Equities

Bank stocks are being jettisoned from portfolios almost as fast as they were added after the election, on the back of the perceived dovish Fed shift and concerns about the efficacy of Trump's policy goals. The latter has raised the specter of a cooling in economic growth, which would remove the major source of support for bank stocks. Indeed, there is little fundamental support to drive earnings outperformance. Total bank credit growth is contracting and credit quality is no longer adding to profitability. Bank productivity growth is sinking quickly, because balance sheet expansion has ended but banks are adding to their cost structures. If the yield curve begins to narrow on fears of economic disappointment, it will remove the primary driver of capital inflows into banks. Regional banks have been particularly hard hit, but the entire banking group is at risk of a letdown. Bottom Line: Continue to shy away from banks, and please see the March 6 Weekly Report for more details on our banking view. The ticker symbols for the stocks in the S&P Banks index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT.

Special Report

The aim of this Special Report is to elaborate on and explain the different views on China that have coexisted at BCA in recent years. Although BCA strives to achieve consensus among its strategists, this is not always possible, as has been the case with China. Peter Berezin of the Global Investment Strategy service and Yan Wang of China Investment Strategy have been positive, while Arthur Budaghyan of Emerging Markets Strategy has been negative on both China's business cycle and China-related plays. The focal points of divergence are centered on how Peter, Yan, and Arthur view and explain the relationship between savings, debt, and the misallocation of capital, as well as how they see China's potential roadmap going forward. The debate is moderated by BCA Global Strategist Caroline Miller. Caroline: Peter and Yan, the world - including the Chinese government - is climbing a wall of worry about China's debt load. Why are you guys still smiling? How many Maotai did you have last night? Peter: I don't know what a Maotai is, but I am sure that if I had more than one I wouldn't be smiling this morning. But yes, I am not as worried as Arthur that China is in the midst of an unsustainable credit bubble. Genuine credit bubbles tend to happen during periods of euphoria. U.S., Spanish, and Irish banks all traded at lofty multiples to book value on the eve of the financial crisis, having massively outperformed their respective indices in the preceding years. That's obviously not the case for Chinese banks today, which remain one of the most loathed sectors in the global equity market (Chart 1). The U.S., Spanish, and Irish housing booms also occurred alongside ballooning current account deficits, something that doesn't apply to China (Chart 2). One can debate whether China is in the midst of a property bubble, but even if it is, it looks a lot more like the one Hong Kong experienced in the late 1990s. When that bubble burst, property prices plummeted by 70%. Yet, Hong Kong banks were barely affected (Chart 3). Chart 1Chinese Banks: Unloved And Unwanted Chart 2Recent Credit Bubbles Developed ##br##Amid Widening Current Account Deficits Chart 3Hong Kong Is The Correct Analogy Yes, there is a lot of debt in China. But there is a lot of savings too. In fact, to a large extent, China's high debt levels are just a function of its high saving rate. The evidence suggests that national saving rates and debt-to-GDP ratios are positively correlated across emerging economies (Chart 4). China sits close to the trend line, implying that its debt stock is roughly what you would expect it to be. Chart 4Positive Correlation Between National Savings And Indebtedness Arthur: Allow me to both agree and disagree with Peter. No, there is no bubble in Chinese equities, but yes, there is a bubble and euphoria in China's property market. Property prices have risen exponentially and are extremely high by any metric. Chinese bank equity valuations have already adjusted, but bank stocks could still sell off if their profits shrink considerably, as I expect. Bank shares are not expensive, but not cheap either, if one adjusts for non-performing loans. I concur that China's property market adjustment will likely resemble that of Hong Kong as opposed to that of the U.S. As Peter noted, in Hong Kong in the late 1990s, property prices plunged by 70%, but few homeowners defaulted on their mortgages. Yet property starts/construction also collapsed by 80% (Chart 5). Chart 5Hong Kong's Property: ##br##Few Mortgage Defaults ##br##But Collapse In Construction Presently in China, the risk is not mortgage defaults but a renewed drop in property construction as well as other types of capital spending. Less construction/capital spending entails less demand for commodities, materials/chemicals and industrial goods. China's residential and non-residential construction activity will contract anew as speculative/investment demand for property weakens. Yan: I agree with Peter that China's rising debt is fundamentally a function of the country's abundant savings. Moreover, the fact that the country's massive savings pool is primarily intermediated via the banking sector and other debt instruments exacerbates the debt buildup. If a country's savings are primarily intermediated by the stock market through equity financing, then high savings do not necessarily lead to high debt, as "savers" become "shareholders" rather than "creditors." In China's case, the country's still relatively undeveloped and volatile equity market has not yet been able to play a meaningful role in financial intermediation. Instead, banks still play a dominant role channeling financial resources. In other words, China's high savings and a banking-centric financial intermediation system are key drivers of the ever-rising debt level. In fact, as long as these two features persist, the country's debt will inevitably continue to rise, as it simply reflects the accumulated savings. Caroline: Arthur, does this line up with how you think about the relationship between savings and debt? Arthur: My thesis has been that China's abnormal credit growth has been the result of speculative, euphoric behavior among Chinese banks and the shadow banking system - and not the natural result of the country's "excess savings," as Peter and Yan have argued. What economists call "savings" or "excess savings," non-economists refer to as "overproduction" or "excess capacity." This is about concepts, not about China. In economic science, the term "savings" is used to denote the number of goods and services that a nation has produced but not consumed - i.e., they can be used for investment or exports. Peter and Yan are using this textbook definition of "savings." Hence, by "savings" or "excess savings" they mean "excess production." Logically, the glut of goods and services does not flow to banks and create deposits. In brief, "savings" or "excess savings" are real economic variables and have nothing to do with bank deposits - i.e., "monetary savings." Peter, Yan and many other commentators make this mistake by mixing up national savings - which is literally output of goods and services that were not consumed by households and government - with "monetary savings," i.e., deposits in the banking system. I have no doubt China has had a high savings rate, i.e., it has had overcapacity and over-production in a number of sectors. The textbook concept of national savings is calculated as a residual from the national accounts and balance of payments. In particular: Savings - Investments = Current Account Balance and Savings = Investments + Current Account Balance A few remarks on the economic interpretation of this equation are in order. First, in any country, "excess" national savings over investment, i.e., current account surpluses, lead to an accumulation of net foreign assets, but has no implication on domestic loan creation.1 Second, a country that invests a lot and does not run a large current account deficit will have a high savings rate as per the economic textbook's definition of national savings. The opposite also holds true. Critically, national or household savings are in no way linked to the amount of deposits at banks. When households decide to save a part of their income, they do not create new deposits or "monetary savings." They save deposits that already exist in the banking system. To sum up, the amount of deposits in the banking system does not change as a result of households' decision to save a part of their income. When a person gets paid in cash and deposits that cash in a bank as a savings deposit, there is no new money created either. That cash was a deposit and was withdrawn from a bank a few days before, and now this cash returns to the banking system as a deposit again. In this case, the amount of total outstanding money supply in the economy (cash plus deposits) has not changed. In general, when a bank receives a deposit, it does not create new money, or "monetary savings." The deposit simply moves from one bank to another or from cash to deposit. The amount of money supply does not change. When a country enjoys a lot of overcapacity, strong bank loans or money growth will not cause inflation and interest rates will stay low, encouraging more borrowing. This is why in Peter's Chart 4 there is a positive correlation between the national savings rate and debt-to-GDP ratio across countries. Overcapacity entails low inflation; the latter keeps nominal interest rates low, which in turn entices more borrowing and debt build-up. In brief, the linkage between national savings/excess capacity and the credit-to-GDP ratio is indirect via subdued inflation and low interest rates that encourage debt build-up. Caroline: Arthur, you have made the case that savings are not a constraint to loan origination. Can you elaborate? Arthur: The banking system does not intermediate "savings" or "excess savings" from the real economy into loans. The commercial banking system as a whole creates deposits at the time it originates loans. This is true of all countries. Indeed, whenever commercial banks make a loan, they simultaneously create a matching deposit in the borrower's bank account, therefore creating new money in the process (Chart 6). In other words, bank loan origination creates deposits and money.2 Chart 6Commercial Banks: Credit Origination Creates Deposits China's banking system has a lot of deposits because banks have created too many loans. In addition, a bank does not need liquidity (reserves at the central bank) for each loan it originates. It still requires some liquidity to settle its net balance with other banks or to meet minimum reserve requirements. If a bank creates a loan but still has excess reserves at the central bank, it may not require liquidity to "back up" the loan. There are many variables that constrain bank loan origination, but they do not include national savings or "excess savings." We discussed these constraints in detail in our EMS report titled Misconceptions About China's Credit Excesses.3 Finally, when central banks opt to keep short-term interest rates steady, they must provide commercial banks with as much liquidity as the latter demands. This point is greatly relevant to China. For the past few years, China's central bank has silently moved away from controlling money growth (the quantity of money) to targeting interest rates (the price of money) (Chart 7). As a result, nowadays the People's Bank of China (PBoC) has very little quantitative control over money/credit creation by commercial banks. Chart 7The PBoC Has Begun Targeting Rates In Recent Years It is Chinese commercial banks that effectively drive money/credit/deposit creation. The PBoC decides whether or not to accommodate banks' liquidity needs by allowing interest rates to rise or fall, or by keeping them steady.4 To conclude, what habitually drives credit booms in any country are the "animal spirits" of banks and borrowers - not national savings. This has been the case in China too. Caroline: Peter, do you agree with Arthur's assessment? Peter: I don't want to get bogged down in the weeds of monetary theory, but let me briefly address two distinct points that I think Arthur is making. The first is the claim that the ability of banks to create money "out of thin air" is somehow not constrained by the volume of bank reserves and cash in circulation (the so - called "monetary base"). The second is the claim that there is no meaningful link between savings and deposits. I think Arthur is wrong on both counts. On the first claim, it is true that when a bank issues a loan, it also creates a deposit. To the extent that bank deposits are treated as "money," this expands the money supply. This is simply the "money multiplier" taught in introductory economics classes. Where Arthur's logic falls short is in his implicit assumption that all lending translates into additional bank deposits. It doesn't have to. Some of the deposits will be withdrawn and kept as cash. Governments have complete control over how much cash there is in circulation by virtue of their monopoly over the printing press. As long as cash exists, central banks can influence the broad money supply via open market operations. By the way, this is true even in banking systems where there are no reserve requirements. Regarding Arthur's claim that lending can occur without savings, this is often true when someone is borrowing money to buy an asset. However, it is generally not true if they are borrowing money to finance new spending. Let me offer a concrete, albeit somewhat whimsical, example to illustrate this point. Suppose I am living in a closed economy where no one saves anything. Now, let's imagine that I decide to throw a party for myself and need to borrow $1000 to do this. Who is going to provide me with the resources? Well, we just said that no one wants to save, so "something" has to adjust for me to have my party. That "something" is the interest rate. In order to entice someone to spend a bit less, the bank (on my behalf) will offer depositors a higher interest rate. If rates rise by enough, someone will decide to forego a bit of consumption today in order to have more consumption tomorrow. In other words, my decision to borrow must result in someone else's decision to save. So do savings create debt or does debt create savings? The answer is both: interest rates adjust to ensure that the two end up being different sides of the same coin. Caroline: Yan, what's your perspective on China's high debt profile? What could you be missing? Yan: As you can see Arthur and I view China's debt profile through different theoretical lenses. I don't think we can fully reconcile our different frameworks on the matter, but we hope our debate can deepen clients' own understanding of this issue, so they can make up their own minds. What I do want to stress is that those analysts who fear that China's corporate debt problem constitutes an alarming systemic financial risk focus exclusively on the rapid increase in the country's debt-to-GDP ratio. While undoubtedly there is merit to this ratio, I think it is also important to validate this judgement by looking at other indicators. In our previous research, we looked beyond this widely cited conventional indicator for corroborating evidence of a "debt bubble." Our findings suggest that the level of Chinese corporate sector leverage is not as precarious as widely perceived. For example, in the Chinese corporate sector, the area of China's economy where investors worry most about leverage, the debt-to-asset ratio of China's industrial sector has been falling since the late 1990s, down to 56% from 62%, contrary to popular belief (Chart 8). State-owned enterprises have witnessed an increase in their debt-to-asset ratio since the global financial crisis, but it has barely reached late 1990s levels, and has actually rolled over in recent years. Meanwhile, SOEs are a shrinking part of the overall economy and therefore, when looked at in conjunction with the private sector, have not moved the needle on the broader trend of corporate balance sheet "deleveraging." This stands in stark contrast to Japan's corporate sector at the peak of its debt bubble. In the early 1990s, Japan's corporate sector debt-to-asset ratio topped out at 78% when the country's "balance sheet recession" began (Chart 9). Even after two decades of deleveraging, Japan's current corporate debt-to-asset ratio is comparable to China's. To validate this conclusion, we also calculated several other key ratios to compare the leverage situation of Chinese listed companies relative to their global peers. Ratios such as liability-to-assets, net debt-to-EBITDA and interest coverage assess both leverage levels and debt servicing capacity. As Chart 10 shows, our extensive survey, both from the top down and the bottom up, suggests that China's leverage situation is comparable if not superior to its global peers. Chart 8The Leverage Picture From A Balance Sheet Perspective Chart 9Japan's Debt Bubble And Deleveraging Chart 10Leverage Ratios: How China Compares Therefore, I think we should be skeptical about the widely held view that China's corporate sector leverage is precariously high. It is at a minimum inaccurate, if not misleading, to rely solely on the debt-to-GDP ratio to reach such an ominous conclusion. Caroline: Arthur, I take it you don't agree? Arthur: Since January 2009, China's corporate and household debt has risen by RMB 130 trillion (about US$ 19 trillion) or by 100% of GDP (Chart 11). I do not believe even the most sophisticated financial/credit systems can allocate such amounts of credit in such a short time and not misallocate capital. By capital misallocation, I am implying investments in projects that do not generate sufficient cash flow to service debt. The accounting value (valuation) of assets is irrelevant in these cases; the cash flow generation is critical. The debt-to-GDP ratio is a much more superior measure to debt-to-asset-ratio. The basis is that the GDP is a proxy for cash flow, while accounting value of assets could be extremely inflated during a credit bubble. To be sure, I am not suggesting that all investments in China have gone sour. Nobody knows the extent of capital misallocation in China. But I suspect it is large enough to make a difference for the macro outlook/business cycle. Caroline: Peter, you have made the comparison between China today and Japan in the 1990s. Could you expand on that? Peter: Starting in the early 1990s, Japan entered an extended era where the private sector was trying to spend less than it earned (Chart 12). In order to keep unemployment from rising, the Japanese government was forced to run large budget deficits. In effect, the government ended up having to absorb the private sector's excess savings through its own dissaving. The same sort of fiscal trap now stalks China. Up until the Great Recession, China was able to export much of its excess savings. The current account surplus hit a record high of nearly 10% of GDP in 2007. The subsequent appreciation of the RMB undermined this strategy, forcing the government to take steps to boost domestic demand. It is no surprise that China's debt stock began to grow rapidly just as its current account surplus started to dwindle (Chart 13). Chart 11China: The Credit Boom Chart 12Japan Relied On Fiscal Largesse And Current Account Surpluses To Offset The Rise In Private-Sector Savings Chart 13China: Debt Increased When ##br##The Current Account Surplus Began Its Descent Keep in mind that fiscal policy in China entails much more than adjustments to government spending and taxes. Central government spending accounts for a fairly small share of GDP. The vast majority of fiscal stimulus is done via the banking system. This makes Chinese fiscal policy nearly indistinguishable from credit policy. From this perspective, China's so-called "debt mountain" is not much different from Japan's debt mountain once we acknowledge that the bulk of China's corporate debt is, in fact, quasi-fiscal debt. As evidence, note that in sharp contrast to the SOE sector, the ratio of liabilities-to-assets among private Chinese companies has actually been trending lower over the past decade (please see Chart 8). In effect, China's money-losing SOEs are the equivalent of Japan's fabled "bridges