Geopolitics

Highlights EM tech stocks are overbought while banks are fundamentally vulnerable due to bad-loan overhang. EM stocks have never decoupled from the U.S. dollar and commodities prices. There has been no recovery in EM corporate profitability and EPS. We reiterate two equity trades: short EM banks / long U.S. banks, and short Chinese property developers / long U.S. homebuilders. Upgrade Thai stocks to overweight within the EM equity benchmark and go long THB versus KRW. Feature Our Reflation Confirming Indicator - an equal-weighted aggregate of platinum prices (a proxy for global reflation), industrial metals prices (a proxy for China growth) and U.S. lumber prices (a proxy for U.S. reflation) - has decisively rolled over, and is spelling trouble for emerging market (EM) equities (Chart I-1). In particular, platinum prices have relapsed after hitting a major resistance at their 800-day moving average (Chart I-2). Such a technical pattern often leads to new lows. If so, it could presage a major selloff in EM markets in the months ahead. Chart I-1A Red Flag From ##br##Reflation Confirming Indicator Chart I-2Platinum: A Canary##br## In A Coal Mine? The rationale behind using platinum rather than gold or silver prices is because platinum is a precious metal that also has industrial uses. Besides, we have found that platinum prices correlate with EM stocks better than gold or silver. The latter two sometimes rally due to global demand for safety, even as EM markets tank. Finally, platinum seems to be the most high-beta precious metal in the sense that it "catches a cold" sooner and, thus, might be leading other reflationary plays. In short, EM share prices have been flat since August 15, and odds are that they are topping out and the next large move will be to the downside. Can EM De-Couple From The U.S. Dollar? Many investors are asking whether EM risk assets can rally if the greenback continues to rebound. Chart I-3 illustrates that since the early 1980s, there have been no periods when EM share prices rallied amid strength in the real broad trade-weighted U.S. dollar (the dollar is shown inverted on this and the proceeding charts). The same holds true if one uses the nominal narrow trade-weighted U.S. dollar1 (Chart I-4). Chart I-3Real Trade-Weighted ##br##U.S. Dollar And EM Stocks Chart I-4Nominal Trade-Weighted ##br##U.S. Dollar And EM Stocks One could disregard these charts and argue that this time around is different. We don't quite see it that way. Chart I-5Nominal Trade-Weighted ##br##U.S. Dollar And Commodities Notably, the narrative behind the EM rally since February's lows has been based on the Federal Reserve backing off from rate hikes and the U.S. dollar weakening - with the latter propelling a rally in commodities prices. These arguments appear to be reversing: the U.S. dollar is already firming up and commodities prices are at best mixed. The broad index for commodities prices always drops when the U.S. dollar rallies (Chart I-5). In recent months, the advance in commodities prices has been uneven and narrow based. While oil prices have spiked substantially, industrial metals prices have advanced very little. The current oil price rally is proving a bit more durable and lasting than we thought a few months ago. Nevertheless, China's apparent consumption of petroleum products is beginning to contract (Chart I-6). Consequently, resurfacing worries about EM/China's demand for commodities will lead to a meaningful pullback in crude prices in the months ahead, especially since the likelihood that oil producers act to restrain supply at the current prices is very low. As for commodities trading in China such as steel, iron ore, rubber, plate glass and others, they have been on a roller-coaster ride in recent months (Chart I-7). Chart I-6China's Demand For Oil Products Is Very Weak Chart I-7Commodities Prices In China Bottom Line: There are reasonably high odds that as the U.S. dollar strengthens and commodities prices roll over, EM risk assets (stocks, currencies and credit markets) will start to relapse. EM Beyond Commodities: Still Shrinking Profits Table I-1EM Sectors Weights: In 2011 And Now Another question that many investors have been asking is as follows: Is there not a positive story in EM beyond commodities? Given that the weight of the EM equity market benchmark in commodities stocks - energy and materials - has drastically declined in recent years, from 29.2% in 2011 to 13.7% now (Table I-1), and the weight in technology stocks has risen substantially (from 12.9% in 2011 to 23.9% now), couldn't non-commodities stocks drive the index higher? In this regard, we have the following observations: Information technology stocks are overbought. The EM information technology equity index has surged to its previous highs (Chart I-8, top panel). This sector is dominated by five companies that have a very large weight also in the overall EM benchmark: Samsung (3.6% weight in the EM equity benchmark), TMSC (3.5%), Alibaba (2.9%), Hon Hai Precision (1%) and Tencent (3.8%). Their share price performance has been spectacular, and some of them have gone ballistic (Chart I-9). TMSC and to a lesser extent Samsung have benefited from the rising prices of semiconductors (Chart I-9, second panel from top). However, it is not assured that semiconductor prices will continue soaring from these levels as global aggregate demand remains very weak. In short, the outlook for semi stocks is by and large a semiconductor industry call, not a macro one. As for Alibaba and Tencent, they are bottom-up stories - not macro bets at all. At the macro level, we reassert that EM/China demand for technology goods and services as well as for health care will stay robust. Hence, from a revenue perspective, technology and health care companies will outperform other EM sectors. This still warrants an overweight allocation to technology and health care stocks, a recommendation that we have had in place since June 2010 (Chart I-8, bottom panel). Odds are that tech outperformance will persist, but we are not sure about absolute performance, given overbought conditions and not-so-cheap valuations. Excluding information technology, the EM benchmark is somewhat weaker (Chart I-10). Chart I-8EM Technology Stocks: Sky Is Limit? Chart I-9Individual Tech Names Are Overbought Chart I-10EM Equities: Overall And Excluding Tech There is no improvement in EM corporate profitability The return on equity (RoE) for EM non-financial listed companies has stabilized at very low levels, but it has not improved at all (Chart I-11, top panel). The reason we use non-financials' RoE rather than overall RoE is because in EM the latter is artificially inflated at the moment, as banks are originating a lot of new loans but are not sufficiently provisioning for bad loans. Among the three components of non-financials RoE, net profit margins have stabilized but asset turnover is falling and leverage continues to mushroom (Chart I-11, bottom two panels). Remarkably, the relative performance between EM and U.S. stocks has historically been driven by relative RoE. When non-financial RoE in EM is above that of the U.S., EM stocks outperform U.S. ones, and vice-versa (Chart I-12). This relationships argues for EM stocks underperformance versus the S&P 500. Chart I-11EM Non-Financials: ##br##RoE And Its Components Chart I-12EM Versus U.S.: ##br##Relative RoE And Share Prices Overall EM EPS is still contracting in both local currency and U.S. dollar terms (Chart I-13). Even though the rate of contraction is easing for EPS in U.S. dollar terms, it is due to EM exchange rate appreciation versus the greenback this year. Furthermore, EPS in U.S. dollars is contracting in a majority of non-commodities sectors (Chart I-13A, Chart I-13B). The exceptions are utilities and industrials, which both exhibit strong EPS growth despite poor share price performance. The latter could be a sign that strong industrials and utilities EPS have been due to temporary factors and are not sustainable. Chart I-13AEM EPS Growth: Overall And By Sector Chart I-13BEM EPS Growth: Overall And By Sector Banks hold the key. Apart from commodities/the U.S. dollar and tech stocks, EM banks' share prices are probably the most important precursor to the direction of the overall EM benchmark. Financials are the second-largest sector in the EM equity benchmark (26.4% weight), so if bank share prices break down, the broader EM index will likely relapse. Our analysis of bank health in various EM countries leads us to believe that banks are under-provisioned for non-performing loans (NPL) (Chart I-14A, Chart I-14B). As EM growth disappointments resurface, investors will question the quality of banks' balance sheets and push down bank equity valuation. Hence, odds are bank share prices will drop sooner than later. Chart I-14AEM NPLs Are Unrecognized ##br##And Under-Provisioned Chart I-14BEM NPLs Are Unrecognized ##br##And Under-Provisioned In turn, concerns about EM banks will heighten doubts about overall EM growth and the EM equity benchmark will sell off. Bottom Line: EM tech stocks are overbought, while banks are fundamentally vulnerable due to the bad-loan overhang. As commodities prices relapse anew and worries about the EM credit cycle resurface, the EM benchmark will drop considerably. An Update On Two Relative Equity Trades We reiterate two relative equity trades: short EM banks / long U.S. banks, and short Chinese property developers / long U.S. homebuilders. For investors who do not have these positions, now is a good time to initiate them. Short EM banks / long U.S. banks (Chart I-15). The credit cycle in EM/China will undergo a further downturn: credit growth is set to decelerate as banks recognize NPLs and seek to raise capital. Even if a crisis is avoided, the need to raise substantial amounts of equity will considerably erode the value of EM bank shares. Meanwhile, risks to U.S. banks such as a flat yield curve and a possible spillover effect from European banking tremors are considerably less severe than the problems faced by EM banks. Importantly, unlike EM banks, U.S. banks' balance sheets are very healthy. Short Chinese property developers / long U.S. homebuilders (Chart I-16). Chart I-15Stay Short EM Banks##br## Versus U.S. Banks Chart I-16Stay Short Chinese Property ##br##Developers Versus U.S. Homebuilders Chinese property developers are on the verge of another downturn, as the authorities have tightened policy surrounding housing. Residential and non-residential property sales have boomed in the past 12 months, but starts have been less robust (Chart I-17). The upshot could still be high shadow inventories. Going forward, as speculative demand for housing cools off, property developers' chronic malaise - high leverage and lack of cash flow - will come back to play. Remarkably, property stocks trading in Hong Kong have failed to break out amid the buoyant residential market frenzy in the past 12 months, and are likely to break down as demand growth falters in the coming months (Chart I-18). Chart I-17China's Real Estate: ##br##Sales And Starts Will Contract Chart I-18Chinese Property Developers: ##br##On A Verge Of Breakdown? Arthur Budaghyan, Senior Vice President Emerging Markets Strategy & Frontier Markets Strategy arthurb@bcaresearch.com Thailand: Upgrade Stocks To Overweight And Go Long THB Versus KRW The death of King Bhumibol Adulyadej marks the end of an era not only because he symbolized national unity but also because his entire generation is passing. This generational shift has far-reaching consequences for Thailand's political establishment: in the long run it could hurt the Thai military's - and its allies' - attempt to cement their dominance over parliament. However, as Box II-1 (on page 17) explains, there is a low probability of serious domestic instability over the next 12 months2 - although beyond that risks will be heating up. For now, the military junta faces no major political or economic constraints: The junta has already consolidated control over all major organs of government and has purged or intimidated political enemies. The military will have to turn power back to parliament, or make a major policy mistake, for the opposition movement to rise again. The government's fiscal deficit has been stable (around 3% of GDP) over the past few years, public debt is at 33% of GDP, government bond yields are low and debt servicing costs are at 5% of total expenditures (Chart II-1). Hence, the military government can ramp up expenditures further to appease the disaffected. Indeed, the military junta has already accelerated public capital expenditures (Chart II-2) and investments have poured into the Northeast, a populous base of opposition to the junta. Chart II-1Thailand: More Room ##br##For Fiscal Stimulus Chart II-2Thailand: Government ##br##Capex Has Been Booming Likewise, fiscal expenditure has also accelerated in areas such as general public services, defense, and social protection (Chart II-3). Additionally, the Bank of Thailand (BoT) has scope to cut interest rates as the policy rate is still above a very low inflation rate (Chart II-4). This will limit the downside for credit growth and contribute to economic and political stability. Chart II-3Rising Public Spending Chart II-4Thailand: No Inflation; Room To Cut Rates The large current account surplus - standing at 11% of GDP - provides the authorities with plenty of fiscal and monetary maneuverability without having to worry about a major depreciation in the Thai baht (Chart II-5). Amid this sensitive political transition, the central bank will likely defend the currency if downward pressure on the baht emerges due to U.S. dollar strength. Therefore, we recommend traders to go long the Thai baht versus the Korean won (Chart II-6). Despite Korea's enormous current account, the won is at risk from depreciation in the RMB and the Japanese yen. Chart II-5Enormous Current Account ##br##Surplus Will Support The Baht Chart II-6Go Long THB Against KRW On the whole, although the Thai economy has been stagnant (Chart II-7), fiscal spending and low interest rates will limit the downside in growth. Bottom Line: We expect relative calm on the political surface in Thailand over the next 12 months and a stable macro backdrop. Therefore, we are using the latest weakness to upgrade this bourse from neutral to overweight within an EM equity portfolio (Chart II-8). Chart II-7Thai Growth Has Been Stagnant Chart II-8Upgrade Thai Stocks ##br##From Neutral To Overweight In addition, currency traders should go long THB versus KRW. Ayman Kawtharani, Research Analyst aymank@bcaresearch.com Matt Gertken, Associate Editor mattg@bcaresearch.com BOX 1 The Military Coup In 2014 Pre-empted The King's Death... The May 2014 military coup was timed to pre-empt this event. The king's health had been declining for years and it was only a matter of time until he died. This raised the prospect of an intense political struggle that could have escalated into a full-blown succession crisis. Thus the military moved preemptively so that it would be in control of the country ahead of the king's death and could reshape the constitutional system in the military's favor before his death, as it has done. ... And This Means Stability For Now If the populist, anti-royalist faction had been in control of government at the time of the king's death, it could have attempted to manipulate the less popular new king and take advantage of the vacuum of royal authority in order to reduce the role of the military and their allies. That in turn could have sparked a wave of mass protests from royalists, pressuring the government to collapse, or a military coup that would not have carried the king's implicit approval like the 2014 coup. That would have fed the narrative that a final showdown between the factions was finally emerging, and would have been highly alarming to foreign investors. But Risks Still Linger Make no mistake: a new long-term cycle of political instability is now emerging. Potential military mistakes and the return to parliamentary rule are potential dangers. The country's deep divisions - between (1) the Bangkok-centered royalist bureaucratic and military establishment and (2) the provincial opposition -have not been healed but aggravated since the 2014 coup and the new pro-military constitution: The junta's constitutional and electoral reforms will weaken the representation of the largest opposition party, the Pheu Thai Party, and will marginalize a large share of the 65% of the country's population that lives in the opposition-sympathetic provinces. It is also conceivable that the new king could trigger conflict by lending support to the populist opposition. For instance, he could pardon the exiled leader of the rural opposition movement, or he could transform the powerful Privy Council. However, we do not expect discontent to flare up significantly until late 2017 or 2018 when the military steps back and a new election cycle begins.3 We will reassess and alert investors if we foresee a rapid deterioration in the palace-military network, or in the military's ability to prevent seething resistance in the provinces. 1 The narrow U.S. dollar is a trade-weighted exchange rate versus the euro, Canadian dollar, Japanese yen, British pound, Swiss franc, Australian dollar, and Swedish krona. Source: The Federal Reserve. 2 The exception is that isolated acts of terrorism remain likely and could well strike key areas in Bangkok, signaling the reality that the underground opposition to military dictatorship remains alive and well. 3 The junta will use the one-year national period of mourning to its advantage and opposition forces will not want to be targeted for causing any trouble during a time of mourning. The junta could very easily delay the transition to nominal civilian rule, including the elections slated for November 2017. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Special Report

Highlights Muni Credit Cycle: The reading from our Municipal Health Monitor supports low Muni/Treasury yield ratios for now, but will become less supportive near the end of 2017. This is consistent with historical lags between the muni and corporate credit cycles. Issuance: State & local government investment spending will increase in 2017, as will muni issuance for new capital. Pensions: The pension funding problem will only get worse in the coming years. Credit ratings do not adequately reflect the risk from under-funded pensions. Election: Muni/Treasury yield ratios have not yet discounted Donald Trump's recent plunge in the polls. Maintain an overweight allocation to municipal bonds for the time being, but stand prepared to gradually reduce exposure as the muni credit cycle starts to turn in late 2017. Feature The financial crisis marked a major inflection point in the municipal bond market. Not only did the economic fall-out from the housing crash lead to historically large state & local government budget gaps, but the end of bond insurance and a growing realization that municipal default is possible have focused investor attention on credit quality more than ever before. In this Special Report we zero-in on the Municipal/Treasury (M/T) yield ratio.1 We identify its major short-run and long-run drivers, and assess where it is headed in the context of the municipal bond credit cycle. The Longer-Run Outlook For Yield Ratios An important input to our understanding of the municipal credit cycle is our Muni Health Monitor (MHM). The MHM is a composite of eight indicators of state & local government budget health. Full details of the indicator and its components can be found in the Appendix to this report. The MHM has an excellent track record of signaling the major inflection points in muni ratings migration (Chart 1). We observe that the MHM bottomed in 2006, one year before the previous trough in ratings migration. The MHM also crossed into "deteriorating health" territory six months before municipal downgrades started to outpace upgrades in 2008. More recently, the MHM crossed back into "improving health" territory in Q4 2012. Muni ratings migration also peaked in Q4 2012 and upgrades began outpacing downgrades in Q4 2014. Chart 1The Municipal Health Monitor Leads Ratings We pay attention to the trends in muni ratings because ratings and state & local government net borrowing explain more than 50% of the variation in the average M/T yield ratio since 1997 (Chart 2). Further, increased investor focus on the creditworthiness of municipal issues has made the yield ratio even more responsive to ratings and net borrowing since the Great Recession. So where are we currently situated in the muni credit cycle? The MHM remains in "improving health" territory, but appears to have entered an extended bottoming-out phase. Given the re-leveraging that has already occurred in the corporate sector, it would be extremely unusual for the MHM to improve further during this cycle. In fact, our Corporate Health Monitor tends to lead the MHM by about two years (Chart 3). This squares with what we know about the behavior of state & local governments throughout the economic cycle. Chart 2The Muni Credit Cycle Illustrated I Chart 3The Muni Credit Cycle Illustrated II Typically, the corporate sector will increase debt loads when times are good and will then be forced to de-lever when the economy enters recession, profits contract and those debt loads become unsustainable. State & local government budget gaps, on the other hand, will tend to narrow during an economic recovery as rapid income growth translates into increased tax revenue. It is only during a recession that state & local government budget gaps widen, since tax revenue plummets while expenditure growth - particularly for social benefits - remains firm. The end result is that the municipal credit cycle tends to lag the corporate credit cycle. This is also apparent in the ratings data (Chart 3, bottom panel), which suggest that we should expect to see muni downgrades (and hence yield ratios) head higher near the end of next year. The typical lag between the corporate credit cycle and the municipal credit cycle suggests that M/T yield ratios should remain well behaved until late-2017, and then begin to move higher. However, the extraordinary length of the current economic recovery gives us some cause to believe that the lags in this cycle may be somewhat longer. We turn to a macro analysis of net state & local government borrowing to shed some further light on this issue. Net borrowing is simply the difference between revenues and expenditures. On the revenue side of the ledger, state & local governments have already seen a significant deceleration in tax receipts during the past year (Chart 4). Every source of tax revenue - except for property taxes - has slowed alongside what has been disappointing overall economic growth so far in 2016. While a return to the 10% revenue growth that was seen in the mid-2000s is unlikely, we expect most of the recent deceleration will soon be reversed. Aggregate weekly hours bounced sharply in September (Chart 5), and federal income tax withholdings also continue to grow rapidly. Both indicators suggest that income growth will be stronger during the next few months, which will support state & local tax receipts. On the expenditures side, while spending on social benefit programs has increased, state & local governments have largely dealt with budget gaps by cutting back severely on discretionary spending (Chart 6). Investment spending has also collapsed and, as a result, gross municipal bond issuance has been dominated by refinancing (Chart 6, bottom two panels). Chart 4S&L Government Revenue Chart 5Income Growth Will Rebound Chart 6S&L Government Expenditures This could all be about to change. Both U.S. Presidential candidates have prioritized infrastructure spending as part of their platforms. Hillary Clinton plans to increase infrastructure spending by $500 billion. This consists of $250 billion of federal infrastructure spending over the next five years and $25 billion of seed money to create a national infrastructure bank. The bank would also accept an additional $225 billion in direct loans. Clinton's plan would also bring back the Build America Bonds (BABs) program. Donald Trump has also expressed a desire to invest heavily in infrastructure, and has floated figures in the range of $1 trillion, although he has been less specific about the details. Historically, about 70% of public investment has occurred at the state & local government level (Chart 7). This suggests that if infrastructure spending became a priority it would lead to a large increase in state & local government investment and hence municipal bond issuance. However, with Clinton's plan it is still unclear whether the bulk of infrastructure spending would be financed through the Treasury market or the muni market. Certainly, to the extent that increased spending is financed through the BABs program, then tax-exempt muni issuance would not be impacted. In our view, state & local government investment spending will head higher in 2017 even without any support from the new President. The need for state & local governments to invest in infrastructure has been evident for some time, but only recently have budgets become healthy enough for governments to consider it. There is a strong correlation between state & local government investment spending and the net percentage of states with a total balance (general fund plus rainy day fund) that exceeds 5% of expenditures (Chart 8). This figure has just recently moved into positive territory and, not coincidentally, more than $200 billion worth of infrastructure spending will be on ballots requesting voter approval in November.2 Chart 7State & Local Government ##br##Drives Investment Chart 8Healthy Enough##br## To Invest The combination of resilient, but not surging, revenue growth and increased investment spending in 2017 is consistent with the idea that the muni credit cycle will follow the lead of the corporate cycle and start to turn near the end of next year. Bottom Line: The reading from our Municipal Health Monitor supports low Muni/Treasury yield ratios for now, but will become less supportive near the end of 2017. This is consistent with historical lags between the muni and corporate credit cycles. The Pension Problem Of course, the elephant in the room with regards to the long-run outlook for municipal credit quality is pensions. So far pensions have only entered our discussion of the muni credit cycle tangentially, since the pension funded ratio is a component of the MHM (see Appendix). However, large unfunded pension liabilities - should they persist - have the potential to be severely destabilizing for the muni market at some point in the future. According to the U.S. National Accounts, aggregate defined benefit pension entitlements at the state & local government level total $5.6 trillion, only 65% of which are currently funded by assets. However, this aggregate figure masks large divergences between a few municipalities with unsustainable pension liabilities and the majority of municipalities where pension liabilities are probably manageable. Chart 9Low Returns Put Pressure On Pensions In a recent report,3 the Center for Retirement Research at Boston College found that 36 states should be able to fund their existing liabilities by making annual payments that total less than 15% of revenue. However, five states - Illinois, New Jersey, Connecticut, Hawaii and Kentucky - require annual payments in excess of 25% of revenue. The breakdown is found to be similar at the city level, where pension costs were found to be manageable for the majority of cities, although Chicago, Detroit, San Jose, Miami, Houston, Baltimore, Wichita and Portland all face annual pension costs that exceed 40% of revenue. Unfortunately, while the pension situations of most municipalities are currently manageable, they are only likely to get worse. Changes in the aggregate pension funded ratio closely track returns from a portfolio that is 50% invested in the S&P 500 and 50% invested in the Barclays Treasury index (Chart 9). Based on current equity valuations, it is probably only reasonable to expect 6% annual nominal returns from the equity market during the next 10 years,4 and the 10-year Treasury yield suggests that 1.8% is a reasonable expectation for annual nominal Treasury returns. Taken together, annual nominal investment returns from a 50/50 portfolio during the next decade could be close to 4%, far below the historical average of 8.9% and also below the 7.6% average return assumed by state & local pension plans in 2014. The two main points are that: The pension problem is likely to get worse, not better Given that large under-funded pensions are concentrated in only a few states, inter-state muni allocations are very important On this second point, we observe that states with lower pension funded ratios have higher General Obligation (GO) bond yields (Chart 10), and also that not all of the difference is reflected in credit ratings. We ran a cross-sectional regression of GO bond yields against credit rating and found that a correlation remains between the residual from that regression and the pension funded ratio (Chart 11). In other words, credit rating does not adequately control for the risk presented by under-funded pensions. Chart 10Municipal Bond Yields Vs. Pension Funded Ratios Chart 11Municipal Bond Yields Vs. Pension Funded Ratios: Controlling For Credit Rating Bottom Line: The pension funding problem will only get worse in the coming years. Credit ratings do not adequately reflect the risk from under-funded pensions. The Short-Run Outlook For Yield Ratios So far we have discussed the muni credit cycle and noted that M/T yield ratios should begin to move higher on a sustained basis at some point near the end of 2017. However, the near-term drivers of M/T yield ratios suggest that an overweight allocation to municipal bonds remains appropriate for the time being. We have found that the bulk of near-term volatility in M/T ratios can be explained by four factors (Chart 12): The Global Policy Uncertainty Index5 Gross municipal bond issuance Net municipal mutual fund flows Ratings migration The Brexit shock to policy uncertainty has now mostly been reversed. Meanwhile, our Muni Excess Supply Indicator (Chart 12, panel 4) shows that gross issuance has been outpacing fund inflows of late. This should put upward pressure on yield ratios, although this pressure has been largely offset by still supportive ratings migration (Chart 12, bottom panel). Considering all factors, this short-term model shows that the average M/T yield ratio is close to fair value. A reading close to fair value is consistent with muni returns that should exceed those from duration-equivalent Treasuries most of the time (Table 1), even before adjusting for the muni tax advantage. In fact, Table 1 shows that the odds of muni underperformance only really increase once the M/T ratio appears more than one half standard deviation expensive on our model. Chart 12A Short-Term Muni Model Table 1Municipal Bond Excess Returns* Based On Fair Value Model** Residual: 2010 - 2016 The other near-term factor that supports a continued overweight allocation to municipal debt is the prospect of a Clinton victory in next month's election. Since the beginning of the year, the average M/T ratio has closely tracked the probability of a Trump election victory (Chart 13). The reasoning is entirely logical. Trump has promised large tax cuts for the highest earners. Such tax cuts would significantly de-value the tax advantage of municipal bonds and pressure yield ratios higher. In contrast, Clinton promises to raise taxes on high income individuals. This would make the tax advantage of municipal debt more valuable, and pressure yield ratios lower. Chart 13Trump Is Bad For Yield Ratios The average M/T yield ratio has not yet discounted Trump's recent plunge in the polls. This argues for the maintenance of an overweight allocation to municipal debt in the near term. Bottom Line: M/T yield ratios appear fairly valued in the near-term, and have not yet discounted Donald Trump's recent plunge in the polls. Maintain an overweight allocation to municipal bonds for the time being, but stand prepared to gradually reduce exposure as the muni credit cycle starts to turn in late 2017. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com Appendix: The BCA Municipal Health Monitor The BCA Municipal Health Monitor is an equal-weighted composite of eight indicators meant to quantify trends in state & local government budget gaps and debt service capability. The components consist entirely of data that are publicly available from the Bureau of Economic Analysis, Federal Reserve, Bureau of Labor Statistics and the National Association of State Budget Officers. The eight components are described below, and shown graphically in Charts A1 & A2. Chart A1Muni Health Monitor Components I Chart A2Muni Health Monitor Components II Leverage: The ratio of total state & local government liabilities (excluding unfunded pension liabilities) to total financial assets. Interest Coverage: State & local government current budget surplus (excluding interest expenditures) divided by interest expenditures. The current surplus is calculated as the difference between current revenues and current expenditures (i.e. investment spending is excluded). Pension Funded Ratio: Total assets of state & local government pension funds divided by total pension liabilities. Revenue: State & local government current revenue in nominal terms, as a deviation from its 18-quarter trend. Surplus Margin: State & local government current budget surplus as a % of current revenue. Liquidity: State & local government total financial assets less short-term liabilities, as a % of total financial assets. Employment Growth: Year-over-year % change in state and local government employment. Total Balance: Aggregate state government total year-end balance. The total balance is the general fund balance plus the rainy day fund, as a % of total expenditures. 1 The average M/T yield ratio shown in this report is calculated by taking an equal-weighted average of M/T yield ratios for 2-year, 5-year, 10-year and 30-year maturities. For each maturity point the yield ratio is calculated as the ratio between the Bloomberg Fair Value Aaa Municipal bond yield and the Federal Reserve's constant maturity Treasury yield. 2 http://www.bloomberg.com/news/articles/2016-09-13/mega-deals-lead-ballo… 3 http://crr.bc.edu/briefs/will-pensions-and-opebs-break-state-and-local-… 4 Please see Global Investment Strategy Special Report, "Global Equity Valuations: Risks And Opportunities", dated July 1, 2016, available at gis.bcaresearch.com 5 The index was created by Professors Scott Baker, Nick Bloom and Steven Davis and is driven by the number of times terms related to economic and policy uncertainty are found in newspaper articles. Full details of the methodology are available at www.policyuncertainty.com

Highlights Our protector portfolio is a combination of assets that have a low or negative correlation with equities that give investors some downside protection. Replacing cash and/or Treasuries with our protector portfolio in 60-30-10 or 60-40 benchmark portfolios would have produced superior returns since 2011. We continue to advocate allocating investments to our protector portfolio in the near term as it represents an effective hedge against immediate risks such as a negative market reaction to the upcoming elections and/or disappointing third quarter profits. Feature Both equities and bonds are under pressure, as a higher likelihood of a December interest rate hike is beginning to be priced in at the same time as nervousness about Q3 earnings results has intensified. This confluence of factors - less liquidity and earnings disappointment - has been the central argument of our defensive portfolio stance for some time: any handoff from liquidity to growth would be shaky, and potentially premature. Indeed, as we wrote in the September 26 Weekly Report, liquidity conditions will largely remain favorable for risk assets for some time because even with a December rate hike, interest rates are well below equilibrium, i.e. are not restrictive. However, equity investors will suffer through bouts of earnings disappointments, similar to the chronic disappointment in GDP growth. As we show in Chart 1, throughout the economic recovery, expectations for economic growth have been revised lower and are only now finally in line with what we expect is close to reality. As highlighted in last week's report, investors' expectations about earnings are most likely to undergo the same fate because profit margins will remain a lasting headwind: investors have not yet adjusted to this new reality (Chart 2). That will hold equity gains to low single digits, at best. Chart 1Years Of One-Way (Down) Revisions Chart 2Earnings Set To Disappoint? Overall, our view is that the economic backdrop is stable as there are low odds of a recession-inducing monetary tightening occurring, and we do not see any other negative shocks that are concerning enough to trigger a recession. Still, above and beyond our worry about profit disappointments, many client queries are currently focused on U.S. election risks. On September 26, we warned of market volatility leading up to the election, since investors may continue to assign too low odds of a Trump Presidential win. However, we would expect markets to quickly recover - at least until Trump reveals his true policy colors. We took a page from the market reaction to Brexit as a possible guideline to the outcome of Trump winning the election, i.e. the election is ultimately won by a non-status quo candidate. Investors will recall that the post-vote U.K. equity market reaction to Brexit was short-lived but savage. However, the uncertainty around the upheaval of institutions and structures in the euro area and the U.K. are far greater than the election of a non-conformist U.S. President within an institutionally sound system with checks and balances. All of that said, we recognize that we could be wrong and that the U.S. election has taken over the pole position on investors' list of concerns. More specifically, investors are worried about negative financial market fallout from a Trump win.1 So, how should investors hedge the downside risk of these election results? And for that matter, what about other near-term risks? Protector Portfolio Explained This publication has been advocating for some time that investors hold some portion of their capital in a protector portfolio (currently a combination of TIPS, gold and the U.S. dollar). The goal is to find assets with a low or negative correlation to U.S. equities and offer a measure of protection against a steep selloff in stocks. As Chart 3 shows, a portfolio of 60/30/10, where 10% is placed in the protector portfolio, would have outperformed a traditional 60/30/10 allocation in which the 10% is held in straight cash since 2011 (in a ZIRP world). A 60/40 allocation where 40% is placed in the protector portfolio also beats a 60/40 stock/Treasury allocation since 2011. Chart 3Protector Portfolio Enhances Performance ##br## Since 2011 Chart 4Protector Components Are ##br## Negatively Correlated With S&P 500 The three assets included in our protector portfolio were chosen with specific risks in mind: USD: As the main global reserve currency, the U.S. dollar benefits when global risk aversion is on the rise. Admittedly, when fears have emanated from U.S. soil, the dollar has performed less well compared to other safe-haven assets, such as the Swiss franc and/or Swiss bonds. Nonetheless, for U.S. investors, investing in one's home currency can provide a natural hedge/advantage. In Chart 4, we show the one-year correlation between USD and S&P 500 equity returns. Since 2009, the correlation has been negative and the implication is that by holding USD, investors are already implicitly defensive. Gold: Gold traditionally does well in times of extreme geopolitical uncertainty and also as a hedge against inflation. More recently, gold has done less well as a hedge because the negative correlation between equity prices and gold broke down from 2011 until earlier this year (Chart 4). Gold has once again become negatively correlated with equity prices and we believe it will be an effective safe-haven asset should inflation become a concern. TIPS: Both 10-year TIPS and nominal Treasuries are negatively correlated with U.S. equity returns and both provide some measure of insurance in risk-off periods/phases of economic disappointment. Nonetheless, we prefer TIPS at the moment since they offer a measure of protection against a back-up in inflation expectations (also Chart 4). In sum, our protector portfolio is a combination of assets that are uncorrelated enough with equities to give investors some protection against a range of downside risks. Protector Portfolio: But Beware Buy And Hold Chart 5Protector Buy And Hold Will Not Work As Chart 2 has shown, our protector portfolio has outperformed both a 60-30-10 and 60-40 portfolio in recent years. However, longer -term performance has been less outstanding (Chart 5). Indeed, adding a constant proportion of safe-haven assets to a balanced portfolio over an extended period underperforms the balanced portfolio benchmark for long stretches of time: there are non-negligible costs associated with holding safe-haven assets over prolonged periods. The bottom line is that timing plays a critical part in investing in safe-haven assets. Owning a fixed share of protector portfolio assets over long horizons will not beat a traditional buy and hold strategy, although superior returns over cash offer a compelling case in a NIRP world. We continue to recommend that investors hedge against downside risk in the form of the protector portfolio - or simply by choosing the safe haven that most closely corresponds as a hedge to the specific risk at hand. However, it is important to know that safe-haven assets fall in and out of favor through time and the protector portfolio will at some point no longer be justified, and/or its components will need to be adjusted. For example, only after 2000 did Treasuries start providing a good hedge against equity corrections. The contrary is true for gold - it acted as one of the most secure investments during corrections until that time, but then became correlated with S&P 500 total returns from 2012-early 2016. That said, gold's coefficient has turned negative again, and it should be viewed as an all-weather safe haven, especially if deflation risks begin to dissipate. The Most Relevant Safe Haven In Case Of A Policy Mistake Chart 6Fed Policy Mistake? Buy Protector Portfolio As we wrote above, our base investment case is that the prospect of less liquidity and the risk of an earnings disappointment mean that investors should keep a defensive portfolio stance and be prepared for pullbacks in equities in the single digits. However, the Minutes of the latest FOMC meeting highlight that a fairly low threshold has been set for a December interest rate rise. If financial market participants interpret incoming economic information more bearishly than the Fed, then a December rate hike risks being perceived by investors as a policy mistake. Under this scenario, risk assets could be set for a much greater fall, buoying the case for further portfolio insurance. Which safe havens will outperform? We take our cue from the market reaction to the December, 2015 rate hike. In that episode, equity prices fell 12%. The protector portfolio in its current configuration2 increased 10%. The bulk of the appreciation was due to a strong run in gold prices (surely helped in part by massive woes in China) and TIPS (Chart 6). We believe that this basket of assets would once again offer an important buffer against equity losses associated with a policy mistake. The Most Relevant Safe Haven For A Trump Win If a Trump win triggers a correction in risk assets, we would expect the U.S. dollar to rally due to Trump policy uncertainty and heightened geopolitical risk. We noted above that USD does not always rally when a stress event occurs on U.S. soil. However, in the past several weeks, the performance of the dollar as well as Treasury yields has been linked to Trump's probability of winning the election. Whenever the odds of a Trump presidency rise, these risk-off assets have appreciated. And The Most Relevant Lessons From The Election Cycle This month's Geopolitical Strategy Special Report 3 provides a final forecast and implications for the elections. As we note above, we agree that a Trump win is a red herring in terms of the key issues investors face. But we also agree with our geopolitical strategists that there are several important lessons from the election cycle that may have long term ramifications for investors. Below, we highlight the most relevant for financial market participants: The median voter has moved to the left on economic policy. Trump's victory over an army of seasoned, relatively orthodox GOP contenders in the primary exposed the fact that the party's grassroots voters no longer care deeply about fiscal austerity and no longer wish to tolerate the corporate incentive for importing cheap labor. Similarly, demographic trends favoring millennials and minorities (who tend to vote left on economic policies), portends a shift by which the GOP attempts to capture left-leaning voters. Fiscal conservatism (and social conservatism, for that matter) will have less to show by way of official party machinery. The 2016 election campaign has amplified the notion that the news media works in narratives. These narratives work as a filter that preempts and distorts the presentation and, to some extent, reception of facts. This phenomenon was influential in Trump's rise - the first "Twitter" candidacy - as well as his recent decline. Investors cannot be too wary of what the mainstream press or financial "smart money" says about any particular political trend or event. It is essential to separate the wheat from the chaff by using empirics and looking at macro and structural factors to identify the constraints rather than the preferences of candidates or politicians. U.S. Economy: Neither Hot Nor Cold The NFIB survey of small business survey ranks as one of our preferred indicators of U.S. business confidence. The employment related indicators serve as a key input into our payroll model; questions about the pricing environment often provide a good leading/coincident gauge about inflation trends, and; as Chart 7 shows, the labor cost versus pricing series provides an excellent leading indicator for the profit margin outlook. The latter remains in a downtrend, reinforcing our message that profit margins will remain a headwind to earnings growth for still some time. Overall, small business optimism has been generally flat this year, after peaking in late 2014. It is somewhat discouraging that "demand" as a most important problem is no longer falling. Consumption has been one of the more robust areas of growth in the past several years and we expect consumption to continue to outshine other areas of the economy. However, even here, the data should be monitored closely. Chart 7Small Business Concerns (Part 1) Chart 8Small Business Concerns (Part 2) Retail sales (excluding gasoline and autos) growth has been slowing throughout 2016 and September data did not buck this trend (Chart 8). Results among retailers varied substantially, with growth strongest at building supply stores, sporting goods stores, vehicle dealers and furniture stores. Laggards include electronics and appliance stores - segments that are still under siege from falling prices. The bottom line is that in aggregate, consumption is holding up reasonably well and should continue to do so, as long as employment gains and modest wage growth remain intact. Stay tuned. Lenka Martinek Vice President, U.S. Investment Strategy lenka@bcaresearch.com 1 Our Geopolitical Strategy service concurs that a Trump win is a red herring, i.e. is unlikely to occur and is a distraction from more relevant issues. For more insight, please see Geopolitical Strategy Monthly Report "King Dollar: The Agent Of Righteous Retribution", dated October, 2016, available at gps.bcaresearch.com 2 At the time, the protector portfolio performed slightly less well, as 30-year government bonds were used instead of TIPS. 3 Please see Geopolitical Strategy Special Report "U.S. Election: Final Forecast & Implications", dated October 12, 2016, available at gps.bcaresearch.com Market Calls

Special Report

Hillary Clinton has a 65% chance of winning the election; she receives 334 electoral college votes according to our model. Trump still requires an exogenous shock to win. Meanwhile, the USD is poised to rally - and leftward-moving policymakers will applaud its redistributive effects while MNCs suffer the consequences.

Hillary Clinton has a 65% chance of winning the election; she receives 334 electoral college votes according to our model. Trump still requires an exogenous shock to win. Meanwhile, the USD is poised to rally - and leftward-moving policymakers will applaud its redistributive effects while MNCs suffer the consequences.

Our Treasury yield fair value model suggests that the 10-year Treasury yield has an additional +19bps of upside. Stay at below benchmark duration.

As the U.S. median voter is shifting to the left, redistributive policy could come into play. A strong dollar helps to achieve this goal as it results in a bigger share of labor income in the economy. EM and commodity currencies could bear the brunt of the pain. Favor the euro on its crosses. Stay short CAD/NOK, but tighten stops.

Special Report

This week's <i>Special Report</i> looks at the three controversial predictions that I made at this year's <i>BCA New York Investment Conference</i>.

This month's <i>Special Report<i/> looks at the Fed's policy options in the event that there is a negative economic shock while the policy rate is still very depressed. The Fed's "Plan A" is more QE and forward guidance, which are not up to the task. There is no "Plan B", which means that risk assets will be hit hard during the next downturn.

The monetary policy sweet spot won't end for equities until interest rates climb above the equilibrium rate - that won't happen even with a rate hike in December. But even though equity markets will continue to cheer a go-slow Fed in the short run, the sustainability of these gains will be dubious until a healthier environment for earnings takes hold.