Financials

While bank stocks are quick to react positively to any indication that the regulatory burden may eventually be diminished, beneath the surface, there are mounting signs of profit headwinds. The latest Fed Senior Bank Loan Officer Survey revealed that banks are tightening lending standards on most loan categories. Worrisomely, demand for commercial, consumer, mortgage and C&I loans is also waning. In fact, C&I loan growth is now contracting on a 3-month rate of change basis. A cooling in bank balance sheet expansion may expose a heavier cost structure than desired in the coming quarters, given that bank employment has been on the upswing. Absent any renewed steepening in the yield curve, the surprise could be that bank stocks underperform in the coming months after overshooting since the election. The ticker symbols for the stocks in this index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT. Banks Are Tightening Lending Standards Banks Are Tightening Lending Standards

Highlights Brazilian growth will recover modestly in 2017, but it will be insufficient to stabilize the public debt-to-GDP ratio. With interest rates still at double digits, public debt dynamics will become unsustainable as the ratio reaches or surpasses 85-90% of GDP over the next couple of years. The central bank has been financing the government by buying local currency bonds. Going forward, the path of least resistance, and most likely scenario, is direct or indirect public debt monetization by the central bank of Brazil. This will allow the nation to avoid fiscal stress/crisis but the price for it will be large exchange rate depreciation. In the end, investors will lose capital in Brazilian financial markets in U.S. dollar terms. Feature Brazil's financial markets have rallied sharply over the past 12 months, even as the economy has continued to disappoint. Growth has fallen short of even our downbeat expectations, yet the tremendous rally in its financial markets had sent our bearish strategy wide of the mark. In the past year, we have argued that even if the Brazilian economy recovers, it is likely headed towards a public debt trap because the recovery will be muted and the starting point of fiscal accounts/government debt is already quite poor. So, has Brazil achieved escape velocity - i.e., has growth gained enough momentum to thwart concerns about public debt sustainability? Escape Velocity Chart I-1Despite A Strengthening Global Economy, ##br##Brazilian Growth Is Relapsing Despite A Strengthening Global Economy, Brazilian Growth Is Relapsing Despite A Strengthening Global Economy, Brazilian Growth Is Relapsing It is tempting to conclude that the rally in Brazilian markets has been so powerful that the country has broken away from its five-year bear market, and hence that public debt sustainability is not an issue at all. In other words, financial markets seem confident that Brazil has achieved escape velocity. We do not think so. Notably, in recent months Brazil's economy has surprised to the downside, despite the ongoing improvement in global growth: Brazil's manufacturing PMI overall index has rolled over decisively, despite broad-based strength in the global business cycle (Chart I-1). More importantly, export prices in general, and iron ore and soybean prices in particular, have rallied a lot in the past year. Hence, the external sector has been a positive force for the economy, yet the latter has failed to revive. Having appreciated dramatically, the currency is no longer cheap. This is confirmed within Brazil's trade dynamics since export volumes are slipping relative to import volumes. As fiscal spending growth has until now been decent, the epicenter of the retrenchment has clearly been household consumption and business investment (Chart I-2 and Chart I-3). Chart I-2Brazilian Households Are ##br##Still Feeling Massive Pain... Brazilian Households Are Still Feeling Massive Pain... Brazilian Households Are Still Feeling Massive Pain... Chart I-3...As Is The ##br##Business Sector ...As Is The Business Sector ...As Is The Business Sector Household debt-service costs remain elevated at 22% of disposable income (Chart I-4). This, and ongoing job losses, are keeping a lid on consumer spending. Manufacturing production is still collapsing, and capacity utilization is at a 20-year low (Chart I-3, bottom panel). This is not a sign of a competitive exchange rate or vibrant manufacturing sector. Due to the economic contraction, Brazil's primary and overall fiscal deficits have reached 2.5% and 8.9% of GDP (Chart I-5), respectively, despite the authorities' attempts to secure considerable one-off revenues. Chart I-4Brazil: Elevated Household Indebtedness ##br##Will Prevent A Consumption Rebound Brazil: Elevated Household Indebtedness Will Prevent A Consumption Rebound Brazil: Elevated Household Indebtedness Will Prevent A Consumption Rebound Chart I-5Brazil's Fiscal Accounts Brazil's Fiscal Accounts Brazil's Fiscal Accounts Remarkably, the level of Brazil's real GDP has already contracted by 7.6% from its peak in 2014, producing the worst depression in more than 116 years (Chart I-6). Bottom Line: Not only has Brazil failed to achieve escape velocity, but also its growth dynamics have underwhelmed even the most pessimistic of forecasts. As a result, public debt dynamics have become unsustainable. Fiscal And Credit Impulses In 2017 Going forward the outlook for Brazil's economy will hinge on credit and fiscal impulses: If government spending rises by 6.3% in 2017, which is equivalent to the 2016 IPCA inflation rate as mandated by the fiscal spending cap (known as PEC 55), the federal fiscal spending impulse in 2017 will be 79 billion BRL, or 1.23% of GDP (calculated using our 2017 nominal GDP estimate) (Chart I-7, top panel). Chart I-6Brazil's Worst Recession In 116 Years Brazil's Worst Recession In 116 Years Brazil's Worst Recession In 116 Years Chart I-7Fiscal And Credit Impulses Fiscal And Credit Impulses Fiscal And Credit Impulses The impact of fiscal policy on growth is defined by government spending and taxes. Odds are that taxes need to be hiked to achieve the 2017 budget targets. Unless growth recovers strongly, doubtful in our view, there are non-trivial odds of impending tax hikes. The latter will counteract the positive fiscal impulse from government expenditures. The credit impulse is calculated as an annual change in credit growth, or the second derivative of the outstanding stock of credit. If we assume private and public banks' credit growth will be 0% and -5%, respectively, in 2017 overall loan growth will contract by 2.5%, and the credit impulse will be 0.54% of GDP (Chart I-7, middle panel). Even though interest rates are declining, real (inflation-adjusted) rates remain high at 5.4%, and banks' balance sheets are impaired by mushrooming NPLs following the credit boom years. This will preclude a revival in loan growth in the banking system. Aggregating the fiscal spending and credit impulses together, there will be about a 2% boost to nominal GDP growth in 2017 (Chart I-7, bottom panel). However, as it is likely that taxes will rise, the overall combined effect on the economy will be less than that. Bottom Line: Odds are that the aggregate fiscal and credit impulse will be only mildly positive in 2017 - assuming no tax hikes. This portends only moderate nominal GDP growth in 2017. Government Debt Simulation Revisited The Brazilian economy will probably recover and our baseline view assumes real GDP growth will be modestly positive for 2017. However, the recovery will not be vigorous enough to halt the exponential rise in the public debt-to-GDP ratio. Table I-1 presents a scenario analysis for Brazil's public debt. Table I-1Brazil: Public Debt Sustainability Scenarios 2016-2019 Has Brazil Achieved Escape Velocity? Has Brazil Achieved Escape Velocity? We considered three scenarios: base case, optimistic and pessimistic. For each scenario, we have made assumptions for nominal GDP growth, nominal government revenue growth, nominal government expenditure growth (based on the fiscal spending cap), and on the average (or blended) interest rate on all local currency public debt. Chart I-8Brazil's Is Headed Towards ##br##A Public Debt Crisis Brazil's Is Headed Towards A Public Debt Crisis Brazil's Is Headed Towards A Public Debt Crisis In our base case scenario, the public debt-to-GDP ratio reaches 84% in 2018 and 91% in 2019 (Chart I-8). With double-digit interest rates, the 91% public debt load spirals out of control. In short, even in our base case scenario, which assumes a return to modest growth in 2017 and a decent recovery in economic activity in 2018 and 2019, Brazil is unlikely to avoid a debt trap. For the base case, we use the following assumptions For nominal GDP growth in 2017 we use the most recent Brazilian Central Bank Survey year-end forecast of real GDP growth of 0.5% plus our estimate of 5% inflation to arrive at 5.5%. In 2018, we assume real GDP growth of 2.5% plus 4.5% inflation to arrive at 7%. And in 2019 we also assume growth of 7%. For nominal government revenue growth, we use 5% in 2017 and 8% for both 2018 and 2019, as we assume government revenue reasonably tracks nominal GDP growth. A caveat: the actual 2016 federal government revenue growth number of 4.3% was heavily boosted by non-recurring revenues such as privatization revenue, repayment by the national development bank (BNDES) of 100 billion BRL, tax amnesty/repatriation programs, and so on. In brief, the government used all means at its disposal to boost its revenue via one-off items. As these are non-recurring and impossible to predict, we did not attempt to account for them. Yet, in future, these non-recurring sources of fiscal revenue will be harder to come by. To be consistent, we do not incorporate one-off expenditures, such as financial support for local governments, or recapitalization of public banks and state-owned companies. In a nutshell, we assume potential one-off public sector revenues will offset one-off expenditures. With the dire state of the economy, and likely need for bailouts and financial assistance from the federal government, this is a reasonable assumption. Besides, with most states and local governments near bankruptcy, staving off insolvency remains a much more urgent matter that will likely drain central government coffers in the near term. As to nominal government expenditures, since these are capped by the previous year's inflation rate due to the fiscal spending cap (or PEC 55), we use 6.3% growth in 2017 (i.e. 2016 IPCA inflation), and 5% in both 2018 and 2019, respectively. Investors, however, should keep in mind that the spending cap only applies to primary expenditures. Critically, it does not include interest on public debt, spending on education and health in 2017, and nonrecurring expenditures. If anything, federal government spending will likely exceed the 2017 cap as the government may spend more on healthcare and education to offset overall fiscal austerity. Table I-2Composition Of Brazilian Federal Debt Has Brazil Achieved Escape Velocity? Has Brazil Achieved Escape Velocity? For the average, or blended, interest rate on public debt, we used calculations by Dr. Jose Carlos Faria, Chief Brazil Economist at Deutsche Bank.1 We use Dr. Faria's assumptions for local currency average interest rate on public debt in 2017, 2018 and 2019, for our pessimistic scenario. The impact of lower policy interest rates (i.e. the central bank's SELIC rate) on the public debt service is a drawn out process because not all debt is rolled/re-priced over every year. Table I-2 illustrates the breakdown of Brazil's public debt by type. Therefore, the impact of declining interest rates on public debt dynamics will be slow. Bottom Line: With interest rates still in the double digits, Brazil's public debt dynamics will become unsustainable if the ratio reaches or surpasses 85-90% of GDP. The odds are substantial that this limit will be breached in the next few years. The best cure for debt sustainability is growth. So far, however, Brazil has failed to achieve growth strong enough to stabilize its public debt trajectory. A Word On Social Security Reform It is widely accepted that pension (social security) reform is desperately needed to help keep Brazil's public debt on a sustainable path. It does appear that reforms will be passed this year, as they have good momentum in Congress. That said, it will take many years for the positives of pension reforms to kick in and help the fiscal accounts, and in turn improve Brazil's public debt profile. According to the IMF,2 it will take roughly until 2020-2025 to see any decrease in social security expenses as a percentage of GDP, even if the reforms involve an increase in the retirement age, a benefits freeze, and a removal or change of the indexation of pensions to the minimum wage (and/or a change to the minimum wage formula). Bottom Line: The benefits of social security reform will only come into effect after 2020-30 or so, if passed in full. Therefore, they will not prevent Brazil's public debt-to-GDP ratio from surpassing the 85-90% mark in 2019. A Way Out: Debt Monetization? Chart I-9Brazil's Central Bank Has Been ##br##Expanding Its Local Currency Assets Brazil's Central Bank Has Been Expanding Its Local Currency Assets Brazil's Central Bank Has Been Expanding Its Local Currency Assets Being strangled by economic contraction, high debt/fiscal deficits, and a lack of political capital to embark on painful fiscal austerity, the path of least resistance for any country in general and Brazil in particular is debt monetization. That would lead to a considerable exchange rate depreciation. There are already hints that the central bank has been funding the government since 2014. In particular: The Brazilian central bank's domestic currency assets have expanded dramatically - by 640 BRL billion, or 10% of GDP - since January 2015 (Chart I-9). Most of this balance sheet expansion - 460 BRL billion or 7% GDP has been due to the rise in the central bank's holdings of federal government securities (Chart I-10). On the liability side of the central bank's balance sheet, a considerable rise has occurred in Banco Central do Brasil repos with commercial banks and deposits received from financial institutions. The amount of outstanding repos and these deposits has risen by 220 BRL billion since January 2015 (Chart I-11). Chart I-10The Central Bank Has Been ##br##Accumulating A Lot Of Public Debt... The Central Bank Has Been Accumulating A Lot Of Public Debt... The Central Bank Has Been Accumulating A Lot Of Public Debt... Chart I-11....But Withdrawing Liquidity Via ##br##Repos & Deposits Received ...But Withdrawing Liquidity Via Repos & Deposits Received ...But Withdrawing Liquidity Via Repos & Deposits Received Essentially, the central bank has purchased 460 BRL billion of government securities since January 2015 and, hence, injected a lot of liquidity into the banking system. Then, Banco Central do Brasil simultaneously withdrew liquidity via repo agreements and deposits received from financial institutions. This has basically sterilized half of the central bank's government bond purchases, i.e. the operation withdrew half of the liquidity expansion that was first made. Without the central bank intervention to buy 460 BRL billion of government securities in the past two years, the 626 BRL billion and 557 BRL billion overall fiscal deficits in 2015 and 2016, respectively, would not have been financed and local bond yields would have risen. Chart I-12The BRL Is Expensive Again The BRL Is Expensive Again The BRL Is Expensive Again Looking ahead, as the fiscal accounts continue bleeding, public debt burden will rise to around 85% of GDP and the banking system - wounded by non-performing loans - will struggle to expand its balance sheet further. In turn, the central bank might be tempted to continue monetizing the government's debt without, however, sterilizing its operations. In such a scenario, the currency will depreciate meaningfully. Markedly, Brazil's real effective exchange rate has risen above its historical mean and is somewhat expensive (Chart I-12). Brazil needs lower interest rates, more abundant banking system liquidity and a cheaper currency to embark on a sustainable recovery. The latter is required to avoid the fiscal debt trap. The exchange rate depreciation is an important relieve valve. Given that only 4% of government debt is denominated in foreign currency, a deprecation of the Brazilian real is the least painful solution. Bottom Line: Going forward, the only way for Brazil to stabilize the public debt-to-GDP ratio is to boost nominal GDP growth. This can be achieved by reducing interest rates aggressively, injecting large amounts of liquidity into the wounded banking system and devaluing the currency. Unless financial markets in Brazil sell off, there is a non-trivial probability that the authorities will embark on outright or covered public debt monetization. This would allow the country to avoid fiscal stress/crisis. Yet, the price will be large exchange rate depreciation. Chart I-13Stay Underweight Brazil ##br##Versus The EM Equity Benchmark Stay Underweight Brazil Versus The EM Equity Benchmark Stay Underweight Brazil Versus The EM Equity Benchmark Investment Implications We have been wrong on Brazilian markets in the past 12 months, but we do not see a reason to alter our view. The currency will plunge due to the ongoing debt monetization, and foreigners will not make money in Brazilian financial markets in U.S. dollar terms. We reiterate our short positions in the BRL versus the U.S. dollar, ARS and MXN. Stay long CDS and underweight Brazilian credit within EM sovereign and corporate credit portfolios. Continue underweighting this bourse within an EM equity portfolio (Chart I-13). Interest rate cuts will continue, but with the BRL set to depreciate considerably versus the U.S. dollar in the next 12 months - as we expect - buying local bonds for the U.S. dollar based investors is not the best strategy. Santiago E. Gomez, Associate Vice President santiago@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 These figures come from the appendix on page 9 of the Deutsche Bank report titled, "Brazil at a Debt Crossroad - Again", dated January 23, 2017. 2 Please refer to the following IMF report on Brazil, available at http://www.imf.org/external/pubs/ft/scr/2016/cr16349.pdf Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights In any country, excess national savings, i.e., current account surpluses, lead to an accumulation of net foreign assets, but have no implications on domestic loan creation. Savings are not necessary for the banking system to originate loans. Quite the opposite, new loans boost purchasing power and spending and, thereby, create new income and additional savings. Unlimited loan/money creation will ultimately lead to currency depreciation and/or inflation. The RMB is at major risk because Chinese banks continue creating enormous amount of credit/money "out of thin air." Feature This week we publish the third report in our trilogy series on money, credit, savings and investment, where we address several misconceptions that dominate mainstream macroeconomic thought as well as the investment industry. Our previous Special Reports were: Misconceptions About China's Credit Excesses, and China's Money Creation Redux And The RMB.1 This third report focuses on: (1) Elaborating on the link - or lack thereof - between the investment-savings identity and domestic credit creation in any country; (2) Demonstrating how new loans lead to new income and ultimately new savings creation, and not, vice versa; (3) Discussing the macro limits to money/credit creation among banks. Macroeconomics has many areas that are not well understood or developed. We do not pretend to have all the answers related to savings and loan origination and their links to other factors. Even though all points of this report are applicable to any economy, the practical relevance and goal of our analysis is to demonstrate that China's credit excesses are not the natural outcome of its unique macro features such as a high savings rate. In fact, the leverage expansion that has been underway since early 2009 (Chart I-1) is nothing more than a credit bubble driven by banks willingness to create credit exponentially and policymakers' tolerance of it. Chart I-1Chinese Companies Are Extremely Leveraged Favor Indian Banks Versus Chinese Ones Favor Indian Banks Versus Chinese Ones That said, this does not mean that the Chinese credit bubble is about to burst. BCA's Emerging Markets Strategy service has been negative on China's credit cycle and growth since 2010, yet has never used the word "crisis". China may well experience one at some point, but it is impossible to time it. A more distinct possibility is that the country's growth could stagnate/slump further, and financial markets leveraged to its growth sell off materially - particularly in the wake of last year's rally. The investment implications are that there is more downside to Chinese financial markets and China-related plays globally. National Savings And Domestic Credit Creation One of the prevailing notions that justifies China's large credit excesses, as elaborated by some of my colleagues at BCA and others in the investment industry as well as academia is as follows: A current account surplus implies that national savings exceed investment. If a country generates a lot of national savings, as China does, it must either absorb those savings through domestic investment or, where possible, export the savings to the rest of the world by running a large current account surplus. As a reminder to readers, the investment-savings identity is as follows: Investment = Savings is an identity for a closed economy; and Savings (S) - Investment (I) = Current Account Balance (CA) holds true for an open economy. While on the surface this proposition might appear very intuitive, a deeper examination reveals there is no link at all between the national savings-investment identity (S - I = CA) and domestic credit creation in any country: S - I = CA is an identity of the real economy. It means an economy produces more goods and services than it consumes, and that the difference between production and consumption (excess supply) is being exported. Hence, "excess savings" here are "real excess savings" in the form of goods and services that were produced but not consumed in the economy, but rather sold abroad. These "real excess savings," or the CA surplus, have nothing to do with aggregate deposits in the country's banking system, or money/credit origination by its banks. As we elaborated in the first report of our three-part series, banks do create loans and deposits "out of thin air". Banks do not intermediate deposits into loans. They create deposits when they originate loans. For a more detailed discussion on this, readers should refer to our report titled, Misconceptions About China's Credit Excesses.2 Consequently, banks can create as much in the way of loans as they like (subject to the regulatory capital constraints), regardless of the country's current account balance. Chart I-2 and Chart I-3 depict that, historically, in various countries there has been no correlation between the national and household savings rates and bank credit origination. Chart I-2China: Credit And Savings ##br##Are Not Correlated China: Credit And Savings Are Not Correlated China: Credit And Savings Are Not Correlated Chart I-3The U.S., Korea And Taiwan: ##br##Credit And Savings Are Not Correlated NPL Ratios In Perspective: India & China NPL Ratios In Perspective: India & China When a country runs a current account surplus, it does not mean it brings in "excess savings" and invests those funds domestically. A current account surplus (or an excess of national savings over investment) only means that the country's net foreign assets will rise - i.e., the nation's "excess savings" have to be exported in the form of capital outflows (more on this below). On the whole, the S - I = CA identity is derived from the national accounts and balance of payments, and it has no relationship to how loans and deposits are created within the domestic banking system. Empirical evidence supports neither positive nor negative correlation between the current account balance and loan origination. For example, Germany has had massive current account surpluses, but its non-financial debt-to-GDP ratio has been stable (Chart I-4). On the contrary, the U.S. and Turkey have been running large current account deficits, while their domestic credit and leverage has boomed (Chart I-5 and Chart I-6). Chart I-4Germany: National Savings And Debt India: Public Bank Loan Growth Has Slumped India: Public Bank Loan Growth Has Slumped Chart I-5U.S.: National Savings And Debt India's Capital Spending Is Sluggish India's Capital Spending Is Sluggish Chart I-6Turkey: National Savings And Debt Indian Consumer Health Is Strong Indian Consumer Health Is Strong As the popular argument goes, more national savings lead to more deposits within the domestic banking system and ultimately more domestic loans stem from the application of the intermediation of loanable funds (ILF) model of banking. The ILF model states that banks intermediate deposits (savings) into loans. Yet, as we argued in the first report of this series, the ILF model is simply wrong. Commercial banks create both loans and deposits, simultaneously, "out of thin air". Consequently, any macro thesis that uses or relies on the ILF model is misguided. Bottom Line: National savings is a real economy concept, and has no relevance to loan creation and leverage in the country in question. Below we show that current account (CA) surpluses ("excess savings") lead to an accumulation of net foreign assets, but have no implication for domestic leverage. CA Surplus = Accumulation Of Net Foreign Assets CA surpluses are consistent with a nation expanding its net foreign assets, while CA deficits are congruent with a reduction in a country's net foreign assets. They do not suggest anything about domestic credit origination and leverage. Chart I-7U.S. Net International Investment Position India's Employment Is Turning The Corner India's Employment Is Turning The Corner The mechanism of converting CA surpluses into net foreign assets (external assets minus external liabilities) is somewhat different between fully floating and managed exchange rate regimes, so we consider both cases: A fully flexible exchange rate (the central bank does not interfere in the currency market): Let's assume Country A had a current account surplus over a given period. Exporters can keep the proceeds abroad and buy foreign assets, or bring them back and sell these dollars to other domestic players who want to buy foreign assets. Alternatively, exporters can sell these dollars to foreigners who sold assets in Country A and want to repatriate capital out of Country A. In this case, the nation's net foreign assets still rise because foreigners' claims on its assets shrink. Provided the central bank does not intervene in the currency market and the balance of payments, by definition, equals zero, the current account surplus is offset by a deficit on capital/financial accounts. In brief, the sole result of an excess of national savings relative to domestic investment is net capital/financial outflows and an ensuing increase in a country’s net foreign assets. This does not lead to any change in the banking system’s local currency loans.3 Chart I-7 demonstrates that the U.S.'s net foreign assets have dropped from - US$ 0.4 trillion in 1995 to - US$ 6 trillion currently, because the U.S. has been running current account deficits - i.e., on a net basis, foreigners have accumulated enormous amounts of claims on America. In spite of these persistent CA deficits and a low national savings rate, the U.S. bank loan-to-GDP ratio has risen substantially over the same period, proving the lack of relationship between national savings and loan origination. In the case of a managed or fixed exchange rate system (i.e., when the central bank intervenes in the currency market, by buying/selling foreign exchange), the dynamics are somewhat different, yet the end result is the same. If Country B has a current account surplus and its central bank is involved in managing the exchange rate, the central bank could buy foreign currency and thereby accumulate net foreign assets. Hence, the dynamics are the same, but the nation's central bank, rather than other economic agents, amasses more net foreign assets. If foreign exchange interventions are not completely sterilized, the central bank’s accumulation of foreign assets will be accompanied by issuance of high-power money (banks' reserves at the central bank) and new money (bank deposit) creation, but not a loan creation.4 Some observers might argue that the increase of bank reserves at the central bank would lead commercial banks to originate more loans. However, in the first and second reports of our trilogy series, we documented that commercial banks in the majority of countries, including all advanced economies and China, do not require central bank liquidity to originate loans. On the contrary, banks originate loans first and then, if needed, ask the central bank for liquidity. Chart I-8The PBoC Has Begun ##br##Targeting Rates In Recent Years India: PMIs Are Positive India: PMIs Are Positive In the case of China, there is evidence that from early 2014 until very recently, the People's Bank of China (PBoC) was targeting short-term interest rates (Chart I-8). When any central bank targets the price of money (interest rates), it cannot steer/manage the quantity of money - i.e., it has to provide/withdraw as much liquidity as commercial banks desire at a given interest rate level. Therefore, since early 2014, the PBoC has met commercial banks' demand for liquidity by keeping interest rates at its preferred target. In such a case, commercial banks - not the PBoC - decide on the amount of loan origination at a given interest rate level. Even in this case, the CA balance has no bearing on loan origination by commercial banks. Central banks nowadays steer loan growth and economic growth primarily via interest rates. Unless the current account dynamics lead the monetary authorities to alter interest rates, balance of payments dynamics will not have direct impact on credit growth. Bottom Line: A CA surplus raises a nation's net foreign assets, while a CA deficit reduces its net foreign assets. CA balances do not affect or determine commercial banks' capacity for domestic credit creation. Savings Are Not A Constraint On Loan Origination Mainstream economic literature typically relies on treating deposits as savings - i.e., refraining from spending by households or enterprises. Then, it uses the Intermediation of Loanable Funds (ILF) model to argue those savings flow to the banking system to become deposits. In turn, banks intermediate these savings (deposits) into loans. We have to again emphasize that the ILF model is simply wrong - in reality, this is not how the banking system works in any country in the world. This was the focal point of the first report of our trilogy. In particular, Fabian Lindner states that "...saving does not finance investment. No saving and abstention of consumption is needed for any lending to take place since lending and borrowing money are pure financial transactions that only affect gross financial assets and liabilities."5 Similarly, Zoltan Jakab and Michael Kumhof utter: "In the ILF model, bank loans represent the intermediation of real savings, or loanable funds, between non-bank savers and non-bank borrowers. But in the real world, the key function of banks is the provision of financing, or the creation of new monetary purchasing power through loans, for a single agent that is both borrower and depositor". 6 They also provide a further distinction between savings and financing: "...if the loan is for physical investment purposes, this new lending and money is what triggers investment and therefore, by the national accounts identity of saving and investment (for closed economies), saving. Saving is therefore a consequence, not a cause, of such lending. Saving does not finance investment, financing does." 6 Let's consider an example: Company A - which intends to build a production facility - requests a loan from Bank Z. After approving the loan request, Bank Z opens an account for Company A and grants a loan of $100 million by crediting Company A's bank account and in turn creating purchasing power for the company. Hence, Bank Z originated a loan and deposit of $100 million "out of thin air". As Company A uses this amount to pay for construction of production facility, it pays the builder, architects, engineers and various suppliers. These entities, in turn, pay their own suppliers as well as their employees, while the profits (dividends) are remitted to shareholders. All entities, and ultimately their employees and shareholders involved in the project, derived income from the original loan. Thus, their income was contingent on the loan that was originated by Bank Z and spent by Company A. Without it, these households, other companies and their shareholders would not have earned that income. In turn, these households and companies would spend/consume part of their income and save the other part. A few observations: Loan creation by Bank Z generated household income and enterprise profits that otherwise would not have occurred. This extra income would produce extra saving. In other words, without the loan origination by Bank Z, these extra savings would not have arisen. The fact that all companies and their employees involved in this project decided to save a part of their income does not mean they deposited new funds at their banks. Their "savings" already existed in the banking system. In fact, these deposits were created by Bank Z when the latter originated the loan. Ultimately, with banks willing to originate new loans, spending can exceed current income. Claudio Borio of the Bank for International Settlements corroborates this point: "Crucially, the provision of financing does not require someone to abstain from consuming. It is purely a financial transaction and hence distinct from saving... The equality of saving and investment is an accounting identity that always holds ex post and reveals nothing about financing patterns. In ex post terms, being simply the outcome of expenditures, saving does not represent a constraint on how much agents are able to spend ex ante. If we step back from comparative statics and consider the underlying dynamics, it is only once expenditures take place that income and investment, and hence saving, are generated".7 Bottom Line: Savings are not necessary for the banking system to originate loans and finance investment and consumption. Quite the opposite, new loans boost spending and create new income and additional savings (even though they may not impact the savings rate). Applying this to China, this means that the absolute amount of household savings is high because before 2008 booming exports, and since 2008 mushrooming loan growth, produced robust income growth. In sum, households decide on their savings rate, yet the credit boom since 2008 has tremendously boosted their income and has thereby expanded the absolute amount of their savings. Limits On Country Loan Origination Does this mean any country (specifically, its commercial banks) can originate unlimited amounts of loans/money, and thereby print their way to prosperity? To date, no country we are aware of has accomplished this. Indeed, if this were the case, there would be no poor countries. In the first report of our trilogy, we elaborated on the constraints banks face in originating loans, such as tighter monetary policy, lack of credit demand, government regulations and capital requirements, bank shareholders appetite to lend and liquidity constraints for banks. Chart I-9China: Signs Of Budding Inflation India's Share In Global Trade India's Share In Global Trade Herein we elaborate on limits at a macro level for banks to originate loans and finance investment and consumption. The supply side of an economy and its capacity to produce goods and services that are in demand is ultimately a macro constraint on credit/money issuance. China's ability to sustain such rapid money creation has been due to its strong supply side - i.e., its productive capacity. This makes China different from other emerging markets such as Turkey. China has low inflation and a CA surplus, while Turkey has had high inflation and a large CA deficit. Ultimately, a country's growth trajectory depends on its potential growth, which is the sum of labor force growth and productivity growth. China's "economic miracle" of the past 30 years has been due to its productivity, not credit/money creation. Money/credit origination greases the wheels of the supply side "machine" but does not replace it. Indeed, China's productivity boom over the past three-plus decades has been due to reforms that have allowed for the emergence and development of private enterprises, and attracting foreign technology/know-how. It has not been due to government control over the economy and credit creation. By and large, China