to nowhere": They are a necessary evil. Caroline: Arthur, your thoughts? Arthur: What Peter and Yan in effect propose is that Chinese banks should continue creating credit/money "out of thin air" in order to create demand for these "excess" goods, i.e., overcapacity sectors. In a nutshell, a number of Chinese companies made bad decisions by over expanding capacity, and now banks have to continue lending/creating demand to justify these bad investments. As a result, persisting explosive credit growth has allowed these unviable or zombie enterprises to survive, and they are not compelled to restructure. This is not how capitalism and markets work. This is de facto socialism. Socialism usually does not lead to prosperity. One of the key reasons behind the failure of socialist economic models is that productivity growth in socialist systems is very low, often close to zero. The basis is that productivity growth is generated not by government officials but by the private sector and entrepreneurs. China's economic success over the past 35 years or so has been due to allowing private enterprises to function and flourish - not because government officials necessarily made correct business and investment decisions. I am for countercyclical fiscal and monetary policies. However, the credit boom in China has gone well beyond the countercyclical policy framework. The concept of countercyclical policies does not suggest that the government or public banks should continue to spend in perpetuity to support fundamentally unviable businesses that invested too much and created excess capacity. Besides, "countercyclical" means for a couple of years. China has been expanding bank/credit/money for about nine years - since January 2009. Peter and Yan argue that they should keep doing it further. If the authorities do what Peter and Yan propose, investors should be structurally - not cyclically - bearish on Chinese stocks. Chart 14There Has Been No Shortage ##br##Of Demand Since 2010 The basis is that a socialist growth model is not friendly for shareholders. Shareholders often lose money when companies operate for maximizing employment rather than profits. This is why Chinese SOEs and bank stocks trade at low multiples - because they destroy capital and value for their shareholders. Notably, "overproduction" and "excess capacity" could be an outcome of either a demand downturn or oversupply/overproduction. Keynes recommended countercyclical policies to fill the gaps when demand shrinks. Chart 15Fiscal Outlays & Credit Origination ##br##Are Close To 50% Of GDP In China's case, there has been no domestic demand downturn to warrant multi-year countercyclical policies. China did the right thing in early 2009 to offset its export plunge amid the Global Financial Crisis, and it helped the global economy recover. However, since 2010 global demand and mainland exports have been stable (Chart 14), making the extended and ongoing credit boom in China unwarranted and excessive. As to the argument that most credit should be counted as a form of fiscal spending, I do not think Chinese policymakers themselves would agree with this statement. In fact, if this is correct, it would mean that government officials are allocating about 50% of GDP each year. Chart 15 illustrates general (central plus local) government spending and annual credit origination as a share of GDP. How fast would productivity grow in an economy where government bureaucrats allocate 50% of GDP annually? It is true that China's central government has a low debt load so it can afford to take over a large chunk of corporate debt. If and when they do so, I will change my view. So far, they have not done this, and will likely only contemplate such a policy move when things get really messy. Investors do not want to be long China plays going into such a scenario. That said, a tactical buying opportunity could emerge when the government takes over a large chuck of corporate debt. Caroline: Yan, how worried should we be about the misallocation of capital in China? Yan: Every economy experiences some level of capital misallocation. The real question is whether China's level of capital misallocation is more serious than that of its global peers. Theoretically, if a country has a bigger capital misallocation problem than others, the economy should have systemically lower capacity utilization, weaker pricing power, and lower profitability. These metrics are easily cross-referenced: Chart 16 contextualizes China's industrial sector capacity utilization ratio relative to global peers. By and large, most countries' capacity utilization ratios hover around 80%, not much different from China's, especially since the 2000s. In fact, barring some obvious outliers, capacity utilization ratios across countries have been largely synchronized, reflecting the ebb and flow of the global business cycle. Chart 16Capacity Utilization: A Global Perspective Industrial sector output prices have shown similar swings (Chart 17). Almost all countries suffered producer price deflation in recent years, and are now experiencing a synchronized upturn in wholesale pricing power. China's falling PPI was widely regarded as a tell-tale sign of misallocation of capital. Conversely, this was in fact more a reflection of stagnating global aggregate demand and weak resource prices worldwide than structurally weak pricing power among Chinese manufacturers. Chart 17Producer Prices: A Global Perspective Similarly, Chinese listed companies' deteriorating Return on Equity (ROE) was again singled out as a sign of capital misallocation. This view is easily debunked by Chart 18, as ROEs have fallen in all major markets. In fact, Chinese companies' ROEs have been structurally higher than the global averages. Even some Chinese sectors that have been derided as being plagued by massive overcapacity and inefficiency such as materials and energy exhibit ROEs almost identical to their global peers. The important point is that we should put China in a global context, rather than analyzing it in isolation. Some Chinese firms' efficiency and profitability have weakened notably over the past several years, but to me, this is more of a reflection of the sluggish global macro backdrop, rather than an indictment of China's discrete growth model. Caroline: Turning to the investment implications, Yan, how does the debt bubble concern impact your view on Chinese equities? Yan: Global investors' widespread concerns over Chinese debt levels and other macro issues have contaminated Chinese stocks with a broad-brushed bearish undertone. Chinese equities have been unduly punished, underweighted and under-owned for many years. As shown in Chart 19, Chinese investable stocks' ROEs have been structurally higher than the global benchmark, and have followed similar cyclical fluctuations. However, their stock prices are trading at massive discounts to the global benchmarks, based on conventional yardsticks (Chart 19). This in my view represents the "China risk premium," which is unjustified and unsustainable. I expect the misperception will eventually unwind, and Chinese shares will be re-rated. This is the fundamental factor supporting my positive view on Chinese equities. Strategically it makes sense to overweight Chinese stocks against their global peers. Chart 18Chinese ROEs Are Not Inferior To Global Peers Chart 19Chinese Equities' Large Valuation Gap Caroline: Arthur, how does your view impact your outlook for investment prospects in China and the rest of the emerging markets space? Arthur: There has not been any adjustment in China's corporate leverage. Deleveraging in China has not yet started. On the contrary, the credit bubble is getting larger. I mean the credit-to-GDP ratio continues rising exponentially and credit and bank loan growth remain in double digits (Chart 20). It is very risky to be bullish on financial assets linked to a bubble when the adjustment has not yet begun. It is like running in front of a steamroller trying to collect pennies. Besides, when there is a major imbalance in the system like the credit bubble happening in China now, I tend to overplay the importance of marginal policy tightening and underplay the significance of easing. Recent marginal policy tightening in China - in particular the clampdown on shadow banking, including banks' off-balance-sheet asset expansion - will cause credit growth to decelerate. This is a major risk to Chinese and EM growth in the second half of this year (Chart 21). Chart 20China: Money/Credit Is Still Booming Chart 21Is China's Recovery At Risk? Even if China does not have a full-blown crisis, we are likely to experience another down leg in China plays, commodities and EM risk assets similar to the second half of 2015, when Chinese import volumes contracted and global markets tanked. A few words about the potential adjustment trajectory are in order. I have been negative on China's growth and China-related plays in global financial markets since 2010, but I have never used the word "crisis." China may or may not have a crisis, but investors holding risk assets exposed to China's growth will suffer considerable losses again similar to the 2011-16 period. It is essential to differentiate cyclical from structural growth drivers. If the government does not allow credit growth to slow, cyclical growth will hold up. However, in this scenario, China will move toward a socialist model and structural growth will tumble. That said, the growth deceleration would be gradual, as depicted in Chart 22. Chart 22Toward Socialism = Secular Stagnation And Inflation If we assume China's productivity is currently growing at a rate of about 5.5-6% (which is already very high and hard to sustain), and if the country embarks on a socialist path, odds are that productivity growth will drop by 50-100 basis points in each of the following years. In five years or so, productivity growth would be only around 1-3%. This path is the ultimate recipe for economic stagnation in China. The only thing the authorities can do in this scenario is to boost growth from time to time via credit and fiscal stimulus. This will produce mini-cycles around a falling primary growth trend. The latest acceleration in China's growth is probably one of these mini-cycles. How can investors invest in this scenario? The stylized mini-cycles depicted in Chart 22 look nice, because we drew them ourselves. In reality, they will not be symmetric or smooth. In short, investing around economic mini-cycles is difficult because it assumes near-perfect timing. Caroline: Peter, is it all that bad? Peter: I think Arthur is too pessimistic. Investors have been predicting a Japanese debt crisis for years. It hasn't materialized and probably won't. They are making the same mistake about China. If China averts a debt crisis, as I think is likely, that's good news for global equities. In the developed market universe, Europe and Japan stand to benefit the most, given the cyclical bent of their stock markets. We are overweight both regions in local-currency terms. For global bonds, the implications are somewhat mixed. On the one hand, the high probability that the Chinese government can maintain the status quo of continued credit expansion for the foreseeable future means that a hard landing for the economy - and the associated drop in safe-haven developed economy government bond yields that this would trigger - is unlikely to occur. On the other hand, high levels of Chinese savings will continue to fuel the global savings glut, keeping real long-term bond yields lower than they would otherwise be. On balance, investors should maintain a modest underweight allocation toward global bonds. Caroline: Yan, do domestic politics play into your outlook for the RMB versus the dollar and on a trade-weighted basis? What is your outlook for monetary policy given recent signs of improving economic momentum? Yan: How President Donald Trump will deal with China on the RMB issue is a wildcard. Recent rhetoric suggests that the new U.S. administration intends to follow normal legal protocol to decide if China is manipulating its currency. This is a significant departure from Candidate Trump's repeated campaign trail promises. If the U.S. Treasury follows the formal process laid out in the statute, it is unlikely to label China a currency manipulator in the next semi-annual assessment to be published in April, simply because the country does not meet all the criteria for that label at the moment. The odds of an immediate clash between the U.S. and China on the RMB have ebbed. From China's domestic perspective, how the People's Bank of China intends to manage the exchange rate is also a thorny issue. From a long term point of view, the PBoC clearly wants to achieve a free-floating exchange rate, but the recent downward pressure on the RMB due to elevated capital outflows has forced the PBoC to heavily intervene to prevent a vicious, disorderly cycle, in which currency depreciation and capital flight reinforce each other. In terms of monetary policy, China's improving economic momentum has allowed the PBoC to follow the Fed in raising short-term interest rates. However, tighter capital account control measures will remain in place until the downward pressure on the RMB from capital outflow dissipates. Moreover, investors have been overwhelmingly focused on the negative economic effects of a weaker RMB, somehow ignoring the reality that as the world's largest manufacturer and exporter, China also stands to benefit from a weaker currency. In my view, the depreciation of the trade-weighted RMB since 2015 has played a critical role in reflating the Chinese economy (Chart 23). A weaker RMB has helped producer prices to reflate, and lowered the real cost of funding for manufacturers, which in turn has eased China's monetary conditions and supported cyclical growth improvement. In this vein, the downside of the RMB should be self-limiting, as the reflationary impact of a weaker exchange rate will help boost Chinese growth, which in turn will reduce downward pressure on the currency. Caroline: Peter and Arthur, is rampant capital flight still a risk? Where do you see the RMB heading over the coming 12-18 months? Peter: I think the RMB will weaken somewhat over the coming year, but that is more a reflection of my bullish view on the dollar than a bearish view on the yuan. Much of the capital flight that China has experienced recently has just been an unwinding of the hot money flows that entered the country over the preceding four years. Despite all the talk about a credit bubble, Chinese corporate external debt has fallen by around $400 billion since its peak in mid-2014 - a decline of over 50% (Chart 24). At this point, most of the hot money has exited the country and hence, I expect the pace of capital outflows to subside. Chart 23A Weaker RMB Leads Cyclical Recovery Chart 24The Rise And Fall Of Corporate Foreign Credit Nevertheless, the chronic shortfall of domestic demand that I described earlier will keep pressure on the Chinese government to try to export excess production abroad by running a larger current account surplus. This requires a weak currency. Thus, while I don't expect the yuan to plummet, I don't expect it to soar either. Arthur: I believe the RMB is set to depreciate by 10% or more against the U.S. dollar in the next 12 months or so. The Chinese yuan is not expensive, but it will stay under downward pressure because the mainland banking system has created too many yuan. When the supply of money goes vertical, its price drops. It seems the Chinese people are sensing there is too much RMB floating around, and they are trying to get rid of local currency. They have been overpaying for properties and have been shifting their wealth into foreign currencies. Finally, in China, the real deposit rate has turned negative (Chart 25, top panel). In the past, when the real deposit rate turned negative, the central bank hiked interest rates (Chart 25, bottom panel). If households do not get a more attractive deposit rate, they will opt for foreign currency, real assets like property or riskier investments domestically. All of this entails negative consequences for China's financial stability. Chart 25Real Deposit Rate Is Negative In brief, I expect capital outflows to persist and policymakers to allow the currency to depreciate further. Caroline: Peter/Yan/Arthur: Final thoughts: What are each of you watching for signs that China's macro landscape is evolving as you expect? Conversely, what would signal that your assessment has missed the mark? Peter: I am watching for signs of a policy mistake. Until China can reorient its economy towards one that is more consumer-centric, it will have to rely on high levels of investment to sustain aggregate demand. Any attempt to aggressively curb debt growth will only backfire. Arthur talks about resource misallocation from subpar investment projects, but there is no worse resource misallocation than a person who wants a job but can't find one. I am also watching trade policy. I don't think a trade war between China and the U.S. is in the cards for the time being, but if the U.S. economy turns down in 2019, as I expect, Trump will be backed into a corner. And with another election looming, he will strike out at China. That could trigger a global trade war. Yan: I agree with Peter that we should watch for policy mistakes and some sort of "Trump shock," both of which constitute downside risks. A less talked-about risk is potential growth overheating, which could require much tighter policy, leading to greater economic volatility. In fact, some cyclical indicators that are tightly linked to industrial activity have rebounded sharply, which is also reflected in the rebound in some raw materials prices. If exports get a further boost from continued improvement in the U.S. economy, the possibility of China's economy overheating cannot be completely dismissed. Another potential trouble spot is the housing market. The Chinese authorities have begun to tighten housing policy, but developers appear to be gearing up for another construction cycle. Sales of construction equipment such as heavy trucks and excavators have soared. Historically, construction machine sales have been tightly correlated with real estate development (Chart 26). If history is any guide, the renewed strength in construction equipment sales could be a harbinger of an impending boom in new home construction. This is good news for business activity and GDP growth, but probably antithetical to policymakers' broad agenda. We will follow up on these issues closely in our future reports. Arthur: The key variables to watch are various interest rates, credit/loan growth and inflation - in addition to keeping an eye on lending standards and credit demand. Recent increases in borrowing costs amid the enormous credit overhang give me confidence to argue that China's credit origination and economic growth are bound to decelerate later this year. A billion-dollar question is whether the recent rise in China's consumer inflation is transitory or the beginning of a notable uptrend (Chart 27). If consumer price inflation rises to 3% and higher, the game will be over - interest rates will need to go up and credit growth will tumble. If interest rates do not rise amid intensifying inflationary pressures, capital outflows will escalate and the currency will depreciate a lot. Chart 26An Upturn In Housing Construction? Chart 27China: Inflation Is Picking Up I will be wrong if policymakers manage to slow down credit growth from 11-12% toward 7-8% or so without generating notable economic weakness. This can occur only if productivity growth in China accelerates meaningfully. It is difficult to observe productivity growth in real time - it is a black box. 1 Please see Emerging Markets Strategy Special Report, titled "Do Credit Bubbles Originate From High National Savings?" dated January 18, 2017, available at ems.bcaresearch.com. 2 Please see Emerging Markets Strategy Special Report, titled "Misconceptions About China's Credit Excesses," dated October 26, 2016, available at ems.bcaresearch.com. 3 Please see Emerging Markets Strategy Special Report, titled "Misconceptions About China's Credit Excesses," dated October 26, 2016, available at ems.bcaresearch.com. 4 Please see Emerging Markets Strategy Special Report, titled "China's Money Creation Redux And The RMB," dated November 23, 2016, available at ems.bcaresearch.com.

Special Report

The aim of this Special Report is to elaborate on and explain the different views on China that have coexisted at BCA in recent years. Although BCA strives to achieve consensus among its strategists, this is not always possible, as has been the case with China. Peter Berezin of the Global Investment Strategy service and Yan Wang of China Investment Strategy have been positive, while Arthur Budaghyan of Emerging Markets Strategy has been negative on both China's business cycle and China-related plays. The focal points of divergence are centered on how Peter, Yan, and Arthur view and explain the relationship between savings, debt, and the misallocation of capital, as well as how they see China's potential roadmap going forward. The debate is moderated by BCA Global Strategist Caroline Miller. Caroline: Peter and Yan, the world - including the Chinese government - is climbing a wall of worry about China's debt load. Why are you guys still smiling? How many Maotai did you have last night? Peter: I don't know what a Maotai is, but I am sure that if I had more than one I wouldn't be smiling this morning. But yes, I am not as worried as Arthur that China is in the midst of an unsustainable credit bubble. Genuine credit bubbles tend to happen during periods of euphoria. U.S., Spanish, and Irish banks all traded at lofty multiples to book value on the eve of the financial crisis, having massively outperformed their respective indices in the preceding years. That's obviously not the case for Chinese banks today, which remain one of the most loathed sectors in the global equity market (Chart 1). The U.S., Spanish, and Irish housing booms also occurred alongside ballooning current account deficits, something that doesn't apply to China (Chart 2). One can debate whether China is in the midst of a property bubble, but even if it is, it looks a lot more like the one Hong Kong experienced in the late 1990s. When that bubble burst, property prices plummeted by 70%. Yet, Hong Kong banks were barely affected (Chart 3). Chart 1Chinese Banks: Unloved And Unwanted Chart 2Recent Credit Bubbles Developed ##br##Amid Widening Current Account Deficits Chart 3Hong Kong Is The Correct Analogy Yes, there is a lot of debt in China. But there is a lot of savings too. In fact, to a large extent, China's high debt levels are just a function of its high saving rate. The evidence suggests that national saving rates and debt-to-GDP ratios are positively correlated across emerging economies (Chart 4). China sits close to the trend line, implying that its debt stock is roughly what you would expect it to be. Chart 4Positive Correlation Between National Savings And Indebtedness Arthur: Allow me to both agree and disagree with Peter. No, there is no bubble in Chinese equities, but yes, there is a bubble and euphoria in China's property market. Property prices have risen exponentially and are extremely high by any metric. Chinese bank equity valuations have already adjusted, but bank stocks could still sell off if their profits shrink considerably, as I expect. Bank shares are not expensive, but not cheap either, if one adjusts for non-performing loans. I concur that China's property market adjustment will likely resemble that of Hong Kong as opposed to that of the U.S. As Peter noted, in Hong Kong in the late 1990s, property prices plunged by 70%, but few homeowners defaulted on their mortgages. Yet property starts/construction also collapsed by 80% (Chart 5). Chart 5Hong Kong's Property: ##br##Few Mortgage Defaults ##br##But Collapse In Construction Presently in China, the risk is not mortgage defaults but a renewed drop in property construction as well as other types of capital spending. Less construction/capital spending entails less demand for commodities, materials/chemicals and industrial goods. China's residential and non-residential construction activity will contract anew as speculative/investment demand for property weakens. Yan: I agree with Peter that China's rising debt is fundamentally a function of the country's abundant savings. Moreover, the fact that the country's massive savings pool is primarily intermediated via the banking sector and other debt instruments exacerbates the debt buildup. If a country's savings are primarily intermediated by the stock market through equity financing, then high savings do not necessarily lead to high debt, as "savers" become "shareholders" rather than "creditors." In China's case, the country's still relatively undeveloped and volatile equity market has not yet been able to play a meaningful role in financial intermediation. Instead, banks still play a dominant role channeling financial resources. In other words, China's high savings and a banking-centric financial intermediation system are key drivers of the ever-rising debt level. In fact, as long as these two features persist, the country's debt will inevitably continue to rise, as it simply reflects the accumulated savings. Caroline: Arthur, does this line up with how you think about the relationship between savings and debt? Arthur: My thesis has been that China's abnormal credit growth has been the result of speculative, euphoric behavior among Chinese banks and the shadow banking system - and not the natural result of the country's "excess savings," as Peter and Yan have argued. What economists call "savings" or "excess savings," non-economists refer to as "overproduction" or "excess capacity." This is about concepts, not about China. In economic science, the term "savings" is used to denote the number of goods and services that a nation has produced but not consumed - i.e., they can be used for investment or exports. Peter and Yan are using this textbook definition of "savings." Hence, by "savings" or "excess savings" they mean "excess production." Logically, the glut of goods and services does not flow to banks and create deposits. In brief, "savings" or "excess savings" are real economic variables and have nothing to do with bank deposits - i.e., "monetary savings." Peter, Yan and many other commentators make this mistake by mixing up national savings - which is literally output of goods and services that were not consumed by households and government - with "monetary savings," i.e., deposits in the banking system. I have no doubt China has had a high savings rate, i.e., it has had overcapacity and over-production in a number of sectors. The textbook concept of national savings is calculated as a residual from the national accounts and balance of payments. In particular: Savings - Investments = Current Account Balance and Savings = Investments + Current Account Balance A few remarks on the economic interpretation of this equation are in order. First, in any country, "excess" national savings over investment, i.e., current account surpluses, lead to an accumulation of net foreign assets, but has no implication on domestic loan creation.1 Second, a country that invests a lot and does not run a large current account deficit will have a high savings rate as per the economic textbook's definition of national savings. The opposite also holds true. Critically, national or household savings are in no way linked to the amount of deposits at banks. When households decide to save a part of their income, they do not create new deposits or "monetary savings." They save deposits that already exist in the banking system. To sum up, the amount of deposits in the banking system does not change as a result of households' decision to save a part of their income. When a person gets paid in cash and deposits that cash in a bank as a savings deposit, there is no new money created either. That cash was a deposit and was withdrawn from a bank a few days before, and now this cash returns to the banking system as a deposit again. In this case, the amount of total outstanding money supply in the economy (cash plus deposits) has not changed. In general, when a bank receives a deposit, it does not create new money, or "monetary savings." The deposit simply moves from one bank to another or from cash to deposit. The amount of money supply does not change. When a country enjoys a lot of overcapacity, strong bank loans or money growth will not cause inflation and interest rates will stay low, encouraging more borrowing. This is why in Peter's Chart 4 there is a positive correlation between the national savings rate and debt-to-GDP ratio across countries. Overcapacity entails low inflation; the latter keeps nominal interest rates low, which in turn entices more borrowing and debt build-up. In brief, the linkage between national savings/excess capacity and the credit-to-GDP ratio is indirect via subdued inflation and low interest rates that encourage debt build-up. Caroline: Arthur, you have made the case that savings are not a constraint to loan origination. Can you elaborate? Arthur: The banking system does not intermediate "savings" or "excess savings" from the real economy into loans. The commercial banking system as a whole creates deposits at the time it originates loans. This is true of all countries. Indeed, whenever commercial banks make a loan, they simultaneously create a matching deposit in the borrower's bank account, therefore creating new money in the process (Chart 6). In other words, bank loan origination creates deposits and money.2 Chart 6Commercial Banks: Credit Origination Creates Deposits China's banking system has a lot of deposits because banks have created too many loans. In addition, a bank does not need liquidity (reserves at the central bank) for each loan it originates. It still requires some liquidity to settle its net balance with other banks or to meet minimum reserve requirements. If a bank creates a loan but still has excess reserves at the central bank, it may not require liquidity to "back up" the loan. There are many variables that constrain bank loan origination, but they do not include national savings or "excess savings." We discussed these constraints in detail in our EMS report titled Misconceptions About China's Credit Excesses.3 Finally, when central banks opt to keep short-term interest rates steady, they must provide commercial banks with as much liquidity as the latter demands. This point is greatly relevant to China. For the past few years, China's central bank has silently moved away from controlling money growth (the quantity of money) to targeting interest rates (the price of money) (Chart 7). As a result, nowadays the People's Bank of China (PBoC) has very little quantitative control over money/credit creation by commercial banks. Chart 7The PBoC Has Begun Targeting Rates In Recent Years It is Chinese commercial banks that effectively drive money/credit/deposit creation. The PBoC decides whether or not to accommodate banks' liquidity needs by allowing interest rates to rise or fall, or by keeping them steady.4 To conclude, what habitually drives credit booms in any country are the "animal spirits" of banks and borrowers - not national savings. This has been the case in China too. Caroline: Peter, do you agree with Arthur's assessment? Peter: I don't want to get bogged down in the weeds of monetary theory, but let me briefly address two distinct points that I think Arthur is making. The first is the claim that the ability of banks to create money "out of thin air" is somehow not constrained by the volume of bank reserves and cash in circulation (the so - called "monetary base"). The second is the claim that there is no meaningful link between savings and deposits. I think Arthur is wrong on both counts. On the first claim, it is true that when a bank issues a loan, it also creates a deposit. To the extent that bank deposits are treated as "money," this expands the money supply. This is simply the "money multiplier" taught in introductory economics classes. Where Arthur's logic falls short is in his implicit assumption that all lending translates into additional bank deposits. It doesn't have to. Some of the deposits will be withdrawn and kept as cash. Governments have complete control over how much cash there is in circulation by virtue of their monopoly over the printing press. As long as cash exists, central banks can influence the broad money supply via open market operations. By the way, this is true even in banking systems where there are no reserve requirements. Regarding Arthur's claim that lending can occur without savings, this is often true when someone is borrowing money to buy an asset. However, it is generally not true if they are borrowing money to finance new spending. Let me offer a concrete, albeit somewhat whimsical, example to illustrate this point. Suppose I am living in a closed economy where no one saves anything. Now, let's imagine that I decide to throw a party for myself and need to borrow $1000 to do this. Who is going to provide me with the resources? Well, we just said that no one wants to save, so "something" has to adjust for me to have my party. That "something" is the interest rate. In order to entice someone to spend a bit less, the bank (on my behalf) will offer depositors a higher interest rate. If rates rise by enough, someone will decide to forego a bit of consumption today in order to have more consumption tomorrow. In other words, my decision to borrow must result in someone else's decision to save. So do savings create debt or does debt create savings? The answer is both: interest rates adjust to ensure that the two end up being different sides of the same coin. Caroline: Yan, what's your perspective on China's high debt profile? What could you be missing? Yan: As you can see Arthur and I view China's debt profile through different theoretical lenses. I don't think we can fully reconcile our different frameworks on the matter, but we hope our debate can deepen clients' own understanding of this issue, so they can make up their own minds. What I do want to stress is that those analysts who fear that China's corporate debt problem constitutes an alarming systemic financial risk focus exclusively on the rapid increase in the country's debt-to-GDP ratio. While undoubtedly there is merit to this ratio, I think it is also important to validate this judgement by looking at other indicators. In our previous research, we looked beyond this widely cited conventional indicator for corroborating evidence of a "debt bubble." Our findings suggest that the level of Chinese corporate sector leverage is not as precarious as widely perceived. For example, in the Chinese corporate sector, the area of China's economy where investors worry most about leverage, the debt-to-asset ratio of China's industrial sector has been falling since the late 1990s, down to 56% from 62%, contrary to popular belief (Chart 8). State-owned enterprises have witnessed an increase in their debt-to-asset ratio since the global financial crisis, but it has barely reached late 1990s levels, and has actually rolled over in recent years. Meanwhile, SOEs are a shrinking part of the overall economy and therefore, when looked at in conjunction with the private sector, have not moved the needle on the broader trend of corporate balance sheet "deleveraging." This stands in stark contrast to Japan's corporate sector at the peak of its debt bubble. In the early 1990s, Japan's corporate sector debt-to-asset ratio topped out at 78% when the country's "balance sheet recession" began (Chart 9). Even after two decades of deleveraging, Japan's current corporate debt-to-asset ratio is comparable to China's. To validate this conclusion, we also calculated several other key ratios to compare the leverage situation of Chinese listed companies relative to their global peers. Ratios such as liability-to-assets, net debt-to-EBITDA and interest coverage assess both leverage levels and debt servicing capacity. As Chart 10 shows, our extensive survey, both from the top down and the bottom up, suggests that China's leverage situation is comparable if not superior to its global peers. Chart 8The Leverage Picture From A Balance Sheet Perspective Chart 9Japan's Debt Bubble And Deleveraging Chart 10Leverage Ratios: How China Compares Therefore, I think we should be skeptical about the widely held view that China's corporate sector leverage is precariously high. It is at a minimum inaccurate, if not misleading, to rely solely on the debt-to-GDP ratio to reach such an ominous conclusion. Caroline: Arthur, I take it you don't agree? Arthur: Since January 2009, China's corporate and household debt has risen by RMB 130 trillion (about US$ 19 trillion) or by 100% of GDP (Chart 11). I do not believe even the most sophisticated financial/credit systems can allocate such amounts of credit in such a short time and not misallocate capital. By capital misallocation, I am implying investments in projects that do not generate sufficient cash flow to service debt. The accounting value (valuation) of assets is irrelevant in these cases; the cash flow generation is critical. The debt-to-GDP ratio is a much more superior measure to debt-to-asset-ratio. The basis is that the GDP is a proxy for cash flow, while accounting value of assets could be extremely inflated during a credit bubble. To be sure, I am not suggesting that all investments in China have gone sour. Nobody knows the extent of capital misallocation in China. But I suspect it is large enough to make a difference for the macro outlook/business cycle. Caroline: Peter, you have made the comparison between China today and Japan in the 1990s. Could you expand on that? Peter: Starting in the early 1990s, Japan entered an extended era where the private sector was trying to spend less than it earned (Chart 12). In order to keep unemployment from rising, the Japanese government was forced to run large budget deficits. In effect, the government ended up having to absorb the private sector's excess savings through its own dissaving. The same sort of fiscal trap now stalks China. Up until the Great Recession, China was able to export much of its excess savings. The current account surplus hit a record high of nearly 10% of GDP in 2007. The subsequent appreciation of the RMB undermined this strategy, forcing the government to take steps to boost domestic demand. It is no surprise that China's debt stock began to grow rapidly just as its current account surplus started to dwindle (Chart 13). Chart 11China: The Credit Boom Chart 12Japan Relied On Fiscal Largesse And Current Account Surpluses To Offset The Rise In Private-Sector Savings Chart 13China: Debt Increased When ##br## The Current Account Surplus Began Its Descent Keep in mind that fiscal policy in China entails much more than adjustments to government spending and taxes. Central government spending accounts for a fairly small share of GDP. The vast majority of fiscal stimulus is done via the banking system. This makes Chinese fiscal policy nearly indistinguishable from credit policy. From this perspective, China's so-called "debt mountain" is not much different from Japan's debt mountain once we acknowledge that the bulk of China's corporate debt is, in fact, quasi-fiscal debt. As evidence, note that in sharp contrast to the SOE sector, the ratio of liabilities-to-assets among private Chinese companies has actually been trending lower over the past decade (please see Chart 8). In effect, China's money-losing SOEs are the equivalent of Japan's fabled "bridges to nowhere": They are a necessary evil. Caroline: Arthur, your thoughts? Arthur: What Peter and Yan in effect propose is that Chinese banks should continue creating credit/money "out of thin air" in order to create demand for these "excess" goods, i.e., overcapacity sectors. In a nutshell, a number of Chinese companies made bad decisions by over expanding capacity, and now banks have to continue lending/creating demand to justify these bad investments. As a result, persisting explosive credit growth has allowed these unviable or zombie enterprises to survive, and they are not compelled to restructure. This is not how capitalism and markets work. This is de facto socialism. Socialism usually does not lead to prosperity. One of the key reasons behind the failure of socialist economic models is that productivity growth in socialist systems is very low, often close to zero. The basis is that productivity growth is generated not by government officials but by the private sector and entrepreneurs. China's economic success over the past 35 years or so has been due to allowing private enterprises to function and flourish - not because government officials necessarily made correct business and investment decisions. I am for countercyclical fiscal and monetary policies. However, the credit boom in China has gone well beyond the countercyclical policy framework. The concept of countercyclical policies does not suggest that the government or public banks should continue to spend in perpetuity to support fundamentally unviable businesses that invested too much and created excess capacity. Besides, "countercyclical" means for a couple of years. China has been expanding bank/credit/money for about nine years - since January 2009. Peter and Yan argue that they should keep doing it further. If the authorities do what Peter and Yan propose, investors should be structurally - not cyclically - bearish on Chinese stocks. Chart 14There Has Been No Shortage ##br##Of Demand Since 2010 The basis is that a socialist growth model is not friendly for shareholders. Shareholders often lose money when companies operate for maximizing employment rather than profits. This is why Chinese SOEs and bank stocks trade at low multiples - because they destroy capital and value for their shareholders. Notably, "overproduction" and "excess capacity" could be an outcome of either a demand downturn or oversupply/overproduction. Keynes recommended countercyclical policies to fill the gaps when demand shrinks. Chart 15Fiscal Outlays & Credit Origination ##br##Are Close To 50% Of GDP In China's case, there has been no domestic demand downturn to warrant multi-year countercyclical policies. China did the right thing in early 2009 to offset its export plunge amid the Global Financial Crisis, and it helped the global economy recover. However, since 2010 global demand and mainland exports have been stable (Chart 14), making the extended and ongoing credit boom in China unwarranted and excessive. As to the argument that most credit should be counted as a form of fiscal spending, I do not think Chinese policymakers themselves would agree with this statement. In fact, if this is correct, it would mean that government officials are allocating about 50% of GDP each year. Chart 15 illustrates general (central plus local) government spending and annual credit origination as a share of GDP. How fast would productivity grow in an economy where government bureaucrats allocate 50% of GDP annually? It is true that China's central government has a low debt load so it can afford to take over a large chunk of corporate debt. If and when they do so, I will change my view. So far, they have not done this, and will likely only contemplate such a policy move when things get really messy. Investors do not want to be long China plays going into such a scenario. That said, a tactical buying opportunity could emerge when the government takes over a large chuck of corporate debt. Caroline: Yan, how worried should we be about the misallocation of capital in China? Yan: Every economy experiences some level of capital misallocation. The real question is whether China's level of capital misallocation is more serious than that of its global peers. Theoretically, if a country has a bigger capital misallocation problem than others, the economy should have systemically lower capacity utilization, weaker pricing power, and lower profitability. These metrics are easily cross-referenced: Chart 16 contextualizes China's industrial sector capacity utilization ratio relative to global peers. By and large, most countries' capacity utilization ratios hover around 80%, not much different from China's, especially since the 2000s. In fact, barring some obvious outliers, capacity utilization ratios across countries have been largely synchronized, reflecting the ebb and flow of the global business cycle. Chart 16Capacity Utilization: A Global Perspective Industrial sector output prices have shown similar swings (Chart 17). Almost all countries suffered producer price deflation in recent years, and are now experiencing a synchronized upturn in wholesale pricing power. China's falling PPI was widely regarded as a tell-tale sign of misallocation of capital. Conversely, this was in fact more a reflection of stagnating global aggregate demand and weak resource prices worldwide than structurally weak pricing power among Chinese manufacturers. Chart 17Producer Prices: A Global Perspective Similarly, Chinese listed companies' deteriorating Return on Equity (ROE) was again singled out as a sign of capital misallocation. This view is easily debunked by Chart 18, as ROEs have fallen in all major markets. In fact, Chinese companies' ROEs have been structurally higher than the global averages. Even some Chinese sectors that have been derided as being plagued by massive overcapacity and inefficiency such as materials and energy exhibit ROEs almost identical to their global peers. The important point is that we should put China in a global context, rather than analyzing it in isolation. Some Chinese firms' efficiency and profitability have weakened notably over the past several years, but to me, this is more of a reflection of the sluggish global macro backdrop, rather than an indictment of China's discrete growth model. Caroline: Turning to the investment implications, Yan, how does the debt bubble concern impact your view on Chinese equities? Yan: Global investors' widespread concerns over Chinese debt levels and other macro issues have contaminated Chinese stocks with a broad-brushed bearish undertone. Chinese equities have been unduly punished, underweighted and under-owned for many years. As shown in Chart 19, Chinese investable stocks' ROEs have been structurally higher than the global benchmark, and have followed similar cyclical fluctuations. However, their stock prices are trading at massive discounts to the global benchmarks, based on conventional yardsticks (Chart 19). This in my view represents the "China risk premium," which is unjustified and unsustainable. I expect the misperception will eventually unwind, and Chinese shares will be re-rated. This is the fundamental factor supporting my positive view on Chinese equities. Strategically it makes sense to overweight Chinese stocks against their global peers. Chart 18Chinese ROEs Are Not Inferior To Global Peers Chart 19Chinese Equities' Large Valuation Gap Caroline: Arthur, how does your view impact your outlook for investment prospects in China and the rest of the emerging markets space? Arthur: There has not been any adjustment in China's corporate leverage. Deleveraging in China has not yet started. On the contrary, the credit bubble is getting larger. I mean the credit-to-GDP ratio continues rising exponentially and credit and bank loan growth remain in double digits (Chart 20). It is very risky to be bullish on financial assets linked to a bubble when the adjustment has not yet begun. It is like running in front of a steamroller trying to collect pennies. Besides, when there is a major imbalance in the system like the credit bubble happening in China now, I tend to overplay the importance of marginal policy tightening and underplay the significance of easing. Recent marginal policy tightening in China - in particular the clampdown on shadow banking, including banks' off-balance-sheet asset expansion - will cause credit growth to decelerate. This is a major risk to Chinese and EM growth in the second half of this year (Chart 21). Chart 20China: Money/Credit Is Still Booming Chart 21Is China's Recovery At Risk? Even if China does not have a full-blown crisis, we are likely to experience another down leg in China plays, commodities and EM risk assets similar to the second half of 2015, when Chinese import volumes contracted and global markets tanked. A few words about the potential adjustment trajectory are in order. I have been negative on China's growth and China-related plays in global financial markets since 2010, but I have never used the word "crisis." China may or may not have a crisis, but investors holding risk assets exposed to China's growth will suffer considerable losses again similar to the 2011-16 period. It is essential to differentiate cyclical from structural growth drivers. If the government does not allow credit growth to slow, cyclical growth will hold up. However, in this scenario, China will move toward a socialist model and structural growth will tumble. That said, the growth deceleration would be gradual, as depicted in Chart 22. Chart 22Toward Socialism = Secular Stagnation And Inflation If we assume China's productivity is currently growing at a rate of about 5.5-6% (which is already very high and hard to sustain), and if the country embarks on a socialist path, odds are that productivity growth will drop by 50-100 basis points in each of the following years. In five years or so, productivity growth would be only around 1-3%. This path is the ultimate recipe for economic stagnation in China. The only thing the authorities can do in this scenario is to boost growth from time to time via credit and fiscal stimulus. This will produce mini-cycles around a falling primary growth trend. The latest acceleration in China's growth is probably one of these mini-cycles. How can investors invest in this scenario? The stylized mini-cycles depicted in Chart 22 look nice, because we drew them ourselves. In reality, they will not be symmetric or smooth. In short, investing around economic mini-cycles is difficult because it assumes near-perfect timing. Caroline: Peter, is it all that bad? Peter: I think Arthur is too pessimistic. Investors have been predicting a Japanese debt crisis for years. It hasn't materialized and probably won't. They are making the same mistake about China. If China averts a debt crisis, as I think is likely, that's good news for global equities. In the developed market universe, Europe and Japan stand to benefit the most, given the cyclical bent of their stock markets. We are overweight both regions in local-currency terms. For global bonds, the implications are somewhat mixed. On the one hand, the high probability that the Chinese government can maintain the status quo of continued credit expansion for the foreseeable future means that a hard landing for the economy - and the associated drop in safe-haven developed economy government bond yields that this would trigger - is unlikely to occur. On the other hand, high levels of Chinese savings will continue to fuel the global savings glut, keeping real long-term bond yields lower than they would otherwise be. On balance, investors should maintain a modest underweight allocation toward global bonds. Caroline: Yan, do domestic politics play into your outlook for the RMB versus the dollar and on a trade-weighted basis? What is your outlook for monetary policy given recent signs of improving economic momentum? Yan: How President Donald Trump will deal with China on the RMB issue is a wildcard. Recent rhetoric suggests that the new U.S. administration intends to follow normal legal protocol to decide if China is manipulating its currency. This is a significant departure from Candidate Trump's repeated campaign trail promises. If the U.S. Treasury follows the formal process laid out in the statute, it is unlikely to label China a currency manipulator in the next semi-annual assessment to be published in April, simply because the country does not meet all the criteria for that label at the moment. The odds of an immediate clash between the U.S. and China on the RMB have ebbed. From China's domestic perspective, how the People's Bank of China intends to manage the exchange rate is also a thorny issue. From a long term point of view, the PBoC clearly wants to achieve a free-floating exchange rate, but the recent downward pressure on the RMB due to elevated capital outflows has forced the PBoC to heavily intervene to prevent a vicious, disorderly cycle, in which currency depreciation and capital flight reinforce each other. In terms of monetary policy, China's improving economic momentum has allowed the PBoC to follow the Fed in raising short-term interest rates. However, tighter capital account control measures will remain in place until the downward pressure on the RMB from capital outflow dissipates. Moreover, investors have been overwhelmingly focused on the negative economic effects of a weaker RMB, somehow ignoring the reality that as the world's largest manufacturer and exporter, China also stands to benefit from a weaker currency. In my view, the depreciation of the trade-weighted RMB since 2015 has played a critical role in reflating the Chinese economy (Chart 23). A weaker RMB has helped producer prices to reflate, and lowered the real cost of funding for manufacturers, which in turn has eased China's monetary conditions and supported cyclical growth improvement. In this vein, the downside of the RMB should be self-limiting, as the reflationary impact of a weaker exchange rate will help boost Chinese growth, which in turn will reduce downward pressure on the currency. Caroline: Peter and Arthur, is rampant capital flight still a risk? Where do you see the RMB heading over the coming 12-18 months? Peter: I think the RMB will weaken somewhat over the coming year, but that is more a reflection of my bullish view on the dollar than a bearish view on the yuan. Much of the capital flight that China has experienced recently has just been an unwinding of the hot money flows that entered the country over the preceding four years. Despite all the talk about a credit bubble, Chinese corporate external debt has fallen by around $400 billion since its peak in mid-2014 - a decline of over 50% (Chart 24). At this point, most of the hot money has exited the country and hence, I expect the pace of capital outflows to subside. Chart 23A Weaker RMB Leads Cyclical Recovery Chart 24The Rise And Fall Of Corporate Foreign Credit Nevertheless, the chronic shortfall of domestic demand that I described earlier will keep pressure on the Chinese government to try to export excess production abroad by running a larger current account surplus. This requires a weak currency. Thus, while I don't expect the yuan to plummet, I don't expect it to soar either. Arthur: I believe the RMB is set to depreciate by 10% or more against the U.S. dollar in the next 12 months or so. The Chinese yuan is not expensive, but it will stay under downward pressure because the mainland banking system has created too many yuan. When the supply of money goes vertical, its price drops. It seems the Chinese people are sensing there is too much RMB floating around, and they are trying to get rid of local currency. They have been overpaying for properties and have been shifting their wealth into foreign currencies. Finally, in China, the real deposit rate has turned negative (Chart 25, top panel). In the past, when the real deposit rate turned negative, the central bank hiked interest rates (Chart 25, bottom panel). If households do not get a more attractive deposit rate, they will opt for foreign currency, real assets like property or riskier investments domestically. All of this entails negative consequences for China's financial stability. Chart 25Real Deposit Rate Is Negative In brief, I expect capital outflows to persist and policymakers to allow the currency to depreciate further. Caroline: Peter/Yan/Arthur: Final thoughts: What are each of you watching for signs that China's macro landscape is evolving as you expect? Conversely, what would signal that your assessment has missed the mark? Peter: I am watching for signs of a policy mistake. Until China can reorient its economy towards one that is more consumer-centric, it will have to rely on high levels of investment to sustain aggregate demand. Any attempt to aggressively curb debt growth will only backfire. Arthur talks about resource misallocation from subpar investment projects, but there is no worse resource misallocation than a person who wants a job but can't find one. I am also watching trade policy. I don't think a trade war between China and the U.S. is in the cards for the time being, but if the U.S. economy turns down in 2019, as I expect, Trump will be backed into a corner. And with another election looming, he will strike out at China. That could trigger a global trade war. Yan: I agree with Peter that we should watch for policy mistakes and some sort of "Trump shock," both of which constitute downside risks. A less talked-about risk is potential growth overheating, which could require much tighter policy, leading to greater economic volatility. In fact, some cyclical indicators that are tightly linked to industrial activity have rebounded sharply, which is also reflected in the rebound in some raw materials prices. If exports get a further boost from continued improvement in the U.S. economy, the possibility of China's economy overheating cannot be completely dismissed. Another potential trouble spot is the housing market. The Chinese authorities have begun to tighten housing policy, but developers appear to be gearing up for another construction cycle. Sales of construction equipment such as heavy trucks and excavators have soared. Historically, construction machine sales have been tightly correlated with real estate development (Chart 26). If history is any guide, the renewed strength in construction equipment sales could be a harbinger of an impending boom in new home construction. This is good news for business activity and GDP growth, but probably antithetical to policymakers' broad agenda. We will follow up on these issues closely in our future reports. Arthur: The key variables to watch are various interest rates, credit/loan growth and inflation - in addition to keeping an eye on lending standards and credit demand. Recent increases in borrowing costs amid the enormous credit overhang give me confidence to argue that China's credit origination and economic growth are bound to decelerate later this year. A billion-dollar question is whether the recent rise in China's consumer inflation is transitory or the beginning of a notable uptrend (Chart 27). If consumer price inflation rises to 3% and higher, the game will be over - interest rates will need to go up and credit growth will tumble. If interest rates do not rise amid intensifying inflationary pressures, capital outflows will escalate and the currency will depreciate a lot. Chart 26An Upturn In Housing Construction? Chart 27China: Inflation Is Picking Up I will be wrong if policymakers manage to slow down credit growth from 11-12% toward 7-8% or so without generating notable economic weakness. This can occur only if productivity growth in China accelerates meaningfully. It is difficult to observe productivity growth in real time - it is a black box. 1 Please see Emerging Markets Strategy Special Report, titled "Do Credit Bubbles Originate From High National Savings?" dated January 18, 2017, available at ems.bcaresearch.com. 2 Please see Emerging Markets Strategy Special Report, titled "Misconceptions About China's Credit Excesses," dated October 26, 2016, available at ems.bcaresearch.com. 3 Please see Emerging Markets Strategy Special Report, titled "Misconceptions About China's Credit Excesses," dated October 26, 2016, available at ems.bcaresearch.com. 4 Please see Emerging Markets Strategy Special Report, titled "China's Money Creation Redux And The RMB," dated November 23, 2016, available at ems.bcaresearch.com.

Highlights Either go long Eurodollar / short Euribor June 2019 interest rate futures. Or long the U.S. 5-year T-bond / short German 5-year bund. Or long euro/dollar (though our preferred long euro expression is long euro/pound near term and long euro/yuan structurally). All three of the above are just one big correlated trade. Long-term equity investors should consider a 50:50 combination of Germany (DAX) and Sweden (OMX) as a superior alternative to the Eurostoxx50 or Eurostoxx600. But near term, remain cautious on risk-assets. Feature On the face of it, the ECB has committed to leave interest rates where they are for a very long time. "The Governing Council continues to expect the key ECB interest rates to remain at present or lower levels for an extended period of time, and well past the horizon of the net asset purchases"1 But take a closer look at this commitment, and an extended period of time could mean as little as a year. As things stand, "the horizon of the net asset purchases" has only nine more months to run, and "well past" could justifiably mean just six months or less beyond that. Furthermore, at the last press conference Draghi emphasized that forward guidance "is an expectation" and that the probabilities of the ECB's expectations are constantly changing. Remember also that the ECB has three policy interest rates:2 the deposit rate (-0.4%), the repo rate (0%) and the marginal lending rate (0.25%) - and the ECB doesn't have to move all three in tandem. Indeed in 2015, the ECB cut the deposit rate before the other two rates (Chart I-2). So it is quite conceivable that the ECB could hike the deposit rate before the other two rates and as soon as a year or so from now. Chart of the WeekGermany/Sweden Combination Has Run A Good Race With The U.S. Chart I-2The ECB Could Hike Its Deposit Rate Early ECB council member Ewald Nowotny hinted as much in a Handelsblatt interview last week, saying that all interest rates wouldn't have to be increased simultaneously nor to the same extent. "The ECB could raise the deposit rate earlier than the prime rate." A Major Mispricing: ECB Versus Fed This neatly brings us to one of the most extreme pricings in financial markets at the moment. The expected difference between ECB looseness and Fed tightness two years ahead stands at a 20-year extreme (Chart I-3). Chart I-3An Extreme Pricing: ECB Versus Fed Yet the percentage of the euro area population in employment is at an all-time high (Chart I-4), while on an apples for apples comparison, there is no difference between economic growth, inflation, or inflation expectations in the euro area and the U.S.3 Moreover, Draghi points out that "the risks surrounding euro area growth relate predominantly to global factors." If these global risks do materialise, it would prevent both the ECB and the Fed hiking rates through 2018. But if these global risks do not materialise, allowing the Fed to continue hiking through 2018, is it really conceivable that the ECB just sits pat? We think not. On this basis, investors should either go long Eurodollar / short Euribor June 2019 interest rate futures. Or long the U.S. 5-year T-bond / short German 5-year bund. Or long euro/dollar (though we prefer long euro/pound near term and long euro/yuan structurally). We say "either or" because all three positions are just one big correlated trade (Chart I-5). Chart I-4Percentage Of Euro Area Population In##br## Employment Near An All-Time High! Chart I-5Correlated Trade: Interest Rate Futures,##br## Bond Yield Spreads, Ans EUR/USD The French Election: "System 1" And "System 2" The looming risk to this big correlated trade takes the form of the upcoming French Presidential Election. Two data points do not make a trend, but some people are worried that the same dynamic that delivered shock electoral victories for Brexit and Donald Trump in 2016 could propel Marine Le Pen to the Elysée Palace in 2017. This worry is overdone. In explaining the Brexit and Trump shock victories, an important point has been understated. These days many voters care more about politicians' personalities than policies. Emotional appeal arguably matters more than rational appeal. Behavioural psychologist and Nobel Laureate Daniel Kahneman calls the emotional way of thinking "System 1", and the colder rational way of thinking "System 2". Both the Brexit and Trump campaigns resonated strongly with emotional System 1. A lot of voters warmed to Boris Johnson, a leader of the Brexit campaign, and to Donald Trump. By contrast, the Bremain and Hillary Clinton campaigns tried to appeal mainly to cold rational System 2. But as Kahneman explains, when cold rational System 2 competes with emotional System 1, emotional System 1 almost always wins. In this regard, the dynamic of the French Presidential election is very different to the U.K.'s EU Referendum and the U.S. Presidential Election. Charles Grant, director of the Centre for European Reform, points out that "Emmanuel Macron's personality, and notably his charm, calm authority and courage may well (emotionally) appeal to more voters than Marine Le Pen's simplistic remedies and bitterness." Therefore, a final run off between Le Pen and Macron - as now seems highly likely - does not give us sleepless nights. But we would be concerned if the final run off were between Le Pen and the much less emotionally appealing François Fillon (Chart I-6 and Chart I-7). Chart I-6A Final Run Off Between Le Pen & Macron... Chart I-7...Does Not Give Us Sleepless Nights Incidentally, both Daniel Kahneman and Charles Grant will be speaking at our forthcoming New York Conference on September 25-26, and promise to provide fascinating investment insights from their areas of expertise. So book your places now! A Better Way To Invest In Europe: Germany And Sweden All of this might suggest that the Eurostoxx50 should outperform the S&P500. Not necessarily. Extreme economic and political tail-events aside, there is almost no connection between national or regional economic relative performance and stock market relative performance. As we demonstrated in the Fallacy Of Division,4 by far the biggest driver of Eurostoxx50 versus S&P500 performance is its sector skew. The Eurostoxx50 has a major 15% weighting to banks and a minor 7% weighting to tech. The S&P500 is the mirror image; a minor 7% weighting to banks and a major 22% weighting to tech. Furthermore, this overarching driver is captured in just the three largest euro area banks versus the three largest U.S. tech stocks. So relative performance simply reduces to whether Banco Santander, BNP Paribas and ING outperform Apple, Microsoft and Google,5 or vice-versa. Everything else is largely irrelevant. But this begs the question: can a different combination of European markets neutralise the sector skew and thereby provide a fairer head-to-head contest with the tech-heavy S&P500? At first glance, the answer seems to be no. Europe simply does not have the same type of technology companies that the U.S. has. So no combination of European markets can match the S&P500 tech exposure. On the other hand, Europe is the world-leader in a different type of technology: innovative industrial equipment and materials. It turns out that a 50:50 combination of Germany (DAX) and Sweden (OMX) matches the exposure to European industrial equipment and materials with the exposure to American tech. At the same time, the DAX/OMX combination largely removes Europe's bank overweight. The upshot is that the DAX/OMX combination has run a very good race with the S&P500 through the past 10 years, while the Eurostoxx50 has failed to keep the pace (Chart of the Week). In effect, DAX/OMX versus S&P500 reduces to Siemens, Bayer and Atlas Copco versus Apple, Microsoft and Google (Chart I-8). Compared to the euro area banks, Europe's innovative industrial equipment and materials are a much better long-term match-up against U.S. tech (Chart I-9). Indeed, my colleague, Brian Piccioni, BCA Technology strategist, points out that Bayer is a good play on the revolutionary new genetic modification technology CRISPR-Cas9.6 Chart I-8DAX/OMX Vs. S&P500 = Siemens, Bayer & Atlas Copco ##br##Vs. Apple, Microsoft & Google Chart I-9European Innovative Industrial Equipment & Materials ##br##Is A Good Match-Up Against American Tech Investors who want a long-term equity exposure to Europe should consider a 50:50 combination of Germany (DAX) and Sweden (OMX) as a superior alternative to the Eurostoxx50 or Eurostoxx600. Nevertheless, those who can fine-tune their timing should await a better entry-point for all risk-assets. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 From the ECB introductory statement to the press conference, March 9 2017. 2 The deposit rate (-0.4%) is the rate at which commercial banks park their excess liquidity; the repo rate (0%) is the usually quoted policy rate for the ECB's standard money market operations; and the marginal lending rate (0.25%) is the rate at which commercial banks borrow from the central bank, usually when they cannot access interbank funding. 3 Please see the European Investment Strategy Weekly Report 'Fake News In Europe' January 26, 2017 available at eis.bcaresearch.com 4 Published on March 9, 2017 and available at eis.bcaresearch.com 5 Listed as Alphabet. 6 Please see the Technology Strategy and Global Investment Strategy Special Report 'CRISPR-Cas9: Investment Implications' March 17, 2017 available at www.bcaresearch.com Fractal Trading Model* There are no new trades this week. We are expressing a tactical short position in equities through a short exposure to the Netherlands AEX. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Highlights Please note that today we are publishing an abbreviated Weekly Bulletin as tomorrow we will publish Great Debate: Does China Have Too Much Debt Or Too Much Savings? The latter report will elaborate on long-standing view differences on China within BCA. I will be debating my colleagues Peter Berezin and Yan Wang on the issues surrounding China's savings and debt as well as the growth outlook. Arthur Budaghyan Feature Singapore: MAS Will Cap Interest Rates Higher U.S. interest rates will temporarily place upward pressure on Singaporean local interest rates (Chart I-1). However, Singapore is not in position to tolerate higher borrowing costs due to lingering credit excesses and deflationary pressures that currently prevail in its economy. The Monetary Authority of Singapore (MAS) will therefore respond by injecting liquidity to keep interbank rates low. The MAS operates monetary policy by guiding the exchange rate - and by default - often allowing interest rates to fluctuate freely. Yet higher interest rates are not an optimal policy option at the moment. If and as U.S. interest rates and the U.S. dollar rise, the MAS will intervene to cap local rates even if it entails a weaker Singapore dollar. While there is a recovery going on in non-oil export volumes and narrow money (M1) (Chart I-2), many other cyclical indicators are still negative. Chart I-1Rising Libor Rates Will Exert ##br##Upward Pressure On Singaporean Rates Chart I-2Singapore: Non-Oil ##br##Exports Are Picking Up The exchange rate-targeting system was introduced in the early 1980s when exports stood at 150% of GDP. Today, exports relative to GDP have fallen substantially to 115% of GDP (Chart I-3). On the other hand, total private non-financial sector debt levels have risen to 180% of GDP (Chart I-3). Therefore, the Singaporean economy has become much more leveraged to interest rates and somewhat less exposed to global trade. Improving exports will not be sufficient to offset the negative impact of rising borrowing costs. Moreover, our proxy for interest payments on domestic debt has also surged and now stands at close to 10% of GDP (Chart I-4). What is precarious is that the rise in interest payments relative to income has occurred in a period when rates are close to record-low levels. Chart I-3Singapore: Debt Is ##br##Overshadowing Exports Chart I-4Singapore: Interest Payments Are ##br##Large Despite Record Low Rates If borrowing costs rise, it will likely cause major debt deflation concerns. The MAS will not allow this to happen. Employment is stagnating, while employment in the construction and manufacturing sectors is contracting (Chart I-5). Weak employment has weighed on the consumer sector. Retail and department store sales are still shrinking (Chart I-6). Chart I-5Singapore: Employment Is Weak Chart I-6Retail Spending Is Contracting Importantly, the real estate sector, one of the major pillars of the Singapore economy, is depressed. Property prices across the board are deflating, while vacancy rates are rising (Chart I-7). Bank loan growth to property developers has also stalled (Chart I-7, bottom panel). Weak economic growth should be reflected on banks' balance sheets. Surprisingly, non-performing loans (NPLs) among Singapore's three largest banks still stands at a low 1.4%. If and as loan losses begin to rise, commercial banks will rush to increase provisioning for these losses, which will hurt their profits and keep credit growth subdued. Furthermore, Singaporean banks are also very exposed to Malaysia. Singapore's largest banks have extended loans to Malaysia of approximately 67 billion Singapore dollars - or 16% of GDP. Aggregate external loans stand at 137% of GDP (Chart I-8). Economic fundamentals are currently very weak and will continue to deteriorate in Malaysia. This warrants more assets write-offs among Singapore banks and less appetite to expand their balance sheet. Chart I-7Property Sector In Singapore Chart I-8Singaporean External Loans Are Enormous On the whole, if Singaporean interest rates begin to rise due to either depreciation of the Singapore dollar or higher U.S. interest rates, the central bank will intervene to bring local rates down. It would not be the first time the MAS has intervened to bring down interest rates. In 2015 when EM risks escalated, local interbank rates spiked. The MAS promptly injected liquidity in the banking system by buying back its outstanding MAS bills, and by also purchasing government securities, supplying liquidity to the banking system. This essentially placed a cap on interbank rates. Chart I-9Go Long Singapore Real ##br##Estate Stocks Vs. Hong Kong What is noteworthy is that the Singapore dollar weakened as a result of the intervention, although the MAS's official monetary policy stance was not stimulative - i.e. the monetary authorities did not target to weaken the trade-weighted SGD. In that instance, the MAS decided to focus on interest rates/funding market stability and ignore the exchange rate's response. This highlights that despite the MAS's official monetary policy framework of guiding the exchange rate, it will not allow interest rates to rise. Unlike Singapore, Hong Kong does not operate an independent monetary policy and as such will be forced to import higher U.S. rates. As a bet on higher interest rates in Hong Kong and the U.S. relative to Singapore, investors should consider going long Singaporean real estate stocks and shorting Hong Kong real estate stocks. Chart I-9 shows that Singaporean real estate stocks outperform Hong Kong's when the latter's interest rates/bond yields rise relative to Singapore and when Singapore's M1 growth accelerate relative to Hong Kong. As discussed above, the MAS has the capacity and will to inject liquidity to lower interest rates. Hong Kong, however, does not have this privilege due to the currency's peg to the greenback. Besides, Singapore's property correction is now much more advanced than Hong Kong's. In fact, Hong Kong property prices are still rising, i.e., the real estate market adjustment in Hong Kong has not yet started. While both city states are vulnerable to a potential slowdown in Chinese inflows, Hong Kong real estate prices will ultimately fall from a higher starting point. Bottom Line: A rising U.S. dollar and U.S. interest rates may exert upward pressure on Singaporean local interest rates. However, the Singaporean central bank will respond by injecting liquidity, which will cap rates relative to the U.S. and Hong Kong. This opens a tactical trade opportunity (for the next 3 months): Long Singapore real estate stocks / short Hong Kong real estate shares. Asian equity portfolio investors should have a neutral allocation to Singapore stocks within the EM/emerging Asian benchmarks. Ayman Kawtharani, Research Analyst ayman@bcaresearch.com Colombia: Not Out Of The Woods Yet Even though global economic growth has been improving and commodities prices have rallied, Colombia's growth is still bound to disappoint. We remain structurally bullish on the nation's longer-term prospects. That said, there will still be more downside this year. Credit growth will continue to decelerate, despite the beginning of a rate cut cycle (Chart II-1). Interest rates are still high, both in nominal and real terms (Chart II-2). This along with poor consumer and business confidence (Chart II-3) will depress credit demand and spending. Chart II-1Colombia: Negative Credit Impulse Chart II-2Borrowing Costs Are Still High Chart II-3Consumer & Business Confidence Are Weak Furthermore, the central bank's liquidity injections into the banking system have dropped considerably (Chart II-4). In the past few years, abundant liquidity provisioning by the central bank had allowed commercial banks to sustain robust credit growth. Hence, a withdrawal of banking system liquidity will cap loan origination. The current account deficit remains wide at $12.5 billion, or 5.2% of GDP. Financing such a wide deficit will prove challenging. Besides, BCA's Emerging Markets Strategy team believes oil prices are at risk of additional declines. Hence, we are bearish on the Colombian peso. Fiscal policy is set to tighten as the budget deficit has ballooned due to strong spending and shrinking revenues (Chart II-5). Recently introduced tax reforms represent a step forward with respect to the country's structural reforms agenda, as it will simplify the tax code and reduce corporate tax rates. Chart II-4Withdrawal Of Liquidity Will Cap Credit Growth Chart II-5Government Fiscal Balance Is Deteriorating However, redistributing the tax burden onto individuals, mainly by increasing the VAT from 16% to 19%, will reinforce the slump in household spending. In terms of high frequency data, there are little signs of economic revival (Chart II-6). Retail sales volume remain tame. The latest bounce in this series most likely reflects consumers front running the impending VAT hike. Furthermore, oil production is likely to decline further, and non-oil exports are still contracting. In terms of financial markets, we recommend the following: We are closing our bet on yield curve flattening - receive 10-year/pay 1-year swap rates. Initiated on September 16, 2015, this trade has produced a 190 basis-point gain (Chart II-7). At the moment, the risk-reward for this position is no longer attractive. Chart II-6Cyclical Economic Activity Remains Subdued Chart II-7Take Profits On The Yield Curve Trade We remain neutral on Colombian equities and sovereign credit relative to their respective EM universes. Even though our long Colombian bank stocks/short Peruvian banks bet has been deep in the negative, we are reluctant to cut it. The basis is that Colombia's central bank may opt to cut rates further, even if the peso depreciates anew. In contrast, the Peruvian central bank is more likely to hike rates if its currency comes under downward pressure. Bank share prices will likely react to marginal shifts in relative interest rates between the two countries. Andrija Vesic, Research Assistant andrijav@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Cable stocks continue to demonstrate market leadership, largely on the back of the industry ability to persistently raise selling prices at a rate much faster than overall inflation. Cable operators' ability to continually evolve offerings and provide attractive content is reflected in the recovery in consumer spending on cable services, which has unfolded despite cord cutting. Importantly, content inflation rates have remained within the range of the past few years, underscoring that threats to robust profit margins remain limited. Relative valuations remain sufficiently attractive to expect ongoing better-than-market performance. Stay overweight. The ticker symbols for the stocks in the S&P cable & satellite index are: BLBG: S5CBST - CMCSA, CHTR, DISH.

The S&P managed care index is testing new highs relative to the broad market, aided by optimism that an ACA overhaul will mean less pressure for insurers to cover high risk, high cost subscribers. Regardless of the proposed changes, the outlook for managed care stocks remains upbeat. They still command less than a market multiple, despite a solid growth outlook. The labor market remains strong, which is conducive to ongoing membership growth. Importantly, premiums are set on a trailing cost basis, and the previous surge in medical costs implies that a period of higher premiums looms just as costs are falling. Indeed, our proxy for medical costs has dropped sharply, heralding a steep decline in the medical loss ratio. There are high odds that this trend will be sustained, given that spending on overall health care is decelerating relative to total spending, an environment that has typically been associated with managed care outperformance. The less consumers are spending on procedures, the fewer claims that will be made, all else equal. That is particularly evident in the easing in pharmaceutical shipment growth and inflation rates. The bottom line is that the S&P managed care index remains a core portfolio overweight. The ticker symbols for the stocks in the S&P managed care index are: BLBG: S5MANH - UNH, AET, ANTM, CI, HUM, CNC.

Dear Client, In addition to an abridged Weekly Report, we are also including a Special Report written by our Global ETF Strategy team. BCA's Global ETF Strategy, launched in September joins comprehensive ETF analysis with BCA's global macroeconomic thematic research: its aim is to help clients connect the dots from BCA themes to individual ETF ticker symbols with real-time market expressions of our views. The team is currently producing a series of reports on smart-beta ETF selection, whereby they examine the key factors recognized by academia and investment practitioners as persistent drivers of market performance. In this second installment, the team focuses on dividend-focused funds. Although the team finds that dividends do not qualify as a true standalone factor consistently explaining equity returns, dividend policy can add to multi-factor models' explanatory power at the margin. Given the popularity of dividend investing, we think dividend policy could be a fruitful subject for further research. Best regards, Lenka Martinek Feature U.S. financial markets breathed a collective sigh of relief last week when the FOMC followed through on a fully discounted 25 bps rate hike, but did not increase the number of expected rate hikes for the year. In other words, the Fed successfully delivered a "dovish hike", thus reassuring investors that the policy sweet spot - the period when interest rates are rising but have not become restrictive - will last a while longer (Chart 1). Chart 1A "Dovish Hike" Chart 2Low Structural Unemployment Rate The Fed's assessment of the economy is not very different from our own, though there were a few details in the economic projections worth highlighting. First, the estimate for the structural rate of unemployment was scaled down further by a tenth of a percentage point to 4.7%. This may seem minor, but it suggests that policymakers believe the labor market has more running room before wage inflation moves higher. Granted, any forecast for structural unemployment should be taken with a dose of salt, but our bias throughout this cycle - and as outlined in our November Special Report - has been to expect wage inflation to lag relative to past cycles due to structural factors (Chart 2). And as can be seen in Chart 3, Japan provides a roadmap: in that country, demographic factors helped push the unemployment rate to below 3% without creating inflationary pressures. Of course, the U.S. economy is very different from Japan and we do not expect unemployment to drop as low. However, as occurred in Japan, we would not be surprised to see the FOMC trim its forecast for the structural unemployment rate further in the coming quarters. A related point is that the Fed also adjusted the wording of the FOMC statement regarding its inflation targets. The statement said that the Fed was looking for a "sustained" return to 2% inflation, while also referring to its inflation target as a "symmetric" one. Our interpretation is that the Fed is trying to clarify that it will not react too aggressively if core inflation were to drift somewhat above 2%. Clearly, the Fed is beginning to see the balance of risks toward higher inflation. That makes sense, given that the economy is operating close to full employment. However, we maintain that a sustained rise in inflation above the Fed's 2% core PCE target is not imminent. Indeed, the message from last week' CPI report reinforces our view that with the exception of a few components, inflation is very well contained (Chart 4). Our diffusion index of the major inflation components is in negative territory. Importantly, price surveys continue to show that businesses are not able to easily raise prices. For example, despite the continued optimism in the headline components of the NFIB small businesses survey, small businesses have not been able to - and do not yet anticipate being able to - raise prices. This reinforces our long-held view that after a long period of disinflation - and outright deflation in the retail sector - inflation expectations are extremely well-anchored and savvy consumers know how to extract a better deal. Core PCE inflation may converge on the Fed's target of 2% in the second half of 2017, but an inflation overshoot should not be a major driver of investment decision-making over the next 6-12 months. Chart 3Japan: A Low Unemployment Rate ##br##And Little Wage Inflation Chart 4Inflation ##br##Still Low In the end, it is Fed Chair Yellen's least sophisticated remarks that provide the best summation. During the FOMC press conference, she stated that "the simple message is the economy is doing well". Indeed, the moderate pace of growth that has prevailed since the beginning of the recovery means that the typical imbalances and pressure points that accumulate in the advanced stages of a business cycle are so far still absent. The backdrop overwhelmingly favors stocks relative to government bonds on a cyclical horizon. To be sure, equities are expensive, but as we wrote last week, relative to competing assets, valuations are not extreme. The greater near-term risk continues to be a phase of economic and earnings disappointments that could develop later this year, since there remains a tremendous amount of optimism in the business community regarding regime change in Washington. Note that the policy uncertainty index remains very elevated (Chart 5) and Trump's "skinny budget", which aims to slash spending across all discretionary items save military and veterans affairs, will be contested. Our geopolitical team notes that Democrats could threaten a government shutdown later this year to try to force Republicans' hand at removing the most controversial elements of the budget. Democrats can filibuster parts of the appropriations process which makes the concrete budget allocations. Chart 5Political Uncertainty Still Elevated On this basis, we remain skeptical that fiscal policy will be clean fuel for the equity bull market. However, we adhere to Yellen's "simple message" that the economy is on a stable footing. That implies that Washington disappointments will most likely lead to equity setbacks rather than a painful breakdown. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com Appendix Monthly Asset Allocation Model Update Our Asset Allocation (AA) model provides an objective assessment of the outlook for relative returns across equities, Treasuries and cash. It combines valuation, cyclical, monetary and technical indicators. The model was constructed as a capital preservation tool, and has historically outperformed the benchmark in large part by avoiding major equity bear markets. Please note that our official cyclical asset allocation recommendations deviate at times from the model's recommendation. The model is just one input to our decision process. The model's recommendation weightings for the major asset classes are unchanged: neutral equity exposure at 60% (benchmark 60%), neutral Treasury allocation at 30% (benchmark 30%) and cash at 10% (benchmark 10%). The diffusion index of the three components for The Equity Model remained neutral. The technical component "buy" signal strengthened, with sturdy advances for both the breadth & trend and momentum indicators. The monetary component, which measures overall liquidity conditions within the financial and economic system and designed to lead equity prices, is slightly more bullish and still favorable for equities. The earnings-driven component continues to give a cautious signal. Real operating earnings remain at a significant distance from positive economic expectations which have moved higher yet again. Moreover, earnings momentum is still sluggish, based on our earnings diffusion index, which compares nominal earnings growth relative to four key macro proxies for business costs. The model's recommendation for bonds remains at benchmark which still fits with our neutral qualitative stance for Treasuries in balanced portfolios since November 7, 2016. Although the cyclical component of the bond model is more constructive than the valuation component, the further deterioration in the technical component maintains the "sell" signal for Treasuries firmly in place. Chart 6Portfolio Total Returns Chart 7Current Model Recommendations Note: The asset allocation model is not necessarily consistent with the weighting recommendations of the Cyclical Investment Stance. For further information, please see our Special Report "Presenting Our U.S. Asset Allocation Model", February 6, 2009. Highlights Factor attribution began a half-century ago with the Capital Asset Pricing Model ("CAPM"). Although the CAPM itself has been superseded, selected factors have exerted a consistent influence on equity performance. The empirical evidence does not support including dividends among the proven factors, yet dividend-focused funds are the most numerous in the smart-beta universe. The ambiguity surrounding dividends' effect on equity performance leaves plenty of room for smart-beta purveyors to build a better mousetrap, but our own research suggests that they will have to do so with something other than purely dividend-related metrics. Reflecting the fact that many of the dividend funds already incorporate multi-factor inputs, we evaluate them based on their exposure to all of the metrics within our Equity Trading Strategy service's multi-factor model. Feature Welcome to the second installment of our series on smart-beta ETF selection. Over the course of the series, we intend to examine the factors widely recognized by academia and investment practitioners as persistent drivers of equity performance. Each Special Report will weigh the evidence for the factor's efficacy, consider the metrics that best reveal its presence and compare our ideal metrics with the metrics utilized by our proprietary Equity Trading Strategy ("ETS") multi-factor model. It will then evaluate the menu of smart-beta ETFs using either our ETS model's metrics or an augmented version of them. The series began last month with a review of the Value factor, enshrined by Fama and French's research, and the current subset of Value smart-beta ETFs.1 This month we examine Dividend smart-beta ETFs. Subsequent installments will examine Quality, Momentum and Volatility,2 and we will likely wrap up the series with a review of Multi-Factor smart-beta ETFs. This installment provides some background on factor investing and the smart-beta process before subjecting Yield (Dividends) to scrutiny to determine whether or not it really constitutes a standalone equity factor. Back To The Beginning The ubiquity of beta in discussions of investing performance originates from the Capital Asset Pricing Model ("CAPM"), as advanced by William Sharpe and other researchers in the early 1960's. The CAPM posits that the expected return of stock XYZ is solely a function of XYZ's riskiness relative to the overall equity market. XYZ's riskiness is a function of its covariance with the market, and is represented in the CAPM's simple linear model as the coefficient "beta.3" The elegantly simple CAPM holds that any stock's expected return (E(rs)) is the sum of the risk-free rate (rf) and the product of its beta (ßs) and the difference between the expected market return (E(rm)) and the risk-free rate (rf): E(rs) = rf + ßs x (E(rm) - rf) As noted by several researchers, including Eugene Fama and Kenneth French,4 CAPM's return predictions are woefully errant when applied to stocks. As Chart 1 indicates, the returns projected by the CAPM bear little relationship to empirical results. It turns out that low-beta stocks have systematically outperformed high-beta stocks on a risk-adjusted basis (Chart 2), just as low-book-multiple stocks have crushed high-book-multiple stocks without regard for beta (Chart 3). This is powerful evidence for value, and for the low-volatility factor that we will examine in a subsequent report, but it is damning for the simple application of the CAPM to stocks. Chart 1CAPM Sounded Great In Theory ... Chart 2... But It Flopped In Practice Chart 3Low-Book-Multiple Stocks Systematically ##br##Flout CAPM Predictions A New Vocabulary Despite its empirical shortcomings, the CAPM provides an intuitive way of conceptualizing the risk-return tradeoff, and it paved the way for the asset-pricing research that followed it. The notion that individual securities' risks come in two flavors, market and idiosyncratic, is a critical element of portfolio theory and its thou-shalt-diversify commandment. It is also the basis, as we shall see, for beta, alpha and the factor-investing approach enabled by smart-beta ETFs. For that application, let us add an alpha term to the CAPM to account for the component of realized returns that cannot be explained by market exposures: rs = rf + ßs x (E(rm) - rf) + a Rearranging terms to solve for alpha shows it to be the difference between the realized return and the return expected by CAPM: a = rs - (rf + ßs x (E(rm) - rf)) From CAPM To Factors To Smart Beta In today's accepted usage, alpha is the ex-post difference between portfolio and benchmark return, adjusted for risk. It is the component of return attributed to portfolio manager skill, whereas beta is the return accruing to simple market exposure. As return-attribution research has uncovered the systematic factors underpinning performance, beta has claimed an increasing share of the pie from alpha. The salubrious effect for investors, especially those who employ third-party managers, has been to demystify the sources of portfolio returns. Beta's expanding share has also opened the door to a middle course between purely active and purely passive portfolio management strategies. Factor research has made it possible to join the main advantages of passive strategies - transparency, predictability and low cost - with active strategies' aim of delivering a risk-adjusted return profile distinct from those offered by cap-weighted benchmarks. Investors have embraced the factor approach and traditional asset managers have obliged them with a torrent of smart-beta ETF choices. Both should put investors on alert: according to the late Barton Biggs, there is no investment idea so good that it can't be destroyed by too much money, and fund company enthusiasm may correlate more closely with its own profits than its clients'. Biggs' admonition is always on our mind, but we don't think the established factors are in imminent danger of losing their zest. Factor excess returns are not new news. 25 years after Fama and French's paper, low-book-multiple stocks continue to outperform high-book-multiple stocks and smaller stocks continue to outperform larger stocks. We do not see the comparatively modest aggregate smart-beta ETF AUM as a catalyst for bidding away the returns that have durably accrued to factors. Are Dividends Really An Equity Factor? For the purposes of this report, our first objective is to determine whether or not Dividends can properly be considered a factor alongside the big five (Value, Quality, Momentum, Volatility and Size). Unable to find compelling evidence for their inclusion, we do not think they should. Yield may be a promising factor in fixed income, but extending the concept to equities is problematic. Across all capitalization buckets for the last 20 years, it cannot even be said that dividend payers outperform non-dividend payers (Chart 4). The empirical record for more sophisticated slicing and dicing is mixed, depending on the level of granularity. Breaking the universe of U.S. equities into non-dividend payers and dividend payers, and then segmenting the latter by yield into the lowest three deciles, the median four deciles and the highest three deciles, Fama and French's 90-year dataset supports the idea that higher-yielding stocks generate higher total returns (Chart 5). The breakout is neatly consistent, with dividend payers outperforming non-dividend payers, and each yield cohort of the dividend payers outperforming the lower-yielding cohorts beneath it (Chart 6, top panel). Zoom into the dividend payers at the quintile and decile levels, however, and the consistency disappears as the tidy staircase pattern begins instead to resemble a jagged picket fence (Chart 6, lower panels). Chart 4Dividends Have Been Hazardous To Investors' ##br##Wealth Over The Last 20 Years ... Chart 5... Though They've Rewarded Investors ##br##Over Nine Decades Chart 6Not Ready For A Close-Up Adjusting for risk makes the picture even murkier. While the non-payers and the lowest-yielding cohorts always post the smallest risk-adjusted returns, they are the only cohorts the highest-yielders manage to beat. The median 40 is the winner among our 30-40-30 cohorts, while the fourth and the second quintiles bracketing the median 40 easily outpace the top quintile, and the eighth, fourth and seventh deciles break away from the rest of the decile pack (Chart 7). It should come as no surprise that our long top 30%/short bottom 30% litmus test failed to reveal any viable excess return strategies based on dividend yields. Our attempts to develop simple portfolio construction rules based on markers of dividend quality and sustainability failed to conclusively advance the dividend cause. Long/short strategies founded on dividend growth added no value to a simple portfolio built from dividend yield and change in share count (Chart 8). Payout ratio metrics, which might shed some light on both quality and sustainability, provided pretty solid results, but they weren't enormous winners (Chart 9). Our analysis left us unable to conclude that Yield merits inclusion among the established equity factors. Chart 7No Theme To Risk-Adjusted Return Profiles Chart 8No Viable Long/Short Dividend-Growth Strategy ... Chart 9... But Payout Ratios Work Pretty Well An Ideal Dividend Index The fact that the way forward for dividend strategies is not obvious is good news for smart-beta sponsors. The ambiguity leaves plenty of room for developing better index-construction methods. Some sources of improvement might include: A means of identifying and sidestepping "yield traps," high and/or growing yields that are actually a distress signal. A way to review historical metrics to gain a sense of ongoing dividend growth. An evaluation of a dividend's source, valuing dividends supported by operating cash flows more highly than those supported by financing activities or asset dispositions. A process for limiting sector exposures, and an awareness of the most auspicious backdrops for taking on exposure to specialized yield plays like mortgage REITs, MLPs and BDCs. Ticking off every item on this wish list, however, would necessarily involve infringing on other factors' turf. Quality, Value, Size and Volatility could all spill into the process of assessing dividend quality and sustainability. Given that our attempts at creating our own tests to measure up to the wish list came up empty, it seems that a cross-disciplinary approach might be the only option. Even if the indexes are not based completely on dividend-derived metrics, it may be possible for a few dividend accents to add some incremental value to the overall stew. Smart-Beta Fund Evaluation These issues were on our mind when we set out to define the metrics that we would use to evaluate the indexes created by our Dividend smart-beta ETF subset. The two payout metrics in the ETS model, dividend yield and change in shares outstanding, are pretty thin gruel for evaluating the dividend ETFs. The ETS payout metrics were selected based on their interaction with the Value, Safety, Quality, Momentum and Sentiment metrics, 23 in all, that comprise the rest of the stock-level inputs into our model. They were not intended to be stand-alone measures. Many of the ETFs in our subset explicitly screen for Quality, Value and/or Low Volatility. They could just as accurately be described as multi-factor funds in a dividend-first wrapper, and we have therefore deployed the entire ETS model to evaluate them. To assess whether or not their constituent selection process consistently improves upon a simple dividend strategy, we compare their ETS scores to those of VIG, the Vanguard Dividend Appreciation ETF, which tracks the NASDAQ US Dividend Achievers Select Index of stocks (ex-REITs and LPs) with at least 10 consecutive years of dividend increases. First Trust Rising Dividend Achievers ETF (RDVY) RDVY's ETS scores have stood out from its smart-beta peers' since the fund's inception at the beginning of 2014. Its concentrated 50-stock portfolio allows it to focus on exposure to its preferred growth and sustainability metrics. Only stocks that have grown their dividends over 3- and 5-year periods, and their non-zero earnings per share over a 3-year period, make it through the growth filters. The sustainability filters admit only stocks with cash-to-debt ratios of at least 50% and dividend payout ratios of 65% or less. Chart 10Good Things Come To Those Who Wait Although the fund has outperformed VIG since inception, its relative performance has not been nearly as consistent as its relative ETS scores (Chart 10). It has taken a 40% surge over the 12 months ended February 28th to put RDVY over the top. We recognize that performance can be capricious, however, and place more weight on RDVY's consistently stellar relative ETS scores, which are 20% more, on average, than its smart-beta peers'.5 RDVY's 50-basis-point ("bps") expense ratio exceeds the 36-bps group average, but we think its screens and concentration are worth the incremental 14 bps. The fund is on the smaller side with $127 million of AUM, and daily turnover of just over $2 million, but larger investors can make use of the creation/redemption unit process to transact in larger volumes without concern. We recommend RDVY for investors seeking large- and mid-cap dividend exposure. FlexShares Quality Dividend Index Fund (QDF) QDF stands second to RDVY on an ETS score basis. Its relative scores have been remarkably stable, rarely falling below 110% en route to averaging 113% of the aggregate Dividend smart-beta score. QDF's selection process is proprietary, and it incorporates measures of cash flow, profitability, and management's skill at deploying capital and financing its activities. The mix has enabled QDF to outperform VIG from the get-go, and steadily pad its lead ever since (Chart 11). Its 37-bps expense ratio is right in line with the group's and its $1.7 billion AUM and $5 million average daily turnover provide a nice sense of ballast. We recommend QDF, along with RDVY, as the best Dividend smart-beta options. Chart 11Wire-To-Wire Outperformance WisdomTree MidCap Dividend Fund (DON) O'Shares FTSE US Quality Dividend ETF (OUSA) WisdomTree has been a pioneer in creating dividend-weighted indexes, but the formula it's applied to selecting constituents for DON, its mid-cap dividend ETF, has not found favor with the ETS model. The fund's constituents have repeatedly earned an aggregate ETS score below 40, holding its relative score below 80% for extended periods. OUSA is a newer fund, with less than a year of history, but its ETS scores have been noticeably weak. We would avoid OUSA until it compiles enough of a track record to permit more conclusions about its process and we would advise investors seeking targeted mid-cap exposure to gain it via funds other than DON. Dividends' Curious Attraction Our work in researching this Special Report has brought dividends' many contradictions to light. In countries like the U.S., where ordinary income is taxed at a higher rate than capital gains, dividends represent an especially tax-inefficient way of redeeming a portion of one's investment. Either share buybacks or sales to third parties would yield more after-tax cash. Humans feel a strong pull to book gains, and steadily redeeming portions of a successful investment has an intuitive emotional appeal: "Let's quit while we're ahead, let's go while the getting is good." It's exactly the wrong thing to do with investments, however. If the quarterly dividend flow assuages the remorse over a mistaken investment, encouraging an investor to stick with a losing position, it's even worse. It is possible that dividends, even though they're small, help reinforce our innate resistance to selling losers and letting winners run. From management's perspective, legacy dividend payments can act as handcuffs. Fearful of issuing a signal that is sure to be interpreted negatively by the market, firms take pains to refrain from cutting dividends. Dividend declarations, then, are a part of the capital budgeting process that is not rooted in economics. A rigorously utility-maximizing visitor from outer space may have found the oil majors' borrowing to fund their dividends in the midst of the severe downturn in crude prices to be very odd indeed. All of these shortcomings may help explain why we were unable to find clear evidence that dividends exert a clear and consistent influence on stock prices. And yet, dividends are enormously popular, with dividend funds by far outnumbering every other flavor of smart-beta ETF. We, too, like to think of positions in balanced portfolios on a total-return basis, as does our U.S. Investment Strategy service, which has successfully recommended the Dividend Aristocrats much longer than we have. Total return is important, but we are increasingly leaning toward the view that specialty dividend plays, purchased at the right point of the cycle, are the best way for an investor to capture income from equity holdings. Such an all-or-nothing approach may well be superior to the one-foot-in, one-foot-out stance that is embodied by the average 2% large-cap dividend yield. Our U.S. Investment Strategy service has successfully surfed the cyclical wave in mortgage REITs, and we are attempting to do so now with the inclusion of BIZD, the business development company ETF, in our U.S. portfolios. Adding cycle analysis would make our smart-beta studies too long, but we are conducting research into the interaction between factor performance and cycle phases, and we will share our findings with our clients in standalone Special Reports if they are insightful enough to merit their attention. Doug Peta, Vice President Global ETF Strategy dougp@bcaresearch.com Jennifer Lacombe, Research Analyst Global ETF Strategy Jenniferl@bcaresearch.com Philippe Morissette, Associate Vice President Equity Trading Strategy philippem@bcaresearch.com 1 Please see Global ETF Strategy/Equity Trading Strategy Special Report, "Smart-Beta ETF Selection, Part I - Value Funds," published February 15, 2017, at etf.bcaresearch.com. 2 Size may be too straightforward to allow for an index-construction edge. 3 Stock XYZ's beta is equal to the covariance of its returns with the market's returns, divided by the variance of the market's returns, where its covariance with the market equals its returns' correlation with the market's times the product of XYZ's volatility and the market's volatility. 4 Fama, Eugene F. and French, Kenneth R., "The Capital Asset Pricing Model: Theory and Evidence," Journal of Economic Perspectives, Volume 18, Number 3 (Summer 2004), pp. 25-46. 5Befitting its benchmark status, VIG’s ETS scores have averaged 99.8% of the entire subset’s since inception.

Highlights Portfolio Strategy Contrary to popular perception, non-cyclical sectors have led the market so far this year, while deep cyclical sectors are breaking down, in relative performance terms. Our models point to more of the same ahead. The oversold rebound in the pharmaceutical group may soon run into resistance so we recommend trimming positions to neutral. Put the proceeds into restaurants, a quasi-defensive group that enjoys a brightening sales outlook without pharma's political and regulatory risk. Recent Changes S&P Pharmaceuticals - Downgrade to neutral. S&P Restaurants - Upgrade to overweight. Table 1 Feature Equities are exhibiting signs of mild fatigue. Breadth has begun to narrow, and new highs have sagged compared with new lows (Chart 1). Both of these technical developments have warned of previous tactical pullbacks. The recent reset in oil prices may also test investor nerves. Oil prices have been a critical macro variable, because they influence inflation expectations and the corporate bond market (high yield bond spreads shown inverted, Chart 1). Crude oil price corrections have accurately timed equity retreats (Chart 1), and general risk aversion phases. To be sure, the global economy is no longer on a deflationary precipice, suggesting that weaker oil prices may not foreshadow a soft patch, but they may be a good enough excuse for profit taking in the equity market after a good run. Contrary to popular perception, cyclical sectors have not led the broad market so far in 2017. In fact, energy, materials and industrials have all broken down in relative performance terms (Chart 2), after peaking in mid-December. Only the technology sector has stayed resilient. Chart 1Short-Term Fatigue Chart 2Cyclicals Have Broken Down Chart 3Overshoot Renormalization Insipid cyclical sector performance has occurred within the context of a synchronized lift in global economic growth and recovering corporate sector pricing power. So why are cyclical sectors lagging? It may simply be a digestion phase. However, a different interpretation is that a number of key macro factors fail to confirm the durability of last year's outperformance, suggesting that defensive outperformance could last. Concerns that the current global inventory cycle may not morph into a broad-based upturn in global final demand continue to linger: the global credit impulse remains anemic, the Fed and China are tightening monetary policy and commodity markets are cracking (Chart 3). The lack of any meaningful improvement in Chinese loan demand signals that the economy may be quick to cool as the authorities tap the breaks on credit growth. It would take a decisive depreciation in the U.S. dollar to boost the relative profit fortunes of capital spending-dependent cyclical sectors on a sustainable basis. On a more positive note, the Fed's benign forward guidance last week bears close attention. If the U.S. dollar loses upside support, particularly with the ECB contemplating a retreat from full throttle easing, it could change the investment landscape. By reminding markets that their inflation target is symmetric, the Fed signaled it will be willing to tolerate a modest inflation overshoot, which is positive for risk assets in the short run. A softer U.S. dollar would take the pressure off of developing countries, support commodity prices, and bolster our cyclical sector sales models and Cyclical Macro Indicators. However, Chart 4 shows that the objective message from our models remains consistent with continued defensive sector outperformance. With a more protectionist U.S. Administration, we remain reluctant to position exclusively for a much weaker dollar. The ongoing underperformance of emerging market equities relative to U.S. and global benchmarks reinforces that foreign-sourced profit growth continues to lag (Chart 5). Positioning for cyclical sector earnings outperformance requires healthier profits abroad, to spur a new capital investment cycle. Chart 4Heeding The Message From Our Models... Chart 5... And The Markets We will look to selectively add cyclical exposure when the objective message from our Indicators provides confirmation that earnings-driven outperformance lies ahead. At the moment, there is no such confirmation. In fact, the elevated reading in the SKEW index continues to signal that a defensive posture will optimize portfolio performance (Chart 5). In sum, we continue to characterize the broad market's current momentum as an overshoot phase, with additional technical upside potential, but the rally is starting to fray around the edges. In this environment, holding a mostly defensive basket with selective beta exposure is still recommended. Importantly, within the defensive universe, there are tweaks to be made, especially if the U.S. dollar stops rising. Fade The Pharmaceuticals Rebound Health care has been the second strongest of the eleven broad sectors year-to-date, contrary to popular perception. That is in line with the flattening yield curve, cresting in inflation expectations and a modest correction in oil prices (Chart 6), all of which have revived the allure of non-cyclical sectors. Moreover, our Cyclical Macro Indicator (CMI) for the health care sector remains firm, supported by the ongoing large pricing power advantage. Relative value is the most attractive it has been in five years. While the latter provides little timing help, it indicates low risk, especially with technical conditions still deeply oversold (Chart 7). Chart 6Health Care Is Storming Back Chart 7Still Cheap And Oversold The heavyweight pharmaceutical group has led the sector's tactical charge, recouping the ground lost, in relative performance terms, leading up to the U.S. election. While we were caught off guard by the severity of the pullback last September/October, we refrained from selling into an oversold market and noted our intention to lighten positions whenever the inevitable relief rally occurred. The time has come to execute on this thesis. Pharmaceutical stocks are very cheap and have discounted a hostile regulatory environment. The relative forward P/E is well below its historic mean, even though both 12-month and 5-year relative forward earnings growth expectations are depressed (Chart 8). Typically, the latter would serve to artificially inflate valuations. These conditions exist even though free cash flow growth remains strong; merger activity has been solid, albeit ebbing in recent months; and companies have used excess capital to reduce total shares outstanding (Chart 8). In other words, relative forward earnings would have to decline substantially to validate these expectations. Is this plausible? Much depends on the regulatory environment. While details of the U.S. Administration's proposal to replace the Affordable Care Act have started to leak out, final details are still elusive and legislative action is not imminent. So far, it appears as if a worst case scenario would see an increase in the number of uninsured Americans, with a rising cost of insurance (to the benefit of managed care companies). According to the Department of Health & Human Services, the uninsured rate of the U.S. population nearly halved from 16% in 2010 to 9% in 2015. That led to a lift in the number of procedures performed and bolstered hospital bottom lines. Hospitals are a major pharmaceutical buying group. Higher utilization rates fed increased pharmaceutical demand for a number of years. However, drug spending growth has dropped off, and if the legion of uninsured patients rises anew in the coming years, then hospital utilization rates will decline, taking drug consumption growth down with it. Moreover, Trump wants to streamline the FDA's approval process, which would ultimately boost the number of high margin new drugs coming to market. Drug stocks boomed back in the mid-1990s, the last time FDA approval rates accelerated meaningfully (Chart 9). Chart 8Full Capitulation Chart 9Full Capitulation But at the same time, if government is given leeway to negotiate drug prices directly with drug companies, then pricing power will continue to converge down toward overall corporate sector pricing power, especially if drug consumption rates ease (Chart 9). At the moment, drug consumption growth remains above the rate of overall consumption growth, but that is much slower than during the boom following the introduction of the Affordable Care Act. Retail sales at pharmacies are growing robustly, and hospitals are still adding staff, signaling that they continue to position for expansion, i.e. rising procedure volumes (Chart 10). On the downside, the strong U.S. dollar is a big drag on top-line growth. Drug imports exceed exports by a wide margin, resulting in a negative trade balance and a drag on U.S. drug company profits, all else equal. The combination of a sales growth deceleration and adequate channel inventories has capped drug output growth (Chart 10). That is a productivity and profit margin headwind. Against this background, the industry will need an external assist to deliver profit outperformance. Relative profit estimates rise when disinflationary forces reign supreme, as measured by the NFIB planned price hikes series (shown inverted, Chart 11). This measure of future corporate pricing power intentions has rolled over, but broader measures of inflation are creeping higher. Ergo, drug earnings forecasts may be challenged to keep pace with the overall corporate sector. Chart 10... But Growth Rates Are Slowing Chart 11Mixed Signals The good news is that even though U.S. dollar strength is an export drag, the negative drug trade balance suggests that it will hurt other industries more. Indeed, a rising currency often coincides with profit outperformance (Chart 11). There is not enough evidence that exogenous factors will offset slowing domestic drug consumption growth. In all, the case for a further and sustained relative performance recovery has weakened, and we are taking advantage of this year's oversold bounce to move to the sidelines. Bottom Line: Trim the S&P pharmaceuticals index to neutral. This position was deep in the money initially, but last year's downdraft pushed it into a loss position of 10%. BLBG: S5PHARX-JNJ, PFE, MRK, BMY, LLY, AGN, ZTS, MYL, PRGO, MNK. Restaurants: Increasing Appetite The broad consumer discretionary sector has been treading water, largely owing to fears that a border adjustment tax (BAT) will undermine the retailing sub-component. This consolidation has restored value and created an attractive technical entry point (Chart 12, bottom panel). Importantly, industry earnings fundamentals are on the upswing. Our consumer discretionary sector Cyclical Macro Indicator has perked up (Chart 12), supported by an increase in wages, and more recently, the decline in oil prices. The latter is freeing up disposable income, which consumers have an incentive to spend given that household net worth (HNW) has climbed to all-time highs as a percent of disposable income (Chart 13). Chart 12A Good Place To Shop Chart 13Piggyback The Wealth Effect While we remain overweight housing related equities (homebuilders and home improvement retailers) in addition to our upbeat view on the media and advertising complex, a buying opportunity has surfaced in the neglected S&P restaurants index. We booked gains on an underweight position and lifted exposure to neutral back in late-October. Since then, value has improved further, while leading sales indicators continue to firm. Stronger consumer finances should flow into the casual dining industry. Sales have already started to reaccelerate, and should climb further based on the leading message from HNW (Chart 14). The lower income, $15K-$35K, cohort is also feeling increasingly confident, according to the latest Conference Board survey data (Chart 14). Meanwhile, the National Association of Restaurants Performance Index has regained momentum (Chart 15), signaling increased activity and rising confidence among restaurateurs. While the gap between the cost of dining out and dining in remains wide, it has begun to narrow, which is a plus for store traffic, all else equal. Chart 14Buy Into Weakness Chart 15At A Turning Point Domestically... Chart 16... And Globally? Our restaurants profit margin proxy (comprising restaurants CPI versus a blend of the industry's wage bill and food commodity costs) is trending higher. That is notable because it has a good track record in leading relative earnings growth estimates (Chart 15). Nevertheless, it is not all good news. International exposure remains a headache. Typically, soft EM currencies warn of translation drags on foreign sourced revenue (Chart 16). This cycle, there is an offset, as EM interest rates have come down, which is a plus for domestic demand (Chart 16). Thus, the headwind from outside the U.S. should abate as the year progresses. Adding it all up, factors are falling into place for a playable rally in the under-owned and unloved S&P restaurants index. This group offers attractive quasi-cyclical defensive exposure to replace the S&P pharmaceuticals index, without the political and regulatory risks. Bottom Line: Redeploy funds from the pharma downgrade and boost the S&P restaurants index to overweight. BLBG: S5REST-MCD, YUM, CMG, SBUX, DRI. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

Highlights Once the Brexit starting gun is fired, the EU27's high-level guidelines and red lines will create more vulnerabilities and uncertainties for the U.K. than for the euro area. The BoE will be more boxed in than the ECB. Brexit trades have more legs. We describe four structural disruptors to economies and financial markets (on page 6). Our favourite structural investment themes are Personal Product equities, euro/yuan, and real estate in Spain, Ireland and Germany. Feature "Many in Great Britain expected a major calamity... but what happened was near enough nothing ." The citation above perfectly describes the 9 months that have elapsed since the U.K.'s June 23 2016 vote to exit the EU. In fact, it refers to the 9 months that elapsed after Britain declared war on Germany on September 3 1939 - a period of calm, militarily speaking, which became known as the 'Phoney War'.1 But outside the military sphere a lot did happen in the Phoney War. Most notably, a propaganda war ensued. On the night of September 3 1939 alone, the Royal Air Force dropped 6 million leaflets over Germany titled 'Note to the German People'. Chart of the WeekOne Big Correlated Trade: Pound/Euro And Eurostoxx600 Vs. FTSE100 Brexit Phoney War And The Markets Fast forward 77 years. The 9 months since the Brexit vote has also been a period of calm, economically speaking. Indeed, the U.K. economy has sailed along remarkably smoothly. And this has fuelled a propaganda war for those who believe that Brexit's economic impact will be near enough nothing. But outside the economic sphere, a lot has happened in the Brexit Phoney War: The pound has slumped 12% versus the euro and 17% versus the dollar. The FTSE100 has surged 16%, substantially outperforming the 8% gain in the Eurostoxx600 The U.K. 10-year gilt yield is down 40 bps when the equivalent German bund yield is up 40 bps and the equivalent U.S. Treasury yield is up 90 bps. These relative moves appear to reflect different asset class stories, but it is crucial to realise that: All of these relative moves are just one big correlated trade. The relative moves in bond yields have just tracked the expected differences in central bank policy rates two years ahead (Chart I-2 and Chart I-3). This is exactly in line with the theory that a bond yield just equals the expected average interest rate over the bond's lifetime. Chart I-2Difficult Brexit = Gilt Yields Fall Vs. Bund Yields Chart I-3Difficult Brexit = Gilt Yields Fall Vs. T-Bond Yields Likewise, the moves in pound/dollar and pound/euro have also closely tracked the same expected differences in central bank policy rates (Chart I-4 and Chart I-5). Again, this is exactly in line with theory. Over short horizons, the biggest driver of exchange rates is fixed income cross-border portfolio flows - which always seek out the highest yield adjusted for hedging costs. Chart I-4Difficult Brexit = Pound/Euro Falls Chart I-5Difficult Brexit = Pound/Dollar Falls In turn, FTSE100 performance versus the Eurostoxx600 has near-perfectly tracked the inverse direction of pound/euro. Once more, this is exactly as theory would suggest. The FTSE100 and Eurostoxx600 are just a collection of multinational dollar-earning companies quoted in pounds and euros respectively. So when pound/euro weakens, the dollar earnings increase more in FTSE100 index terms than in Eurostoxx600 index terms, resulting in Eurostoxx600 underperformance (Chart of the Week). Now that the Brexit battle is about to begin in earnest, what will happen to these Brexit trades? Brexit Battle Begins It is not our intention here to forecast all the twists and turns of the Brexit battle. We will leave that to a later report. Instead, we just want to list the likely opening salvos. With Parliamentary approval now sealed, Theresa May is due to trigger Article 50 of the Lisbon Treaty in the week commencing March 27 and thereby formally begin the Brexit battle. Expect the first EU27 response within 48 hours, probably through the President of the European Council, Donald Tusk. In this response, Tusk may also give the date for the first European Council 'Brexit' summit. This EU27 Brexit summit will take place within 8 weeks of the Article 50 trigger, and likely after the two-round French Presidential Election in April/May. At the Brexit summit, the EU27 will establish its strategy, high-level guidelines and red lines for the Brexit negotiations. The European Council will present these negotiating guidelines to the European Commission. Drawing upon its own legal and policy expertise, the Commission will then draft a mandate which sets out more technical details of each area of negotiation. Next, the Council of the EU2 must approve this draft mandate by qualified majority vote (obviously excluding the U.K.) Once approved, the European Commission can begin the detailed negotiations with the U.K., keeping within the final mandate's guidelines. But what does all this mean for investors? The preceding analysis showed that the dominant driver for all Brexit trades is the expected difference in central bank policy interest rates two years ahead. Recall that not long ago the BoE was vying with the Fed to be the first to hike rates in this cycle, while the ECB was likely to ease further. But after the Brexit vote and the resulting uncertainty about the U.K.'s position in the world, the tables have turned. The EU27's high-level negotiating guidelines and red lines are likely to create more vulnerabilities and uncertainties for the U.K. than for the euro area. And now, these vulnerabilities and uncertainties are amplified by Scotland First Minister, Nicola Sturgeon, calling for a second referendum on Scottish Independence. For central bank policy, this means that the BoE will be hamstrung; whereas, absent any tail-events, the ECB can continue to back away from its extreme dovishness - a process that Draghi verbally started at the ECB Press Conference last week. Therefore, at least into the early summer, stay: Overweight U.K. gilts versus German bunds. Long euro/pound. Long FTSE100 versus Eurostoxx600 (or Eurostoxx50). Long U.K. Clothes and Apparel equities versus the market (Chart I-6). Short U.K. Real Estate equities versus the market (Chart I-7). But a word of warning for risk control. Remember that all five positions are in effect just one big correlated trade. So they will all work together, or they will all not work together! Chart I-6Difficult Brexit = U.K. Clothes And Apparel Outperforms Chart I-7Difficult Brexit = U.K. Real Estate Equities Underperform Four Disruptors The final section this week takes a wider-angle view of the world, and briefly highlights four structural disruptors to economies and financial markets in the coming years. Disruptor 1: Protectionism. Since the Great Recession, an extremely polarised distribution of economic growth has left most people's standard of living stagnant - despite seemingly decent headline economic growth and job creation (Chart I-8). Looking to find a scapegoat, economic nationalism and protectionism have resonated very strongly with voters in the U.K. and U.S. - resulting in Brexit and President Donald Trump. Other voters could follow in the same vein. But history teaches us that protectionism ends up hurting many more people than it helps. Disruptor 2: Technology. The bigger danger is that people are misdiagnosing the illness. The vast majority of middle-income job losses are not due to globalization, but due to technology. Specifically, Artificial Intelligence (AI) is replacing secure middle-income jobs and displacing workers into insecure low-income manual jobs - like bartending and waitressing - which AI cannot (yet) replace (Table I-1). And AI's impact on middle-income jobs is only in its infancy.3 The worry is that by misdiagnosing the illness as globalization and wrongly taking a protectionist medicine, the illness will intensify, rather than improve. Chart I-8Disruptor 1: Protectionism Table I-1Disruptor 2: Technology Disruptor 3: Debt super-cycles have reached exhaustion. The protectionist medicine carries a further danger. Major emerging market economies are coming to the end of structural credit booms and need to wean themselves off their credit addictions (Chart I-9). At this point of vulnerability, aggressive protectionism risks tipping these emerging economies into a sharp slowdown. Chart I-9Disruptor 3: Debt Super-Cycles Have Reached Exhaustion Disruptor 4: Equities are overvalued. Disruptors one, two and three come at a time when equities are valued to generate feeble total nominal returns over the next decade (Chart I-10). Risk premiums are extremely compressed. And if investors suddenly demand that risk premiums rise to average historical levels, it necessarily requires equity prices to adjust downwards. Chart I-10Disruptor 4: Equities Are Overvalued The long-term investment message is crystal clear. With the four disruptors in play, we strongly advise long-term investors not to follow passive (equity) index-tracking strategies. Instead, we advise long-term investors to stick to bespoke structural investment themes. Our favourite structural investment themes are Personal Product equities, euro/yuan, and real estate in Spain, Ireland and Germany. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 C N Trueman 'The Phoney War'. 2 The Council of the EU should not be confused with the European Council. 3 Please see the European Investment Strategy Special Report, "The Superstar Economy: Part 2," dated January 19, 2017, available at eis.bcaresearch.com Fractal Trading Model This week's trade is to short Netherlands equities, but wait until after the election result. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations