risks It is difficult to fathom why a greenback surge will not be disruptive especially for the emerging markets (EM) and U.S. cyclical sector proxies trading in tandem with EM. According to the Bank for International Settlements, U.S. "Dollar credit to non-banks outside the United States reached $9.8 trillion at end-Q2 2015. Borrowers resident in EM accounted for $3.3 trillion of this amount, or over a third."1 The EM still have a large stock of U.S. dollar denominated debt to service, both interest payment and principal repayments/refinancing (Chart 3). While the FX straight jacket is not in place as in the 1990s, at least a mini EM crisis seems inevitable if the trade-weighted U.S. dollar moved up 10% from current levels as is likely owing to a BAT. Keep in mind that recent U.S. dollar moves of a similar magnitude (as in 2015), (Chart 3) have been rather unsettling, causing tremors in the EM that reverberated across the globe. Tack on uncertainty surrounding the Chinese renminbi that would only aggravate the U.S. dollar's rise and factors are falling into place for another troublesome EM episode. As a result, global final demand may come under pressure and U.S. exporters may initially suffer more than they benefit from the export subsidy they would enjoy. Another U.S. dollar induced global manufacturing recession would bode ill for U.S. cyclicals exposed to the EM. A Few Words On Manufacturing While the intent of bringing back manufacturing jobs to U.S. shores is appealing, practically it will prove very difficult. Developed economies are services oriented economies with manufacturing dwindling toward 10-15% of GDP (Chart 4). Moreover, the U.S. is a closed economy dominated by PCE comprising 70% of the overall economy. Thus, shifting the U.S. more toward a net export driven economy is also likely to prove challenging. Chart 4Tough To Shift The U.S. Economy's Profile Tough To Shift The U.S. Economy's Profile Tough To Shift The U.S. Economy's Profile Chart 5Will Capex Revive? Will Capex Revive? Will Capex Revive? Finally, manufacturing is tightly linked to capital expenditures and a recent post by the Atlanta Fed2 tried to shed some light as to why investment in the U.S. has lagged especially versus previous recoveries when the economy was near full employment (Chart 5 & Table 1). Interestingly, the biggest hindrance against boosting capex has been lack of skilled labor, and not the lack of financing or poor sales outlook or low return on investment for example. In fact the larger the firm (in terms of sales) the more pronounced the inaccessibility to qualified staff as a factor constraining investment. While tax reform aims to boost capex by accelerated depreciation schedule in the first year, it does not address the small business complaint of inability to find skilled labor. Table 1Impact Of "High Pressure" Labor Conditions On Capital Spending Sector Ranking By BAT-ting Average Sector Ranking By BAT-ting Average BAT Winners Therefore, we would want to bulletproof the portfolio by identifying industries that would do well owing to the BAT and resulting U.S. dollar appreciation. U.S. domestic services oriented firms fit the bill, and there is room for sizable outperformance if our thesis proves accurate. Chart 6 highlights 47 sub-industries from 9 GICS1 sectors (energy & materials are excluded) that we singled out that satisfy the domestic and services oriented prerequisite (See Appendix on page 8 for more details). U.S. manufacturers with little or no foreign sales exposure would also stand to get an earnings boost, especially relative to the broad market and to their internationally geared peers. Homebuilders, select construction materials and building products companies would be included in this category. Energy is a special case (please refer to Box 1 on page 6). Meanwhile, high profit margin businesses with sticky pricing power and high effective tax rates also come out on top of our analysis as these outfits would benefit more from overall tax reform. Table 2 shows the top 11 sectors in the S&P 500 on the three metrics. Chart 6Buy Domestic Services Buy Domestic Services Buy Domestic Services Table 2 Sector Ranking By BAT-ting Average Sector Ranking By BAT-ting Average Health care, utilities, and telecom services score well on all three counts. Real estate and financials also get high marks. In contrast, technology, materials, energy and industrials get poor grades on most of our metrics, with the balance of sectors falling somewhere in between. Box 1 Energy Is A Special Case Chart 7U.S. Remains A Net Importer Of Oil U.S. Remains A Net Importer Of Oil U.S. Remains A Net Importer Of Oil The energy sector is a special case. The U.S. still imports north of 7 MMb/d of oil and represents about 10% of the trade deficit (Chart 7). Were energy to be included in the BAT legislation, WTI crude oil prices would likely shoot higher by ~$10/b as U.S. oil consumers (refiners) would seek to avoid the $10+ BAT on imported light sweet crude by buying domestic oil, and U.S. oil producers would try to benefit from the export subsidy. U.S. exploration & production companies and energy servicers would be clear winners, while refiners would be losers. Nevertheless, the dollar jump would be an offsetting factor. Given the outsized impact on the consumer (gasoline price inflation sapping discretionary spending power) and the close political and energy-security relationship with Canada (60% of net U.S. petroleum imports), there is a high likelihood that energy would be exempt from the BAT. In fact, small and medium businesses (SME) would disproportionately benefit from lower corporate taxes especially compared with S&P 500 constituents that are privileged with a lower effective tax rate. Large capitalization multinationals with sizable foreign sourced sales/profits already use the "double Irish" or "Dutch sandwich" to bring down their tax bills. Keep in mind that SMEs also tend to have low or no foreign sales exposure insulating them from the looming U.S. dollar appreciation. Thus, small caps have a considerable advantage versus their large cap brethren upon implementation of the BAT and general tax reform, and we continue to recommend a small cap tilt in our size bias. For reference purposes Table 3 highlights small cap GICS1 sectors on an operating profit margin and effective tax rate basis. What follows in the appendix is a list of sub-industries per GICS1 sector we have identified that would likely stand to benefit from the BAT implementation assuming a U.S. dollar appreciation. Table 3 Sector Ranking By BAT-ting Average Sector Ranking By BAT-ting Average Bottom Line: We are comfortable maintaining a defensive versus cyclically exposed portfolio, that would shield us from the BAT implementation, especially if a greenback induced correction materialized in the coming months. Anastasios Avgeriou, Vice President Global Alpha Sector Strategy & U.S. Equity Strategy anastasios@bcaresearch.com 1 "Dollar credit to emerging market economies" by Robert Neil McCauley, Patrick McGuire and Vladyslav Sushko, 6 December 2015, Bank for International Settlements, Quarterly Review, December 2015, available at: http://www.bis.org/publ/qtrpdf/r_qt1512e.htm 2 http://macroblog.typepad.com/macroblog/2017/02/can-tight-labor-markets-inhibit-investment-growth.html Appendix Consumer Discretionary Advertising Broadcasting Cable & Satellite Casinos & Gaming Movies & Entertainment Publishing & Printing Restaurants Specialized Consumer Services Consumer Staples Food Distributors Financials Asset Management & Custody Banks Consumer Finance Diversified Banks Insurance Brokers Investment Banking & Brokerage Life & Health Insurance Multi-line Insurance Multi-Sector Holdings Property & Casualty Insurance Regional Banks Health Care Health Care Distributors & Services Health Care Facilities Life Sciences Tools & Services Managed Health Care Industrials Diversified Support Services Environmental & Facilities Services Human Resource & Employment Services Railroads Research & Consulting Services Trading Companies & Distributors Trucking Information Technology Data Processing & Outsourced Services Electronic Manufacturing Services Internet Software & Services IT Consulting & Other Services Real Estate Health Care REITs Hotel & Resort REITs Industrial REITs Office REITs Real Estate Services Residential REITs Retail REITs Specialized REITs Telecommunication Services Alternative Carriers Integrated Telecommunication Services Utilities Electric Utilities Independent Power Producers & Energy Traders Multi-Utilities Highlights The U.S. Border Adjustment Tax is likely to pass; Yet the political pieces are not in place; Trump himself will be the decisive factor; Trade retaliation would detract from trade benefits of the tax; Stay long volatility; small caps versus large caps; and long USD versus EM currencies. Remain short China-exposed S&P 500 stocks, and German exporters versus consumer services. Feature Donald Trump is a trend-setter. After winning the U.S. election on a protectionist platform that played well to voters in the Midwest, Trump has established an anti-globalization brand of politics. His success has revealed the preferences of the American "median voter."3 Other U.S. politicians are taking notice. The "Border Adjustment Tax" (BAT) is part of this new political trend, though it did not originate with Trump. The House GOP leadership has presented it as a response to economic dislocation in the American heartland, which propelled Trump to the White House. Is it protectionism? Yes, and in this analysis we explain why. The rest of the world is highly unlikely to treat the BAT as a standard Value Added Tax (VAT). It will therefore spark trade retaliation unless Congress addresses outstanding issues. So far President Trump is on the fence, and his support is necessary for passage. We think he will ultimately go with the proposal. The prospect of turning the tables on the U.S.'s trade partners, while spurring domestic investment and capital spending, speaks to his core promises to his voters. Trump's support for the plan should be read as a headwind for markets in the short term due to the uncertainties of implementation and trade disputes. If he should oppose the plan, it would be bullish for U.S. stocks in the short term, since it would mean cutting the corporate tax without radically altering the global status quo. It would signal that he is more interested in economic growth and corporate profits than changing the world or balancing the U.S. budget. Why Reform The Corporate Tax System? American policymakers have long struggled with the country's corporate income tax system. Leaving aside party politics, there are three main complaints:4 Corporate tax revenues are weak: Revenues have disappointed as companies have shifted profits to tax havens and used deductions and loopholes to avoid paying the 35% statutory rate. This erosion of the tax base has contributed to budget deficits as well as public dissatisfaction with governing institutions (Chart 1). U.S. companies have lost competitiveness: American businesses are overtaxed relative to their developed-market peers, taking a toll on competitiveness both at home and abroad (Chart 2). The middle class is losing out: U.S. workers are not as well compensated as their developed-market peers and have lost their share of American wealth in recent decades (Chart 3). The corporate tax contributes to this because companies foist the tax onto workers. Over-Taxation Is In The Eye Of The Beholder Over-Taxation Is In The Eye Of The Beholder U.S. Competitiveness Has Suffered U.S. Competitiveness Has Suffered Will Congress Pass The Border Adjustment Tax? Will Congress Pass The Border Adjustment Tax? The Republican Party examined fundamental tax reform in 2005 but could not make progress on it - instead it settled for the Bush tax cuts, which focused primarily on cutting household tax rates.5 Now that the Republicans have control of all three branches of government again, its leaders are attempting broad tax reform anew. The GOP is primarily concerned with corporate competitiveness, but they also need to appease the middle class - the source of the populist angst that supported both Obama and Trump (the former being the Republicans' arch-nemesis, the latter a strange bedfellow). The GOP also wants to raise some revenue to make their desired tax rate cuts "revenue neutral," i.e. somewhat fiscally defensible, at least enough to pass the bill. Enter Paul Ryan, Speaker of the House, and Kevin Brady, Chairman of the Ways and Means Committee, and their "Better Way" tax plan, which proposes a sweeping overhaul of the U.S. tax system.6 The core idea is to pay for tax cuts by transforming the current corporate income tax system into a "destination-based cash-flow tax" (DBCFT) with border adjustability ("border adjustment tax" or BAT for short).7 We will get to the definition of that, but first, what is the ultimate point? The plan would purportedly drive corporate investment and economic growth by allowing companies to write off the expense of new investments immediately, the first year, rather than gradually through depreciation. (Depreciation schedules often mean that the tax write-off barely covers the cost of investment, thereby causing companies to err on the side of risk-aversion.) The plan would also remove the preferential treatment of corporate debt over equity, which is built into the current tax code through the deduction of interest - this change would discourage corporate indebtedness and encourage equity financing. Finally the plan would not allow U.S. companies to write off the expense of imported goods, as currently, and as such is essentially a tax on the U.S. trade deficit. Roughly, it could yield about $108 billion in revenue (assuming a 20% rate on the $538 billion deficit). The BAT is the chief tax uncertainty today for investors. That is because there are few constraints on the GOP passing some kind of corporate tax cut this year. Presidents Reagan, Clinton, and Bush all managed to pass major tax legislation in their first years, and Trump has stronger majorities than Bush did (Table 1). The GOP has been planning tax reform throughout the Obama administration, staffers and think tanks have "off the shelf" plans, and lawmakers know that time is short. There is every reason to think it will happen fast. In recent decades, the average length of time from the introduction of a major tax reform to the president's signature has been five months. Table 1Major Tax Legislation And The Congressional Balance Of Power Will Congress Pass The Border Adjustment Tax? Will Congress Pass The Border Adjustment Tax? In other words, Trump and his party would need to have a train wreck to fail to pass something this year. That is not beyond belief! But the overriding question is whether the tax reform will be focused on cutting rates, or transforming the system. Currently, the market seems to think the BAT will go through. A basket of stocks based on potential winners and losers suggests that investors believe it will pass (Chart 4). Meanwhile, however, the share prices of high-tax companies (who should benefit the most if taxes are cut) have fallen back from the pop after Trump's election. This could signal the opposite expectation, or that that investors recognize that many high-tax sectors stand to lose from a tax on imports (Chart 5). There is considerable uncertainty in this measure. We think the Trump administration will ultimately accept the House GOP's BAT proposal. But the road between here and there will be tortuous, as past attempts at tax reform show. We expect dollar volatility, which is relatively restrained at present, to rise as the BAT debate intensifies, given that the proposal is bullish for the greenback (Chart 6). Exporters Think Border Adjustment Tax Will Pass Exporters Think Border Adjustment Tax Will Pass High-Tax Companies Fear Policy Disappointments High-Tax Companies Fear Policy Disappointments No Border Adjustment Tax Effect On The Dollar Yet No Border Adjustment Tax Effect On The Dollar Yet Bottom Line: The Trump administration and GOP would have to be unusually incompetent to fail to achieve tax reform this year. The question is whether it will be mere rate cuts or a radical reform to the tax system as a whole. This is critical to the U.S. and global economy - especially given that the passage of a BAT will intensify trade disputes with the U.S. Why Is A Border Adjustment Tax "Protectionist"? Diagram 1 provides a simple illustration of how the current U.S. corporate tax works compared to the proposed BAT. The current system is a "worldwide" corporate income tax. The U.S. government taxes American companies based on their global profits (global revenues minus global costs). No matter where they incur costs, they can write them off, and no matter where they make profits, they must pay tax on them, at least in principle. Diagram 1Explaining The Border-Adjusted Destination-Based Cash-Flow Tax Will Congress Pass The Border Adjustment Tax? Will Congress Pass The Border Adjustment Tax? The new system, by contrast, would be a "destination-based" tax in which the government taxes companies only on domestic profits (domestic revenues minus domestic costs). This means that revenues earned abroad from exports or sales in foreign jurisdictions would be free from tax. However - and here is the tricky part - it also means that costs incurred abroad, imports or purchases in foreign jurisdictions, would be ignored by the tax authority, i.e. they could not be written off like domestic costs. As the "rebate" in the Diagram shows, the BAT is effectively a tax on imports and subsidy to exports. This is not as egregiously protectionist as it sounds at first, because it is very similar to a Value-Added Tax (VAT), which is the dominant tax system across the world. The U.S. is a massive outlier for not having a VAT. But notice that the amount of the rebate to the exporting company in the diagram is higher (at $40) than the amount of tax that would be due if it paid a tax on its foreign profits, since ($200 - $100) x 20% = $20. The WTO may rule against the law if it believes major U.S. exporters will pay net negative taxes as a result of the rebate. Moreover, the BAT has certain differences from a VAT that ensure that the world will see it as a protectionist affront. The BAT is a combination of a VAT, which is a tax on consumption, and an income tax, which is the current system. However, the BAT would allow companies to write off wages and salaries as costs, just like under the current system. Under VAT systems, this is not possible because wages are not consumption and therefore not deductible.8 If the GOP proposal becomes law without addressing this difference - that is, without denying corporates the wage deduction, or taxing them in some other way to compensate - it will likely prompt global trade retaliation. While the World Trade Organization may deem the BAT legal by interpreting it as a VAT, it will not do so if U.S. companies cannot show that they are not getting a leg up on their international rivals by retaining the wage deduction from the former corporate income tax code. Wages are obviously a very large part of a company's expenses. They make up about 68-72% of U.S. companies' costs (Chart 7), and have grown at about 2-4% each year for the export-oriented sector (Chart 8). If U.S. companies can write off the wage expense in their exported goods, then foreign countries will have to adjust, possibly by imposing duties to counteract the share of taxes avoided by that write-off. Wages Make For A Large Tax Deduction Wages Make For A Large Tax Deduction Exporters Face Strong Growth In Wages Exporters Face Strong Growth In Wages Bottom Line: The BAT is a hybrid of tax systems. It is likely that the WTO and U.S. trading partners will object to it as an import tax and export subsidy, particularly because of the wage deduction. The House GOP could adjust the proposal ahead of time or afterwards to avoid this conflict, but that has not happened yet. In addition, corporate lobbying against removing wage deductions would be severe. Will A BAT Get Passed Into Law? Currently, the House GOP leaders face a rising wave of criticism about the BAT proposal and have begun to signal greater flexibility in drafting the law so as to win over various stakeholders. A salient point to remember about U.S. tax legislation is that it is very rare in recent decades for a ruling party to bungle it. Only eight pieces of tax legislation have been vetoed by presidents since 1975, only two of which were serious bills, and in both cases the president vetoed the legislation pushed by an opposition-controlled Congress (Table 2). By the time a serious tax bill makes it to the president's desk, a veto is unlikely, especially if the president and Congress belong to the same party. Table 2Major Tax Legislation Is Set Up For Success Will Congress Pass The Border Adjustment Tax? Will Congress Pass The Border Adjustment Tax? Even more salient, only 23 pieces of tax legislation since 1975 have been struck down in either of the two houses. Of these, seven were attempts to amend the constitution (not likely to pass), nine were attempts to amend the internal revenue code for highly specific things (spirits, cigars, the holding of conventions on cruise ships). Only seven were major bills, and in only one of these cases did the Senate strike down the bill, which was a case of a Republican Senate defending a Republican president from an opposition Congress. In only one case did the ruling party in the House kill a serious tax bill proposed by one of its own members, but it is not comparable to the tax reform in question today.9 What this means is that the BAT is highly likely to be passed into law if the House remains loyal to its leader Paul Ryan, and to the Ways and Means Committee chair Kevin Brady, the two authors of the BAT proposal. However, Trump could derail Ryan's best laid plans. Trump seemed to throw a wrench in the gears when he cast doubt on border adjustment tax, saying that it was too complicated. However, the Trump administration has recently made comments favorable to the BAT. Peter Navarro, chief of the new National Trade Council, highlighted it as a way to bring manufacturing supply chains back into the U.S. (note the protectionist angle of the comment). Meanwhile Sean Spicer, Trump's spokesman, said it would be a good way to make Mexico pay for the infamous wall to be constructed on the border (again, note that the angle is protectionist and populist, not about balancing the budget).10 In each case, the Trump team has gone to pains to emphasize that the BAT is only one option among many. Yet the fact that they have repeatedly brought it up as a solution to their own populist promises is suggestive. We think Trump will ultimately hew to the Republican Party leadership on tax reform.11 Why? Time's a'wastin': Party control of all three branches is a fleeting boon and 2018 mid-term campaigning would make the BAT harder to pass because it could hike the prices of consumer goods. Republicans have a plan ready to go, the House ultimately controls the purse, and Trump wants to move fast on tax cuts and boosting the economy. Furthermore, Republicans remember how short-lived the Democrats' control of Congress was after 2008. Trump wants to be transformative, not merely transactional:12 Trump was elected in a populist revolution and has vowed to improve American manufacturing and trade. His protectionist and mercantilist vision is fundamentally aligned with the chief aims of the BAT: remove the "tax" on corporate investment to improve U.S. capital stock and productivity, and remove incentives to locate, operate, and stash profits offshore. There is at least some positive correlation between higher VAT rates and positive trade balances, and the law is simultaneously supposed to boost productivity (Charts 9 and 10). Higher Investment Helps Productivity Higher Investment Helps Productivity Will Congress Pass The Border Adjustment Tax? Will Congress Pass The Border Adjustment Tax? Trump needs domestic and international "legitimacy": His protectionist platform will stand on firmer ground if he adopts policy that is at least debatable at the WTO, as opposed to imposing tariffs willy-nilly through bare executive power, which is eventually vulnerable to congressional and judicial oversight. Domestic courts have already shown an inclination to halt Trump's controversial executive orders.13 By contrast, they would almost certainly defer to Congress even on the most radical tax reforms. Trump needs a tradeoff for infrastructure spending: Unpopular presidents cannot set the legislative agenda.14 But Trump may be able to trade GOP-style corporate tax reform - which offsets tax cuts with new revenue provisions, such as the BAT - in return for infrastructure spending, which the GOP is reluctant to embrace. Trump is willing to lead a crusade against the WTO: This may be a necessary prerequisite for the passage of this bill, and Trump is heaven-sent to play the role. He would be to the WTO what George W. Bush was to the United Nations. It would be disastrous for the U.S.-built international liberal order, but it would give Trump the ability to pursue protectionism while rallying the public around the flag against America's "globalist" enemies. (Sovereignty over taxation is a cause that is hard to beat in the U.S.)15 BAT allows Trump to save face on the "Wall" with Mexico: As the White House spokesman hinted, Trump may use creative accounting to satisfy his promise that Mexico would pay for the wall. Will Congress Pass The Border Adjustment Tax? Will Congress Pass The Border Adjustment Tax? Moreover, if Trump comes out in support of the BAT, it will likely get passed: Precedent: President John F. Kennedy's and Jimmy Carter's efforts at tax reform failed because Congress was not supportive, which is not a problem today; whereas Ronald Reagan's personal support for the 1986 tax reform - despite his reservations about the attempt to transform the system and broaden the base - proved critical in helping the bill move through Congress.16 Political science: The political context is a better determinant of presidential success than individual talents, and rising political polarization in the U.S. has created an environment in which "majority presidents," those whose party has a majority in Congress, are even more likely to be successful, while "minority presidents" are more likely to fail on key initiatives. The relevant factors of political context are the party's grip on Congress, the extent of polarization, and, somewhat less significantly, whether the president is in his "honeymoon period" and enjoys public support.17 Of these factors, Trump is only weak on public support, though not among conservatives (Chart 11), who could vote their representatives out of office if they defy Trump on tax reform. The Senate could still cause a serious hang-up. But if Trump and the House GOP stand behind the legislation then Senate Republicans would have to be suicidal to oppose it.18 What about the corporate lobbies that oppose the BAT? Certainly it is highly controversial at home. The tax could hurt import-heavy U.S. businesses and punish citizens with a high propensity to consume - i.e. the poor and elderly, both constituents that make up an important part of Trump's base. But that suggests that there will be carve-outs or phased implementation for key imports like food, fuel, and clothing. Such compromises will be messy, and will mitigate any dollar appreciation and reduce the tax revenues to be gained, but would probably enable the bill to get passed. The opposition of retailers like Wal-Mart and Target is overrated in terms of their power as a lobby. Importers form a slightly larger lobby than exporters, which makes sense given that the U.S. is a net importing economy, but neither of them comprises a large share of total lobbying (Chart 12). The sectors that suffer the most from the import tax also tend to pay higher effective tax rates and thus stand to benefit from the rate cuts (Chart 13). The opposition of the Koch brothers is also overrated, given their unhelpful attitude toward Trump's candidacy for president! Will Congress Pass The Border Adjustment Tax? Will Congress Pass The Border Adjustment Tax? Will Congress Pass The Border Adjustment Tax? Will Congress Pass The Border Adjustment Tax? Bottom Line: The BAT is a radical plan to spur corporate investment and production in the United States, and that goal matches Trump's vision. Trump will be hard pressed to find a more effective, structural way of achieving his goals. And the two-year window with assured GOP control of government will close faster than one might think. Risks To The View A major risk to the BAT is that Trump will fear the repercussions on his political base of higher consumer prices, as hinted above. Consumer pain is a necessary consequence of his mercantilist vision of rebalancing the U.S. from consumption to investment and bringing down the U.S. trade deficit, so Trump will have to decide whether he means what he says. Moreover, if the dollar rises sharply as a result of the BAT, as expected, it would cause pain for the economy and S&P 500 companies, which source 44% of earnings outside the U.S. According to BCA's Global Investment Strategy, the impact of a much stronger dollar on U.S. assets denominated in foreign currencies could amount to a loss worth of 13% of U.S. GDP! (Not to mention Trump's personal wealth from overseas.) Given the huge uncertainties of a totally new tax system, and potential disruption to the economy, it would be perfectly understandable if Trump refused to hitch his fate as president to this wonkish grand experiment. Further, it is not as if there is no alternative to the BAT. Since Republicans will be humiliated if they fail to deliver on tax cuts, Trump's opposition to the BAT would force the House GOP to go back to good ol' fashioned tax cuts without significant revenue raising measures, and specific add-ons to deal with concerns like corporate inversions. Trump would still likely get the repatriation of overseas earnings, a political win, and the economy would experience an increase in investment from tax rate cuts without the uncertain consequences of deeper change. Ronald Reagan's administration offers a precedent for this sequencing, since he began his term with simple tax cuts in 1981 and only later attempted the dramatic tax overhaul of 1986. There is also a risk that the business lobby against the BAT proves stronger than expected and gains traction in the media and popular opinion as a result of the feared consequences on consumer prices. Tax reform is never going to be easy and will always hang in a precarious balance. These are serious risks, but we think Trump and the GOP will move now rather than make any assumptions about their ability to win subsequent elections and enact massive tax reform. The fact that the GOP controls all three branches of government, the BAT plan is well in the making, and Trump is looking to reshape the American economy in ways that align with the BAT, make the odds of passage higher than 50%. Unfortunately, this also means the world should brace for a sharp spike in trade disputes. Bottom Line: There are plenty of reasons to think the BAT plan could collapse of its own weight. The path of least resistance is certainly not the BAT. But we think the preponderance of power in GOP hands in Washington favors radical change, even if it ends up being a policy mistake. Investment Implications: Trade War The WTO is supposed to presume innocence with a country's laws, and it might also approve the BAT on the basis that proponents argue: the U.S. imposing the BAT is not much different from a VAT country increasing its VAT rate while simultaneously slashing the payroll tax (as France has done under President Hollande's administration). This view is misguided. The WTO will rule on the statute and international trade treaties, not the special pleading of the advocates. It may or may not accept that the BAT is equivalent to a VAT; it may or may not object to the wage deduction as a holdover from the "direct" tax on income. The GOP has not yet introduced a draft law, but given the express intention - in the Ryan plan, not even to mention Trump - to put "America first" with a "pro-America approach for global competitiveness," it seems likely that a clash of interests is in the making. In other words, American proponents of the tax are not even hiding its overt protectionist intentions. The WTO will probably discover a subsidy for U.S. exporters and a violation of the principle of trade neutrality with respect to imports. WTO litigation will take years. When the European Union sued the U.S. over its use of Foreign Sales Corporations, a comparable dispute, the proceedings began in 1999 and the WTO ruled against the U.S. in 2002. Ultimately, the U.S. Congress amended the law to avoid retaliation in 2004.19 Trump and the GOP would be less likely to amend their pet project in the current environment, especially if the litigant is the EU at the WTO! Trump, as mentioned, would be inclined to take the fight to the WTO - he has even threatened to withdraw the United States from it. His support group feeds on conflict with supra-national bodies and he may see foreign retaliation as a convenient reason to impose tariffs of his own. The trade environment would deteriorate in the meantime. In 2002, it was assumed that the U.S. and EU could work out an agreement without punitive measures, but that assumption does not hold today. And it would not only be the EU leveling complaints. In short, the U.S. would face foreign retaliation, during the proceedings and likely as a consequence of the WTO ruling. The Trump administration would attempt to mitigate the blowback through a series of bilateral deals, and perhaps the U.S. law would ultimately be modified, but the entire saga would have a negative impact on global trade. Financial markets had many factors to contend with during this period (like the dot-com bubble), and they will similarly respond to large currents in the coming years aside from any BAT. Nevertheless, the tax would reinforce our themes of global multipolarity, mercantilism, and protectionism - and thus reinforce several of our existing trades: We continue to favor small caps over large caps. Small caps are insulated from global trade, will benefit most from the cut in tax rates, and will suffer least from any appreciation of the dollar. Long volatility - Long VIX 20-25 call spread for expiration in March; Long USD versus short EM currencies; Short China-exposed S&P stocks; Short German exporters versus long consumer services. If Trump comes out in opposition to the BAT, he would send a bullish signal for markets in the short term. It would mean, first, that the U.S. will have corporate tax cuts without the broader uncertainties of the BAT; and second, that Trump is actually a pragmatist who eschews radical change if he thinks it will cause too much trouble for U.S. consumers or economic growth. However, it would not necessarily mean that the U.S. would avoid a trade conflict, given Trump's executive powers.20 Of course, the BAT's failure - which is not our baseline - would also be worse for the deficit and debt, as the GOP tax cuts would have no offsetting revenue increases but would rely purely on creative accounting, "dynamic scoring," to appear fiscally acceptable. This legislation would also likely fail to simplify the tax code as much as the BAT would. Matt Gertken, Associate Editor mattg@bcaresearch.com 3 Please see BCA Geopolitical Strategy, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 4 Please see Alan J. Auerbach, "A Modern Corporate Tax," Center for American Progress, dated December 2010, available at www.americanprogress.org. 5 Please see President's Advisory Panel on Federal Tax Reform, "Final Report," dated November 1, 2005, available at govinfo.library.unt.edu. 6 Please see "A Better Way: Our Vision For A Confident America: Tax," dated June 24, 2016, available at abetterway.speaker.gov. 7 Our colleagues at BCA's Global Investment Strategy have recently provided a very helpful Q&A on the border adjustment tax (BAT), and we would refer readers to that report for a detailed discussion. Please see BCA Global Investment Strategy Special Report, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 20, 2017, available at gis.bcaresearch.com. 8 Please see Reuven S. Avi-Yonah, "Back To 1913?: The Ryan Blueprint And Its Problems," Tax Notes 153: 11 (2016), 1367-47, reprinted by University of Michigan, available at www.repository.law.umich.edu. 9 Amo Houghton, a liberal-leaning Republican from New York, proposed the Taxpayer Protection and IRS Accountability Act of 2002, a bill to streamline IRS administration. It failed in the Republican Congress under President Bush. 10 Please see Shawn Donnan, "Trump's top trade adviser accuses Germany of currency exploitation," Financial Times, January 31, 2017, available at www.ft.com, and Bob Bryan, "Trump press secretary says the administration is considering a 20% border tax on Mexican imports to help pay for the wall," Business Insider, January 26, 2017, available at www.businessinsider.com. National Economic Council Director Gary Cohn has also indicated that the BAT is an option but not yet decided upon, see CNBC, "Squawk on the Street," February 3, 2017, available at www.cnbc.com. 11 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Monthly Report, "Transformative Vs. Transactional Leadership," dated September 14, 2016, available at gps.bcaresearch.com. 13 The U.S. Ninth Circuit Court of Appeals has already issued a temporary injunction against President Trump's executive orders on immigration. Please see "State of Washington & State of Minnesota v. Trump," available at www.ca9.uscourts.gov. 14 Please see John Lovett, Shaun Bevan, and Frank R. Baumgartner, "Popular Presidents Can Affect Congressional Attention, For A Little While," Policy Studies Journal 43: 1 (2015), 22-44, available at www.unc.edu. 15 Please see BCA Geopolitical Strategy Weekly Reports, "The Trump Doctrine," dated February 1, 2017, and "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com. 16 Joseph A. Pechman, "Tax Reform: Theory and Practice," The Journal of Economic Perspectives 1:1 (1987), pp. 11-28 (15). 17 Jeffrey E. Cohen, Jon R. Bond, and Richard Fleisher, "Placing Presidential-Congressional Relations In Context: A Comparison Of Barack Obama And His Predecessors," Polity 45:1 (2013), 105-126. 18 The Senate Financial Services Committee's support will be critical. Chairman Orrin Hatch has criticized but not yet declared against the BAT. Even if he does, it would not necessarily kill the deal. One of his predecessors, Senator Bob Packwood, initially opposed the Tax Reform Act in 1986 but was ultimately persuaded to support it. If Hatch and the Finance Committee support the initiative, it will pass the Senate. First, the tax overhaul can be accomplished by "reconciliation," a congressional trick that will enable the GOP to avoid a Senate filibuster and pass the tax reform with a simple majority. Second, the Republicans today have almost exactly the proportion of seats in the Senate as the average in previous examples of successful tax reform (see Table 1). So there would have to be a higher share of Republican defectors than in the past to overturn the bill. This is possible but unlikely if Trump and the House GOP are behind the bill. 19 Please see Congressional Research Service, "A History of the Extraterritorial Income (ETI) and Foreign Sales Corporation (FSC) Export Tax-Benefit Controversy," dated September 22, 2006, available at digital.library.unt.edu. 20 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com.

Highlights The Fed's evident desire to lift its policy rate next week - presumably to get out ahead of inflation that has yet to show up in its preferred gauge - will weigh on gold. Oil ... not so much. This is because fundamentals once again are asserting themselves in the evolution of oil prices, something that has been evident even before markets balanced last year. Gold, meanwhile, remains exquisitely sensitive to Fed policy expectations and their effects on the USD and real rates, as with other currencies. Energy: Overweight. We are looking to re-establish our long WTI Dec/17 vs. short Dec/18 spread if it trades in contango again, i.e., if Dec/17 is less than Dec/18. We believe the combination of OPEC and non-OPEC adherence to their production Agreement will remain high, and demand likely will remain stout. Base Metals: Neutral. Spot copper is down ~ $0.10/lb on COMEX over the past week. We expect transitory supply issues in Chile and Indonesia to be resolved, and reflationary stimulus in China to wane going into the 19th National Congress of the Communist Party in the autumn, and, with it, copper demand. We remain neutral. Precious Metals: Neutral. Gold is weakening as the Fed's March meeting approaches next week, given the overwhelming expectation for a 25bp rate hike. We remain long volatility, expecting fiscal-policy uncertainty in the U.S. to be resolved over the next few months, and Fed policy drivers to become more focused. Ags/Softs: Underweight. We are not expecting significant changes in the USDA's estimates of stocks globally, and therefore remain underweight. Feature The choreographed messaging of voting and non-voting FOMC members asserting the need for a policy-rate hike over the past two weeks succeeded in pushing markets' expectations for such action to 88.6% as of Tuesday's close, up from 44.6% at the end of February. This despite the fact that the Fed's preferred inflation gauge - core PCE - has yet to show any sign of pushing up and thru the Fed's target of 2% growth yoy (Chart of the Week). Nor, for that matter, has core PCE shown any tendency to remain above 2% yoy growth over the past two decades (Chart 2). Chart of the WeekThe Fed's Preferred Inflation ##br##Gauge Still Quiescent The Fed's Preferred Inflation Gauge Still Quiescent The Fed's Preferred Inflation Gauge Still Quiescent Chart 2Core PCE Has Been ##br##Quiescent For Decades Core PCE Has Been Quiescent For Decades Core PCE Has Been Quiescent For Decades Between mid-December 2016 and the end of last month, gold prices rallied ~11.3% largely on the expectation the Fed would not raise rates until at least June, and, even then, would be constrained by uncertainty over what Congress and the Trump Administration would offer up in terms of fiscal policy later this year. Now, with the Fed succeeding in raising the market's expectation of a March rate hike, gold markets are left to re-calibrate the number of hikes to expect this year, and the likely implications for the USD and real rates. We believe the Fed will execute three rate hikes this year, but this will be highly dependent on how markets react to the now fully priced-in hike markets expect next week. Synchronized Growth, Inflation And Feedback Loops It is likely the Fed feels confident accelerating its rates normalization because, for the first time since the Global Financial crisis, we are getting a globally synchronized recovery in GDP. All else equal, this will give the U.S. central bank a bit of headroom to experiment with an earlier-than-expected rate hike. This synchronized growth also will provide a positive backdrop for commodity demand this year and next (Chart 3). The possibility of highly stimulative - or even just moderately stimulative - fiscal policy in the U.S. at a time when the economy is apparently at or close to full employment, will be positive for aggregate demand, and could be inflationary if its principal result is to lift real wages in the U.S. In addition to synchronized growth, we also are seeing evidence of synchronized inflation in the largest economies in the world (Chart 4). Chart 3Synchronized Global Growth ##br##Could Embolden The Fed Synchronized Global Growth Could Embolden The Fed Synchronized Global Growth Could Embolden The Fed Chart 4Synchronized Inflation Globally ##br##Likely Caught The Fed's Attention Synchronized Inflation Globally Likely Caught The Fed's Attention Synchronized Inflation Globally Likely Caught The Fed's Attention This synchronized growth and inflation is, we believe, important to the Fed, in that its effects constitute something of a global feedback loop. As we have noted in earlier research, the Fed is much more sensitive to how its policy actions affect other economies, given the deepening of global supply chains over the past two decades or so. Equally, policymakers are well aware the evolution of monetary policy and economic growth in other economies affects the U.S. growth and policy variables important to the Fed.1 Absent a policy shock in the U.S., Europe or China, the backdrop for EM growth should remain positive for at least 2017, even with reflationary stimulus waning in China, a left-tail risk to commodity prices that we identified in last week's publication.2 We expect the Fed's policy normalization to be tempered by continued monetary accommodation globally, which will be supportive of growth at the margin. This will keep global oil demand growth on track to average 1.50 - 1.60mm b/d this year and next, and, importantly for inflation and inflation expectations, keep EM oil demand growing. The income elasticity of per-capita oil consumption in EM economies typically is ~ 1.0, meaning a 1% increase in EM incomes is associated with a 1% increase in EM oil demand.3 EM growth accounts for close to 85% of the growth we expect in global oil demand this year. This is important, given EM oil demand, which we proxy with the U.S. EIA's non-OECD oil consumption time series, to be a common factor that explains the evolution of the CPI series shown above (Chart 5). EM oil demand is able to explain the synchronization of inflation in the three largest economies in the world is because incremental growth is occurring in the EM economies, and this is driving global growth. We continue to expect high compliance in the OPEC - non-OPEC production deal negotiated by the Kingdom of Saudi Arabia (KSA) and Russia at the end of last year, which will, against the backdrop of continued global growth, cause inventories to fall and for markets to backwardate. We believe last week's increase in U.S. crude oil inventories to be the last big build, and expect the decline to begin later this month. On average vessels leaving the Persian Gulf destined for the U.S. have a 45- to 50-day sailing period depending on multiple factors such route, weather and sea conditions. Therefore, the recent increase in U.S. crude oil inventories can be linked to the arrival of the final fleet of vessels in concert with the pre-OPEC agreement production surge undertaken by the GCC. Evidence of this phenomenon is apparent in the ~500k b/d increase in U.S. crude oil imports (374k b/d coming from Iraq) over the prior week. We expect OECD oil stocks to start declining this month and fall some 300mm bbl before the end of 2017. This supply-demand dynamic will continue to dominate financial-market influences on oil prices, as we argued in last week's publication (Chart 6).4 Gold, on the other hand, will continue to take its cue from Fed policy and policy expectations, particularly as regards expectations for the USD, which should strengthen at the margin, given the Fed's new-found hawkishness, and real rates, which also should strengthen (Chart 7). Chart 5EM Oil Demand Continues##br## To Drive Inflation EM Oil Demand Continues To Drive Inflation EM Oil Demand Continues To Drive Inflation Chart 6IF KSA And Russia Can ##br##Coordinate Production... IF KSA And Russia Can Coordinate Production... IF KSA And Russia Can Coordinate Production... Chart 7Gold Will Continue To Take##br## Its Cue From Fed Policy Gold Will Continue To Take Its Cue From Fed Policy Gold Will Continue To Take Its Cue From Fed Policy Bottom Line: Oil prices will continue to be dominated by supply-demand-inventory fundamentals, with monetary policy effects on the evolution of prices taking a secondary role. Gold prices will continue to take their cue from Fed policy and policy expectations. We look to re-establish our long Dec/17 WTI vs. short Dec/18 WTI spread if it trades thru flat (i.e., $0.00/bbl). Given our gold view, we remain long volatility via the put spreads and call spreads we recommended February 23 - i.e., long Jun/17 $1,200/oz puts vs. short $1,150/oz puts, and long $1,275/oz calls vs. short $1,325/oz calls. The position was up 15% as of Tuesday's close. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Reports "Global Inflation and Commodity Markets," dated August 11, 2016, and "Memo To The Fed: EM Oil, Metals Demand Key To U.S. Inflation," dated August 4, 2016, available at ces.bcaresearch.com. 2 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Gold's Known Unknowns, And Fat Tails," dated February 23, 2017, available at ces.bcaresearch.com. 3 Oil consumption frequently is employed to approximate EM income growth, given the income elasticity of demand for oil is ~ 1.0, meaning a 1% increase in income (GDP) produces an increase in demand for oil of approximately 1.0%. The OECD notes, "Non-OECD countries are found to have a higher income elasticity of oil demand than OECD countries. On average across countries, a one per cent rise in real GDP pushes up oil demand by half a per cent in OECD countries over the medium to long run, whereas the figure is closer to unity for most non-OECD countries." Please see "The Price of Oil - Will It Start Rising Again?" OECD Economics Department Working Paper No. 1031, p. 6 (2013). 4 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Days Of Oil Future's Past: Mean Reversion," dated March 2, 2017, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in

Highlights Substituting certain imports with local production will ensure that Russia's inflation rate will become less sensitive to fluctuations in the exchange rate and more sensitive to local wages/unit labor costs. In such a scenario, the central bank will not need to pursue pro-cyclical monetary policy. This is on top of the counter-cyclical fiscal policy emerging from the new fiscal rule. Less pro-cyclical monetary and fiscal policies argue for more stability in the real economy than in the past. Altogether, this warrants a lower beta for Russian financial assets relative to EM benchmarks. Meanwhile, geopolitics is likely to remain a tailwind for Russia. Continue overweighting Russian stocks, ruble, local fixed-income and credit relative to their EM counterparts. A new trade: Go long the ruble and short crude oil. Feature Russian equities and the ruble have been high-beta bets on oil prices. While the positive correlation between crude prices and Russian financial markets is unlikely to change soon, the country's stock market and currency will likely become low-beta within the EM universe. Sound macro policies and some import substitutions will make inflation less sensitive to the exchange rate. As such, the central bank will not need to hike interest rates amid falling oil prices. The key point is that fiscal and monetary policies are becoming less pro-cyclical. This will reduce volatility in the real economy, which in turn will warrant a lower risk premium on Russian assets, particularly within the EM aggregates. Meanwhile, geopolitics is likely to remain a tailwind for Russia. Both Europe and the U.S. have lost appetite for direct confrontation. And while some of the exuberance immediately following Trump's victory will wear off, the U.S. and Russia are unlikely to revisit the 2014 nadir in relations. Orthodox Macro Policies... Russia has adhered to orthodox macro policies amid a severe recession over the past two years: On the fiscal front: The government has maintained constant nominal expenditure growth and substantially cut spending in real terms (Chart I-1). The fiscal deficit is still large at 3.8% of GDP, but it typically lags oil prices (Chart I-2). Hence, the recovery in oil prices over the past year should lead to a notable improvement in the budget balance. For 2017, the budget is conservative, as it assumes $/bbl 40 Urals. Early this year, the Ministry of Finance adopted a new fiscal rule where it will buy foreign currency when the price of oil is above the set target level of 2700 RUB per barrel ($40 oil price times 67 USD/RUB exchange rate) and sell foreign exchange when the oil price is below that level (Chart I-3). Chart I-1Russia Has Undergone ##br##Through Real Fiscal Squeeze... Russia Has Undergone Through Real Fiscal Squeeze... Russia Has Undergone Through Real Fiscal Squeeze... Chart I-2...Which Is Now Over ...Which Is Now Over ...Which Is Now Over Chart I-3Oil Price Threshold For ##br##The New Fiscal Rule Oil Price Threshold For The New Fiscal Rule Oil Price Threshold For The New Fiscal Rule The objective of this policy is to create a counter-cyclical ballast that will limit fluctuations in the ruble caused by swings in oil prices. With respect to monetary policy, Russia's central bank has been highly prudent. Unlike many other emerging countries, the central bank has refrained from injecting liquidity into the banking system (Chart I-4) and has maintained high real interest rates (Chart I-4, bottom panel). Chart I-5 demonstrates that the central bank's domestic assets have been flat, while the same measure has surged for many other EM central banks. Although this measure does not reflect central banks' net liquidity injections, it in general validates that Russia's monetary authorities have been more conservative than their counterparts in many developing countries. This is ultimately positive for the currency. Chart I-4Russian Central Bank: ##br##Tight Monetary Stance Russian Central Bank: Tight Monetary Stance Russian Central Bank: Tight Monetary Stance Chart I-5Russian Central Bank Has Been ##br##Conservative Among Its Peers Russian Central Bank Has Been Conservative Among Its Peers Russian Central Bank Has Been Conservative Among Its Peers Furthermore, the central bank has been forcing banks to acknowledge non-performing loans (Chart I-6, top panel) and has been reducing the number of dysfunctional banks by removing their licenses (Chart I-6, bottom panel). This assures that the credit system has already gone through a cleansing process, and a gradual credit recovery will commence soon. This is also in stark contrast with many other EM banking systems, where credit-to-GDP ratios continue to rise. In brief, Russia is advanced on the path of deleveraging (Chart I-7), while many EM countries have not even begun the process. Chart I-6Russian Central Bank Has ##br##Forced Banking Restructuring Russian Central Bank Has Forced Banking Restructuring Russian Central Bank Has Forced Banking Restructuring Chart I-7Russia Is Very Advanced ##br##In Its Deleveraging Cycle Russia Is Very Advanced In Its Deleveraging Cycle Russia Is Very Advanced In Its Deleveraging Cycle Bottom Line: The new fiscal rule will reduce fluctuations in the ruble. The central bank's ongoing tight policy stance will also put a floor under the ruble. Even though we expect oil prices to drop meaningfully in the months ahead, any ruble depreciation will be moderate. ... Plus Some Imports Substitution... The dramatic currency devaluation in 2014-15 and sanctions imposed on Russia by the West have led to the substitution of some imported goods with locally produced ones. First, the most visible import substitution has occurred in the agriculture sector. Chart I-8 suggests that in agriculture import substitution has been broad-based and significant. Second, while there has been some import substitution in the industrial sector, it has been less pronounced. Demand for industrial goods and non-staples (autos and furniture, for example) has plunged significantly. Hence, local production has also collapsed, but less so than imports (Chart I-9). Chart I-8Russia: Import ##br##Substitution In Agriculture Russia: Import Substitution In Agriculture Russia: Import Substitution In Agriculture Chart I-9Some Import ##br##Substitution In Manufacturing Some Import Substitution In Manufacturing Some Import Substitution In Manufacturing As domestic demand recovers, manufacturing production of industrial goods will increase. However, it is not clear how much of this demand recovery will be met by rising imports versus domestic production. On one hand, the ruble is not expensive, and argues for more import substitution going forward - i.e. relying more on domestic production rather than imports. On the other hand, Russia is hamstrung by a lack of manufacturing productive capacity, technology and know-how in many sectors to produce competitive products. FDI by multinational companies will likely rise from extremely low levels (Chart I-10), yet it is unlikely to be sufficient to make a major difference in terms of Russia's competitiveness. Third, the ruble depreciation has helped Russia increase oil and natural gas production (Chart I-11). Chart I-10Russia: Meager Net FDI Inflows Russia: Meager Net FDI Inflows Russia: Meager Net FDI Inflows Chart I-11Russia: Oil And Natural Gas Output Is Robust Russia: Oil And Natural Gas Output Is Robust Russia: Oil And Natural Gas Output Is Robust Finally, in an attempt to lessen dependence on foreigners, Russian President Vladimir Putin has been pushing the use of domestic technology. For example, Microsoft products will be replaced by locally developed software. Bottom Line: The combination of currency depreciation and trade sanctions has led to some import substitution. ...Will Make Inflation Less Sensitive To The Currency Chart I-12Russia: Unit Labor ##br##Costs Have Collapsed Russia: Unit Labor Costs Have Collapsed Russia: Unit Labor Costs Have Collapsed The collapse of the ruble has drastically reduced labor costs in Russia's manufacturing sector (Chart I-12). A diminished share of imports in domestic consumption - import substitution - will ensure Russia's inflation rate becomes less sensitive to fluctuations in the exchange rate and more sensitive to local wages/unit labor costs instead. Tame wages and some improvement in productivity - as output recovers - will cap Russian unit labor costs and restrain inflation in the medium term. In such a scenario, the central bank will not need to pursue pro-cyclical monetary policy - i.e., hike interest rates when oil prices drop and the ruble depreciates. Less pro-cyclical monetary and fiscal policies will diminish fluctuations in the economy, and economic visibility will improve. This bodes well for the nation's financial assets. We do not mean to suggest that the central bank of Russia will immediately pursue counter-cyclical monetary policy - i.e., that it will be able to cut interest rates when oil prices fall. While this would be ideal for the national economy, it is not a practical option for now. Bottom Line: Less pro-cyclical monetary and fiscal policies argue for more stability in the real economy than in the past. Altogether, this warrants a lower beta for Russian financial assets relative to EM benchmarks. The Growth Outlook The Russian economy is about to exit recession (Chart I-13, top panel), but growth recovery will be timid: Bank loans will recover after pronounced contraction over the past two years. The credit impulse - the change in bank loan growth - has already turned positive (Chart I-13, bottom panel). Retail sales volumes and auto sales have not yet recovered but manufacturing output growth is already positive (Chart I-14). Rising nominal and real wages argue for a pick-up in consumer spending (Chart I-14, bottom panel). Capital spending has collapsed both in absolute terms and relative to GDP (Chart I-15). Such an underinvested position and potential recovery in consumer spending warrant a pickup in investment outlays. The key difference between Brazil and Russia - the two economies that plunged into deep recession in the past 2-3 years - is public debt load and sustainability. Chart I-13Russia: Recovery Is At Hand Russia: Recovery Is At Hand Russia: Recovery Is At Hand Chart I-14Russia: Economic Conditions Russia: Economic Conditions Russia: Economic Conditions Chart I-15Russia: Capex Recovery Is Overdue Russia: Capex Recovery Is Overdue Russia: Capex Recovery Is Overdue The public debt-to-GDP ratio is 77% in Brazil and 16% in Russia, while fiscal deficits are 9% and 3.8% of GDP, respectively. Public debt could spiral out of control in Brazil1 in the next two years, while it is not an issue in Russia. Bottom Line: Russia is about to embark on a mild and gradual economic recovery, even if oil prices relapse. Russia Is In A Geopolitical Sweet Spot Geopolitical headwinds will continue to abate for Russia. We expect that some of the loftiest expectations of a U.S.-Russia détente will fail to materialize as the Trump Administration continues to face domestic pressures. However, the 2014 nadir in relations will not be revisited. Meanwhile, Russia will benefit from several geopolitical tailwinds: The path of least resistance for tensions between Russia and the West is down. The Trump administration is highly unlikely to increase sanctions against Russia. Congress is likely to open an investigation into allegations of Russian interference in the 2016 U.S. election, but we highly doubt that any genuine "smoking guns" linking the Kremlin to the election result will be found. As such, we expect the thaw in U.S.-Russia relations to continue, albeit haltingly and without any possibility that the two powers become allies. Washington has recently removed sanctions related to U.S. tech exports to Russia. While U.S. sanction can be easily removed by presidential decree, EU sanctions require a unanimous vote on behalf of the European council. A summary can be found bellow. Table I-1 Russia: Entering A Lower-Beta Paradigm Russia: Entering A Lower-Beta Paradigm Putin's support remains high (Chart I-16), giving him a sense of confidence that modest structural reforms and economic opening is possible without undermining his support base. Military intervention in Syria has largely been a success, from Moscow's point of view. Chart I-16Popularity Of Putin And Government Popularity Of Putin And Government Popularity Of Putin And Government None of the current candidates in the upcoming elections in Europe are overtly anti-Russia. In France, leading candidate Emmanuel Macron is mildly hawkish on Russia, but the other two candidates - Marine Le Pen and François Fillon are downright Russophile. In Germany, the historically sympathetic to Russia Socialist Democratic Party (SPD) has taken a lead against Angela Merkel's ruling party. Even if Angela Merkel retains her Chancellorship, it is likely that the Grand Coalition would have to give the SPD a greater role given their dramatic rise in polling. Despite two major diplomatic incidents between Turkey and Russia,2 relations between the two countries continue to improve. In fact, the Turkstream project - which will connect Russia with Turkey via the Black Sea - has been approved by both sides. This is a positive development for the Russian energy sector as the capacity of that pipeline is large, standing at 63 Bn cubic meters per year. In Syria, the two countries have gone from outright hostility to coordinating their military operations on the ground, a dramatic reversal. The Rosneft IPO was a success, a positive sign for foreign investments in Russia. While the issuance was conducted for budget reasons, it is a sign that Russia is willing to open itself to foreign investors. The caveat being that it will only do so selectively. Further evidence of this selective opening is the recent announcement by the head of the Finance Ministry debt department that the next Eurobond auction will be conducted privately. Past investments from western firms in Russia failed due to the fact that a large number of Western oil companies were complacent in their investment analysis and failed to do due diligence.3 Furthermore, foreign investments in Russia have often failed because it was caught in the cross fire between the Kremlin and the various oligarchs who brought in the foreign investment.4 Given that President Vladimir Putin has largely neutered oligarchs, FDI that arrives in the country will have full blessing of the government. Finally, we would expect western energy companies to be more selective in their foreign investments given the recent crash in oil prices. As BCA's Geopolitical Strategy has been warning since 2014, globalization is in a structural decline and protectionism may follow. The Trump administration has threatened to use tariffs against both geopolitical adversaries, like China, and allies, like Germany. The border adjustment tax, proposed by Republicans in Congress, is a protectionist measure that could launch a global trade war.5 Due to the fact that Russia exports commodities, we would expect Russia's export revenue stream to be unaffected compared to countries who export more elastic goods such as consumer products. Bottom Line: We expect geopolitical dynamics to play in Russia's favor going forward. These will mark a structural shift in how foreign investment is conducted in Russia and risk assets will continue re-pricing. Investment Conclusions Chart I-17Continue Overweighting Russian Stocks Continue Overweighting Russian Stocks Continue Overweighting Russian Stocks Russian stocks will outperform the EM equity benchmark in the months ahead (Chart I-17). Stay overweight. Typically, the Russian bourse has outperformed the EM index during risk-on phases and underperformed in risk-off episodes - i.e., Russia has been a high-beta market. This will likely change, and we expect Russia to outperform in a falling market. Also, maintain the long Russian stocks and ruble / short Malaysian stocks and ringgit trades. Continue overweighting Russian sovereign and corporate credit within the EM credit universe. Continue overweighing local currency bonds within EM domestic bond portfolios. A new trade: Go long the ruble and short oil. When oil prices drop, as BCA's Emerging Markets Strategy team expects to happen in the months ahead, the ruble might weaken too. However, adjusted for the carry, the aggregate long ruble/short oil position will prove profitable. Stephan Gabillard, Research Analyst stephang@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Report titled, "Has Brazil Achieved Escape Velocity?", dated February 8, 2017, link available on page 14. 2 Turkey shot down a Russian Sukhoi Su-24 on November 24th 2015 and Andrei Karlov, the Russian ambassador to Turkey got shot dead by a Turkish police officer in Ankara on December 19th 2016. 3 The BP and TNK deal failed for obvious reasons. BP and TNK had already come in confrontation when in the mid-1990's BP had bought a 10 percent stake in Sidanco only to see TNK strip the company of its asset. Furthermore, TNK was involved in other mergers inside Russia, making extremely confusing to understand what assets it actually owned. 4 Putin's campaign to sideline Khodorkovsky and Berezovsky for example sometimes came at odds with foreign investment in Russia. 5 Please see BCA Geopolitical Strategy Special Report, "Will Congress Pass The Border Adjustment Tax," dated February 8, 2017, available at gps.bcaresearch.com.

Energy services shares have pulled back as oil prices have marked time over the last few weeks, but in the background, the conditions to sustain a rally are falling into place. The growth in total OECD oil stocks has rolled over decisively, and a continued supply/demand rebalancing should occur given that world oil production growth has slipped to nil courtesy of OPEC output cuts. The bond market has increased confidence that oil prices will not tumble anew, as reflected in the sharp narrowing in energy corporate bond spreads. Many companies have used the recovery in oil prices to refinance and bolster balance sheets, underscoring that the financial means to boost exploration exist. With energy services pricing power trying to make an early exit from deflation on only a small boost to the global rig count, there is scope for the attractively valued S&P oil & gas field services index to surprise on the upside. We have this at high-conviction overweight. The ticker symbols for the stocks in the S&P oil & gas field services index are: BLBG: S5ENRE - SLB, HAL, BHI, NOV, FTI, HP, RIG. Energy Services Have Lagged, But Not For Long Energy Services Have Lagged, But Not For Long

Highlights Crude-oil fundamentals stand out among commodities because of the active efforts by critical producers to rein in supply since the end of last year. This can be seen in even-higher compliance with the production accord - a supply shock in many ways - negotiated by the Kingdom of Saudi Arabia (KSA) and Russia: Last month, Reuters estimated 94% compliance on the 1.2mm b/d in cuts pledged by OPEC states. We expect compliance to remain high, which will strengthen the divergence between oil prices and the USD, as markets look toward the upcoming summer driving season in the Northern Hemisphere. Active supply management and robust demand growth wrought by lower prices could continue to overwhelm a strong USD's influence on oil prices, if this Agreement becomes a durable modus operandi for KSA and Russia going forward. We give a high probability to this outcome, even as the Fed leans into its interest-rate normalization. Energy: Overweight. This past Thursday, we closed our long WTI Dec/17 vs. short Dec/18 backwardation spread at +$0.96/bbl (Dec/17 over); it was initiated February 9 at -$0.11/bbl (Dec/17 under), resulting in a 972.7% gain. We also closed our Dec/19 short WTI vs. long Brent spread, elected February 6 at +$0.07/bbl (WTI over) at -$1.17/bbl (WTI under), for a gain of 1,771.4%. Base Metals: Neutral. Any demand uptick for base metals' coming from U.S. fiscal stimulus will not hit markets until 2H18 at the earliest. We remain neutral. Precious Metals: Neutral. Based on last week's analysis, we are tactically long a Jun/17 gold put spread (long the $1200/oz put vs. short the $1150/oz puts) and call spread (long the $1275/oz call vs. short the $1325/oz calls) at a net debit of $21/oz. Ags/Softs: Underweight. The USDA expects continued demand from China to keep soybeans relatively well bid versus corn and wheat in the 2017/18 crop year. Total planted area for these crops is expected to be the lowest since 2011, keeping ending stocks flat to lower. Feature Prior to the end of the 1990s, crude-oil prices were, to use one of the most popular catch-phrases in finance, mean-reverting: The price of crude oil imported to the U.S. averaged just over $19/bbl from Mar/83, when WTI futures began trading, to 1999 (Chart of the Week). This meant WTI traded at ~ $20/bbl on average over that period. Prices were volatile, but pretty much returned to $20ish/bbl, which allowed traders to take a view on how soon prices would revert to their mean. Whenever prices were too far removed from that level, markets expected producers - OPEC mostly - to adjust output to meet current and expected demand conditions. Since roughly 2000 - maybe a little earlier - oil prices have followed a random walk.1 During this time, oil prices have been negatively correlated with the broad trade-weighted index (TWI) for the USD. One striking characteristic of oil prices and the USD TWI during this time is both followed random walks, which "like the walk of a drunken sailor, wanders indefinitely far, listing with the wind," to borrow Paul Samuelson's well-turned metaphor (Chart 2).2 Chart of the WeekOil's Past As Prelude: ##br##A Return To Mean Reversion? Oil's Past As Prelude: A Return To Mean Reversion? Oil's Past As Prelude: A Return To Mean Reversion? Chart 2Oil Prices And The USD Followed ##br##A Common Long-term Trend Until 1Q16 Oil Prices And The USD Followed A Common Long-term Trend Until 1Q16 Oil Prices And The USD Followed A Common Long-term Trend Until 1Q16 We believe this was caused by OPEC's decision to become a price-taker at the end of the 1990s - shortly after Dec/98 or thereabouts - after years of unsuccessfully trying to manage oil prices via production adjustments. After the price of oil imports in the U.S. dropped below $10/bbl (nominal), it appears the Cartel took the decision to respond to prices set by market forces (supply, demand, inventories and exchange rates), and to abandon its price-management efforts. The long-term correlation between oil and the USD was due to the fact that while oil prices and the USD followed random walks, they followed a common long-term trend as they wandered indefinitely about. This held up to the end of 1Q16, when a massive sell-off in risky-asset markets globally took oil prices below $30/bbl (Chart 3).3 This came on the heels of a price collapse brought about by OPEC's Nov/14 decision to launch a market-share war. By no means did this high correlation mean oil and the USD were always moving in lock step. The collapse in oil prices at the end of the last century led to a production-cutting agreement among OPEC states, Norway and Mexico, which lifted U.S. import prices from less than $10/bbl at the end of 1998 to $30/bbl by Nov/00. Likewise, export disruptions in Venezuela in 2002 - 2003 and, to a lesser extent, hurricane losses in the U.S. Gulf in 2005 sharply curtailed supply and lifted oil prices above what could have been expected given the USD's level at the time, as the Chart of the Week shows.4 End Of Oil's Random Walk? The price collapse of 1Q16 marked the bottom of the price move begun a few months prior to the Nov/14 market-share war declaration. The subsequent divergence between oil prices and the USD since then has been remarkable (Chart 4). The market-share strategy, which essentially allowed Cartel members to produce full-out and grab as much market share as possible, was engineered by KSA, and, we believe, initially was directed at undermining Iran's efforts to restore oil production lost to nuclear-related sanctions. From time to time, it also appeared OPEC was trying to retard the continued growth of shale-oil production in the U.S., which, by 2014, was increasing at an annual rate of more than 1mm b/d, enough to replace the entire output of Libya. Chart 3Close-up Of USD vs. ##br##Brent Divergence Close-Up Of USD Vs. Brent Divergence Close-Up Of USD Vs. Brent Divergence Chart 4The Divergence Between ##br##Oil Prices And The USD Is Remarkable The Divergence Between Oil Prices And The USD Is Remarkable The Divergence Between Oil Prices And The USD Is Remarkable This strategy was a complete failure. The price collapse that ensued brought KSA and Russia - both highly dependent on oil revenues - to the brink of financial ruin, compelling them to find a way to work together.5 After several false starts in 2016, they succeeded late in the year with a negotiated production cut. OPEC pledged to reduce output by as much as 1.2mm b/d, and non-OPEC producers agreed to cut output by close to 600k b/d, half of which is expected to come from Russia. Recent tallies by Reuters indicate 94% of the cuts from OPEC states that signed on to the deal have actually been realized.6 Should KSA and Russia find a way to coordinate their and their allies' production in a way that maintains the backwardation we expect later this year - the result of production cuts (Chart 5), and robust demand growth (Chart 6) - we could see oil prices become mean-reverting once again. Chart 5If KSA And Russia Can ##br##Coordinate Production ... If KSA And Russia Can Coordinate Production ... If KSA And Russia Can Coordinate Production ... Chart 6... And Demand Continues To Grow, ##br##The Oil-Price Backwardation Could Persist ... And Demand Continues To Grow, The Oil-Price Backwardation Could Persist ... And Demand Continues To Grow, The Oil-Price Backwardation Could Persist This likely requires the forward curves for WTI and Brent to remain backwardated, so as to moderate the growth in shale production, and for prices to remain between $55/bbl and $65/bbl, so as not to set off another shale boom. Gulf sources have indicated KSA prefers prices this year of ~ $60/bbl, which, we believe would allow it to keep some control over the rate at which shale production revives.7 Chart 7Supply Destruction And Robust Growth ##br##Rallied Oil Despite A Strong USD Supply Destruction And Robust Growth Rallied Oil Despite A Strong USD Supply Destruction And Robust Growth Rallied Oil Despite A Strong USD Investment Implications We are not calling for a return to mean-reversion in oil prices just yet. We are, however, highlighting the possibility for such a sea-change in the market if all the supply-side pieces fall into place - i.e., KSA, Russia and their respective allies find a way to work together to moderate U.S. shale-oil production. That said, we will be watching closely to see whether the KSA - Russia Agreement becomes a durable modus operandi in the oil market, particularly as regards the management of inventories and production in the market generally. If these states are able to keep prices ~ $60/bbl, and gain some control over the forward curve's slope - i.e., literally manage their production for backwardation - then there is a chance oil prices could once again become mean-reverting. In a mean-reverting world with backwardated oil prices, commodity-index exposure is favored, since investors would, once again, earn positive roll yields as the indices are rebalanced monthly in the underlying futures markets. Bottom Line: The persistent negative correlation between oil prices and the USD broke down following the global asset sell-off in 1Q16. Since then, the combination of supply destruction and robust demand growth has allowed oil prices to rally despite a strong USD (Chart 7). If KSA and Russia can continue to cooperate in their production-management deal - i.e., find a way to manage production so that prices remain closer to $60/bbl than not - and Brent and WTI forward curves backwardate, markets could once again become mean-reverting. In such a world, commodity-index exposures are favored - particularly those heavy on crude-oil and refined-products price exposure - for their positive roll yield. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Technically, oil prices have been I(1) variables (integrated of order 1) since about 2000, meaning they are mean-reverting in first differences (e.g., today's price minus yesterday's price). Please see Geman, Helyette (2007), "Mean Reversion Versus Random Walk in Oil and Natural Gas Prices," pp. 219 - 228, in Advances in Mathematical Finance. Haidar, Imad and Rodney C. Wolff (2011) obtained similar results, reporting crude prices were mean-reverting from Jan/86 - Jan/98, then random-walking since then; please see pp. 3 - 4 of "Forecasting Crude Oil Price (revisited)," presented at the 30th USAEE/IAEE North American Conference in Washington, D.C., during October 2011. Our own research corroborates these results - we find WTI and Brent were mean-reverting from Mar/83, when WTI futures started trading, to Mar/98; and were random-walking I(1) variables after that. 2 Please see Samuelson, Paul A. (1965), "Proof That Properly Anticipated Prices Fluctuate Randomly," in Industrial Management Review, 6:2. 3 This is to say, these variables were cointegrated, and could be expressed in a linear combination using an error-correction model. 4 Our colleague, Mathieu Savary, who runs BCA Research's Foreign Exchange Strategy, addressed these oil-USD divergences in "Party Like It's 1999," published November 25, 2016. It is available at fes.bcareseach.com. 5 We discuss this at length in the feature article of Commodity & Energy Strategy published September 8, 2016, entitled "Ignore The KSA - Russia Production Pact, Focus Instead On Their Need For Cash." Both states were burning through cash reserves, and were trying tap foreign markets for additional funds by selling interests in their most valuable holdings - via the IPO of, and via the sale of just under 20% of Rosneft held by the Russian government. Russia placed its Rosneft shares late last year with Glencore and Qatar's sovereign wealth fund, while KSA is expected to IPO Aramco in late 2018. 6 Please see "OPEC compliance with oil curbs rises to 94 percent in February: Reuters survey," published by the news service online February 28, 2017. 7 Please see "Exclusive: Saudi Arabia wants oil prices to rise to around $60 in 2017 - sources," published by Reuters online February 28, 2016. Investment Views and Themes Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016

Highlights Global manufacturing inventories are low but this does not guarantee higher share prices for global cyclical stocks. If an increase in inventories is accompanied by strengthening final demand, it will be very bullish for the global business cycle. If final demand growth falters, global cyclical plays will relapse amid rising inventories. China's inventory depletion has been due to the large fiscal and credit impulse in the past 12 months - i.e., improving final demand has been instrumental to inventory shedding. Looking forward, the mainland's aggregate credit and fiscal impulse seems to have topped out raising the odds of a reversal in EM/China plays sooner than later. The risk/reward of EM/China plays remains unattractive. Feature Global Manufacturing Inventories Global manufacturing inventories have been depleted over the past 12 months, and inventory levels are generally low (Chart I-1 and Chart I-2). Chart I-1Global Manufacturing Inventories Are Low Global Manufacturing Inventories Are Low Global Manufacturing Inventories Are Low Chart I-2Global Manufacturing Inventories Are Low Global Manufacturing Inventories Are Low Global Manufacturing Inventories Are Low Could inventory re-stocking extend the current manufacturing cycle recovery worldwide? Will low inventories and re-stocking in China lengthen the nation's business cycle upswing? Chart I-3 demonstrates inventory cycles and manufacturing production within manufacturing-intensive economies. The correlation is not stable. Currently, this entails that low manufacturing inventories and a potential rise in inventories over the course of this year do not guarantee acceleration in industrial output growth. Having reviewed manufacturing inventory cycles and their correlation with share prices, we conclude that the key to share prices is final demand - not inventory swings. Manufacturing inventories have dropped in the past 12 months because final demand has been robust (Chart I-4). Historically, periods of re-stocking have often coincided with poor equity market performance. Indeed, Taiwanese, Korean, Japanese and German non-financial share prices have no stable correlation with their respective manufacturing inventory cycles (Chart I-5). In short, manufacturing inventories could rise in the months ahead, but this does not guarantee higher share prices in cyclical industries. Chart I-3Inventories And Production ##br##Are Not Always Correlated Inventories And Production Are Not Always Correlated Inventories And Production Are Not Always Correlated Chart I-4Robust Demand Has Led ##br##To Inventory Depletion Robust Demand Has Led To Inventory Depletion Robust Demand Has Led To Inventory Depletion Chart I-5Non-Financial Share Prices And##br## Inventories: Little Correlation Non-Financial Share Prices And Inventories: Little Correlation Non-Financial Share Prices And Inventories: Little Correlation By and large, the outlook for corporate profits is contingent on final demand rather than re-stocking. All of the above confirms that inventories are a residual of demand and supply. Stronger-than-expected demand is bullish for share prices, though it also often coincides with declining inventories. By contrast, rising inventories typically reflect demand falling behind output growth (one can define it as involuntary re-stocking) and these periods are not favorable for share price gains in cyclical industries. One caveat is that there could be a re-stocking cycle amid strengthening demand or, in other words, voluntary re-stocking. If this transpires in the coming months, it will be extremely bullish for share prices as it will supercharge output growth. While the latter scenario - inventory re-stocking amid strengthening final demand - could very well occur within the advanced economies this year, odds of such positive dynamics are low in EM/China. Bottom Line: Share prices in global cyclical sectors are driven by swings in final demand - not in inventories. Going forward, global manufacturing inventories will rise. If this rise is accompanied by strengthening demand, it will be very bullish for the global business cycle. Otherwise, global cyclical plays will relapse as inventories rise. What Drives China's Inventory Cycles Chart I-6 shows that China's manufacturing inventories typically deplete when the credit and fiscal impulse is rising, and vice versa. China's manufacturing inventories have been exhausted because demand has been strong in the past 12 months. In turn, demand strength has originated from the country's massive fiscal and credit stimulus push from the first half of 2016. Chart I-6China: Strong Policy Stimulus Led To Manufacturing Inventories Reduction China: Strong Policy Stimulus Led To Manufacturing Inventories Reduction China: Strong Policy Stimulus Led To Manufacturing Inventories Reduction That said, China's aggregate fiscal and credit impulse seems to have recently rolled over, pointing to a top in its manufacturing mini-cycle and commodities prices (Chart I-7). This signals a potential deceleration in final demand. On the whole, the ongoing modest tightening by the People's Bank of China and by the bank regulator (the China Banking Regulatory Commission) amid a lingering credit bubble is raising the odds of a moderate credit slowdown in the months ahead. Even modest credit growth deceleration will result in a negative credit impulse (Chart I-8, top panel). Meanwhile, the mainland's fiscal impulse has already dropped (Chart I-8, bottom panel). Chart I-7China: Aggregate Credit And Fiscal##br## Stimulus Has Topped Out China: Aggregate Credit And Fiscal Stimulus Has Topped Out China: Aggregate Credit And Fiscal Stimulus Has Topped Out Chart I-8China: A Breakdown Of Credit ##br##And Fiscal Impulses China: A Breakdown Of Credit And Fiscal Impulses China: A Breakdown Of Credit And Fiscal Impulses On the whole, these developments are leading us to maintain our negative bias toward EM risk assets and China plays. What has gone wrong in our view/analysis on China in the past 12 months is that the nation's credit growth has stayed much stronger than we expected. In our April 13, 2016 report,1 we did a scenario analysis and argued that China's large fiscal stimulus push would be offset by a negative credit impulse if credit growth slowed from 11.5% to below 10%. In reality, credit growth has been between 11.5-12.5%, producing a positive credit impulse. Barring tightening by the central bank or bank regulators, mainland banks can continue originating loans/money at a double-digit pace, as they have been doing for many years (Chart I-9). In general, commercial banks do not need savings to create money/loans and there are few limits on Chinese banks originating loans "out of thin air," as we argued in our Trilogy of Special Reports on money/loan creation, savings and investment.2 Chart I-9China's Credit/Money Growth##br## Remains Rampant China's Credit/Money Growth Remains Rampant China's Credit/Money Growth Remains Rampant Therefore, if credit growth does not slow, our negative view on China's growth will be off-the-mark again. The pressure point in such a case will be the exchange rate. Unlimited money creation/oversupply of local currency is bearish for the value of the RMB. The RMB will continue depreciating, but it is not certain if it will hurt EM risk assets. It is a major consensus view nowadays that the Chinese authorities will not allow growth to suffer ahead of the Party Congress in autumn of this year. Yet, the PBoC and bank regulators are modestly tightening to "normalize" credit growth. Some clients may wonder why we are placing so much emphasis on the rollover of credit and fiscal impulses now, while placing little emphasis on these same indicators in 2016 when they were recovering. The rationale is as follows: when there is a credit bubble - as there is in China now - we tend to downplay the importance of policy easing and put more significance on policy tightening. The opposite also holds true: when the credit/banking system is healthy, we tend to downplay the impact of moderate policy tightening and put greater emphasis on policy easing. In a credit bubble, it does not take much tightening to trigger a downtrend that unwinds excesses. Similarly, moderate tightening in a healthy credit system should not be feared. From a big picture perspective, we turned bearish on China's growth several years ago due to the formation of a credit bubble. The bubble has only gotten larger and an adjustment has not yet even started. This does not justify altering our fundamental assessment of China's growth outlook. It would have been ideal to turn positive tactically on EM/China plays a year ago. Unfortunately, we did not do that. Presently, chasing the market higher might not be the best investment idea. Based on all this and given: the sharp rally in EM/China plays and widespread investor complacency and consensus that "everything" will be fine before the end of this year; modest tightening in Chinese monetary policy amid lingering credit and asset (property and the corporate bond market) bubbles; our outlook for higher U.S. bond yields and a stronger U.S. dollar; the fact that financial markets are forward looking, and timing is impossible; We believe the risk/reward of EM/China plays remains unattractive. In regard to EM ex-China, as we documented in last week's report, domestic demand in the developing economies has not recovered at all, or is mixed at best. DM final demand strength and global manufacturing inventory rebuilding will certainly help Korea and Taiwan, but not other emerging economies. The most important variables for other EM economies including China are domestic demand and/or commodities prices. If commodities prices relapse along with China's credit and fiscal impulse (Chart I-7, bottom panel), EM financial markets will suffer regardless of the growth trends within advanced economies. In fact, strong U.S. growth could lead to higher U.S. interest rate expectations and prop up the U.S. dollar. This will also be a bad omen for EM and commodities. Bottom Line: China's inventory depletion has been due to the large fiscal and credit impulse in the past 12 months - i.e., improving final demand has been instrumental to inventory shedding. Looking forward, the mainland's aggregate credit and fiscal impulse seems to have topped out, raising the odds of a reversal in EM/China plays sooner than later. Industrial Metals Inventories And Prices There is no good data reflecting industrial metals inventories globally. London Metal Exchange and Shanghai Futures Exchange data are likely not indicative of global metals stockpiles. China accounts for close to 50% of global demand for industrial metals, and its demand is critical to prices. Given that the large spike in metals prices in the past several months has coincided with improving Chinese economic data, one would expect the mainland to be the driving force behind the rally. However, Chart I-10 demonstrates that China's imports of industrial metals actually contracted in 2016. This is puzzling, but we have to take it at face value. The top panel of Chart I-11 depicts that traders' net long positions in copper are at a six-year high. This might partially explain the rally in copper in the recent months. Chart I-10China's Import Of Base Metals##br## And Base Metals Prices China's Import Of Base Metals And Base Metals Prices China's Import Of Base Metals And Base Metals Prices Chart I-11Traders Are Long ##br##Copper And Oil Traders Are Long Copper And Oil Traders Are Long Copper And Oil Clearly, China has been depleting its stock of industrial metals, and is likely primed to increase its imports. Nevertheless, periods of metals re-stocking by the mainland have historically not entailed higher industrial metals prices (Chart I-10). On the contrary, rising Chinese imports of metals have actually coincided with falling prices. One can interpret this relationship as China buying industrial metals when prices are falling. This is consistent with China attempting to buy commodities on dips. As to metals inventories in China, the picture is as follows: Steel inventories have plummeted and are low (Chart I-12). One can safely argue that there will be an inventory re-stocking cycle in China. Nevertheless, it is highly uncertain if this will be bullish for steel prices and steel stocks. In fact, there has been a mild negative correlation between steel prices and inventories; historically, when inventories have risen, prices declined (Chart I-12, top panel). This confirms that inventory levels are a residual of demand and supply, and prices are often driven by final demand - not inventories. This is also corroborated by the bottom panel of Chart I-12, which illustrates that share prices of global steel companies are sometimes negatively correlated with China's steel inventories. Stock prices occasionally sell off when inventories rise, and rally when inventories are shrinking. In contrast to steel and steel products, iron ore inventories have risen, and it seems the re-stocking cycle is well advanced (Chart I-13). Chart I-12China: Steel Inventories And Prices China: Steel Inventories And Prices China: Steel Inventories And Prices Chart I-13China: Iron Ore Inventories And Prices China: Iron Ore Inventories And Prices China: Iron Ore Inventories And Prices Yet, again there is no strong correlation between inventories and prices of iron ore (Chart I-13). In our discussions with clients, investors often attribute the rally in industrial metals in general and steel prices in particular over the past 12 months to supply cutbacks in China. While supply reductions have helped in the case of certain metals, it is also evident that the rally in industrial commodities has been driven by rising demand globally and in China. First, China's aggregate credit and fiscal impulse was positive until very recently, implying strengthening demand and thereby higher metals prices. Second, if there were only production cutbacks in steel and other commodities and not demand recovery, the mainland's manufacturing PMI would not have risen (Chart I-14). Finally, steel production has risen both in China and the rest of the world (Chart I-15). Hence, world steel supplies have expanded in the past 12 months. Given this has coincided with rising steel prices, it confirms there has been notable improvement in demand for steel. Chart I-14China: Steel Prices Are Up ##br##Because Of Strong Demand China: Steel Prices Are Up Because Of Strong Demand China: Steel Prices Are Up Because Of Strong Demand Chart I-15Chinese And Global ##br##Steel Production Chinese And Global Steel Production Chinese And Global Steel Production We are not experts in the ebbs and flows of commodities supplies, but it seems the Chinese government's mandated steel capacity cutbacks have not prevented rising steel output in China. In the meantime, rising prices amid rising production and falling inventories are indicative of robust final demand for many metals. Bottom Line: Industrial metals prices have risen because demand in the real economy and among financial investors has been strong. That said, a rollover in China's fiscal and credit impulse and a strong U.S. dollar will likely create headwinds for industrial metals prices over the course of this year. A Word About Oil Inventories OECD oil product inventories have continued to rise, despite supply cuts (Chart I-16, top panel). At the same time, our proxy for change in China's oil inventories has been very elevated for a while, depicting strategic and/or commercial inventory building on the mainland (Chart I-16, bottom panel). It is true that supply curtailments have been instrumental to the rally in oil prices, but the continued inventory buildup also indicates that supply is still outpacing demand. Besides, traders' net long positions in crude have spiked close to their 2014 highs (Chart I-11, bottom panel). This corroborates that demand for crude, like for copper, has partially been financial rather than from final consumers. Finally, U.S. rig counts have recovered somewhat, which may be indicative of a continued rise in America's oil output (Chart I-17). Chart I-16Oil Inventories Keep On Rising Oil Inventories Keep On Rising Oil Inventories Keep On Rising Chart I-17U.S. Rig Counts And Oil Production U.S. Rig Counts And Oil Production U.S. Rig Counts And Oil Production Bottom Line: While we do not have expertise to follow or forecast oil supply dynamics, we are biased in believing that the risk-reward for oil prices is unattractive because of a strong U.S. dollar and potentially weak EM/China asset prices, which could trigger a reduction in net long positions in crude. Investment Conclusions Complacency reigns in the global financial markets. EM equity volatility has fallen close to its cycle lows, the U.S. VIX is depressed, U.S. equity investor sentiment is very elevated and EM corporate credit spreads have plummeted to a ten-year low (Chart I-18). While the timing of a reversal is impossible, the risk-reward profile of EM financial markets is greatly unattractive. The U.S. trade-weighted dollar has consolidated recently, and might be primed for another upleg. As the U.S. dollar resumes its uptrend, EM risk assets will likely sell off. Finally, EM share prices have failed to outperform the developed bourses much, despite the rally in commodities and amelioration in Chinese growth (Chart I-19). Chart I-18Complacency Reigns Complacency Reigns Complacency Reigns Chart I-19EM Equities Have Not Yet Outperformed EM Equities Have Not Yet Outperformed EM Equities Have Not Yet Outperformed Remarkably, analysts' net earnings revisions for EM stocks have so far failed to turn positive (Chart I-20). Either analysts' EPS expectations were originally still too high, or companies are failing to deliver profits. Whatever the reason, the implication is that the consensus is more bullish on EM than is suggested by the underlying fundamentals. Within an EM equity portfolio, our overweights remain Taiwan, Korea, India, China, Thailand, Russia and central Europe. Our underweights are Malaysia, Indonesia, Turkey, Brazil and Peru. We are neutral on other bourses. Finally, the EM equity benchmark is at a critical technical resistance level (Chart I-21) but odds do not favor a sustainable breakout. Chart I-20EM EPS Net Revisions Are Still Negative EM EPS Net Revisions Are Still Negative EM EPS Net Revisions Are Still Negative Chart I-21EM Stocks: A Breakout Attempt EM Stocks: A Breakout Attempt EM Stocks: A Breakout Attempt Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Report titled, "Revisiting China's Fiscal And Credit Impulses", dated April 13, 2016, available at ems.bcaresearch.com 2 Trilogy of Special Reports on money/loan creation, savings and investment, titled, "Misconceptions About China's Credit Excesses" dated October 26, 2016, "China's Money Creation Redux And The RMB", dated November 23, 2016 and "Do Credit Bubbles Originate From High National Savings?", dated January 18, 2017, available at ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights We expect the high level of compliance with the OPEC - non-OPEC production agreement engineered by the Kingdom of Saudi Arabia (KSA) and Russia will endure, leading to significant reductions in global oil inventories this year and next. All else equal, this should backwardate WTI and Brent forward curves later this year. However, recent developments in the North American pipeline market - i.e., U.S. President Donald Trump's orders to revive development of the Keystone XL (KXL) and completion of the Dakota Access (DAPL) pipelines - could send as much as 1mm barrels/day (bbl/d) of crude south from Canada and the Bakken, which would boost inventories at Cushing and other Midwest storage facilities later in this decade. Depending on when these pipelines are completed - likely by 2020 in the case of KXL - the WTI forward curve could return to a sustained contango.1 The expanded flows of heavy crude via KXL, and light-tight oil south via the DAPL could undo a subtle benefit arising from the backwardation induced by the KSA - Russia production pact, which we uncovered in our modeling. Energy: Overweight. At Tuesday's close, our short Dec/19 WTI vs. long Dec/19 Brent spread elected last week at $.07/bbl (WTI over) was up 700%. Our long Dec/17 WTI vs. short Dec/18 WTI front-to-back spread, entered into at -$0.11/bbl on Feb 9/17, was up 263%. Base Metals: Neutral. BHP declared force majeure at its Escondida mine, which accounts for ~ 5% of global supply, after workers voted to strike. Union leaders agreed to another round of government-mediated talks with BHP management. Precious Metals: Neutral. Fed Chair Yellen's Senate Banking Committee testimony was more hawkish than expected, which rallied the USD and muted gold's overnight strength. We continue to look to get long gold at $1,180/oz. Ags/Softs: Underweight. The USDA revised grain and soybean supply/demand estimates last week, showing markets tightening slightly, with ending stocks for the 2016/17 crop year expected to be a touch lower. We remain bearish. Feature Chart of the WeekStorage Drawdowns Should Accelerate ##br##As U.S. Oil Imports Slow Storage Drawdowns Should Accelerate As U.S. Oil Imports Slow Storage Drawdowns Should Accelerate As U.S. Oil Imports Slow Regular readers of BCA's Commodity & Energy Strategy service will not be surprised by the very high compliance levels seen in the wake of the OPEC - non-OPEC production Agreement engineered by KSA and Russia late last year.2 Because the stakes are so high for KSA and Russia - and their respective oil-producing allies - we expect compliance to remain high into June, resulting in a drawdown of global oil storage, the stated goal of the deal. We believe the pact will result in both WTI and Brent forward curves returning to backwardation, as global storage levels fall some 300mm bbl (Chart of the Week). We are positioned for this outcome by being long Dec/17 WTI vs. short Dec/18 WTI. We are expecting to see the last of the Persian Gulf export surge to the U.S. this month, as the 45- to 50-day sailing time from the Gulf to the U.S. implies the last of these vessels will be arriving this week or next. This backwardation will, in all likelihood, restrain the rate at which U.S. shale-oil producers return rigs to the market next year. Chart 2Curve Shape Can Affect Rig Counts Curve Shape Can Affect Rig Counts Curve Shape Can Affect Rig Counts WTI Term Structure And Rig Counts: It's Complicated Recent modeling we've completed suggests curve shape can affect rig counts in the U.S. light-tight oil fields. When we regress U.S. rig count on the WTI forward curve, we find rig counts can be expected to increase when the forwards are in contango, and to decline when the market is backwardated. A flat forward curve can be expected to keep rig counts fairly constant (Chart 2).3 Obviously, the starting point for these outcomes is critical. We simulated rig counts by assuming Monday's closing prices for March through June WTI futures, then assumed different levels for July WTI futures as a starting point for estimating rig counts to end-2018. We used $50, $55 and $60/bbl in July as our starting point. All else equal, with the July/17 WTI at ~ $55/bbl and the forward curve backwardated by 10% 18 months out, we would expect to see average rig counts fall by 4.38 rigs/month in 2018, given the three-to-four month lag between rigs actually being deployed and the price signal being sent by the futures market. A contango term structure produces the opposite result. With the July/17 WTI at ~ $55/bbl and the forward curve in a contango of 10% 18 months out, we would expect to see rig counts increase by 4.57 rigs/month in 2018. There obviously is a price threshold from which the forward curve originates in this analysis, which we believe to be between $50 and $55/bbl. Below this level, we would expect shale producers to retreat back to their core production areas, and await a price signal to increase their rig counts. Above $60/bbl, backwardation and contango matters for rig counts over the next 2 to 2.5 years. A backwardated forward curve will, all else equal, incentivize a slightly lower level of rigs being deployed than a contango. For example, a 10% contango with a $60/bbl starting point results in 5.24 rigs/month being deployed, while 10% backwardation would lead us to expect 5.02 rigs/month being deployed. Sustaining Backwardation Will Be Difficult A sustained backwardation will be threatened later in this decade by the expansion of the North American pipeline grid, following U.S. President Trump's orders to revive the Keystone XL (KXL) pipeline's development and the completion the Dakota Access Pipeline (DAPL). The KXL and DAPL buildouts, if approved, will expand U.S. midcontinent crude deliveries by 1mm bbl/d, according to Genscape's tally.4 The KXL volumes would add close to 600k bbl/d to Canadian exports, and would flow directly into Cushing, OK. Another 400k bbl/d of light-tight oil from the Bakken LTO fields will flow to the midcontinent refining market via the DAPL. "Increased flows into Cushing due to the addition of Keystone XL could lead to a bottleneck of inventories at the hub, which would put downward pressure on crude prices," Genscape notes. Work on the KXL could start this year, and be completed before 2020. The DAPL is ~ 95% complete, and should be done in 6 months or less. Genscape believes the DAPL could be built and line fill could be in place in less than three months. Indeed, "drilling under Lake Oahe in southern North Dakota for Energy Transfer Partner's Bakken-to-Patoka, IL, Dakota Access (DAPL) crude pipeline began immediately upon receiving an easement from the U.S. Army Corps of Engineers on February 8, according to a company spokesman. It is expected to take 83 days for construction and linefill... ." We will monitor these pipeline buildouts closely, given the profound implications they have for U.S. midcontinent and Gulf Coast refiners, who could once again find themselves benefiting from a widening of the Brent vs. WTI differential, and Canadian E&Ps, who can be expected to increase production into this KXL buildout. The key market to watch as these pipelines are under construction will be the WCS vs. WTI spreads (Chart 3). As pipeline capacity opens up, exports of heavy crude from Canada will increase and the WCS - WTI differential will narrow, which will benefit Canadian E&Ps (Chart 4). A return of contango following the opening of these pipelines would benefit U.S. refiners, who can be expected to increase exports. Chart 3Expanding the N. American Pipeline Network##br## Will Widen WTI Differentials Expanding the N. American Pipeline Network Will Widen WTI Differentials Expanding the N. American Pipeline Network Will Widen WTI Differentials Chart 4Crude Differentials Will##br## Adjust To Pipeline Buildouts Crude Differentials Will Adjust To Pipeline Buildouts Crude Differentials Will Adjust To Pipeline Buildouts Bottom Line: The backwardation of the WTI and Brent forwards should accelerate as the last of the surge in exports from the Persian Gulf arrives in the U.S. President Trump's decision to expedite KXL and the completion of the DAPL in 6 months or less will have a profound impact on crude movements and storage levels in the U.S. later in the decade. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 President Trump's decision to revive KXL was endorsed by House and Senate leaders in the U.S. last month, which greatly raises the odds it will go ahead. In addition, the DAPL received an easement from the U.S. Army Corps of Engineers to complete construction. 2 Please see issue of BCA Research's Commodity & Energy Strategy Weekly Report "Raising The Odds Of A KSA-Russia Oil-Production Cut," dated November 3, 2016, available at ces.bcaresearch.com. 3 Our previous modeling indicates Granger causality goes from WTI prices to rig counts - i.e., E&P companies drilling decisions are driven by price levels and curve shape. We believe this relationship arises from the hedging behavior of shale-oil producers, many of whom hedge their forward revenues in the futures markets over a two-year interval. 4 Please see "Keystone XL, Dakota Access Could Cause Bottlenecks at U.S. Mid-Continent Storage Hubs, Shift Crude Prices," published on Genscape's blog February 14, 2017. Genscape is a near-real-time pipeline, storage and shipping monitoring service. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in