is facing two potential growth trajectories, as depicted in Chart I-12 and Chart I-13 and explained in Box 1 on pages 13-15. A credit-driven economic downtrend entails deflation, while the path towards socialism warrants inflation. Barring a deflationary credit-driven growth slump, inflation in China will pick up sooner than later. The reason is that growing state control of the economy and resource allocation means poor capital allocation and much slower productivity - and in turn potential GDP growth. The latter, along with double-digit credit, creates fertile ground for an inflation outbreak (Chart I-9). If banks create too much money/credit, the price of money will go down- i.e., the currency will ultimately depreciate both versus foreign currencies as well as relative to goods/services and real assets like property. Chinese banks have created too much money (RMBs), and it is not surprising property prices have gone exponential and that the RMB is under downward pressure. In fact, Chinese households may be sensing there are too many RMBs floating around, and want to get rid of them by converting them into foreign currencies and buying real assets (real estate). On the whole, the exchange rate is a key to China's macro dynamics. If unrelenting credit creation persists, the yuan will continue to fall because Chinese households and companies will be reluctant to hold local currency. In such a case, credit origination will have to be curtailed to stabilize the exchange rate. Bottom Line: Unlimited credit/money creation will ultimately produce a major currency depreciation and/or inflation. These, in turn, will short-circuit the credit boom. Conclusions When investors and commentators justify exponential moves in credit or asset prices by the unique features of a particular economy - implying this time is really different - critical consideration is warranted. For example, Japan's 1980s bubble was justified by exclusive particularities of the Japanese economy; Hong Kong's real estate bubble of the 1990s was justified by limited land on the island; and the U.S. tech bubble of the late 1990s was explained by a "new era of productivity brought on by technology." Needless to say, in retrospect we know that these were bubbles, and they all deflated. Explaining away China's exponential surge in domestic leverage as a bi-product of its high savings rate makes us wary. The report explains why high national savings rates do not warrant high credit creation. China is facing two potential growth roadmaps, as depicted in Chart I-11 and Chart I-12 and elaborated in Box 1 (see page 13-15). Regardless of which way China's economy evolves, the medium-term outlook for mainland growth is downbeat. BCA's Emerging Markets Strategy team expects double-digit RMB depreciation in the next 12 months. We continue to recommend short positions in the RMB via 12-month NDFs. This is the rationale behind our negative stance on Asian currencies. We believe EM equities, credit markets and currencies will underperform their DM counterparts, regardless of the trajectory of share prices in the U.S./DM. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Assistant andrijav@bcaresearch.com BOX 1 Two Growth Path Forward For China1 1. Short-Term Pain / Long-Term Gain If the authorities were to allow market forces to prevail, the state should withdraw meaningfully from the credit allocation process. In that case, credit markets will bring discipline to both debtors and creditors - in effect, an emerging perception of potential losses rather than government-led bailouts will make creditors less willing to lend, and debtors less willing to borrow and expand. The result will be a considerable dampening in credit origination. In this scenario, it is very likely that credit growth slows from 12% currently to the level of potential nominal GDP growth of 7-8% or lower (Chart I-10), leading to a classic credit-driven economic downtrend (Chart I-11). In that case, cyclical growth will undershoot. Chart I-10China: Credit Is Outpacing ##br##GDP Growth By Wide Margin India Has Been Losing Export Market Share India Has Been Losing Export Market Share Chart I-11Capitalist-Style Credit-Driven Downtrend India's Education Improvement Has Stalled India's Education Improvement Has Stalled However, potential GDP growth (the red line in Chart I-11) - which has been falling in recent years - will stabilize and probably improve. The reason being that by allowing market forces to prevail in credit allocation and corporate restructuring/reorganization, China will ultimately improve its capital allocation and productivity. In brief, potential GDP growth - which equals productivity growth plus labor force growth - will stop falling and, in fact, could improve as productivity growth ameliorates. 2. No Short-Term Pain But Long-Term Stagnation It is essential to differentiate cyclical growth drivers from structural ones. If the government does not allow credit growth to slow, cyclical growth will hold up. However, in this scenario, structural growth will tumble and China will embark on a path of economic stagnation. That said, the growth deceleration would be gradual, as depicted in Chart I-12. Chart I-12Toward Socialism = Secular Stagnation And Inflation Upgrade Indian Bourse Within EM Universe Upgrade Indian Bourse Within EM Universe A rising role of state and government officials in capital allocation and business decision-making guarantees suboptimal capital allocation, resulting in poor efficiency and declining productivity growth. Since China's labor force growth is projected to be flat-to-negative, the sole source of potential GDP growth going forward will be productivity growth. Besides, it is much easier to achieve high productivity growth in manufacturing than in the service sector. Finally, high productivity growth is possible when the productivity level was low. From the current levels, it is hard to grow productivity more than 5-6% annually. Chart I-13Socialist Put Will Depress ##br##Productivity Growth Socialist Put Will Depress Productivity Growth Socialist Put Will Depress Productivity Growth If we assume China's productivity is now about 6% (which is already very high) (Chart I-13), and if the country embarks down this path, odds are that productivity growth might drop by 100 basis points in each of the following years. In five years or so, productivity growth would be only around 1%. Given that labor force growth will be zero, if not contracting, in five years' time, potential GDP will drop to 1% or so, as shown in Chart I-12 on page 14. Hence, 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-recovery cycles around a falling primary growth trend. The latest acceleration in China's growth is probably the first mini-cycle. How can investors invest in this scenario? The mini-cycles depicted in Chart I-12 look nice, because we drew them ourselves. In reality, they will not be symmetric or smooth. Besides, financial market swings for China-related plays will differ from the economy's growth mini-cycles because markets can be driven by factors other than growth like politics, geopolitics, credit events, and other global variables such as the U.S. dollar and bond yields. In short, this analysis explains why we have been and remain bearish on China-related financial markets despite the stimulus that has been injected about a year ago. Investing around economic mini-cycles is difficult because it assumes near-perfect timing. Without that, investors cannot make money. 1 Originally published in January 11, 2017 EMS Weekly Report. 1 Please refer to the Emerging Markets Strategy Special Report, titled "Misconceptions About China's Credit Excesses," dated October 26, 2016, and Emerging Markets Strategy Special Report, titled "China's Money Creation Redux And The RMB," dated November 23, 2016, the links are available on page 18. 2 Please refer to the Emerging Markets Strategy Special Report, titled "Misconceptions About China's Credit Excesses," dated October 26, 2016, the link is available on page 18. 3 This example assumes that neither the central bank nor local commercial banks are buying foreign currency. In the case when a commercial bank buys foreign currency, that transaction creates new money/deposit in the banking system although it does not create a new loan. The opposite is also true: when a commercial bank sells foreign currency, existing money/deposits are destroyed. 4 This example assumes that the local commercial banks are not buying foreign currency and only the central bank buys foreign currency from non-banks. 5 Lindner, F. (2015), "Does Saving Increase the Supply of Credit? A Critique of the Loanable Funds Theory", World Economic Review 4: 1-26, 2015 6 Jakad, Z. and Kumhof, M. (2015), "Banks Are Not Intermediaries of Loanable Funds - and why this Matters", Bank of England, Working Paper 529, May 2015 7 Borio, C. and Disyatat, P. (2015), "Capital Flows and the Current Account: Taking Financing (more) Seriously", BIS Working Papers, No. 525, October 2015 Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Portfolio Strategy The elevated ratio of market cap-to-GDP discounts strong growth far into the future, suggesting that a market validation phase may be lurking. Capital markets-sensitive stocks have had a good run, but the six month outlook is more mixed than bullish. Lift the packaged food group to neutral following the price plunge, because expectations have undershot. Recent Changes S&P Packaged Foods Index - Lift to neutral, locking in a profit of 3%. Table 1 Performance Anxiety Performance Anxiety Feature Equities are approaching their first fundamental test since the post-election surge. Fourth quarter earnings season will soon begin in earnest, with the strong U.S. dollar threatening to temper forward guidance, based on its tight inverse correlation with future net earnings revisions (Chart 1). The post-election stock market valuation expansion has been sentiment-driven: our Equity Sentiment Composite is at a bullish extreme, powering the advance in multiples. That echoes the massive growth forecast upgrade on the back of expectations of a more business friendly, reflationary fiscal policy. The NFIB survey of small business optimism has soared to levels typically reserved for a V-shaped rebound exiting recession (Chart 1). Soaring growth expectations mean that a volatile, equity validation phase is inevitable. The timing is difficult to pinpoint, however, because momentum can be a powerful and seductive force. In other words, performance anxiety and fear of missing out are overwhelming cyclical warning flags. For instance, the total market capitalization (MC) of the U.S. stock market is more than 120% of (nominal) GDP, more than double the 2008 trough (Chart 2). MC as a share of GDP has only been higher during the TMT bubble in the late-1990s. Since the 2008 low, central bank balance sheet expansion and the accrual of earnings to the corporate sector rather than to laborers have powered this remarkable surge. Low interest rates have also incented investors to bid up MC using leverage. Margin debt is now at previous peaks relative to GDP (Chart 2). It is possible that a repeat of TMT period could be unfolding, but betting on a multi-standard deviation event is high risk and low reward, especially given already elevated margin debt, and more recently, rising debt-servicing costs. MC to GDP has averaged 75% over the last forty five years. Even if nominal GDP boomed at 8% per annum for the next five years, market cap would still be over 80% of GDP, or well above the average. It may be too optimistic to expect market cap to stay above average over the next five years even if economic growth booms, because strong growth would imply a shift from interest rate normalization to restrictive settings, and wages would take an ever increasing share of corporate profits, removing two key valuation supports. What is clear is that subsequent long-term returns from current levels of MC/GDP have been poor. Chart 3 inverts and advances MC/GDP by 10-years, and plots that with 10-year rolling equity returns: long-term return potential looks paltry. Admittedly, this valuation gauge does little to forecast short-term market moves, but over the next 3-6 months, our concern is that economic euphoria will prove to have overshot reality. Chart 1Too Many Bulls? Too Many Bulls? Too Many Bulls? Chart 2Investors Already Fully Committed Investors Already Fully Committed Investors Already Fully Committed Chart 3Paltry Long-Term Returns Ahead Paltry Long-Term Returns Ahead Paltry Long-Term Returns Ahead The steady decline in total bank loan growth to nil and slide in federal income tax receipts to zero growth is worrying. The latter is an excellent confirming indicator for overall employment and economic growth (Chart 2, bottom panel). The current message does not confirm the budding economic boom currently discounted by the stock market. Consequently, we recommend a capital preservation mindset and a focus on controlling risk, as opposed to chasing short-term momentum driven returns. Against this backdrop, this week we highlight an undervalued consumer-dependent area and revisit the red-hot financials sector. Where To Next For Capital Markets? Anything financials-related surged after the election. A short covering rally morphed into optimism that the sector's regulatory burden will be loosened, ultimately allowing companies to earn a higher return on equity, thereby warranting increased valuations. In response, we upgraded our overall financial sector view in November, boosting our exposure to the previously lagging asset management & custody bank (AMCB) group to overweight and the capital markets group to neutral. The surge in equities relative to bonds has provided a catalyst for these groups to outperform (Chart 4), and that has the potential to become a longer-term asset preference shift amidst Fed tightening. That dynamic bodes well for a continued re-rating of the AMCB index. Does the same hold true for the higher beta capital markets group? The jury is still out. Capital markets stocks have historically gotten off to a slow start during Fed tightening cycles. Table 2 shows the average relative 6-, 12- and 24-month returns once the Fed begins hiking interest rates. Capital market stocks have underperformed during the first six months, regaining that in the subsequent 6 months, before finally accelerating meaningfully in year two. Using this as a guide (and the most recent hike as the true start to a Fed tightening cycle) would suggest that the initial relative performance surge is vulnerable to a pullback in the first half of this year. Meanwhile, the bull case for capital markets includes more than just higher rates and a steeper yield curve. The share price jump suggests that industry profit outperformance looms (Chart 5). A similar relative performance surge in 2013 was accompanied by a massive earnings surge. Chart 4Good News For Capital Markets... Good News For Capital Markets... Good News For Capital Markets... Chart 5... But Already Discounted? ... But Already Discounted? ... But Already Discounted? Table 2Capital Markets & Fed Tightening Cycles Performance Anxiety Performance Anxiety Earnings outperformance requires a sustained increase in capital formation, but we are reluctant to extrapolate the recent improvement in market and economic sentiment to an actual increase in demand for capital just yet. Typically, a rise in the stock-to-bond (S/B) ratio foretells of an increase in animal spirits. A rise in the S/B ratio signals that deflationary risks are receding, and points to a re-acceleration in new stock issuance (Chart 4), a plus for fee generation. But companies have already been taking advantage of cheap financing to issue equity and debt to fund M&A and buybacks, reflecting the lack of organic growth opportunities in recent years. Incremental equity raises will require a validation of growth-sponsored capital needs, rather than more financial engineering. As a share of GDP, M&A has already reached levels that coincided with previous peaks in speculative activity (Chart 6). At best, a period like 1999 could occur, when M&A stayed at a high level for two years, helping profits and share prices to outperform. But that period was a massive speculative asset bubble, and positioning for a replay is fraught with risk. Chart 6Already Past The Peak? Already Past The Peak? Already Past The Peak? Chart 7Limited New Capital Formation Limited New Capital Formation Limited New Capital Formation We are more concerned that capital formation might not live up to what is quickly becoming embedded in share prices. Chart 7 shows that the yield curve already appears to be peaking, suggesting that economic expectations have hit a ceiling. Moreover, bank loan growth has dropped to nil over the past three months, led by the commercial & industrial credit category (Chart 7). The sharp decline in C&I loan demand implies that business funding requirements are diminishing. This is corroborated by the plunge in corporate bond issuance, which has occurred within the context of narrowing corporate bond spreads and increase in risk appetites, ideal conditions for companies to issue debt (Chart 7). All of this is consistent with the message from the corporate sector financing gap, which is signaling that companies are no longer spending in excess of their cash flow (Chart 7). The corporate sector is not in a financial position to embark on a major expansion phase. Our Corporate Health Monitor remains in deteriorating health territory, underscoring limited balance sheet capacity for growth. That is consistent with a rising corporate bond default rate and more subdued M&A activity (Chart 8). Directionally, M&A activity has a critical influence on swings in capital markets return on equity, given generous profit margins for this vertical (Chart 8). Chart 8Hard To Envision A Continued M&A Boom Hard To Envision A Continued M&A Boom Hard To Envision A Continued M&A Boom Chart 9Firms Are Not Positioning For Growth Firms Are Not Positioning For Growth Firms Are Not Positioning For Growth Even the capital markets industry itself is not yet putting its money to work in anticipation of an upturn in business activity. Staff level changes are pro-cyclical. Companies hire to meet increase demand on their resources and are quick to slash when revenue opportunities diminish. As such, capital markets employment provides a good confirming indicator for earnings momentum. Chart 9 shows that capital markets hiring has dried up, similar to loan demand. The implication is that the expected upturn in relative forward earnings momentum may not materialize in the short run. Perhaps lags will eventually close these gaps, but with valuations now more dear than at any time since the Great Financial Crisis (Chart 9), prudence warrants patience before adopting a more optimistic positioning. Bottom Line: The S&P AMCB index continues to represent a more attractive risk-adjusted exposure to the improvement in market and economic sentiment than the capital markets group, because a meaningful increase in capital formation is still not assured. Stay overweight the former, and neutral on the latter. Time To Nibble On Packaged Foods Packaged foods stocks have been through the grinder in the last few months. We have been underweight this group, because it had not corrected alongside the rest of the consumer products complex (Chart 10), while leading revenue metrics had softened and employment costs had increased. However, the sharp share price decline means that difficult conditions are now being discounted. Chart 11 shows that the relative forward P/E ratio is well under the long-term average. Sales growth expectations have cratered, reflecting the negative impact of food price deflation and the strong U.S. dollar on this export-dependent industry. Chart 10Food Stocks Have Spoiled Food Stocks Have Spoiled Food Stocks Have Spoiled Chart 11Expectations Have Undershot Expectations Have Undershot Expectations Have Undershot We doubt conditions will worsen, especially relative to depressed expectations. In fact, previous drags are stabilizing, on the margin. For instance, the consumer price index for food products has troughed on a growth rate basis, suggesting that the de-rating in sales expectations has run its course (Chart 11). On the downside, capacity utilization rates are still low as a consequence of the previous retrenchment in food spending and increase in capacity. Indeed, the food production footprint has expanded over the last several years, which has been a contributing factor to the rise in labor costs and constraints on profitability. The good news is that industry wage inflation has crested and utilization rates appear to have troughed. Importantly, the U.S. dollar is not undermining growth prospects as much as dire forecasts suggest. Real exports of food and beverage products have surged in recent months (Chart 12). On the flipside, imports have declined, suggesting less fierce foreign competition. Chart 12The Strong Dollar Is Not A Death Knell... The Strong Dollar Is Not A Death Knell... The Strong Dollar Is Not A Death Knell... Chart 13... Especially If It Keeps Costs Down ... Especially If It Keeps Costs Down ... Especially If It Keeps Costs Down Total food demand growth has improved, as measured by the combination of export growth and real domestic food spending (Chart 12). Even the food shipments-to-inventories ratio has edged back into positive territory, a plus for future selling price increases. In addition, a strong U.S. dollar should continue to keep a lid on raw food prices (Chart 13). Low input commodity costs have helped propel our profit margin proxy to new cyclical highs, heralding ongoing margin expansion. The latter demonstrates impressive operating discipline amidst a tough sales backdrop. More recently, sales growth at food and beverage stores has reaccelerated (Chart 13), suggesting that factories will get busier, providing additional support to profit margins and reversing sagging return on equity. If ROE stabilizes, then the valuation compression will end. Bottom Line: Lift the S&P packaged food index to neutral, locking in a 3% profit since our underweight call in September 2015. A further upgrade is possible if utilization rates begin to improve, heralding an increase in pricing power. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

Highlights The uptrend in consumer confidence has the potential to be lasting, and therefore lead to an acceleration in real consumption over the next several quarters. In contrast, the rise in business optimism is thus far built on shakier fundamentals, and therefore vulnerable to disappointment - at least until corporate executives see signs of a pickup in consumer demand. Some of the cyclical tailwinds that have aligned for consumers are: very low essential spending burdens, rising incomes, a positive wealth effect, and improved credit scores. Several areas of the U.S. equity market are set to outperform on the back of this improved consumer profile. Feature Financial markets continue to be optimistic about a more fertile business backdrop under a Trump presidency. At current valuations, equities are likely to undergo a testing phase. Indeed, the equity market's reaction to President-elect's press conference last week - the first in months - may be an omen of what is in store should Trump disappoint relative to what appears like very high expectations for the early days of his Presidency. At first blush, it appears that the surge in sentiment among a broad range of economic agents was precipitated by just one factor: Donald Trump's victory in the presidential election. Measures of both business and consumer confidence all rose sharply after November 8th (Chart 1). An important question is how sustainable and how far-reaching is this new-found optimism? After all, a major missing ingredient in the recovery to date has been faith that the economic future would get better. Last year, over half of respondents to a Nielsen global confidence survey still believed the world was in recession. Our take is that the uptrend in consumer confidence has the potential to be lasting, and therefore lead to an acceleration in real consumption over the next several quarters. In contrast, the rise in business optimism is thus far built on shakier fundamentals, and therefore vulnerable to disappointment - at least until corporate executives see signs of a pickup in consumer demand. This view runs counter to the current popular narrative, where businesses - and therefore their stock prices - perform better once a new era of pro-business policies are ushered in. We have noted in past weekly reports that we believe the equity market has overshot and that policy is likely to under-deliver; it is a high bar to assume that the new American government will succeed in implementing a pro-business strategy of lower corporate taxes, increased infrastructure spending and a lighter regulatory burden, while simultaneously avoiding any negative shocks from trade reform and foreign policy blunders.1 Thus, we interpret the surge in business confidence, as reported in various surveys, to be exaggerated and prone to a pullback. On the flipside, a number of cyclical tailwinds have aligned for consumers. Although consumer sentiment surveys also spiked higher since November, this merely extends an already rising trend. Below, we outline the fundamental factors that support stronger consumption growth in the coming quarters. Cost Of Essentials Is Ultra-Low First, the cost of many essential items have declined throughout the recovery, particularly energy prices (Chart 2). The decline in energy prices since 2014 means that spending on energy as a percent of disposable income is near thirty year lows. Likewise, spending on food and interest payments as a share of income is also as low as it has been in thirty years. It is only the seemingly incessant climb in medical payments that keeps overall spending on essential items above 40% of disposable income. Still, at 41% of total disposable income, spending on essential items is far from burdensome relative to historical norms. Chart 1Confidence Surge: Some Trump, ##br##Some Fundamentals Confidence Surge: Some Trump, Some Fundamentals Confidence Surge: Some Trump, Some Fundamentals Chart 2Essential Spending Burden##br## Is Very Low Essential Spending Burden Is Very Low Essential Spending Burden Is Very Low Incomes Are Rising And Jobs Are Secure Much more importantly, the main driver of consumption trends, income, is on track to accelerate (Chart 3). Despite a moderation in payroll growth, overall income growth is likely to stay perky, now that wage growth is rising. Indeed, as we highlighted in a Special Report in November, the labor market has reached full employment, which is the necessary threshold for a broad-based acceleration in wages (Chart 4). Although there are structural factors that will mitigate rapid wage hikes, it is likely that mild upward pressure on wages will continue throughout 2017 (Chart 5). This is obviously good news because higher wages means that consumers will have the wherewithal to spend more. In addition to this, a tighter job market has boosted job security. Various measures of consumer confidence highlight that over the past year, consumers now have much greater confidence in long-term job prospects. This is important because when job security is high, the propensity to spend instead of save is much higher (Chart 3, bottom panel). Chart 3Income Properties Drives Spending##br## More Than Any Other Factor Income Properties Drives Spending More Than Any Other Factor Income Properties Drives Spending More Than Any Other Factor Chart 4(Part I) Full Employment Calls##br## For Gradually Higher Wages (Part I) Full Employment Calls For Gradually Higher Wages (Part I) Full Employment Calls For Gradually Higher Wages Chart 5Part (II) Full Employment Calls##br## For Gradually Higher Wages Part (II) Full Employment Calls For Gradually Higher Wages Part (II) Full Employment Calls For Gradually Higher Wages Although income is the primary driver of consumption, the trend can be enhanced by several factors, including consumer wealth, the ability of consumer to finance purchases and fiscal handouts. The Wealth Effect Will Remain A Tailwind The wealth effect is the change in spending that accompanies a change, or perceived change, in wealth. The combined wealth effect from real estate and financial markets has been positive for some time (Chart 6). Thus, it is not a new driver of consumer spending, but is nonetheless positive that wealth positions continue to improve. If our forecasts for financial markets and house prices pan out, i.e. that the bull market in stocks continues over time, that bonds experience only a mild bear market and that house price appreciation remains in the mid-single digits, then a positive wealth effect will continue to support consumption in 2017. Debt/Deleveraging Cycle Is Advanced One of the major headwinds to consumer spending since 2008 has been the long, dark shadow of deleveraging. But that process is now well-advanced for the consumer sector. Consumer debt levels as a percent of disposable income peaked in 2008 at over 120%, but are now back under 100%, i.e. at the level that existed prior to the housing bubble and bust. Indeed, the financial obligation ratio for households (both renters and homeowners) is lower today than at any time in the past thirty-five years (Chart 7). Of course, part of this is due to very low interest rates, but our Bank Credit Analyst will show in their February publication that even a 100 basis point rise in borrowing rates from current levels would not lift the interest payment burden to elevated levels by historical standards. Chart 6Wealth Effect Will Remain Positive Wealth Effect Will Remain Positive Wealth Effect Will Remain Positive Chart 7Credit Conditions Are Not Problematic Credit Conditions Are Not Problematic Credit Conditions Are Not Problematic Finally, access to credit remains favorable. In late 2016, lending standards for consumer loans tightened slightly in late 2016, but access to credit generally is not a constraint on spending. A second important point is the ability of those scarred from the housing bust to re-enter the credit market. By law, information about any credit payment delinquencies, including mortgage payment delinquencies, must be removed from an individual's credit record after seven years. Therefore, if no other delinquencies occurred, individuals who experienced a foreclosure see their credit scores recover in seven years and can once again become candidates for mortgage purchases and therefore homeownership. According to research by the Chicago Federal Reserve, since the peak of foreclosures occurred prior to 2011, the bulk of borrowers that foreclosed during the housing bubble and bust are now seeing their credit scores improve. By 2016, both prime and sub-prime borrowers who entered foreclosure between six and nine years earlier (in 2007-10) appear to have recovery rates that are converging with the historical rates of recovery among their predecessor cohorts: nearly 100% of sub-prime borrowers from 2007-2010 who foreclosed have re-attained their previous credit scores, while over 60% of prime borrowers from 2007-2010 re-attained theirs (Chart 8). This means that in large part, the massive drag on housing demand due to poor credit scores from the previous housing bust have been alleviated. Chart 8Share Of Home Mortgage Borrowers Who Recovered ##br##Pre-Delinquency Credit Score After Foreclosure U.S. Consumer: The Comeback Kid U.S. Consumer: The Comeback Kid Fiscal Help? President-elect Donald Trump has promised fiscal stimulus in the form of infrastructure spending, corporate tax cuts and personal income tax cuts. The latter could have a positive impact on consumption, although it would likely be small. According to the Tax Policy Centre, if enacted, the highest income taxpayers (0.1 percent of the population, or those with incomes over $3.7 million in 2016 dollars) would experience an average tax cut of nearly $1.1 million, over 14 percent of after tax income. Households in the middle fifth of the income distribution would receive an average tax cut of $ 1,010, or 1.8 percent of after -tax income, while the poorest fifth of households would see their taxes go down an average of $110 or 0.8 percent of their after-tax income.2 The bottom line is that fiscal policy, if Trump's plan is enacted, could be a small positive tailwind for consumption in 2017. Overall, there are increasing signs that the scar tissue from the Great Recession is finally fading and that the improvement in consumer confidence is sustainable. This, combined with better income prospects will give households the wherewithal to spend more freely and will push real GDP growth up to 2.5% or perhaps slightly stronger. Our past research shows that sustainable capital spending cycles only get underway once businesses see clear evidence that consumer final demand is on the upswing. Thus, perhaps a healthier capex cycle will get underway, and businesses will have a fundamental reason to be more upbeat about their prospects. But for now, it seems more likely that businesses are at risk of being disappointed with the speed and efficacy of federal policy changes. On this basis, favoring equity sectors geared to the consumer rather than capex still makes sense. Favor Consumer-Geared Equity Sectors An acceleration in consumer spending will benefit consumer-sensitive equity sectors and would also support our domestic-over-global equity tilt. In our December 5th report, we outlined the bullish prospects and compelling value on offer in the consumer discretionary sector. In addition, our sister publication, U.S. Equity Strategy service just published their annual high conviction equity list. Home improvement retail, and consumer finance stocks were top of the list of high conviction overweights: Home Improvement Retail (Chart 9): Enticing long-term housing prospects argue for looking through the recent rise in mortgage rates. And as highlighted above, consumers have only recently started re-levering, with banks more than willing to facilitate renewed appetite for mortgage debt. In addition, remodeling activity is booming and anecdotes of house flipping activity picking up steam are corroborating that the housing market is vibrant. Now that house prices have recently overtaken the 2006 all-time highs, the incentive to upgrade and remodel should accelerate. While the recent backup in bond yields has been a setback for housing affordability, the U.S. consumer is not priced out of the housing market. Yields are rising in tandem with job security and wages. Mortgage payments remain below the long-term average as a share of income and effective mortgage rates remain near generationally low levels. Consumer Finance (Chart 10): This group offers early-cyclical exposure and is levered to the rising interest rate environment and debt-financed consumer spending. Chart 9Home Improvement Retail Stocks Home Improvement Retail Stocks Home Improvement Retail Stocks Chart 10Consumer Finance Stocks Consumer Finance Stocks Consumer Finance Stocks Importantly, higher interest rates have boosted credit card interest rate spreads (the industry's equivalent net interest margin metric), underscoring that the next leg up in relative share prices will be earnings led. This group is well-placed to take advantage of the improving consumer trends discussed above. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 Please see U.S. Investment Strategy Weekly Report "Q&A: The Top Ten", dated November 21, 2016, available at usis.bcaresearch.com 2 http://www.taxpolicycenter.org/publications/analysis-donald-trumps-revised-tax-plan/full 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 recommended weightings for the major asset classes are unchanged: neutral equity exposure at 60% (benchmark 60%), slightly overweight Treasury allocation at 40% (benchmark 30%) and underweight cash at 0% (benchmark 10%). The diffusion index of the three components for The Equity Model remained neutral. The technical component retained its "buy" signal, with slightly more advancement in the breadth & trend indicators relative to the momentum indicator. The monetary component, which measures overall liquidity conditions, is still favorable for equities, albeit is moving into less bullish territory. However, on the cyclical front, the earnings-driven component still warrants caution. Even as real operating earnings have marginally improved, they remain at a significant distance from positive economic expectations. Earnings momentum is also sluggish, based on our earnings diffusion index. Our qualitative stance for the allocation of Treasuries in balanced portfolios is neutral (since November 7, 2016) in contrast to the slightly overweight recommendation from our quantitative model, unchanged from last month. Although the valuation and technical components of the bond model are still constructive, the cyclical component is significantly less bullish this month. Chart 11Portfolio Total Returns Portfolio Total Returns Portfolio Total Returns Chart 12Current Model Recommendations Current Model Recommendations Current 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.

Bank stocks have experienced a sentiment-driven surge since the U.S. election, supported by expectations for higher interest rates. However, lost in the exuberance has been a marked deceleration in credit creation. Total bank loan growth has dropped to nil over the last three months, led by the previously booming C&I category. That is a sign that while businesses are expecting an economic improvement, they are not yet positioning for one via increasing working capital requirements. Coupled with increased bank staffing levels, the growth in bank loans-to-employment, a decent productivity proxy, has also dropped to zero. Importantly, the yield curve widening has taken a breather, which may be a catalyst for some profit-taking, especially if upcoming bank earnings results disappoint on the credit growth front. We are underweight this index. The ticker symbols for the stocks in this index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT. Banks: Will Higher Interest Rates Trump Weakening Loan Growth Banks: Will Higher Interest Rates Trump Weakening Loan Growth

Highlights The global 6-month credit impulse is now in its longest upcycle in a decade. Given also that bond yields have had their sharpest spike in a decade, we would not bet on the upcycle lasting much longer. Lean against the rise in bond yields and bank equities. Underweight the Eurostoxx600 versus the S&P500. Underweight the IBEX versus the Eurostoxx600. Feature A few days into the New Year, two over-arching economic questions are exercising our minds. Is the relationship between sharply higher bond yields and weaker bank credit creation still valid? And is the relationship between weaker bank credit creation and decelerating economic growth still valid? Chart of the WeekCredit Impulses Heading In Different Directions Credit Impulses Heading In Different Directions Credit Impulses Heading In Different Directions We suspect the answers are yes and yes. European Investors Must Think Globally, Not Locally Europe is not an investment island. Major European stock market indexes comprise large multinational companies whose sales and profits come from across the world. The upshot is that European stock markets almost always move up and down in tandem with other major world stock markets, such as the S&P500 and Nikkei225 (Chart I-2). Mainstream bond markets might seem to be more parochial, given that they are supposedly under the influence of the local central bank. But investors buy and sell high quality bonds as a global asset class. The upshot is that European bond markets also almost always move up and down in tandem with other major developed bond markets (Chart I-3). Chart I-2Major Equity Markets Move Together Major Equity Markets Move Together Major Equity Markets Move Together Chart I-3Major Bond Markets Move Together Major Bond Markets Move Together Major Bond Markets Move Together Hence, European investors must look first and foremost at global drivers. For us, the most important such driver is the global 6-month credit impulse - which sums the 6-month (dollar) credit impulses in the euro area, the United States and China. Does the global 6-month credit impulse have any predictive power? Yes. Chart I-4 shows that it has consistently led the 6-month cycle in the global government bond yield, which is a good proxy for the global growth cycle. Admittedly, this powerful predictive relationship weakened somewhat through 2013-14 during the most aggressive and distortive phase of worldwide QE. However, in the past couple of years, as QE has waned, the global 6-month credit impulse's predictive power has strongly re-asserted itself (Chart I-5). Chart I-4The Credit Impulse Leads ##br##The Global Growth 'Mini-Cycle' The Credit Impulse Leads The Global Growth 'Mini-Cycle' The Credit Impulse Leads The Global Growth 'Mini-Cycle' Chart I-5The Credit Impulse's Predictive ##br##Power Has Re-Asserted Itself The Credit Impulse's Predictive Power Has Re-asserted Itself The Credit Impulse's Predictive Power Has Re-asserted Itself In effect, the charts illustrate that whatever the structural economic backdrop, the global economy experiences a perpetual 'mini-cycle' lasting about 15-24 months. Higher bond yields (or credit restrictions) weaken the credit impulse; the weaker impulse then depresses growth; the depressed growth lowers bond yields; lower bond yields (or credit easing) strengthen the credit impulse; the stronger impulse then boosts growth; the boosted growth lifts bond yields; and back to the beginning... Remember, the credit impulse measures the growth in the credit flow. The important point to grasp is that the impulse can weaken even if the credit flow numbers themselves seem strong. For example, if the credit flow increased from $100bn to $150bn to $190bn it might appear to be growing very healthily. But actually, the impulse would have weakened from $50bn to $40bn, creating a headwind. Where are we in the perpetual mini-cycle? Today, the euro area credit impulse is losing momentum, while the U.S. impulse is waning. Which leaves China's rising credit impulse as the only component supporting the global credit impulse (Chart of the Week). But for how much longer? To repeat, it would just take the global credit flow to decelerate for the impulse to roll over. Now consider that high-quality bond yields have had their sharpest 6-month spike in a decade. And that the current 10 month upcycle in the global credit impulse already makes it the longest in a decade. Hence, we would not bet on this mini-upcycle lasting much longer. A Few Words On Our Credit Cycle Framework Our credit cycle framework has several features which uniquely define it. First, the framework focusses on bank credit. This is because the magic of fractional reserve banking allows a bank to create money and new spending power out of thin air. When somebody borrows from a bank, his bank account and spending power goes up, but nobody's spending power has to go down. In contrast, when somebody borrows by issuing a bond, it merely reallocates spending power from one person to another person. The borrower sees his bank account and spending power go up, but the lender sees his bank account and spending power go symmetrically down. Spending will rise to the extent that the borrower has a higher propensity to spend than the lender, but this may or may not be the case. Second, as already discussed, the framework focusses on the bank credit impulse - which measures the growth in the bank credit flow. This is just to compare apples with apples. Remember that GDP is itself a flow statistic. So the growth in GDP receives a contribution from the growth in the credit flow1 (and not from the flow itself). Third, the framework focusses on the 6-month bank credit impulse. We choose this periodicity because 6 months is about the time that it takes to for credit to be fully spent, thereby yielding the greatest predictive power from the credit impulse to economic activity. Fourth, the framework calculates the credit cycle using bank credit to the non-financial sector2 rather than the more commonly-quoted money supply statistics such as euro area M3. The simple reason is that not all loans generate economic activity. Bank to bank lending may stay trapped in the financial system. The money supply - which is on the liabilities side of the banks' balance sheet - would not pick up this distinction. As M3 captures all bank deposits, it would still be expanding rapidly, giving the false signal that demand should be growing. Hence, it is better to focus on bank lending - which is on the assets side of the banks' balance sheet - and only count lending that is likely to generate economic activity (Chart I-6). This reasoning only works if the official data on bank loans is accurate and complete. In China, this is unlikely to be the case, given its large shadow banking system. But unofficial shadow lending must eventually show up in the money supply. Therefore, exceptionally for the China sub-component, our credit cycle framework does prefer to use the money supply (Chart I-7). Chart I-6Our Euro Area Credit Impulse##br## Uses Bank Lending... Our Euro Area Credit Impulse Uses Bank Lending... Our Euro Area Credit Impulse Uses Bank Lending... Chart I-7...But Our China Credit Impulse ##br##Uses Money Supply ...But Our China Credit Impulse Uses Money Supply ...But Our China Credit Impulse Uses Money Supply A Few Words On Our Reductionist Framework We are also strong believers in Investment Reductionism. This philosophy stems from two guiding principles: Occam's Razor - which says that when there are competing explanations for the same effect, the simplest explanation is usually the best; and the Pareto Principle - which says that 80% of effects come from just 20% of causes.3 The important point is that most of the moves in most financial markets result from a very small number of over-arching macro drivers. To reiterate, Europe is not an investment island. Investment Reductionism means that much of asset allocation, sector selection, and regional and country allocation distills down to getting the global growth cycle right. The remaining charts should leave readers in no doubt. Chart I-8 shows that the global 6-month credit impulse leads the cyclical direction of the global bond yield, and thereby determines asset class selection. Chart I-9 then shows that the direction of bond yields determines sector selection: for example Banks versus Technology. Chart I-8Investment Reductionism Step 1: The Global##br## Credit Impulse Leads The Bond Yield Cycle Investment Reductionism Step 1: The Global Credit Impulse Leads The Bond Yield Cycle Investment Reductionism Step 1: The Global Credit Impulse Leads The Bond Yield Cycle Chart I-9Step 2: The Bond Yield ##br##Drives Sector Selection Step 2: The Bond Yield Drives Sector Selection Step 2: The Bond Yield Drives Sector Selection Chart I-10 and Chart I-11 then show that the sector selection of Banks versus Technology determines both the regional allocation of Eurostoxx600 versus S&P500, and the country allocation of IBEX versus Eurostoxx600. Chart I-10Step 3: Sector Selection Drives##br## Regional Allocation Step 3: Sector Selection Drives Regional Allocation Step 3: Sector Selection Drives Regional Allocation Chart I-11Step 4: Sector Selection Drives ##br##Country Allocation Step 4: Sector Selection Drives Country Allocation Step 4: Sector Selection Drives Country Allocation To sum up, the global 6-month credit impulse is now in its longest up-cycle in a decade, and bond yields have had their sharpest spike in a decade. Hence, we would not chase cyclicality at this juncture. Which means that on a 6-month horizon: Lean against the rise in bond yields and bank equities. Underweight the Eurostoxx600 versus the S&P500.4 Underweight the IBEX versus the Eurostoxx600. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Equivalently, the credit impulse is the growth in the growth (second derivative) of the credit stock. 2 The non-financial sector includes households, (non-financial) firms and government. 3 Often known as the 80-20 rule. 4 BCA Strategists differ on this position. Fractal Trading Model* This week's trade is to express a tactical short in equities via Italy's MIB. An alternative market-neutral trade is to go short Italy's MIB and symmetrically long Hong Kong's Hang Seng. * 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 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-12 Short Italy's MIB Short Italy's MIB Chart I-13 Short Italy's MIB / Long Hong Kong's Hang Seng Short Italy's MIB / Long Hong Kong's Hang Seng 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 Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II_2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Portfolio Strategy A battle between tighter monetary conditions and the anticipation of fiscal largesse will be a dominant market theme this year. Our high-conviction equity allocation calls do not require making a major directional global economic bet, or second guessing the Fed's desire to continue tightening. The bulk of our calls could currently be considered contrarian, based on recent market momentum and sub-surface relative valuation swings. Recent Changes S&P Insurance Index - Downgrade to high-conviction underweight. Nasdaq Biotech Index - Downgrade to high-conviction underweight. Feature Stocks have already paid for a significant acceleration in earnings and economic growth this year and beyond. Fourth quarter earnings season will be the first real test of investor expectations since the post-election market surge. While recent data have been encouraging, forward corporate profit guidance is unlikely to be robust in the face of the U.S. dollar juggernaut. Currently, the hope is that fiscal stimulus will offset tighter monetary settings, ultimately delivering a higher plane of economic activity. The major risks are that the economy loses momentum before fiscal spending cranks up, and/or that profits diverge from a more resilient economic performance than liquidity conditions forecast. Indeed, fiscal stimulus isn't slated to accelerate until next year (Chart 1), while the impact of anti-growth market moves is far more imminent. Our Reflation Gauge has plunged, heralding economic disappointment (Chart 1). With the economy near full employment, Fed hawkishness could persist even in the face of any initial evidence of economic cooling. Under these conditions, the gap between nominal GDP and 10-year Treasury yields could turn negative in the first half of the year (Chart 2), which would be a major warning sign for stocks. Chart 1Fiscal Stimulus Is Still A Long Way Off Fiscal Stimulus Is Still A Long Way Off Fiscal Stimulus Is Still A Long Way Off Chart 2Warning Signal Warning Signal Warning Signal As a result, while the market has recently been focused almost solely on return, our emphasis at this juncture is on minimizing risk. That is consistent with the historic market performance during Fed tightening cycles. Going back to the early-1970s and using the last seven Fed interest rate hiking periods, it is evident that non-cyclical sector relative performance benefits immensely on both a 12 and 24 month horizon from the onset of Fed tightening (Charts 3 and 4). Cyclical sectors typically lag the broad market, while financials generally market perform1. Chart 312-Month Performance After Fed Hikes 2017 High-Conviction Calls 2017 High-Conviction Calls Chart 424-Month Performance After Fed Hikes 2017 High-Conviction Calls 2017 High-Conviction Calls Some of the other major macro forces that are likely to influence the broad market and sectoral trends are: Ongoing strength in the U.S. dollar and its drag on top-line growth: loose fiscal policy and tight monetary policy is a classic recipe for currency strength. Tack on high and rising interest rate differentials due to policy divergences with the rest of the world (Chart 5), and exchange rate strength is likely to persist in the absence of a major domestic economic downturn. A tough-talking Fed. Wage growth is accelerating and broadening out, and will sharpen the Fed's focus on inflation expectations. With dollar strength constraining revenue growth potential, strong wage gains are profit margin sapping (Chart 2). A divergence between economic growth and profit performance, i.e. stronger growth is unlikely to feed into equal growth in corporate sector earnings given the squeeze on profit margins from a recovery in labor's ability to garner a larger share of aggregate income. Disappointment and/or uncertainty as to the timing and rollout of the much anticipated fiscal spending programs and unfunded tax cuts. Favoring domestic vs. global exposure will remain a key theme. Emerging markets (EM) have not validated the sharp jump in the global vs. domestic stocks, nor cyclical vs. defensives (Chart 6). Chart 5Greenback Is A Drag##br## On S&P 500 Top Line Growth Greenback Is A Drag On S&P 500 Top Line Growth Greenback Is A Drag On S&P 500 Top Line Growth Chart 6Mind##br## The Gap Mind The Gap Mind The Gap EM stocks are pro-cyclical, and outperform when economic growth prospects are perceived to be improving. The surging U.S. dollar is a growth impediment for many developing countries with large foreign liabilities to service. The U.S. PMI is gaining vs. the Chinese and euro area PMI (Chart 7, second panel), heralding a rebound in cyclical share price momentum. World export growth remains anemic and will remain so based on EM currency trends (Chart 7). When compared with the reacceleration in U.S. retail sales, the outlook for domestically-sourced profits is even brighter. The other key sectoral theme is to favor areas geared to the consumer rather than the corporate sector. Consumer income statements and balance sheets are far healthier than those of the corporate sector (Chart 8). As a result, they are in a more propitious position to spend and expand. Chart 7Domestics Will Rise To The Occasion Domestics Will Rise To The Occasion Domestics Will Rise To The Occasion Chart 8Consumers Trump The Corporate Sector Consumers Trump The Corporate Sector Consumers Trump The Corporate Sector We expect all of these forces to truncate rally attempts in 2017. The market is already stretching far enough technically to flag risk of a potentially sizeable correction in the first quarter, i.e. greater than 10%, particularly given the significant tightening in monetary conditions and overheating bullish sentiment that have developed. In other words, it is not an environment to chase the post-election winners, nor turn bearish on the losers that have been eschewed. Against this backdrop, we are introducing our top ten high-conviction calls for 2017. As always, these calls are fundamentally-based and we expect them to have longevity and/or meaningful relative return potential, rather than just reflect recent momentum trends. We recognize the difficulty of trading in and out of positions on a short-term basis. Energy Services - Overweight Chart 9Playable Rally Playable Rally Playable Rally The energy sector scores well in relative performance terms when the Fed is hiking interest rates2, supporting a high-conviction overweight in the energy services group. OPEC's agreement to curtail production should hasten supply/demand rebalancing that was already slated to occur via non-OPEC production declines through 2017. U.S. shale producers slashed capital expenditures by 65% from 2014 to 2016, and the International Oil Companies reduced capital expenditures by 40% over the same period. OPEC's decision to trim output should mitigate downside commodity price risks, providing debt and equity markets with confidence to restore capital availability to the sector. With easier access to capital, producers, especially shale, will be able to accelerate drilling programs in a stable commodity price environment. The three factors traditionally required to sustain a playable rally are now in place. The rig count has troughed. The growth in OECD oil inventories has crested. The latter is consistent with a gradual rise in the number of active drilling rigs. Finally, global oil production growth is falling steadily. Pricing power is likely to be slow to recover this cycle given the scope of previous capacity excesses, but even a move to neutral would remove a major drag and reduce the associated share price risk premium (Chart 9). Consumer Staples - Overweight 2016 delivered a number of company specific body blows to the consumer staples sector, most notably concerns about the pharmacy benefit manger pricing model, which undermined the retail drug store group. Thereafter, the sector was shunned on a macro level following the election, as it was used as a source of capital to fund aggressive purchases in more cyclical sectors. This has set the stage for a contrarian buying opportunity in a high quality, defensive sector with one of the best track records during Fed tightening cycles3. The sector is now closing in on an undervalued extreme, in relative terms, having already reached such a reading in technical terms (Chart 10). Our Cyclical Macro Indicator is climbing, supported by the persistent rise in consumers' preference for saving. The latter heralds an increase in outlays at non-cyclical retailers relative to sales at more discretionary stores. Importantly, consumer staples exports have reaccelerated, despite the strong U.S. dollar, pointing to a further acceleration in sector sales growth, and by extension, free cash flow. The strong U.S. dollar is a major boon, from an historical perspective, given that it typically creates increased global economic and market volatility. The latter is starting to pick up (Chart 10). A strong currency, particularly bilaterally against China, also implies a reduction in the cost of imported goods sold, and heralds a relative performance rebound (Chart 11). Chart 10Contrarian Buy Contrarian Buy Contrarian Buy Chart 11China To The Rescue? China To The Rescue? China To The Rescue? Home Improvement Retail - Overweight Enticing long-term housing prospects argue for looking through the recent rise in mortgage rates. Household formation is reaccelerating, as full employment is boosting consumer confidence, and clocking at a higher speed than housing starts. The implication is that pent-up housing demand will be unleashed. In fact, consumers have only recently started re-levering, with banks more than willing to facilitate renewed appetite for mortgage debt. Remodeling activity is booming and anecdotes of house flipping activity picking up steam are corroborating that the housing market is vibrant. Now that house prices have recently overtaken the 2006 all-time highs, the incentive to upgrade and remodel should accelerate. While the recent backup in bond yields has been a setback for housing affordability, the U.S. consumer is not priced out of the housing market. Yields are rising in tandem with job security and wages. Mortgage payments remain below the long-term average as a share of income and effective mortgage rates remain near generationally low levels. Building supply store construction growth has plumbed to the lowest level since the history of the data. Historically, capacity restraint has represented a boost to home improvement retail (HIR) profit margins and has been inversely correlated with industry sales growth. Stable housing data and improving operating industry metrics entice us to put the compellingly valued S&P HIR on our high-conviction buy list for 2017 (Chart 12). Chart 12Benefiting From Enticing##br## Long-Term Housing Prospects Benefiting From Enticing Long-Term Housing Prospects Benefiting From Enticing Long-Term Housing Prospects Chart 13Healthy Consumer Is A Boon##br## To Consumer Finance Stocks Healthy Consumer Is A Boon To Consumer Finance Stocks Healthy Consumer Is A Boon To Consumer Finance Stocks Consumer Finance - Overweight We are focusing our early-cyclical exposure on overweighting the still bruised S&P consumer finance index. This group is levered to the rising interest rate environment and debt-financed consumer spending. The selloff in the 10-year Treasury bond has been closely correlated with relative performance gains and the current message is to expect additional firming in the latter (Chart 13, top panel). Importantly, higher interest rates have boosted credit card interest rate spreads (the industry's equivalent net interest margin metric), underscoring that the next leg up in relative share prices will be earnings led (Chart 13, bottom panel). On the consumer front, consumer finances are healthy, the job market is vibrant and consumer income expectations are on the rise. In addition, house prices have vaulted to fresh all-time highs and are still expanding on a y/y basis. The positive wealth effect provides motivation for consumers to run down savings rates (Chart 13, second & third panels). Health Care Equipment - Overweight Health care equipment (HCE) stocks have been de-rated alongside the broad health care index, trading at a mere market multiple and below the historical mean, representing a buy opportunity. Revenue growth has been climbing at a double digit clip (Chart 14, third panel) and the surging industry shipments-to-inventories ratio is signaling that still depressed relative sales growth expectations will surprise to the upside (Chart 14, top panel). Synchronized global growth is also encouraging for U.S. medical equipment exports, despite the U.S. dollar's recent appreciation. The ageing population in the developed markets along with pent up demand for health care services in the emerging markets where a number of countries are developing public safety nets, bode well for HCE long-term demand prospects. The bottom panel of Chart 14 shows that the global PMI has been an excellent leading indicator of HCE exports and the current message is positive. The recent contraction in valuation multiples suggests that sales are expected to disappoint in the coming year, an outlook that appears overly cautious, especially within the context of the nascent improvement in industry return on equity (Chart 14, second panel). Chart 14HCE Stocks Are Cheap Given##br## Improving Final Demand Outlook HCE Stocks Are Cheap Given Improving Final Demand Outlook HCE Stocks Are Cheap Given Improving Final Demand Outlook Chart 15More Than##br## Meets The Eye More Than Meets The Eye More Than Meets The Eye REITs - Overweight REITs have traded as if the back up in global bond yields will persist indefinitely, and that the level of interest rates is the only factor that drives relative performance. Improving cash flows and cheap valuations suggest that REITs can decouple from bond yields. Our REIT Demand Indicator (RDI) has climbed into positive territory, signaling higher rental inflation. The latter is already outpacing overall CPI by a wide margin. The RDI is also positively correlated with commercial property prices, implying more new highs ahead. That will support higher net asset values. While increased supply is a potential sore spot, particularly in the residential space, multifamily housing starts have rolled over relative to the total, suggesting that new apartment builds are diminishing. As discussed in previous research reports, contrary to popular perception, relative performance is also depressed from a structural perspective. REIT relative performance is trading well below its long-term trend, a starting point which has historically overwhelmed any negative pressure from a Fed tightening cycle (Chart 15). Tech Hardware Storage & Peripherals - Underweight The S&P technology hardware storage & peripherals (THSP) sector is a disinflationary play (10-year treasury yield change shown inverted, second panel, Chart 16) and benefits when prices are deflating, not when there are whiffs of inflation4. The tech sector has the highest foreign sales/EPS exposure among the top 11 sectors, and the persistent rise in the greenback is weighing on export prospects for the THSP sub-index (Chart 16, third panel), and by extension top and bottom line growth. Computer and electronic products new order growth has fallen sharply recently, warning that THSP sales growth will remain downbeat. Industry investment is also probing multi-year lows (not shown). Asian inventory destocking is ongoing, which will pressure selling prices, but the end of this liquidation phase would be a signal that the worst will soon be over. Technical conditions are bearish. A pennant formation signals that a breakdown looms. Chart 16Tech Stocks Hate Reflation Tech Stocks Hate Reflation Tech Stocks Hate Reflation Chart 17Shy Away, Don't Be Brave Shy Away, Don’t Be Brave Shy Away, Don’t Be Brave Biotech - Underweight The Nasdaq biotech index is following the BCA Mania Index, which includes previous burst bubbles in a broad array of asset classes. The top panel of Chart 17 shows that if history at least rhymes, biotech bubble deflation is slated to continue. Only 45 stocks in the NASDAQ biotech index have positive 12-month forward earnings estimates, comprising 27% of the 164 companies in the index according to Bloomberg. There is still a lot of air to be taken out of the biotech bubble. Historically, interest rates and relative performance have been inversely correlated. The back up in bond yields and Fed tightening represent a draining in liquidity conditions which bodes ill for higher beta and more speculative investments. The biotech derating has been earnings driven and a sustained multiple compression period looms, especially given the sector's poor sales prospects (Chart 17, bottom panel) Worrisomely, not only have biotech stocks fallen despite Trump's win, but recent speculative zeal (buoyant equity sentiment and resurging margin debt, not shown) has also failed to reinvigorate biotech equities. The NASDAQ biotech index is a sell (ETF ticker: IBB:US). Industrials - Underweight The industrials sector was added to our high-conviction underweight list late last year so the turn in calendar does not require a change in outlook. The sector has discounted massive domestic fiscal stimulus and disregarded the competitive drag on earnings from the U.S. dollar, trading as if a profit boom is imminent. Recent traction in surveys of industrial activity is a plus, but is more a reflection of an improvement in corporate sentiment and is unlikely to translate into imminent industrials sector profit improvement. The U.S. dollar surge is a direct threat to any benefit from an increase in domestic infrastructure or private sector investment spending. Commodity prices and EM drag when the dollar is strong. Chronic surplus EM industrial capacity remains a source of deflationary pressure for their currencies, economies and U.S. industrial companies. U.S. dollar strength warns of renewed pricing power pressure (Chart 18). Non-tech industrial capacity is growing faster than output, and capital goods imports prices are contracting (Chart 18). Tack on the relentless surge in the U.S. dollar, and a new deflationary wave appears inevitable. Relative forward earnings momentum is already negative, and is likely to remain so given the barriers to a top-line recovery, and a soaring domestic wage bill. The sector is not priced for lackluster earnings. Chart 18Fade The Bounce Fade The Bounce Fade The Bounce Chart 19Advance Is Precarious Advance Is Precarious Advance Is Precarious Insurance - Underweight Insurance stocks have benefited from the upward shift in the yield curve and the re-pricing of the overall financials sector, but the advance is precarious. Previously robust insurance pricing power has cracked. The CPI for household insurance is barely growing. The latter is typically correlated with auto premiums, underscoring that they may also slip (Chart 19). While higher interest rates are positive for investment portfolio income, they also imply mark-to-market losses on bond portfolios and incent insurers to underwrite at a faster pace with more lenient standards, which is often a precursor to increased competition and less pricing power. Insurance companies have added massively to cost structures in recent years (Chart 19), while the rest of the financials sector was shedding labor costs. Relative valuations have enjoyed a step-function upshift, but the path of least resistance will be lower for as long as relative consumer spending on insurance products retreats on the back of pricing pressure (Chart 19). 2016 Review... Last year's high-conviction calls were hot out of the gate, and generally had very strong gains until the late-summer/early-fall, but were hijacked by the post-election surge in a few sectors. As a result of the end of year fireworks, our high conviction calls trailed the market by just under 2% for the year ending 2016. Had we had the foresight to predict a Trump win and a massive market rally, we could have closed our positions in early November for comfortably positive gains. In total, our average booked gains in the year were 3% in excess of the broad market since the positions were initiated. We are also closing our pair trades, and will re-introduce a number of new trades in the near future. Anastasios Avgeriou, Vice President Global Alpha Sector Strategy & U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see the U.S. Equity Strategy Special Report titled: "Sector Performance And Fed Tightening Cycles: An Historical Roadmap", available at uses.bcaresearch.com. 2 Ibid 3 Ibid 4 Please see the U.S. Equity Strategy Special Report titled: "Equity Sector Winners And Losers When Inflation Climbs", available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

Future Development In Emerging Markets And What Sectors To Look Out For1 The global population is peaking. For Emerging Markets this means significant changes in economic development models. Commodity super-cycles are coming to an end and technological development will become more disruptive for the "old economy". Global growth will be driven by emerging and frontier markets and the accelerated speed of development will ensure leaps in technology and changes in the demographic structure of the workforce in countries that are catching up. The human population in different historic periods totalled roughly the same number, ten billion people. Periods of historic and economic development are becoming shorter. Until recently demographic growth was assumed to be exponential, but in reality it follows a hyperbolic curve, very slow in the beginning and rising faster as it approaches infinity. Growth cannot continue to infinity and models explaining tail events of the growth trajectory are of particular interest. Signs of a slowdown are apparent as humankind is approaching a global population of ten billion. The global growth model is shifting from a quantitative to a qualitative approach, with information and speed of information exchange becoming the determining factors for development. "The sciences do not try to explain, they hardly even try to interpret, they mainly make models. By a model is meant a mathematical construct which, with the addition of certain verbal interpretations, describes observed phenomena. The justification of such a mathematical construct is solely and precisely that it is expected to work - that is correctly to describe phenomena from a reasonably wide area. Furthermore, it must satisfy certain aesthetic criteria - that is, in relation to how much it describes, it must be rather simple". John von Neumann The purpose of describing the model framework in this paper is first of all to provide investors with a glimpse into our long-term investment philosophy and the way we try to think about future developments. We like the framework described below, because of the good fit to reality that it has shown. Considering that the initial parts of the theory were developed in the 1980s, the model accurately predicted many events we are witnessing now. Furthermore, we hope to achieve a certain degree of predictability of future events, and lay out scenarios for how these events might affect investors. This might stimulate modelling and the thought-process. We are not advising changes in investment policy based on this, but rather invite the reader to a dialog about scenario analysis. In the end, as with every theory or model, everybody is entitled to their own views and, in this academic spirit, we welcome ideas of how to develop the framework further and apply it to different areas. Modelling Of Demographic Growth "The main difference of a human being to an animal is the desire for knowledge and the capacity to reason". Aristotle The most cited theory on demographic growth was formulated by English cleric and scholar Thomas Malthus in 1798.2 The theory later became known as the Malthusian growth model and argued that the world population is growing exponentially: P (t) = P0e rt Where P0 is the initial population size, r is the population growth rate and t is time. In essence the theory suggests that the rate of population growth increases with the number of people living on the planet, while the main constraint for growth is the scarcity of resources (Chart 1). With time it has become obvious that the human population is not evolving according to the rules applicable to all other animal species, and that the Malthusian growth model does not describe the growth trajectory correctly (Chart 2). For example, humankind represents the only exception to the inverse relationship rule between the body mass of an animal species and its population size (lower body mass equals larger population).3 Chart 1Malthusian Growth Model ##br## For The World Population The Ten Billion People Rule The Ten Billion People Rule Chart 2Malthusian Growth Model Vs. ##br## Actual Population Growth The Ten Billion People Rule The Ten Billion People Rule In 1960, von Forester, Mora and Amiot, and later Hoerner in 1975,4 demonstrated that population growth is much better described by a hyperbolic growth function5 - very slow in the early stages and exploding as we approach the present day (Charts 3A & 3B). In other words the growth-momentum relationship is not dependant on the number of people, but rather on the number of interactions between those people (the so-called "second order reaction" in physics or chemistry). Chart 3AHyperbolic Growth Function Vs. Malthusian Growth Model ##br## And Real Population Growth The Ten Billion People Rule The Ten Billion People Rule Chart 3BExamples Of Linear, Exponential ##br## And Hyperbolic Growth The Ten Billion People Rule The Ten Billion People Rule Further research tried to connect the population growth model to the economic growth function and understand where the trajectory of population growth is going.6 For example, Nielsen7 (2015) makes the assumption that the world population is going through a demographic transition process (the third in the world's history) from the latest hyperbolic trajectory to a yet unknown trend. One interesting theory was developed by Russian physicist and demographer Sergey Kapitsa (1928 - 2012). Sergey Kapitsa was the son of Nobel laureate physicist and Cambridge professor Petr Kapitsa. Being a physicist himself, Kapitsa applied physical principles to explain population growth in the perspective of the whole planet, and concentrated on the changing phases of growth at the tails of the hyperbolic curve. "Only Contradiciton Stimulates The Development Of Science. It Should Be Embraced, Not Hidden Under The Rug". Sergey Kapitsa In his work to explain population growth, Kapitsa applied methods developed in physics to describe systems with many particles and degrees of freedom.8 Kapitsa saw an advantage in the complexity of the world population, as it would allow a statistical approach to the solution of the problem, averaging out all temporary processes. Kapitsa found several constraints in the simple hyperbolic growth model, occurring at the tail ends of the trajectory. The hyperbolic model would assume that at the beginning of time, approximately 10 people would have inhabited the planet and would have lived for a billion years. At the same time, approaching 2025 our population is due to double each year. To solve these tail problems, Kapitsa introduced a so-called "cut-off growth rate", to tackle growth in the very early stages of humankind, and a "cut-off time" constant. This led to the population growth formula: dN/dt = N 2/K 2 Chart 4World Population Growth The Ten Billion People Rule The Ten Billion People Rule This states that "growth depends on the total number of people in the world N, and is a function - the square - of the number of people, as an expression of the network complexity of the global population".9 Furthermore, the "growth rate is limited, that is to say by the internal nature of the growth process, not by the lack of external resources" (Chart 4). The easy way to understand the population growth relationship is to think about it the following way - if each BCA client would write an investment advice letter to all the other BCA clients, the total number of letters written would be equal the square of the number of clients. Kapitsa also formulated three periods in the development of humankind: "Epoch A", which began 4.4 million years ago and lasted 2.8 million years. This period was characterized by linear growth of the population. "Epoch B", which included the Palaeolithic, Neolithic periods and up to recent history and lasted 1.6 million years, and growth was hyperbolic (1, 2, 3 on the chart). "Epoch C", which according to Kapitsa's calculations, started in approximately 1965, when the global population reached 3.5 billion people (4 and 5 on the chart) and population growth started to slow globally (Chart 5). Chart 5World Population Growth Rate Is Falling World Population Growth Rate Is Falling World Population Growth Rate Is Falling The model was found to be a good connecting medium between a pure mathematical approach to demographics and observations made by palaeontologists, anthropologists and historians. The main conclusions made by Kapitsa are the following: Historical periods are becoming shorter over time. The Palaeolithic period lasted over 2 million years, the Neolithic period lasted "just" 5,000-8,000 years, while the Middle Ages spanned only about 500 years. Time is passing faster, the more complex the global system of interaction becomes. Or, in other words, the larger the world population becomes. Over each historic period, approximately the same number of people have lived on the planet, in the range of 9 to 12 billion. In later papers Kapitsa singles out 10 billion as the exact number (this depends on input parameters in the formula). World population will reach the 10 billion mark before 2060. Growth is determined by social and technological changes and is driven by the number of social and economic interactions within the global system. On a historical timescale, each cycle is 2.5 - 3 times shorter than the previous one, driving the overall growth in population. Information is the controlling factor of growth. Kapitsa equates his population growth model to the economic production function and explains the non-linearity of the function by "information interaction, which is multiplicative and irreversible, and is the dominant feature of the system, determining or rather moderating its growth". Food or other resources are not a constraint factor, as through the whole of history, humankind never actually encountered any constraints in resources which would derail population growth from its hyperbolic trajectory. Humankind is now in a period of demographic transition, where the beginning is the point of most rapid increase of the growth rate (around 1965) and the end is the point of most rapid decrease. On a historic scale this transition is happening in an extremely short period - 1/50,000 of total historical time - while one in ten people who ever lived will experience this period. The rate of transition in this last period is approximately 90 years, which is just a touch longer than the life expectancy in developed countries. Furthermore, changes in the developing world are happening twice as fast as in the developed. And the reason for that is the increase in speed with which we, as human beings, exchange information. Demographic Transition And Implications For The Economy If the demographic transition period is estimated correctly and the population growth trajectory will level off, as the population stabilizes at around 10 billion, the world will face two scenarios. Either we are approaching a zero-growth reality, or development will shift from the usual "quantitative" growth model of the economy (agriculturally and later industrially driven), to a qualitative approach, where the generation and exchange of information will be paramount. This fits very well with the current reality, where we can see both scenarios happening simultaneously. While growth is approaching zero in the developed world, the move to an information-driven society is pronounced in emerging and developed markets alike. The transition period is characterized by a decrease in death rates among the population, followed by a fall in birth rates. At the same time, a surge in wealth levels and standard of living occurs, followed by longer life expectancy as a result (Charts 6A & 6B). These processes are accompanied by urbanization and a shift of the workforce from production sectors to services. Chart 6AGlobal Population ##br## Is Getting Older Global Population Is Getting Older Global Population Is Getting Older Chart 6BAge Dependency Ratio ##br## (Old Population % Of Working Population) Age Dependency Ratio (Old Population % Of Working Population) Age Dependency Ratio (Old Population % Of Working Population) While this transition has taken decades, and sometimes centuries, in the old world, emerging markets are catching up much faster and the gap in development, estimated by the model, might be not more than 50 years (Chart 7). In fact, we already can observe that the later the transition started, the faster the catch-up period. Kapitsa argues that this narrowing is "due to the nonlinear interaction between countries", or in other words, the increased speed of information transfer. What implications will this have for the global economy and emerging market economies in particular? Chart 7Population Transition, As Described By The Model, ##br## In Different Countries bca.emes_sr_2016_12_13_c7 bca.emes_sr_2016_12_13_c7 Chart 8Global Economic Growth ##br## Driven By EM And FM Global Economic Growth Driven By EM And FM Global Economic Growth Driven By EM And FM Global growth will be driven by emerging and frontier markets for the next decades. Developed countries are already at the final stage of development, where growth will oscillate around zero (Chart 8). The implications of demographics for developed world growth have been studied in a recent paper by the Federal Reserve,10 and so we will not go into too much detail. Investors should be aware that, according to the trajectory suggested by the model, the catch-up period and, hence, the period of high growth, will be shorter for emerging and frontier markets than experienced in the developed world. It is fair to assume that by the time frontier countries move into the "emerging" classification, their period of high growth might be limited to several years to a decade. The model suggests that the period of high GDP growth rates is coming to an end and that investors should be prepared for lower growth for longer. World economy will move to a qualitative focus. Kapitsa argues that humankind will not face any resource constraints, as it never has in the past. Resource constraints are overcome by migration and new technology, while the real issue is in the equal distribution of resources (including wealth and knowledge). As a result, in the coming decades the industrial sector might repeat the destiny of the agricultural sector, as seen in the U.S. and other developed economies (Chart 9). Currently only 2.5 - 3% of the world population are working in the agricultural sector, and this is sufficient to produce food for the world. It can be argued that with the further development of technology, such as 3D printing, the problem of industrial overcapacity will become even more prominent and countries with an industrial focus will face a difficult transition period. China is currently one of the EM countries undergoing such a transition, and we can see how the overcapacity created by the "old economy" is weighing on the performance of the overall economy (Chart 10). Chart 9U.S.: Move Of Working Population ##br## From Agriculture And Manufacturing To Services bca.emes_sr_2016_12_13_c9 bca.emes_sr_2016_12_13_c9 Chart 10Decline Of The bca.emes_sr_2016_12_13_c10 bca.emes_sr_2016_12_13_c10 No more commodity super-cycles? This might not be exactly true, but investors need to change the way they look at commodities and resource companies (and materials sector overall) (Chart 11). Long-term projections of supply and demand should resemble or incorporate the population growth function, which will have implications for capital expenditure. We have already seen a shift to acquire more technology rather than focus on the resource base (fields, mines etc.) (Chart 12). Chart 11Commodity Super-Cycles Coming To An End? bca.emes_sr_2016_12_13_c11 bca.emes_sr_2016_12_13_c11 Chart 12Capex Expenditures In The Oil Sector Are Falling bca.emes_sr_2016_12_13_c12 bca.emes_sr_2016_12_13_c12 The trend is towards cost-saving technology, rather than betting on higher prices and production volume. From the model's perspective, no resources will ever become scarce enough to drive prices sky high for a long period. It is rather a question of getting the timing right and finding a relative long-term dislocation between supply and demand, rather than playing fundamental "peak" stories. Chart 13South African Mining Vs. ##br## U.S. Shale Oil, ##br## A Striking Difference bca.emes_sr_2016_12_13_c13 bca.emes_sr_2016_12_13_c13 A good example of a winner in the commodity sector is U.S. shale oil: even after two years of low oil prices many companies are ready to restart production and compete on the market within a short period of time. On the other hand, the once mighty mining sector in South Africa is only a shadow of its former self, since most companies have been chasing quantity (mine expansion) and forgot about quality (extraction methods) (Chart 13). The shift of the workforce from the "old economy" to services. This process is nearly complete in the developed world, while still in full swing in the emerging markets. With an ever-aging population even in emerging markets, social spending will have to increase and new sectors - such as education, healthcare, information technology and leisure - will come into investors' focus. Information Technology. The driver of all progress. Kapitsa suggests that information cannot be treated as a commodity, due to its irreversible nature once shared with other participants. Nevertheless, in the way in which the model determines future progress, there will be surely an ever-growing industry built around information protection. It is also interesting to note that the confusion arising between generations of parents and their children is probably the effect of the ever-growing speed of information generation and exchange, where significant technological shifts are happening within the lifetime of one generation and the old generation finds it hard to keep up. The main outcomes of the appearance of an information-centric society will be the following: Disruption to old industries. We see this all over the place: the oil industry being threatened by renewables, brick-and-mortar retailers by online stores, and the banking industry might be the next victim (Chart 14). If banks fail to adopt blockchain technology into their business model, they might be excluded as an unnecessary middle man. Chart 14Change In The S&P Index Composition 1990 - 2016 The Ten Billion People Rule The Ten Billion People Rule Leaps in development stages in countries. Assuming historical periods are getting shorter and information exchange is intensifying, we might see more leaps in development stages in emerging, but especially in frontier, markets. This will become a central part of any research: to identify which countries might be "jumping" one or several stages in their development, and what those stages/industries/products might be. Chart 15Computer Companies Vs. Smartphone Producers bca.emes_sr_2016_12_13_c15 bca.emes_sr_2016_12_13_c15 In the past 10 years we witnessed several such precedents. One was China skipping the PC stage completely, with the appearance of the broadly affordable smartphone. At the end of the 1990s, tech research would have suggested investing in PC makers, extrapolating growth numbers to the Chinese population. How has this worked out (Chart 15)? Another good example is the banking industry in Africa. Apart from South Africa, which has a rich banking tradition, more and more countries in the region see growing numbers of users in the online banking space. People use their phones for every day banking needs. Many banks do not even have a brick-and-mortar presence. Maybe that is why we see so many established institutions struggling in this part of the world (Charts 16A & 16B). Chart 16AMobile Money Use By Region The Ten Billion People Rule The Ten Billion People Rule Chart 16BNumber Of Mobile Money Services In Sub-Saharan Africa bca.emes_sr_2016_12_13_c16b bca.emes_sr_2016_12_13_c16b Education. The population growth model says that information will be the main growth driver in the future and, as a consequence, education will be the most important process in human life. Education will take up more time and effort than in any other period of human history (Chart 17). Already now, education can last as long as 20 to 30 years. Compare that to the learning period of any animal. In many jobs, we are required to learn for the better part of our working life and take tests, write exams and attend seminars to keep up-to-date with progress in our industry. Healthcare. Probably the most obvious outcome because, as the older generation requires more treatment and care, the whole social system will need to be adjusted. Many countries will be unable to bear this burden financially, and the private sector will have to step in. This is what we have seen in China since 2015 (Chart 18). Chart 17Tuition Fees In The U.S. Are A Large Part Of Inflation bca.emes_sr_2016_12_13_c17 bca.emes_sr_2016_12_13_c17 Chart 18Healthcare As Proportion Of GDP bca.emes_sr_2016_12_13_c18 bca.emes_sr_2016_12_13_c18 Leisure and entertainment. Maybe not as large or obvious, but it's one of the industries that will benefit. The younger generation has already made a shift from material values, such as luxury brands, to assigning higher values to experiences and creating memories (Chart 19). The appearance of "experience day" offerings (such as driving a super-car or jumping out of an airplane), shifting shopping patterns, or the growing number of travellers even in emerging markets confirms this view. One of the questions that remains is: will government turn out to be the largest employer and provider of services, as for example in the UK (largely because of the National Health Service), or will the private sector take over a large part in this role? Chart 19China Spending On Luxury Goods ##br## Growing More Slowly Than On Travel bca.emes_sr_2016_12_13_c19 bca.emes_sr_2016_12_13_c19 Chart 20Still Calling Your ##br## Broker? The Ten Billion People Rule The Ten Billion People Rule Financial markets: future in the algorithms? It is fair to assume that financial markets will move in the direction of total automation, and will probably be "ruled" by algorithms focusing on short-term strategies (Chart 20). Robo-advisors and passive strategies will decrease commission income and force managers to rethink their investment strategies. On the other hand, people tend to save more as they get older (Chart 21). This pattern reverses, once retirement age is hit (think about medical bills etc.). Consequently, we might see lower demand for savings products once the wave of baby boomers hits retirement, which is bad news for insurance companies and for the bond market. Chart 21Consumption And Income In Perspective The Ten Billion People Rule The Ten Billion People Rule Geopolitics - no more large-scale conflicts, but lots of migration? Chart 22Worldwide Battle-related Deaths On The Decline bca.emes_sr_2016_12_13_c22 bca.emes_sr_2016_12_13_c22 Kapitsa also touched on some controversial topics in his papers - the probability of a global war and a migration crisis (keep in mind there was no migration crisis at the time the theory was developed). Kapitsa argued that, on a global scale, factors such as migration or wars do not really matter for the outcome of the model, creating only statistical "noise". But he also drew some interesting conclusions, arguing that large wars, as we saw them in the 20th century, are unlikely to happen anymore. Because of the restriction on "human resources", states will not be able to conscript and sustain large armies, as it was the case in the past, and conflicts will arise only on a local scale (Chart 22). Chart 23Population In The Baltic States Reducing Dramatically bca.emes_sr_2016_12_13_c23 bca.emes_sr_2016_12_13_c23 Conflicts are most likely to arise in areas of the world experiencing a spike in their population growth trajectory. This period of time is characterized by the highest instability in the "system". This means that inequality in the distribution of resources is peaking together with the population growth rate, which causes social unrest. Such inequalities in resource distribution are evened out over time together with the levelling-off of the population, or more rapidly through war or migration. On the topic of migration, Kapitsa noted that in general migration flows are driven by the search for resources, but have reduced substantially over time. Some 2,000 years ago or earlier, whole nations moved, but nowadays migration flows barely exceed 0.1% of global population. From Kapitsa's point of view, migration should be nothing to worry about. In the framework of a complex physical system, as long as migration does not come from another planet, it is unlikely to cause any harm. In Europe we might be witnessing the first countries in history with drastically shrinking populations, due to the policy of freedom of movement, and people migrating in search of resources (better work and life prospects) (Chart 23). Furthermore, the older generation will probably become more influential in terms of casting votes and deciding future development of countries or whole continents. This year's two black swan events (Brexit and the outcome of the U.S. election) were essentially driven by the older generation, and the divide in opinion may become even more pronounced in future (Chart 24). Chart 24Election Results Determined By Older Generations The Ten Billion People Rule The Ten Billion People Rule Oleg Babanov, Editor/Strategist obabanov@bcaresearch.co.uk 1 Based on the work of Sergey Kapitsa (1928 - 2012) 2 Malthus T.R. 1978. An Essay on the Principle of Population. Oxford World's Classics reprint. 3 Brody, S. Bioenergetics and Growth (Reinhold, New York, 1945) Moen, A. N. Wildlife Ecology: an Analytical Approach (Freeman, San Francisco, 1973) Van Valen, L. Evol. Theory 4, 33-44 (1978). 4 Hoerner, von S. Journal of British Interplanetary Society 28 691 (1975) 5 U.S. Census Bureau (2016). International Data Base. http://www.census.gov/ipc/www/idb/worldpopinfo.php. von Foerster, H., Mora, P., & Amiot, L. (1960). Doomsday: Friday, 13 November, A.D. 2026. Science, 132, 255-296. 6 Maddison, A. (2001). The World Economy: A Millennial Perspective. Paris: OECD. Maddison, A. (2010). Historical Statistics of the World Economy: 1-2008 AD. http://www.ggdc.net/maddison/Historical Statistics/horizontal-file_02-2010.xls. 7 Nielsen, R. W. (2015). Hyperbolic Growth of the World Population in the Past 12,000 Years. http://arxiv.org/ftp/arxiv/papers/1510/1510.00992.pdf 8 From here onwards both papers are quoted extensively: S. P. Kapitsa (1996). The Phenomenological Theory of World Population Growth. Russian Academy of Sciences 9 S.P. Kapitsa (2000). Global Population Growth and Social Economics. Russian Academy of Sciences 10 Gagnon, Etienne, Benjamin K. Johannsen, and David Lopez-Salido (2016). "Understanding the New Normal: The Role of Demographics," Finance and Economics Discussion Series 2016-080. Washington: Board of Governors of the Federal Reserve System, http://dx.doi.org/10.17016/FEDS.2016.08

Dear Clients, This is the final publication for the year, in which we recap some of the key developments in 2016 and their long-term implications. We will resume our regular publishing schedule on January 5, 2017. The China Investment Strategy team wishes you a very happy holiday season and a prosperous New Year! Best regards, Yan Wang, Senior Vice President China Investment Strategy Feature Senior Chinese policymakers conveyed in Beijing last week for their annual economic work conference - a high-profile gathering where top officials review the past year's economic performance and set the broad policy tone and development priorities for the coming year. The key messages from this year's meeting suggest that "stability and progress" remain a top priority, but that the importance of a GDP growth target appears less significant. Policymakers recognize the mounting challenges both globally and domestically, which suggests the policy environment will stay accommodative, especially on the fiscal front. Furthermore, the authorities intend to make material progress on "supply-side" reforms, which is both an admission of defeat in terms of progress this year and a pledge for more aggressive efforts going forward. We will be addressing China's policy orientation, growth outlook and asset prices in the New Year. As a year-end tradition, we dedicate this week's report to recapping some important developments of the past year and their long-term implications. A V-Shaped Recovery Under The Economic "New Normal" Chart 1V-Shaped Rebound##br## In The Economic New Normal bca.cis_wr_2016_12_22_c1 bca.cis_wr_2016_12_22_c1 The Chinese economy entered 2016 with worsening growth deceleration, but ended the year with a V-shaped rebound in industrial activity - even though GDP growth remained curiously stable1 (Chart 1). Destocking in the housing market and de-capacity in some industrial sectors were listed as two top priorities of the government for 2016, both of which were abruptly reversed as the year unfolded: strong home sales depleted housing inventories more quickly than expected, leading to a dramatic increase in home prices in major cities - prompting policymakers to re-impose restrictions on housing demand.2 Meanwhile, de-capacity in steel mills and coal mines greatly constrained domestic supply of related products, leading to both a massive increase in imports and a sharp rally in prices as demand improved. As a result, the authorities scrambled to remove some administrative constraints on domestic production on these two industries. The economy's V-shaped growth performance this year challenges some conventional thinking on China's growth fundamentals, particularly on the housing market and overcapacity. On housing, there is no doubt that some regions have abundant supply, which may take a long time to clear. On an aggregate level, however, the massive increase in home prices in some major cities suggest housing inventories may be much smaller than generally perceived.3 Similarly, overcapacity is widely regarded as a chronic feature of the Chinese economy inherent to its investment-heavy growth model - steelmakers and coalmines being two prime examples. However, the dramatic turnaround in these two industries this past year defies this widely held consensus.4 At minimum, China's overcapacity issue cannot be analyzed in isolation from a global context as well as from the current stage of the business cycle. Chart 2Monetary Conditions And ##br##Business Conditions Monetary Conditions And Business Conditions Monetary Conditions And Business Conditions Furthermore, while "supply-side" reforms were listed as a key theme for 2016, improvement in the industrial sector was to a large extent due to measures that boosted aggregate demand. Fiscal spending remained robust at the beginning of the year, following strong acceleration in 2015. More importantly, monetary conditions began to ease notably from the beginning of the year, leading to a notable improvement in business conditions among industrial enterprises (Chart 2). Nonetheless, the growth "new normal" envisioned by the Chinese leadership underlines the assumption of an "L-shaped" growth trajectory. Therefore, the V-shaped rebound in some key industrial indicators was both surprising and possibly unwelcome from the policymakers' point of view. The authorities will likely continue to switch priorities between supply side reforms and demand-side management going forward. Premature withdrawal of policy stimulus remains a key risk for the economy as well as financial markets. From Deflation To Inflation? 2016 marked a decisive end to Chinese producer price deflation, which lasted for more than four years. PPI, still falling at a 5% annual rate at the beginning of the year, turned up sharply toward the end of 2016, rising by over 3% in November, likely even higher this month. Investors' perception on Chinese producer prices and the broader inflation picture has also shifted dramatically. A mere few months ago China was widely blamed for exporting deflation to the rest of the world, which has quickly been replaced by a consensus that China is now exporting inflation. The sudden shift may have to some extent contributed to the bond market riot of late both globally and within China. The end of PPI deflation is a major positive development for the Chinese corporate sector, as it both improves its pricing power and also reduces its real cost of funding (Chart 3). Real bank lending rates deflated by PPI stayed at close to record highs early this year, and have since tumbled by a whopping 10 percentage points - largely due to easing deflation. This is a dramatic relief for some highly levered asset-heavy industries. Importantly, these industries were the biggest casualties in the growth slowdown and posed material risks to the banking sector due to their high debt levels. In this vein, rising PPI and easing financial stress among these firms also bodes well for the banking sector. Nonetheless, it is wrong to conclude that the end of PPI deflation in China means the country will export inflation going forward: Rising producer price inflation, measured as year-over-year growth, is to some extent due to the base effect. In terms of level, producer prices have clearly stopped falling, but gains have been rather mild and still remain at relatively low levels. It is too soon to worry about inflation (Chart 4, bottom panel). Easing deflation has also been attributable to the falling trade-weighted RMB this year (Chart 4, top panel), as producer prices typically follow exchange rate performance by about six months. While PPI may continue to follow the RMB higher in the coming several months, the trade-weighted RMB depreciation has already stalled, which may cap any additional upside in PPI. Unless the economy continues to recover strongly and/or the RMB resumes its depreciation, it is premature to expect PPI to continue to rise going forward. Chart 3Easing Deflation Helps Reduce##br## Real Interest Rates, Massively bca.cis_wr_2016_12_22_c3 bca.cis_wr_2016_12_22_c3 Chart 4PPI Inflation##br## In Perspective bca.cis_wr_2016_12_22_c4 bca.cis_wr_2016_12_22_c4 Domestic inflation does not necessarily lead to rising export prices, if a weaker RMB is the main factor to boost domestic prices (Chart 5). Indeed, rising Chinese domestic producer prices also means Chinese export prices in RMB terms have also been rising. Measured in U.S. dollar terms, however, Chinese export prices are still falling on a year-over-year basis. Similarly, U.S. import prices from China measured in RMB terms have been rising smartly, but in dollar terms are still been falling. This is positive for Chinese exporters' profitability, but is not inflating U.S. prices. Finally, a word on the sharp increase in Chinese bond yields. While growth improvement and easing deflation may have contributed to the sharp rebound in Chinese bond yields in recent weeks, global factors are likely more important. Chart 6 shows Chinese government bond yields have been increasingly synchronized with U.S. Treasurys in recent years, an interesting development considering China's still relatively closed capital markets. The rising correlation could be driven by economic fundamentals due to the tight connection between these two economies. Rising U.S. bond yields reflects changes in growth and inflation expectations in the U.S., which also impact the Chinese economy. Furthermore, the 123-basis-point spike in U.S. Treasurys since July 2016 has narrowed the yield gap with Chinese government bonds, which in turn has pushed up Chinese yields. This means that Chinese interest rates may remain under upward pressure should U.S. Treasury yields continue to grind higher. Chart 5End Of Chinese Deflation Does Not ##br## Necessarily Inflate The World bca.cis_wr_2016_12_22_c5 bca.cis_wr_2016_12_22_c5 Chart 6Chinese Bonds: ##br##The Global Connection bca.cis_wr_2016_12_22_c6 bca.cis_wr_2016_12_22_c6 Bottom Line: Easing deflation is good news for Chinese domestic firms, but it does not mean that China is about to export inflation to the rest of the world. Chinese government bond yields may have also made a cyclical low, and will likely continue to move higher along with global yields. The RMB's Bumpy Transition The RMB officially joined the Special Drawing Right (SDR) basket of the IMF in October, a historical moment marking an emerging country being admitted to the "elite currency" club. Joining the SDR helps promote the international status of the Chinese currency, which may offer some longer-term benefits.5 The immediate challenge for policymakers, however, is to fend off the constant downward pressure on the RMB against the dollar. More specifically, the People's Bank of China (PBoC) has clearly signaled its intention to allow the exchange rate to float, but has been deeply troubled by the potential of a downward spiral between capital outflows and outsized RMB depreciation. Overall, 2016 marks a tentative transition of the RMB exchange rate mechanism to a dirty float scheme. Indeed, the PBoC at the beginning of 2016 explicitly presented its formula of how the RMB's daily official fixing rate against the dollar is calculated. Strictly following this formula would lead to a largely stable trade-weighted RMB. In reality, however, the PBoC appears to have deliberately targeted a weaker exchange rate: the RMB was soft-pegged to the dollar whenever the dollar weakened against other currencies, and it was allowed to fall against the dollar whenever it strengthened broadly. As a result, the RMB depreciated by almost 10% in trade-weighted terms from its 2015 peak, which in no small part helped the economy reflate. However, this strategy also reinforced an already well-entrenched expectation of the RMB's one-way descent against the greenback. Shorting the RMB became a risk-free bet, which further encouraged capital outflows. There has been a rush to purchase foreign assets by the corporate sector, likely also incentivized by the RMB outlook.6 It is unclear how the PBoC will break this dilemma going forward. We expect the central bank will stay the course in further lowering the trade-weighted RMB, while at the same time tightening capital account controls to prevent capital flight.7 Its large current account surplus and official reserves should offer plenty of resources to maintain control. Its tight grip on the exchange rate may be progressively relaxed as it perceives the trade-weighted RMB to be "cheapened enough," which could generate two-way flows of capital. From this perspective, joining the SDR helps attract long-term foreign capital for Chinese risk-free assets. Bottom Line: Joining the SDR marks a historic milestone for the RMB, but the near-term significance is largely symbolic. The RMB's soft peg to the dollar is over. The PBoC is experimenting with a new exchange rate regime. Market Volatility And Financial Reforms Chart 7Policy Uncertainties And ##br##Equity Valuations bca.cis_wr_2016_12_22_c7 bca.cis_wr_2016_12_22_c7 The dramatic stock market rollercoaster ride in 2015 had already seriously damaged Chinese policymakers' credibility. The short-lived circuit-breaker system designed to curb market fluctuations in fact greatly exaggerated volatility at the beginning of the year, which further exposed the regulators' incompetency. Global investors' anxiety on China's macro situation has eased notably in recent months. However, Chinese stocks have ended the year largely flat, even though the industrial sector has staged a sharp recovery with strong earnings growth. Perceived high and rising policy uncertainty clearly dampens investors' appetite for Chinese assets, resulting in a large valuation discount to their global peers (Chart 7). Underneath, regulators' apparent policy blunders in the past two years represent a deeper and more systemic challenge than just incompetency. The country's rapidly developing financial system and capital markets have become increasingly complex, while the regulatory system lagged way behind. The current regulatory framework is poorly coordinated with sometimes conflicting priorities, leaving potentially systemically important developments falling through the cracks. The dramatic buildup of leverage in the stock market in 2015 outside of regulatory oversight was a prime example. This year, the leverage situation in commodities and bond markets has also been poorly scrutinized. A key reform initiative for the financial sector under the "reform blueprint" published a few years ago was to improve coordination among different regulators. The authorities plan to enhance supervision on systemically important financial institutions and systemically important financial infrastructure such as payment, clearing and custody systems to improve coordination of macro-prudential measures as well as collaboration on key financial statistics and information - all of which has yet to begin. The dramatic financial market volatility and policy blunders of late have created a pressing need to accelerate the process. In short, preventing financial risks has become an increasingly important priority of the government, and will remain a key task for 2017, as noted from last week's economic work conference. This necessarily involves fundamental reforms of the country's financial regulatory framework. We will follow up on these issues in the New Year. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Chinese Growth, Cyclical Risks And The Rally In Commodities," dated December 1, 2016, available at cis.bcaresearch.com 2 Please see China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010," dated October 13, 2016 available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "The Chinese Housing Market Conundrum," dated May 25, 2016 available at cis.bcaresearch.com. 4 Please see China Investment Strategy Special Report, "The Myth Of Chinese Overcapacity," dated October 6, 2016 available at cis.bcaresearch.com. 5 Please see China Investment Strategy Weekly Report, "The RMB's Near-Term Dilemma And Long-Term Ambition," dated October 20, 2016 available at cis.bcaresearch.com. 6 Please see China Investment Strategy Special Report, "Demystifying China's Foreign Assets," dated December 15, 2016 available at cis.bcaresearch.com. 7 Please see China Investment Strategy Weekly Report, "How Will China Manage The Impossible Trinity," dated December 8, 2016 available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations