Global

Highlights Recommendation Allocation Quarterly - October 2017 Quarterly - October 2017 The global growth outlook remains strong, with corporate earnings likely to beat expectations for a couple more quarters. Inflation and Fed policy are key to asset allocation. We expect inflation to recover, which will push up interest rates and the dollar. But uncertainty is rising too: for example the composition of the FOMC next year, Chinese policy post the Party Congress, Geopolitics. We keep our pro-risk tilts, particularly overweights in euro area and Japanese equities, U.S. high-yield bonds, private equity, and cyclical sectors. But we reduce portfolio risk by bringing some allocations closer to benchmark, for example downgrading U.S. equities to neutral and reducing the underweight in EM. Feature Overview Growth Is Picking Up - But So Is Uncertainty The outlook for global economic growth remains almost unarguably positive (Chart 1). The key for asset allocation, then, comes down to whether inflation in the U.S. will rebound, and whether therefore the Fed will continue to tighten monetary policy in line with its current projections. This would likely cause long-term interest rates to rise and the dollar to appreciate, which would be positive for developed market equities and credit, but negative for government bonds, emerging market equities and commodities. This scenario has been our expectation - and the basis of our recommendations - for some time, and it remains so. In September, the market started coming around to our view - after months of pricing in that inflation would stay sluggish (which, therefore, had caused the euro and yen, government bonds, EM equities and commodities to perform well). In just a couple of weeks, the futures-market-priced probability of a December Fed hike has moved from 31% to 75%. This was triggered by little more than stabilization of core CPI (Chart 2), due mainly to shelter inflation, which anyway has a low weight in the core PCE inflation data that the Fed most closely watches. To us, this demonstrates just how sensitive the market is to any slight pickup in inflation, due to the fact that its expectations of Fed rate hikes over the next 12 months are so far below what the FOMC is signaling (Chart 3). Chart 1Lead Indicators Looking Good Lead Indicators Looking Good Lead Indicators Looking Good Chart 2Is The Softness In Inflation Over? Is The Softness In Inflation Over? Is The Softness In Inflation Over? Chart 3The Market Still Doesn't Believe The Fed The Market Still Doesn't Believe The Fed The Market Still Doesn't Believe The Fed However, a risk to BCA's view is that the Fed turns dovish. Even Janet Yellen, in the press conference after the FOMC meeting on 20 September, admitted that the Fed needs "to figure out whether the factors that have lowered inflation are likely to prove persistent". If they do, she said, "it would require an alteration of monetary policy." FOMC member (and notable dove) Lael Brainard, in an important speech earlier in September, laid out the argument that, since inflation has missed the Fed's 2% target for five years, inflation expectations have been damaged (Chart 4) and that only a period during which inflation overshot could repair them. With Yellen's term due to expire next February and four other vacancies on the FOMC, personnel changes could significantly change the Fed's direction. Online prediction sites give a somewhat high probability to President Trump's replacing Yellen, with (the rather more hawkish) Kevin Warsh, a Fed governor in 2006-11 (Chart 5). However, presidents tend to like loose monetary policy - President Trump has said as much himself - which raises the possibility of his trying to steer the Fed in a direction that is more tolerant of rising inflation. A possible scenario, then, is of an accommodative Fed which allows equities markets to have a final meltup for this cycle, similar to 1999. Chart 4Have Inflation Expectations Been Damaged? Have Inflation Expectations Been Damaged? Have Inflation Expectations Been Damaged? Chart 5Who Will Trump Choose To Lead The Fed? Quarterly - October 2017 Quarterly - October 2017 Another current source of uncertainty is China. Money supply growth there has slowed sharply this year, after being pushed upwards by the government's reflationary policies in late 2015. This historically has been a good lead indicator of growth and, indeed, many cyclical indicators have surprised to the downside recently (Chart 6). It is also hard to predict whether, after October's five-yearly Communist Party congress, newly re-elected President Xi Jinping will move ahead with implementing structural reforms, even at the expense of a short-term slowdown of growth.1 We continue to think that risk assets have further upside for this cycle. Growth is likely to remain strong, the probability of a U.S. tax cut is rising, and corporate earnings should surprise to the upside for another couple of quarters (Q3 S&P500 EPS consensus forecasts remain cautious at 5% YoY, versus our model which suggests double-digit growth). Nonetheless, the cycle is now mature, global equities have already produced a total return of almost 40% since their recent bottom in February last year, and valuations in almost every asset class are stretched (Chart 7). Moreover, geopolitical risks - such as that from North Korean missiles - will not disappear quickly. We continue to pencil in the possibility of a recession in 2019 or 2020, caused by a sharp rise in inflation, especially in the U.S., which the Fed - whoever is running it - would have to stamp on by raising rates above the equilibrium level. Chart 6Is A Downturn Coming In China? bca.gaa_qpo_2017_10_02_c6 bca.gaa_qpo_2017_10_02_c6 Chart 7Nothing Looks Cheap Nothing Looks Cheap Nothing Looks Cheap Therefore, on the 12-month horizon we continue to recommend pro-risk and pro-cyclical positioning, for example an overweight in equities versus fixed income. However, given the rising uncertainty, we are reducing the scale of our bets a little and so, for example among our equity country and regional recommendations, move a little closer to benchmark by lowering the U.S. to neutral and reducing the degree of our underweight in EM. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com What Our Clients Are Asking How worried should we be about North Korea? Chart 8Threats - But Eventually A Diplomatic Solution Threats - But Eventually A Diplomatic Solution Threats - But Eventually A Diplomatic Solution President Obama reportedly warned President Trump just prior to inauguration that North Korea would be his biggest headache. After 15 missile launches and a nuclear test this year (Chart 8, panel 1), investors are beginning to think the same. How big is the risk that the tension turns into warfare? BCA's Geopolitical strategists have written about the subject extensively.2 They conclude that military action is unlikely. An U.S. attack on North Korean missile or nuclear sites would simply provoke an attack with conventional weapons on Seoul, which is only 50 km from the border. Kim Jong-un undoubtedly knows that if he were to attack Guam or Japan, his country would be wiped out. In the end, then, a diplomatic solution is likely - but this will only be achieved after tension has risen sufficiently to force the two sides to the negotiating table. The analogy is Iran in 2012-15, where sanctions finally forced it to agree to a 10-year freeze in its nuclear plans. For the moment, sanctions seem unlikely to bite. North Korea's trade with China is not yet notably slowing (Chart 8, panel 2) and its GDP growth actually accelerated last year, albeit from stagnating levels, according to estimates from the Bank of Korea (Chart 8, panel 3). So the cycle of new threats and tougher sanctions will continue for a while. Historically, North Korean provocations caused related markets (such as South Korea stocks) to fall sharply for a few days, but this always represented a buying opportunity (Chart 8, panel 4). Given the likelihood of a diplomatic outcome, we think this remains a good rule of thumb. What will happen after China's 19th Party Congress, and will there be a slowdown in the economy? China's twice-a-decade National Party Congress will be held October 18-25. The outcome of the meeting could have important economic and market consequences. The key purpose of the Congress is to rotate China's political leaders. The 19th Party Congress is crucial because it marks the passing of a generation: President Xi Jinping will receive a second five-year term, but is predicted to consolidate his power by placing a younger generation of leaders who support his structural reforms into key positions. When Xi came to power, his reform agenda included de-emphasizing GDP targets; injecting private capital, competition and market discipline into the state-owned corporate sector; and fighting pollution. This agenda has since been compromised, with Xi reverting to infrastructure spending and credit growth to avoid painful adjustments. However, recently, there have been signs of a pullback in reflationary policies (Chart 9). Financial tightening is a key to reviving reform. Tighter controls on banks and leverage will translate into greater market discipline, and will put pressure on the sector most in need of change: SOEs. During the twice-a-decade National Financial Work Conference In late July, Yang Weimin, a key economic policymaker who is close to Xi, said, "The nation can't let leverage rise for the purpose of boosting economic expansion," signaling that the administration is willing to tackle difficult reform issues. He also mentioned the potential risks in the economy such as shadow banking, property bubbles, high leverage in SOEs, and local government debt, adding that the nation should set out its priorities and tackle them. Though it is impossible to predict the precise outcome of the Congress, the leadership reshuffle is likely to benefit Xi's reform agenda. The new leadership is likely to work on rebalancing growth toward consumption and services while encouraging private entrepreneurship and cutting back state-owned enterprises and, most importantly, deleveraging corporate debt. If China's credit impulse rolls over, the recent improvement in industrial profits and domestic demand will come under threat (Chart 9). As a result, China's cyclical growth is set to slow in 2018 as Xi reboots reform. Although economic risks will rise as the reform takes place, we still believe China H shares are attractive relative to other EM markets. In the long run, Xi's renewed reform drive should help China to get out of the "middle income trap'', which could help Chinese stocks to outperform EMs such as South Africa, Turkey and Brazil, where reforms are absent.3 Are Indian equities still a buy? In the three years since Prime Minister Narendra Modi's election, Indian stock prices have outperformed their emerging market peers by more than 20%. But the underlying growth dynamics do not justify this performance. We are turning cautious on India and downgrade Indian equities to neutral for the following reasons. India's GDP growth rate fell to a three-year low of 5.7% yoy in the April-June quarter. The administration's "Make In India" campaign is having limited impact, as seen in the near-zero growth of the manufacturing sector. Capital spending by firms has been dismal, further weighing on the outlook for productivity. Increasing layoffs and business shutdowns have produced considerable slack in the economy. Non-performing loans in the banking system have reached 11.8% of assets. As a result, credit growth to business has fallen almost to zero. This has slowed infrastructure development, as seen in the high level of stalled capital projects. The Reserve Bank of India has only just started the process of pushing banks to raise provisioning for distressed assets. The negative impact of last year's demonetization program is finally showing through. Less than 10% of Indians have ever used non-cash payment methods, and so demand for cyclical goods is slowing. Finally, Indian stocks have risen significantly in recent years, making them expensive relative to EM peers. In addition, profit growth has slowed, and return on equity converged with the EM average. Indian equities have been riding on expectations of reforms from the Modi administration. But, with the exception of the Goods & Services Tax (GST), the reform progress has been disappointing. We are turning cautious on Indian equities until we see improvements in the macro backdrop (Chart 10). Chart 9Sign of slowdown in Chinese Economy Sign of slowdown in Chinese Economy Sign of slowdown in Chinese Economy Chart 10India: Loosing Steam? India: Loosing Steam? India: Loosing Steam? How should global equity investors hedge foreign currency exposures? Chart 11Dynamic Hedging Outperforms Static Hedging Quarterly - October 2017 Quarterly - October 2017 There have been many conflicting views on how to hedge foreign currency exposures in a global equity portfolio. Full hedge,4 no hedge,5 or simply 50% hedge?6 Or should all investors hold the reserve currencies (USD, euro and Swiss Franc), avoid commodities currencies (AUD and CAD) while being neutral on GBP and JPY?7 As published in a Special Report 8 on September 29, 2017, our research has found that not only should investors with different home currencies manage their foreign currency exposures differently, but also a dynamic hedging framework based on the indicators from BCA's Foreign Exchange Strategy service's Intermediate Timing Model (ITTM)9 outperforms all the static hedging strategies for all investors with six different home currencies (USD, EUR, JPY, GBP, AUD and CAD) (Chart 11). A few key observations from Chart 11 Static hedges reduces risk with little impact on returns for the USD and JPY investors only. Unlike the CAD investors, the AUD investors are much better off to hedge than not to, on a risk adjusted basis, even though AUD is also a commodity currencies, like the CAD. The 50% "least regret" hedge ratio has lived up to its reputation as it reduced risk by more than 50% without severely jeopardizing returns. And for the USD based investors, the 50% static hedge has a similar risk/return profile as the dynamic hedge. For all other five home currencies, however, the 50% static hedge underperforms the dynamic hedge. Global Economy Overview: Globally growth has accelerated, with inflation quiescent. We expect growth to continue to be strong, but U.S. inflation will start to normalize, which should trigger further Fed hikes and a rise in long-term rates. Japanese and euro zone growth will be less inflationary, given continued slack in these economies. U.S.: Growth has rebounded sharply after the seasonally weak Q1 and excessive expectations following the presidential election. The Citi Economic Surprise Index (Chart 12, panel 1) shows strong upward surprises. First-half GDP growth came in at 2.2% (above trend, which is estimated at 1.8%), and the manufacturing ISM reached 57.7 in September. The two big hurricanes will probably knock around 0.5 points off Q3 growth but the lesson from previous disasters is that this will be more than made up over the following three quarters. Rebounding capex, and consumption aided by a probable acceleration in wages, should keep GDP growth strong. Euro Area: Due to Europe's greater cyclicality and dependence on the global cycle, growth momentum is unsurprisingly even stronger than in the U.S., with Q2 GDP growth 2.3% YoY and the manufacturing PMI at 57.4. German growth has been particularly robust with the IFO index at 115.9, close to an all-time high, and German manufacturing wages growing by 2.9% YoY. The credit impulse suggests that the strong growth should continue, although the euro appreciation this year (and consequent tightening of financial conditions) might dampen it a little. Japan: Growth continues to be good in the external sector (with exports rising 18% YOY and industrial production 5%), but weak in the domestic economy, where household spending and core inflation continue to flatline. We do, though, see some first tentative signs of inflation: the Bank of Japan's estimate suggests the output gap has now closed, and the tight labor market is showing through in part-time hourly wages, which are rising 2.9%. Emerging Markets: China's PMI has oscillated around 50 all year (Chart 13, panel 3), as the authorities tried to stabilize growth ahead of October's Party Congress. But money supply and credit growth have been slowing all year, and this is now showing through in downside surprises in fixed asset investment and retail sales data. Especially if the congress moves towards structural reform and short-term pain, growth may slow further. This would be negative for other emerging markets, which depend on China for growth. Bank loan growth and domestic consumption generally remain weak throughout EM ex China. Chart 12Global Growth Is Accelerating... Global Growth Is Accelerating... Global Growth Is Accelerating... Chart 13...Propelling Europe And Japan ...Propelling Europe And Japan ...Propelling Europe And Japan Interest Rates: Inflation has been soft this year in the U.S. but is likely to pick up in coming months reflecting stronger economic growth and dollar depreciation. We expect the Fed to raise rates in December and confirm its three hikes next year. That should be enough to push the 10-year Treasury yield up to close to 3%. In Japan and the euro area, however, underlying inflationary pressures are much weaker. So we expect the Bank of Japan to stick to its yield curve control policy, and for the ECB to emphasize, when it announces in October next year's (reduced) asset purchase program, that it will be cautious about raising rates. Global Equities Chart 14Earnings Have Been Strong... Earnings Have Been Strong... Earnings Have Been Strong... Q3 2017 was the second quarter in a row when the price appreciation in global equities was driven entirely by earnings growth, since the forward price-to-earnings ratio contracted by 2% compared to Q2 (Chart 14). Chart 15No Compelling Reasons To Make Large Bets No Compelling Reasons To Make Large Bets No Compelling Reasons To Make Large Bets The scope of the improvement in earnings so far in 2017 has been wide. Not only are forward earnings being revised up, but 12-month trailing earnings growth has also been very strong, with all 10 top-level sectors registering positive earnings growth. Margins have steadily improved globally from the lows in early 2016. Despite the slight multiple compression in Q3, equity valuations are not cheap by historical standards. As an asset class, however, equities are still attractively valued compared to bonds, especially after the recent safe-haven buying drove global bond yields to very depressed levels. We remain overweight equities versus bonds on the 9-12 month horizon. Within equities, however, we think it's prudent to reduce portfolio risk by bringing allocations closer to benchmark weighting because 1) equities are not cheap, 2) volatility is low, 3) geopolitical tension is rising, and 4) year-on-year earnings growth over coming quarters may not be as strong as it has been so far this year because earnings in the first half of the 2016 were very depressed. As such, we downgrade the U.S. to neutral from overweight (+3 percentage points), and reduce the underweight in EM (to -2 from -5). We remain overweight the euro area and Japan (but hedge the yen exposure). Within EM, we have been more positive on China and remain so on a 6-9 month horizon. Sector-wise, we maintain our pro-cyclical tilt. Country Allocations: Downgrade U.S. To Neutral We started the year being "cautiously optimistic" with a maximum overweight (+6 ppts) in U.S. equities.10 We added risk at the end of the first quarter by reducing by half the U.S. overweight in order to upgrade the higher-beta euro area to overweight (+3) from neutral.11 The change has worked well, as the euro area outperformed the U.S. by 542 basis points (bps) in Q2 and then by 370 bps in Q3 in unhedged USD terms. Our DM-only quant model also started the year with a maximum overweight in the U.S., but the overweight was gradually reduced each month until July when the model indicated a benchmark weight for the U.S. The model continued its shift away from the U.S. in August and September, and now the U.S. is the largest underweight in the model. As we have previously stated, we use the quant model as one key input into our decision-making process, but we do not follow it slavishly because 1) no model can capture all the ever-changing driving forces in the market, and 2) the model moves more often than we prefer. In light of the rising geopolitical risks and low levels of volatility in all asset classes, we conclude that there are no longer compelling reasons to make large bets among the countries (Chart 15). Valuation in the U.S. is stretched, but neither is it cheap in EM anymore; both trailing and forward earnings growth in the U.S. are below the global average. Forward earnings in the EM look likely to outpace the global average, but EM trailing earnings growth seems to be losing steam. As such, we recommend investors to be neutral in the U.S. and use the funds to reduce the underweight in EM. Sector Allocation: Stay Underweight Global Utilities Overall, our sector positioning retains its tilt towards cyclicals and against defensives (see Table 1). Our global sector quant model, however, in September reduced its underweight in defensives by upgrading utilities to overweight from underweight, mainly due to the momentum factor. We have decided to overwrite the model result and maintain our underweight recommendation for the following reasons. In October, the model again downgraded utilities to underweight. In the most recent cycle post the Global Financial Crisis (GFC), the relative performance of utilities has been closely correlated with the performance of bonds vs. equities (Chart 16, top panel). This is not surprising given the bond-like nature of the sector. The sector enjoys a higher dividend yield than the global average: other than during the GFC, the excess yield has been in the range of 1-2%. In a low bond-yield environment, this yield pick-up is no doubt attractive. However, our house view is for global bond yields to rise over the next 9-12 months and we maintain our overweight on equities vs. bonds. As such, underweight utilities is in line with our overall risk/return assessment. In addition, even though the utilities sector has a higher dividend yield, the current reading is not particularly attractive compared to the five-year average (panel 4); valuation measures such as price to book (panel 3) show a neutral reading as well. The other sector where we override our quant model is Healthcare, which we favor as a long-term play because of favorable demographic trends, while the quant model points to an underweight due to short-term factors such as momentum and valuation. Smart Beta Update Year-to-date, the equal-weighted multi-factor portfolio has outperformed the global benchmark by 54 basis point (bps). (Table 1 and Chart 17) Among the five most enduring factors - size, value, quality, minimum volatility, and momentum - momentum is the only factor that has prevailed in both DM and EM universes, while quality has outperformed in the DM, but underperformed in EM. (Table 1) Chart 16Maintain Underweight Utilities Maintain Underweight Utilities Maintain Underweight Utilities Chart 17MSCI ACW: Factor Relative Performance MSCI ACW: Factor Relative Performance MSCI ACW: Factor Relative Performance Value has underperformed growth across the board (Table 1). The size performance, however, has large regional divergences in both value and growth spaces. Small cap has outperformed large cap consistently in both the value and growth spaces in the higher-beta euro area, Japan and U.K., while underperforming in the lower-beta U.S. (Table 2) We maintain our neutral view on styles and prefer to use sector positioning to implement the underlying factors given the historically close correlation between styles and cyclicals versus defensives (Chart 17, bottom two panels). Year-to-date cyclicals have outperformed defensives (Table 1). Table 1YTD Relative Performance* Quarterly - October 2017 Quarterly - October 2017 Table 2YTD Total Returns* (%) Small Cap - Large Cap Quarterly - October 2017 Quarterly - October 2017 Government Bonds Maintain Slight Underweight Duration. U.S. bond yields declined significantly in Q3 to below fair-value levels in response to heightened geopolitical risks and hurricanes (Chart 18, top panel). This safe-haven buying spread globally, despite ample evidence of faster global growth (middle panel) and less accommodative monetary policies from the major central banks. There is now considerable upside risk for global bond yields from these current low levels. Maintain Overweight TIPS Vs. Treasuries. The fall in nominal U.S. Treasury yields, however, was concentrated in the real yields, as 10-year break-even inflation widened in Q3 (Chart 18, panel 3). In terms of relative value, TIPS are now fairly valued vs. nominal bonds. However, our U.S. Bond Strategy's core PCE model, which closely tracks the 10-year TIPS breakeven rate (Chart 18, panel 3), is sending the message that inflationary pressures are building in the economy and that core PCE should reach the Fed's 2% target by the end of this year. This suggests that the bond markets are not providing adequate compensation for the inflationary economic backdrop. Underweight Canadian Government Bonds. The Bank of Canada (BOC) delivered another surprise 25 bps rate hike in September, due to "the impressive strength of the Canadian economy" and "the more synchronized global expansion that was supporting higher industrial commodity prices." BCA's Global Fixed Income Strategy has been underweight Canada in its hedged global portfolio and recommends investors not to fight the BOC despite little inflation pressure in the Canadian economy (Chart 19). Chart 18Poor Value in Nominal Government Bonds Poor Value in Nominal Government Bonds Poor Value in Nominal Government Bonds Chart 19Bank of Canada: Shock Hawks Bank of Canada: Shock Hawks Bank of Canada: Shock Hawks Corporate Bonds As inflation recovers and the Fed moves ahead with rate hikes, we expect long-term risk-free rates to rise moderately. Fair value for the 10-year U.S. Treasury yield is currently close to 2.7%. In the context of rising rates and continued economic expansion, we continue to prefer spread product over government bonds. Investment grade bonds in the U.S. trade at an average option-adjusted spread over Treasuries of 110 bps. While Aaa corporate spreads are expensive, other investment grade credit tiers appear fairly valued. Given the deterioration in our U.S. Corporate Health Monitor (Chart 20), amid a rise in leverage, over the past two years (Chart 21) we do not expect the spread to contract further or fall back close to historic lows. However, investors should still be moderately attracted by the carry in a low interest rate environment. Our preference is for U.S. investment-grade corporate bonds over European ones, since the latter could be negatively impacted when the ECB announces its tapering of asset purchases in October. High-yield bonds look attractive after a small rise in spreads and an improvement in the cyclical outlook over the past quarter. The current spread of U.S. high-yield, 360 bps, translates into a default-adjusted yield (assuming a 2.6% default rate and 49% recovery rate over the next 12 months) of 250 bps - close to the long-run average (Chart 22). European junk debt looks less attractive from a valuation perspective. Chart 20Corporate Health Is A Worry In The U.S. Corporate Health Is A Worry In The U.S. Corporate Health Is A Worry In The U.S. Chart 21IG Spreads Unlikely To Contract Further IG Spreads Unlikely To Contract Further IG Spreads Unlikely To Contract Further Chart 22High-Yield Debt Valuations Look Attractive High-Yield Debt Valuations Look Attractive High-Yield Debt Valuations Look Attractive Commodities Chart 23Mixed View Towards Commodities Mixed View Towards Commodities Mixed View Towards Commodities Secular perspective: Bearish We hold a bearish secular outlook for commodities, mainly due to our view on China's slowing economic growth and the increasing shift from traditional energy sources to alternatives. Cyclical perspective: Neutral Our short-term commodities view remains neutral since oil inventory drawdowns will push up the crude oil price further, and because low real interest rates will keep gold from falling this year. But industrial metals are likely to react negatively to the winding down of China's reflation after the Party Congress in mid-October. Precious metal: Short-term bullish, long-term bearish. We expect the Fed to tighten rates only slowly which, over time, will mean the central bank finds itself behind the curve on inflation. Real rates are expected to remain relatively low for the foreseeable future, which will be supportive of gold. Rising tension between North Korea and the U.S. could also give gold a lift. Industrial metals: Bearish The copper price has rallied by 10% during Q3 2017, thanks to supply-side disruptions at some of the world's largest copper mines, along with better-than-expected performance of the Chinese economy. However, mine interruptions will be transitory, and the world copper market is already back in balance (Chart 23, panel 3). Although the rebound in the Chinese PMI is keeping metal prices up, we believe China after the Party Congress will try to reengineer its economy towards being more consumption and services-led, which will temper demand for industrial metals. Energy: Bullish We believe that market has been overly pessimistic on oil, and that this will change due to declining inventories and better demand and supply dynamics. (Chart 23) The U.S. Energy Information Administration revised down its shale production forecast for 2H 2017 by 200,000 barrels/day, which should lower investors' concerns over shale overproduction. Libyan oil production, the biggest threat to our bullish oil view, faltered by 300,000/day in August, keeping OPEC in compliance with its promised cuts. Currencies U.S. Dollar: Year to date, the dollar is down by 8% on a trade-weighted basis (Chart 24). However, after a period of underperformance, the U.S. economy is improving relative to its G10 peers, as seen by the strong rebound in the U.S. ISM manufacturing index. Additionally, the pick-up in money velocity points to a recovery in core inflation. As inflation starts to pick up again, markets will discount additional Fed rate hikes. Stay bullish U.S. dollar over the next 12 months. Chart 24U.S. Dollar Recovery? U.S. Dollar Recovery? U.S. Dollar Recovery? Pound: After a weak start to the year, sterling has recovered all its losses. Strong net FDI inflows have pushed the basic balance back into positive territory. However, Brexit negotiations will impact the financial sector, the largest target for FDI. Additionally, the recent sharp increase in inflation came from the pass-through effect of the weaker currency, and is not reflective of domestic economic activity. We expect increased political uncertainty to weigh down on future growth, forcing the Bank of England to maintain a dovish stance. Stay bearish over the next 12 months. Dollar: On a trade-weighted basis the currency is up 4% year to date, primarily driven by the rally in select metal prices. OECD's measure of output gap still points to substantial slack in the domestic economy, as seen in the downtrend in core inflation and nominal retail sales. However, despite improvements in global trade and domestic real estate activity, the Reserve Bank of Australia will keep policy easy in response to volatile commodity markets. Stay bearish over the next 12 months. Canadian Dollar: Driven by net portfolio inflows near record highs, the currency is up 6% on a trade-weighted basis so far this year. With improving economic activity, as seen in strong retail sales, the Bank of Canada expects the output gap to close in 2018. However, going forward, oil prices are unlikely to double again, and the combination of elevated indebtedness, bubby house prices and rising rates will create headwinds for the household sector. Stay bearish over the next 12 months. Alternatives Chart 25Favor PE, Real Assets Favor PE, Real Assets Favor PE, Real Assets Return Enhancers: Favor private equity vs. hedge funds In 2017 so far, private equity has returned 9%, whereas hedge funds have managed only a 3.5% return (Chart 25). Given their strong performance, private equity firms are raising near-record amounts of capital from investors starved for yield. By contrast, hedge funds continue to underperform both global equities and private equity, as is typical outside of recessions or bear markets. However, increasing concerns about valuations in private markets have pushed private equity dry powder to new highs of $963 billion. We continue to favor private equity over hedge funds, albeit with a more cautious outlook. Within the hedge fund space, we favor event-driven funds over the cycle, and macro funds heading into a recession. Inflation Hedges: Favor direct real estate vs. commodity futures In 2017 to date, direct real estate has returned 3.3%, whereas commodity futures are down over 10%. With energy markets likely to continue to recover lost ground over the coming months, we stress the structural nature of our negative recommendation on commodities. Depressed interest rates will keep financing cheap, making the spread between real estate and fixed income yields attractive. However, the slowdown in commercial real estate has made us more cautious on the overall real estate space. With regards to the commodity complex, the long term transition of China to a service-based economy will continue the structural decline in commodity demand. Continue to favor direct real estate vs. commodity futures. Volatility Dampeners: Favor farmland & timberland vs. structured products In 2017 to date, farmland and timberland have returned 2.2% and 1.5% respectively, whereas structured products have returned 1.4%. Farmland continues to outperform timberland given the latter's lower correlation with growth. Timberland returns have also lagged farmland given the weak recovery in the U.S. housing market. Investors can reduce the volatility of a multi-asset portfolio with the inclusion of farmland and timberland. With regards to structured products, rising rates and deteriorating credit quality in the auto loan market will weigh on returns. Given the Fed's plans to start unwinding its balance sheet this year, increased supply will put upward pressure on spreads. Risks To Our View Our pro-risk positioning would be incorrect if global growth were to slow sharply. But we see little sign that this is a significant risk over the next six to 12 months. Of our three favorite indicators of recession risk, global PMIs remain strong, and the U.S. 10-minus-2 year yield curve is still solidly positive at around 80 BP. Only a small blip up in junk bond spreads in August (Chart 26) is of any concern, and it was probably caused just by geopolitical tensions. With U.S. and European consumption and capex looking strong, probably the biggest risk to global growth would come from China, similar to 2015, if October's Party Congress signals a shift to short-term pain to achieve structural reforms. Perhaps more likely is an upside surprise to growth, with BCA's models - based on consumer and business sentiment - pointing to around 3% real GDP growth in the U.S. and 2½% in the euro area over the coming couple of quarters (Chart 27). Such an acceleration of growth would raise the risk of upside surprises to inflation, which could cause a bigger sell off in bond markets than we currently anticipate. Chart 26Any Need To Worry About Credit Spreads? Any Need To Worry About Credit Spreads? Any Need To Worry About Credit Spreads? Chart 27Could Growth Surprise On The Upside? Could Growth Surprise On The Upside? Could Growth Surprise On The Upside? Chart 28Suppose Inflation Stays Stubbornly Low Suppose Inflation Stays Stubbornly Low Suppose Inflation Stays Stubbornly Low Our positioning is not based on inflation remaining chronically low. But structural changes in the economy could cause this. While the Philips curve has not broken down completely, wage growth in the U.S. is 1-1½% lower than in previous expansions when the unemployment gap was at its current level (Chart 28). Could the Nairu be lower than the Fed's estimate of 4.6%? Has the gig economy somehow changed worker and employer behavior? 1 Please see What Our Clients Are Asking: "What Will Happen After China's 19th Party Congress, And Will There Be A Slowdown In The Economy?" of this report. 2 For their most comprehensive analysis, please see Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 3 Please see Geopolitical Strategy Special Report "China: Looking Beyond The Party Congress'' dated July 19, 2017. available at gps.bcaresearch.com). 4 Perold, A and E. Schulman, 1988, "The free lunch in currency hedging: Implications for investment policy and performance standards," Financial Analyst Journal 44, 45-50. 5 Froot K., 1993, "Currency hedging over long horizons," NBER working paper 4355. 6 Michenaud, S., and B., Solnik, 2008, "Applying Regret Theory to Investment Choices: Currency Hedging Decisions," Journal of International Money and Finance 27, 677-694. 7 Campbell, J., K. de Medeiros and L. Viceira, 2010, "Global Currency Hedging," Journal of Finance LXV, 87-122. 8 Please see Global Asset Allocation Special Report, "Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors," dated September 29, 2017, available at gaa.bcaresearch.com. 9 Please see Foreign Exchange Strategy "In Search of A Timing Model," dated July 22, 2016, available at fes.bcaresearch.com. 10 Please see Global Asset Allocation, "Quarterly - December 2016," dated December 15, 2016. 11 Please see Global Asset Allocation, "Quarterly - April 2017," dated April 3, 2017. GAA Asset Allocation

Highlights In this report, we analyze both static and dynamic hedging strategies to hedge an identical global equity portfolio to six home currencies: the U.S. dollar, the British pound, the euro, the Japanese yen, the Canadian dollar and the Australian dollar. We propose an easy to implement dynamic hedging framework based on the proprietary currency indicators from BCA's Foreign Exchange Strategy (FES) service. It has outperformed all the static hedging strategies since 2001 on a risk-adjusted return basis. In addition, it levels out the playing field for all investors as the hedged returns are quite similar, no matter what their home currencies are. Among the static hedging strategies, the "least-regret" hedge ratio of 50% has lived up to its reputation, as it has reduced risk by more than 50% without severely jeopardizing returns. Over a four-year moving performance cycle (in line with how most portfolio managers are evaluated), the proposed dynamic hedging adds little career risk to portfolio managers compared to the "least regret" 50% static hedging, while provides superior returns most of the time. A global equity portfolio's currency exposure should be managed in a centralized currency overlay under the supervision of the Chief Investment Officer, so that equity and currency managers can both fully utilize their expertise in their respective field, and the organization can manage currency risk more efficiently at the total portfolio level. Feature Dynamic Hedging Outperforms Static Hedging We have received many client requests asking about currency hedging in global equity portfolios with different home currencies. This is not surprising given how currency movements have overwhelmed global equity portfolio returns of late. For example, this year the U.S. dollar's weakness against the major currencies has beefed up returns for U.S. investors who did not hedge their foreign exposure (Table I-1). Table I-1Year-To-Date Currency Movements Have Overwhelmed Equity Returns Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors GAA's equity country allocation recommendations are by default unhedged on USD basis. When a hedge is required we make the recommendation explicit. There have been many conflicting views on whether global equity investors should hedge foreign currency exposure, and if so, what proportion of the exposure should be hedged. Perold and Schulman (1988) suggest fully hedging foreign currency exposure, because significant risk reduction can be achieved without a significant loss of return.1 This is based on their famous "free lunch" claim that average currency returns are zero over the long-term. At the other extreme, Froot (1993) suggests that foreign currencies should not be hedged at all for long-term investors, because purchasing power parity holds in the long term and exchange rates are mean reverting.2 There are many other views in between, including the universal hedge ratio proposed by Black (1989), which is estimated to be 77%.3 Campbell et al (2010) classify currencies into reserve currencies (USD, EUR and CHF), commodity currencies (AUD and CAD) and neutral currencies (JPY and GBP), and suggest that risk-minimizing investors should hold reserve currencies while hedging out commodity currencies, based on the correlations between the currencies and equity markets.4 Realizing the limitations of "static hedging," which assumes constant correlation, mean and variance, many academic researchers have explored "dynamic hedging models" that allow the mean and covariance to be time-varying by using complex econometric modelling techniques.5,6,7 These academic dynamic hedging strategies have shown improvement over the 50% static hedge, but it's very difficult for investors without a strong quantitative background to understand these very complex approaches. In fact, with all these confusing academic recommendations floating around, the "least regret" hedge ratio of 50% has been quite popular among practitioners.8 To help our clients better understand the role of currency management in global equity portfolios, we have joined forces with BCA's Foreign Exchange Strategy (FES) service to de-mystify the currency hedging process, and to propose a simple framework for clients with six different home currencies to dynamically hedge their foreign currency exposure based on the FES team's proprietary Intermediate-Term Timing Model (ITTM) indicators.9 These indicators have been used in their regular weekly publications. The ITTM-based dynamic hedging strategy is back-tested from 2001 because the ITTM indicators only date back to 2001 (See methodology). We have also back-tested a simple trend-following momentum-based dynamic strategy to see how a dynamic hedging methodology works in a longer period from 1976. For comparison we have back-tested ten different static hedging strategies that employ fixed hedge ratios across currencies and time. The test results not only clarify much of the confusion about static hedging, they also demonstrate that on a risk-adjusted return basis, BCA's ITTM-based dynamic hedging strategy has outperformed all static hedging strategies for all investors with six different home currencies since 2001 (Chart I-1). Even in the very long run of 41 years from August 1976, the simple momentum-based dynamic hedging outperforms the static strategies for investors with five home currencies, with only the AUD portfolio being worse off (Chart I-2). Chart I-1Identical Investment, But Different Risk/Return Profiles (3/2001-8/2017) Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Chart I-2Identical Investment, But Different Risk/Return Profiles (8/1976-8/2017) Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Now let's clarify some of the confusion: Does static hedging reduce portfolio risk at little expense of lowering returns? The answer is yes only for USD and JPY portfolios. For both the 41-year period from 1976 and the shorter 16-year period from 2001, a higher hedge ratio results in lower risk with slightly lower return. So fully hedged would be the "optimal" strategy for risk-minimizing investors with USD and JPY as home currencies (Panel 1 and 2 on left side in both Chart I-1 and Chart I-2). For the U.K. portfolio, the answer is a partial yes, because the "optimal hedge ratio" for risk-minizing investors, around 60%-80%, does produce the lowest risk, but the paths to that "optimal" point are totally opposite when different time periods are chosen. In the short period (Chart I-1, bottom left panel), it follows the same pattern as that for U.S. and Japanese investors up to the optimal point. As the hedge ratio increases, however, return drops and risk increases! In the longer period from 1976, as the hedge ratio increases, return increases and risk decreases until the "optimal point," after which risk and returns both increase (Chart I-2, bottom left panel). In the period from 2001, the AUD, CAD and EUR portfolios share a similar pattern to that of the GBP portfolio in the period from 1976. The AUD portfolio behaved the same in both the shorter period (Chart I-1, top right) and the longer period (Chart 2, top right), while the EUR and CAD portfolios behaved differently in the longer-term period from the shorter period. Overall, the CAD portfolio's "optimal" hedge ratio is around 0-30%, the AUD portfolio around 30-60% while the EUR portfolio is around 40% in the shorter period but around 90% in the longer period (Chart I-1 and Chart I-2). It is also worth noting that even though both the CAD and AUD are commodity currencies, AUD investors benefit significantly from hedging, while CAD investors' risk/return profile does not change much. This is because 1) currency returns for AUD investors do not average to zero in the long term due to positive carry, and 2) correlations between foreign currencies, foreign equities and domestic equities are not constant over time or across currencies (Appendix 2, Chart II-1 and Chart II-4) How does the "least regret" 50% static hedge do? The 50% hedge ratio fares quite well compared to the "optimal" static hedge ratio in terms of risk reduction for all portfolios in both periods, because more than half of the total risk reduction (the highest minus the lowest) occurs around the 50% hedge (Chart I-1 and Chart I-2). How does BCA's ITTM-based dynamic hedge do in terms of risk reduction? The ITTM produces better risk-adjusted returns for each portfolio than all the static hedges. In terms of risk, it generates the lowest risk for the EUR and GBP portfolios and is comparable to the 50% static hedge for other portfolios, while it generates a much higher return than all static hedges (Chart I-1 and Chart I-2). How does the BCA Dynamic Hedge (ITTM) compare to the 50% static hedge over time? Chart I-3 shows that the dynamic hedge consistently outperformed the 50% static hedge for all six home currencies since 2001 without significantly increasing hedging transactions, compared to the fixed 50% hedge ratio for all currency pairs. The dash line in each panel of Chart I-3 corresponds to the market cap-weighted aggregate of hedge ratios of foreign currencies for each home currency. On average, they are comparable to 50%. Most portfolio managers are measured on a moving four-year performance cycle. Chart I-4 shows that the ITTM-based dynamic hedging strategy has outperformed the 50% static hedging most of the time on a moving four-year basis, with only CAD, USD and JPY managers suffering brief drawdowns. Chart I-3BCA Dynamic Hedging Adds ##br##Value For All Investors BCA Dynamic Hedging Adds Value For All Investors BCA Dynamic Hedging Adds Value For All Investors Chart I-4Little Career Risk For ##br##Portfolio Managers Little Career Risk For Portfolio Managers Little Career Risk For Portfolio Managers In theory, if hedges were effective, then an identical global equity portfolio should have similar returns for all investors, no matter what home currency they hold. While neither the static hedging strategies nor the momentum-based dynamic hedging approach could pass this criteria, BCA's ITTM-based dynamic hedging approach does. It levels out the playing field for all investors globally. As shown in Chart I-5, in the period from March 2001 to August 2017, if left unhedged, the same global investment exhibits very different annualized returns for investors in different home currencies, with AUD investors at the low end at around 3.2%, and GBP investors at the high end at around 7%. With BCA's ITTM-based dynamic hedge, however, returns for all investors are very similar, no matter which currency is their home currency. Chart I-5BCA Dynamic Hedging Strategy Levels Out The Playing Field Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors The BCA Dynamic Hedging Methodology To back-test all the hedging strategies, we use an identical global equity portfolio that is a market cap-weighted aggregate of nine countries/regions based on MSCI U.S., Japan, the euro area, U.K., Canada, Australia, Switzerland, Sweden and Norway. This universe accounts for about 97% of the current MSCI World index (Chart I-6). The history of the euro area before 1987 (when MSCI data were available) is calculated as a market cap-weighted aggregate of MSCI Germany, France, Spain, Italy, Austria, Belgium and the Netherlands. Chart I-6GAA Global Equity Universe GAA Global Equity Universe GAA Global Equity Universe We evaluate the same global portfolio for investors with six different home currencies: USD, JPY, GBP, EUR, CAD and AUD. The Measurement for Hedging Efficacy: All the academically claimed "optimal" hedge ratios, static or dynamic, are based on risk-minimizing in a mean-variance optimization framework. For practitioners, however, "not meeting return objectives" is a much higher risk priority than minimizing portfolio risk. This is why we advocate risk-adjusted return as our measurement for hedge efficacy. The Objective: We aim to find the hedging strategies that outperform the widely used 50% static hedging strategy on a risk-adjusted return basis. At BCA, our philosophy has always been not to strive to find the optimal solution, but to try our best to find a feasible solution that best meets the stated objective. Interestingly, this approach has produced superior results for the GBP and EUR portfolios, achieving the combination of "highest return - lowest risk." It also levels out the playing field for all investors by generating similar hedged returns for all investors, no matter what home currency they hold (Chart I-1 and Chart I-5). The Proprietary Currency Indicators: The indicators from Foreign Exchange Strategy service's Intermediate Term Timing Model (ITTM) are built under the assumptions that the uncovered interest rate parity (UIP) holds, and the fair value of a currency pair is a function of the real rate differential (using an average of two-year and 10-year real rates), Junk OAS (a proxy for global risk appetite), commodity prices and past-year trends (52-week moving average). When a currency pair deviates from its fair value to an extreme, then the likelihood for a trend reversal is high.9 The Simple Rule-Based Dynamic Hedging: For each home currency, we evaluate the other eight foreign currencies individually based on each pair's ITTM indicator. When a foreign currency overshoots fair value above the upper band of its historical range, then the currency is a short, and the short position is kept until the foreign currency value touches the lower band of its historical range that's below the fair value. The Implementation: We use one-month forward contracts and re-balance on a monthly basis. The gain or loss of the underlying equity index during the month is not hedged, but converted back to the home currency at the month-end spot rate. For history before 2001, we use one-month interest rates to calculate hedged returns (Please see Appendix 1 hedged return calculations using forwards and also interest rates). Example: Chart I-7 illustrates how a Canadian investor uses the ITTM indicator to decide when to hedge JPY exposure when they invest in the MSCI Japan equity index. Chart I-7Canadian Investor: Japanese Index Dynamically Hedged Canadian Investor: Japanese Index Dynamically Hedged Canadian Investor: Japanese Index Dynamically Hedged The top panel shows the hedging signal for JPY (solid line) versus our proprietary ITTM indicator for JPY/CAD exchange rate (dash line). The upper and lower band are set as 7% above fair value and 9% below fair value; the bottom panel shows the relative performance of the MSCI Japan hedged in CAD versus the MSCI Japan unhedged in CAD. Currently CAD investors should hedge their JPY exposure based on the ITTM indicator. Some Suggestions For Asset Allocators Use a centralized currency overlay portfolio to manage foreign currency exposure. The overlay portfolio should be managed by currency specialists (either in-house or using external managers) under the supervision of the CIO. The objective of the overlay portfolio is to manage currency exposure based on the underlying assets of the organization's Total Portfolio, such that the risk/return profile of the total portfolio is improved against its benchmark. Global equity portfolio manager performance should be measured on an unhedged basis in their respective home currency. Some have argued that a fully hedged benchmark such as the MSCI All Country Total Return Index in local currencies should be used to measure the performance of a global equity portfolio manager. We strongly disagree, even though in theory it does not really matter what benchmark is used. MSCI's "total return indexes in local currencies" for global equity aggregates are theoretical in nature. They cannot be replicated in the real world because they are calculated on a daily basis using the previous closing day's exchange rate to calculate foreign equity return10 - such that the "local return" for each foreign equity index is perfectly hedged. Unfortunately this "perfect hedge" is humanly impossible, because as shown in Formula (1) in Appendix 1, only when both the spot rate and forward rate at the time t are equal to the spot rate at time t+1, can the local returns be fully captured! Xiaoli Tang, Associate Vice President xiaolit@bcaresearch.com 1 Perold, A and E. Schulman, 1988, "The free lunch in currency hedging: Implications for investment policy and performance standards", Financial Analyst Journal 44, 45-50. 2 Froot K., 1993, "Currency hedging over long horizons", NBER working paper 4355 3 Black, F., 1989, "Universal hedging: optimizing currency risk and reward in international equity portfolios", Financial Analyst Journal 45, 16-22 4 Campbell, J., K. de Medeiros and L. Viceira, 2010, "Global currency hedging", Journal of Finance LXV, 87-122 5 Gagnon, L., T., McCurdy, and G., Lypny, 1998, " Hedging foreign currency portfolios", Journal of Empirical Finance 5, 197-220 6 Hautsch, N., and J. Inkmann, 2003, "Optimal hedging of the currency exchange risk exposure of dynamically balanced strategic asset allocations", Journal of Asset Management 4, 173-189 7 Brown, C., J., Dark, and W., Zhang, "Dynamic currency hedging for international stock portfolios", 2012, Ph.D. dissertation, University of Melbourn 8 Michenaud, S., and B., Solnik, 2008, "Applying regret theory to investment choices: Currency hedging decisions", Journal of International Money and Finance 27, 677-694 9 Please see BCA Foreign Exchange Strategy Special Report titled "In Search Of A Timing Model", June 22, 2016 available at fes.bcaresearch.com 10 "Note on index calculation in local currency", MSCI Bara Index Calculation Methodologies, p19, May 2010 11 MSCI uses 2 business days as described in "MSCI Index Methodology: MSCI Hedged Indexes", July 2013 Appendix 1 We use one-month forward contracts and re-balance on a monthly basis. The gain or loss of the underlying equity index during the month is not hedged, but converted back to the home currency at the month-end spot rate. Before reliable forward contract rates were available (Jan 2001), we use one-month interest rates instead to calculate hedged returns. Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Please note that for simplification we have ignored the bid-ask spread in all the quotations, and we do not take into account the time lag required to implement a hedge.11 In practice, however, these are valid considerations. Appendix 2: Dynamics Hedging For Six Home Currencies 2.1 The Australian Perspective Correlations: For Aussie investors, foreign currencies in aggregate have a negative correlation with the domestic equity index (especially in the period from 2001), and a mostly positive but low correlation to the unhedged foreign equities. (Chart II-1). So hedging away foreign currency exposure would increase total risk of the global portfolio. This is why a fully hedged portfolio has the highest risk (Chart II-2, Table II-1). Historical Performance: Since 2001, ITTM-based dynamic hedging has produced the highest risk-adjusted return for the global portfolio in AUD. The return profile looks similar to the fully hedged portfolio, but risk is much lower (Table II-1). Over the longer period, the optimal static hedge ratio is about 70%, which is actually quite close to the 50% hedge, as shown in Table II-2. On a five-year rolling basis, as shown in Chart II-2, the ITTM-based dynamic risk/return profile also prevails. Current State: Currently AUD investors should only be hedging their exposure in Swiss francs and U.S. dollars, the two "safe haven" currencies. Actually, our indicators show a close to 100% hedge of the Swiss franc, as shown in Chart II-3, which did hurt the risk/return profile during the GFC period despite an outstanding full-period performance. Table II-1Risk/Return Profile For Global Equity In AUD (2001-2017) Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Table II-2Risk/Return Profile For Global Equity In AUD (1976-2017) Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Chart II-1Australian Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies Australian Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies Australian Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies Chart II-2Australian Perespective: Dynamic Vs. Static Hedging Australian Perespective: Dynamic Vs. Static Hedging Australian Perespective: Dynamic Vs. Static Hedging Chart II-3Australian Perspective: Swiss Index Dynamically Hedged Australian Perspective: Swiss Index Dynamically Hedged Australian Perspective: Swiss Index Dynamically Hedged 2.2 The Canadian Perspective Correlations: For Canadian investors, foreign currencies on aggregate have a negative correlation with the country's domestic equity index, but the correlation with unhedged foreign equities has oscillated in both positive and negative territory. The correlation between Canadian equities and unhedged foreign equities has been always positive, in the range of 0.4-0.8 (Chart II-4). So hedging away foreign currency exposure will increase total risk within a global portfolio. This is why a fully hedged portfolio has the highest risk (Chart II-5, Table II-3 and Table II-4). Historical Performance: Since 2001, the ITTM-based dynamic hedging has produced the highest annualized return for the global portfolio in CAD without significantly increasing volatility from the unhedged scenario. In terms of risk-adjusted return, dynamic hedging has outperformed the best static hedging scenario (40% hedged) by about 46% (Table II-3). On a five-year rolling basis, as shown in Chart II-5, the dynamic risk/return profile also prevails. Current State: Currently Canadian investors should be hedging all foreign currencies except for the Australian dollar. Chart II-6 shows how CAD investors dynamically hedge their exposure to the Swedish krona. Table II-3Risk/Return Profile For Global Equity In CAD (2001-2017) Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Table II-4Risk/Return Profile For Global Equity In CAD (1976-2017) Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Chart II-4Canadian Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies Canadian Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies Canadian Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies Chart II-5Canadian Perspective: Dynamic Vs. Static Hedging Canadian Perspective: Dynamic Vs. Static Hedging Canadian Perspective: Dynamic Vs. Static Hedging Chart II-6Canadian Perspective: Swedish Index Dynamically Hedged Canadian Perspective: Swedish Index Dynamically Hedged Canadian Perspective: Swedish Index Dynamically Hedged 2.3 The Japanese Perspective Correlations: For Japanese investors, correlations among foreign currencies, foreign equities and domestic equities seem to have gone through regime changes since the GFC, as shown in Chart II-7. These regime changes in correlations explain the evolving risk/return profile of the static hedges in Chart II-8. Before the GFC, full hedge and 50% hedge had similar risk profiles, but after the GFC full hedge reduced total risk significantly due to the sharp increase in correlations. Historical Performance: Since 2001, the ITTM-based dynamic hedging has produced the highest risk-adjusted return for the global portfolio in JPY, with a much higher return and slightly higher risk (Table II-5). Fully hedged has the lowest risk in both periods, and 50% is close to the "optimal" static hedge in both periods as well (Table II-5 and II-6). On a five-year rolling basis, as shown in Chart II-8, the ITTM-based dynamic risk/return profile. The 50% static hedge has similar risk profile to the ITTM-based dynamic hedge, but with lower returns. Current State: Currently JPY investors should be only hedging their exposure in Swiss francs and U.S. dollars. Chart II-9 shows how Japanese investors should have hedged CAD exposure. Table II-5Risk/Return Profile For Global Equity In JPY (2001-2017) Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Table II-6Risk/Return Profile For Global Equity In JPY (1976-2017) Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Chart II-7Japanese Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies Japanese Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies Japanese Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies Chart II-8Japanese Perspective: Dynamic Vs. Static Hedging Japanese Perspective: Dynamic Vs. Static Hedging Japanese Perspective: Dynamic Vs. Static Hedging Chart II-9Japanese Perspective: Canadian Index Dynamically Hedged Japanese Perspective: Canadian Index Dynamically Hedged Japanese Perspective: Canadian Index Dynamically Hedged 2.4 The U.S. Perspective Correlations: For U.S. investors, correlations among foreign currencies, foreign equities and domestic equities seem to have gone through regime changes since the GFC, as shown in Chart II-10. These regime changes in correlation explain the evolving risk/return profile of the static hedges in Chart II-11. Before the GFC, full hedge and 50% hedge had similar risk profiles, but after the GFC full hedge exhibited significantly reduced total risk due to the sharp increase in correlations. Historical Performance: Since 2001, the ITTM-based dynamic hedging has produced the highest risk-adjusted return for the global portfolio in USD, with a much higher return and slightly lower risk compared to the 50%, which is the best static hedge for the period (Table II-7). Fully hedged had the lowest risk in both periods, but the return profiles of the static hedges were very similar, supporting the widely held belief that in the long run currency returns are close to zero (Table II-7 and II-8). On a five-year rolling basis, as shown in Chart II-11, the dynamic risk/return profile is close to that of the 50%. Current State: Currently U.S. investors should only be hedging their exposure in euros (Chart II-12). Table II-7Risk/Return Profile For Global Equity In USD (2001-2017) Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Table II-8Risk/Return Profile For Global Equity In JPY (1976-2017) Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Chart II-10U.S. Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies U.S. Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies U.S. Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies Chart II-11U.S. Perspective: Dynamic Vs. Static Hedging U.S. Perspective: Dynamic Vs. Static Hedging U.S. Perspective: Dynamic Vs. Static Hedging Chart II-12U.S. Perspective: EMU Index Dynamically Hedged U.S. Perspective: EMU Index Dynamically Hedged US INVESTOR: EMU INDEX DYNAMIC HEDGE U.S. Perspective: EMU Index Dynamically Hedged US INVESTOR: EMU INDEX DYNAMIC HEDGE 2.5 The Euro Perspective Correlations: For investors that call the euro home currency, the correlation and foreign equities has been positive. The correlation between foreign currencies and domestic equity index, however, has been changing signs over time, currently sitting at near zero! (Chart II-13). This explains the shape of the risk/return profile in Chart II-14 and Table II-9. Historical Performance: Since 2001, the ITTM-based dynamic hedging has produced the highest risk-adjusted return for the global portfolio in euros, which has a higher return and lower risk than the best static hedge of 80% (Table II-9). Over the longer period, the optimal hedge ratio is about 50% hedge, which is actually quite close to those between 40-70%, as shown in Table II-10. On a five-year rolling basis, as shown in Chart II-14, the dynamic risk/return profile definitely prevails. Current State: Currently euro investors should not be hedging any foreign exposure, based on our indicators. Chart II-15 shows how euro investors should have hedged JPY exposure over time since 2001. Table II-9Risk/Return Profile For Global Equity In Euro (2001-2017) Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Table II-10Risk/Return Profile For Global Equity In Euro (1976-2017) Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Chart II-13Domestic And Unhedged Foreign Equities Vs. Foreign Currencies CHART EMU2: DOMESTIC AND UNHEDGED FOREIGN EQUITIES VS. FOREIGN CURRENCIES EURO AREA Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies CHART EMU2: DOMESTIC AND UNHEDGED FOREIGN EQUITIES VS. FOREIGN CURRENCIES EURO AREA Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies Chart II-14Euro Area Perspective: Dynamic Vs. Static Hedging Euro Area Perspective: Dynamic Vs. Static Hedging Euro Area Perspective: Dynamic Vs. Static Hedging Chart II-15Euro area Perspective: Japanese Index Dynamically Hedged Euro area Perspective: Japanese Index Dynamically Hedged Euro area Perspective: Japanese Index Dynamically Hedged 2.6 The British Perspective Correlations: For British investors, correlations between foreign currencies and domestic equities have gone through several regime changes over time in both positive and negative territory, as shown in Chart II-16. The positive correlation between foreign and domestic equities has also increased over time. This would definitely make static hedging worse off (Table II-11 and II-12). Historical Performance: Not surprisingly, since 2001, dynamic hedging has produced the highest risk-adjusted return for the global portfolio in pounds, which has a higher return and lower risk than the best static hedge of 20% (Table II-11). Over the longer period, the optimal hedge ratio is about 90% hedge, Table II-12. On a five-year rolling basis, as shown in Chart II-17, the dynamic risk/return profile prevails, as it shares similar risk as the 50% hedge but with a higher return. Current State: Currently the British investors should not be hedging CAD and Swedish krona, while all six other currencies should be hedged. Chart II-18 shows how U.K. investors should have hedged their AUD exposure over time since 2001. Table II-11Risk/Return Profile For Global Equity In GBP (2001-2017) Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Table II-12Risk/Return Profile For Global Equity In GBP (1976-2017) Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Chart II-16Domestic And Unhedged Foreign Equities Vs. Foreign Currencies CHART UK2: DOMESTIC AND UNHEDGED FOREIGN EQUITIES VS. FOREIGN CURRENCIES U.K. Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies CHART UK2: DOMESTIC AND UNHEDGED FOREIGN EQUITIES VS. FOREIGN CURRENCIES U.K. Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies Chart II-17Dynamic Vs. Static Hedging CHART UK1: DYNAMIC VS. STATIC HEDGING U.K. Perspective: Dynamic Vs. Static Hedging CHART UK1: DYNAMIC VS. STATIC HEDGING U.K. Perspective: Dynamic Vs. Static Hedging Chart II-18U.K. Perspective: Australian Index Dynamically Hedged U.K. Perspective: Australian Index Dynamically Hedged UK INVESTOR: AU INDEX DYNAMIC HEDGE U.K. Perspective: Australian Index Dynamically Hedged UK INVESTOR: AU INDEX DYNAMIC HEDGE

Dear client, I am on the road this week, attending BCA's New York Conference and teaching the BCA Academy. In lieu of a regular report, we are sending you a Special Report, a cooperation with our Global Asset Allocation service. In this piece, my colleague Xiaoli Tang tests the benefits of various currency hedging strategies for global equity portfolios. In addition to traditional hedging rules, Xiaoli deploys the Intermediate-Term Timing Models developed by the Foreign Exchange Strategy team to build dynamic hedging strategies, which result in superior risk/reward profiles. I trust you will find this report interesting and informative. Best regards, Mathieu Savary Highlights In this report, we analyze both static and dynamic hedging strategies to hedge an identical global equity portfolio to six home currencies: the U.S. dollar, the British pound, the euro, the Japanese yen, the Canadian dollar and the Australian dollar. We propose an easy to implement dynamic hedging framework based on the proprietary currency indicators from BCA's Foreign Exchange Strategy (FES) service. It has outperformed all the static hedging strategies since 2001 on a risk-adjusted return basis. In addition, it levels out the playing field for all investors as the hedged returns are quite similar, no matter what their home currencies are. Among the static hedging strategies, the "least-regret" hedge ratio of 50% has lived up to its reputation, as it has reduced risk by more than 50% without severely jeopardizing returns. Over a four-year moving performance cycle (in line with how most portfolio managers are evaluated), the proposed dynamic hedging adds little career risk to portfolio managers compared to the "least regret" 50% static hedging, while provides superior returns most of the time. A global equity portfolio's currency exposure should be managed in a centralized currency overlay under the supervision of the Chief Investment Officer, so that equity and currency managers can both fully utilize their expertise in their respective field, and the organization can manage currency risk more efficiently at the total portfolio level. Feature Dynamic Hedging Outperforms Static Hedging We have received many client requests asking about currency hedging in global equity portfolios with different home currencies. This is not surprising given how currency movements have overwhelmed global equity portfolio returns of late. For example, this year the U.S. dollar's weakness against the major currencies has beefed up returns for U.S. investors who did not hedge their foreign exposure (Table I-1). Table I-1Year-To-Date Currency Movements Have Overwhelmed Equity Returns Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors GAA's equity country allocation recommendations are by default unhedged on USD basis. When a hedge is required we make the recommendation explicit. There have been many conflicting views on whether global equity investors should hedge foreign currency exposure, and if so, what proportion of the exposure should be hedged. Perold and Schulman (1988) suggest fully hedging foreign currency exposure, because significant risk reduction can be achieved without a significant loss of return.1 This is based on their famous "free lunch" claim that average currency returns are zero over the long-term. At the other extreme, Froot (1993) suggests that foreign currencies should not be hedged at all for long-term investors, because purchasing power parity holds in the long term and exchange rates are mean reverting.2 There are many other views in between, including the universal hedge ratio proposed by Black (1989), which is estimated to be 77%.3 Campbell et al (2010) classify currencies into reserve currencies (USD, EUR and CHF), commodity currencies (AUD and CAD) and neutral currencies (JPY and GBP), and suggest that risk-minimizing investors should hold reserve currencies while hedging out commodity currencies, based on the correlations between the currencies and equity markets.4 Realizing the limitations of "static hedging," which assumes constant correlation, mean and variance, many academic researchers have explored "dynamic hedging models" that allow the mean and covariance to be time-varying by using complex econometric modelling techniques.5,6,7 These academic dynamic hedging strategies have shown improvement over the 50% static hedge, but it's very difficult for investors without a strong quantitative background to understand these very complex approaches. In fact, with all these confusing academic recommendations floating around, the "least regret" hedge ratio of 50% has been quite popular among practitioners.8 To help our clients better understand the role of currency management in global equity portfolios, we have joined forces with BCA's Foreign Exchange Strategy (FES) service to de-mystify the currency hedging process, and to propose a simple framework for clients with six different home currencies to dynamically hedge their foreign currency exposure based on the FES team's proprietary Intermediate-Term Timing Model (ITTM) indicators.9 These indicators have been used in their regular weekly publications. The ITTM-based dynamic hedging strategy is back-tested from 2001 because the ITTM indicators only date back to 2001 (See methodology). We have also back-tested a simple trend-following momentum-based dynamic strategy to see how a dynamic hedging methodology works in a longer period from 1976. For comparison we have back-tested ten different static hedging strategies that employ fixed hedge ratios across currencies and time. The test results not only clarify much of the confusion about static hedging, they also demonstrate that on a risk-adjusted return basis, BCA's ITTM-based dynamic hedging strategy has outperformed all static hedging strategies for all investors with six different home currencies since 2001 (Chart I-1). Even in the very long run of 41 years from August 1976, the simple momentum-based dynamic hedging outperforms the static strategies for investors with five home currencies, with only the AUD portfolio being worse off (Chart I-2). Chart I-1Identical Investment, But Different Risk/Return Profiles (3/2001-8/2017) Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Chart I-2Identical Investment, But Different Risk/Return Profiles (8/1976-8/2017) Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Now let's clarify some of the confusion: Does static hedging reduce portfolio risk at little expense of lowering returns? The answer is yes only for USD and JPY portfolios. For both the 41-year period from 1976 and the shorter 16-year period from 2001, a higher hedge ratio results in lower risk with slightly lower return. So fully hedged would be the "optimal" strategy for risk-minimizing investors with USD and JPY as home currencies (Panel 1 and 2 on left side in both Chart I-1 and Chart I-2). For the U.K. portfolio, the answer is a partial yes, because the "optimal hedge ratio" for risk-minizing investors, around 60%-80%, does produce the lowest risk, but the paths to that "optimal" point are totally opposite when different time periods are chosen. In the short period (Chart I-1, bottom left panel), it follows the same pattern as that for U.S. and Japanese investors up to the optimal point. As the hedge ratio increases, however, return drops and risk increases! In the longer period from 1976, as the hedge ratio increases, return increases and risk decreases until the "optimal point," after which risk and returns both increase (Chart I-2, bottom left panel). In the period from 2001, the AUD, CAD and EUR portfolios share a similar pattern to that of the GBP portfolio in the period from 1976. The AUD portfolio behaved the same in both the shorter period (Chart I-1, top right) and the longer period (Chart 2, top right), while the EUR and CAD portfolios behaved differently in the longer-term period from the shorter period. Overall, the CAD portfolio's "optimal" hedge ratio is around 0-30%, the AUD portfolio around 30-60% while the EUR portfolio is around 40% in the shorter period but around 90% in the longer period (Chart I-1 and Chart I-2). It is also worth noting that even though both the CAD and AUD are commodity currencies, AUD investors benefit significantly from hedging, while CAD investors' risk/return profile does not change much. This is because 1) currency returns for AUD investors do not average to zero in the long term due to positive carry, and 2) correlations between foreign currencies, foreign equities and domestic equities are not constant over time or across currencies (Appendix 2, Chart II-1 and Chart II-4) How does the "least regret" 50% static hedge do? The 50% hedge ratio fares quite well compared to the "optimal" static hedge ratio in terms of risk reduction for all portfolios in both periods, because more than half of the total risk reduction (the highest minus the lowest) occurs around the 50% hedge (Chart I-1 and Chart I-2). How does BCA's ITTM-based dynamic hedge do in terms of risk reduction? The ITTM produces better risk-adjusted returns for each portfolio than all the static hedges. In terms of risk, it generates the lowest risk for the EUR and GBP portfolios and is comparable to the 50% static hedge for other portfolios, while it generates a much higher return than all static hedges (Chart I-1 and Chart I-2). How does the BCA Dynamic Hedge (ITTM) compare to the 50% static hedge over time? Chart I-3 shows that the dynamic hedge consistently outperformed the 50% static hedge for all six home currencies since 2001 without significantly increasing hedging transactions, compared to the fixed 50% hedge ratio for all currency pairs. The dash line in each panel of Chart I-3 corresponds to the market cap-weighted aggregate of hedge ratios of foreign currencies for each home currency. On average, they are comparable to 50%. Most portfolio managers are measured on a moving four-year performance cycle. Chart I-4 shows that the ITTM-based dynamic hedging strategy has outperformed the 50% static hedging most of the time on a moving four-year basis, with only CAD, USD and JPY managers suffering brief drawdowns. Chart I-3BCA Dynamic Hedging Adds ##br##Value For All Investors BCA Dynamic Hedging Adds Value For All Investors BCA Dynamic Hedging Adds Value For All Investors Chart I-4Little Career Risk For ##br##Portfolio Managers Little Career Risk For Portfolio Managers Little Career Risk For Portfolio Managers In theory, if hedges were effective, then an identical global equity portfolio should have similar returns for all investors, no matter what home currency they hold. While neither the static hedging strategies nor the momentum-based dynamic hedging approach could pass this criteria, BCA's ITTM-based dynamic hedging approach does. It levels out the playing field for all investors globally. As shown in Chart I-5, in the period from March 2001 to August 2017, if left unhedged, the same global investment exhibits very different annualized returns for investors in different home currencies, with AUD investors at the low end at around 3.2%, and GBP investors at the high end at around 7%. With BCA's ITTM-based dynamic hedge, however, returns for all investors are very similar, no matter which currency is their home currency. Chart I-5BCA Dynamic Hedging Strategy Levels Out The Playing Field Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors The BCA Dynamic Hedging Methodology To back-test all the hedging strategies, we use an identical global equity portfolio that is a market cap-weighted aggregate of nine countries/regions based on MSCI U.S., Japan, the euro area, U.K., Canada, Australia, Switzerland, Sweden and Norway. This universe accounts for about 97% of the current MSCI World index (Chart I-6). The history of the euro area before 1987 (when MSCI data were available) is calculated as a market cap-weighted aggregate of MSCI Germany, France, Spain, Italy, Austria, Belgium and the Netherlands. Chart I-6GAA Global Equity Universe GAA Global Equity Universe GAA Global Equity Universe We evaluate the same global portfolio for investors with six different home currencies: USD, JPY, GBP, EUR, CAD and AUD. The Measurement for Hedging Efficacy: All the academically claimed "optimal" hedge ratios, static or dynamic, are based on risk-minimizing in a mean-variance optimization framework. For practitioners, however, "not meeting return objectives" is a much higher risk priority than minimizing portfolio risk. This is why we advocate risk-adjusted return as our measurement for hedge efficacy. The Objective: We aim to find the hedging strategies that outperform the widely used 50% static hedging strategy on a risk-adjusted return basis. At BCA, our philosophy has always been not to strive to find the optimal solution, but to try our best to find a feasible solution that best meets the stated objective. Interestingly, this approach has produced superior results for the GBP and EUR portfolios, achieving the combination of "highest return - lowest risk." It also levels out the playing field for all investors by generating similar hedged returns for all investors, no matter what home currency they hold (Chart I-1 and Chart I-5). The Proprietary Currency Indicators: The indicators from Foreign Exchange Strategy service's Intermediate Term Timing Model (ITTM) are built under the assumptions that the uncovered interest rate parity (UIP) holds, and the fair value of a currency pair is a function of the real rate differential (using an average of two-year and 10-year real rates), Junk OAS (a proxy for global risk appetite), commodity prices and past-year trends (52-week moving average). When a currency pair deviates from its fair value to an extreme, then the likelihood for a trend reversal is high.9 The Simple Rule-Based Dynamic Hedging: For each home currency, we evaluate the other eight foreign currencies individually based on each pair's ITTM indicator. When a foreign currency overshoots fair value above the upper band of its historical range, then the currency is a short, and the short position is kept until the foreign currency value touches the lower band of its historical range that's below the fair value. The Implementation: We use one-month forward contracts and re-balance on a monthly basis. The gain or loss of the underlying equity index during the month is not hedged, but converted back to the home currency at the month-end spot rate. For history before 2001, we use one-month interest rates to calculate hedged returns (Please see Appendix 1 hedged return calculations using forwards and also interest rates). Example: Chart I-7 illustrates how a Canadian investor uses the ITTM indicator to decide when to hedge JPY exposure when they invest in the MSCI Japan equity index. Chart I-7Canadian Investor: Japanese Index Dynamically Hedged Canadian Investor: Japanese Index Dynamically Hedged Canadian Investor: Japanese Index Dynamically Hedged The top panel shows the hedging signal for JPY (solid line) versus our proprietary ITTM indicator for JPY/CAD exchange rate (dash line). The upper and lower band are set as 7% above fair value and 9% below fair value; the bottom panel shows the relative performance of the MSCI Japan hedged in CAD versus the MSCI Japan unhedged in CAD. Currently CAD investors should hedge their JPY exposure based on the ITTM indicator. Some Suggestions For Asset Allocators Use a centralized currency overlay portfolio to manage foreign currency exposure. The overlay portfolio should be managed by currency specialists (either in-house or using external managers) under the supervision of the CIO. The objective of the overlay portfolio is to manage currency exposure based on the underlying assets of the organization's Total Portfolio, such that the risk/return profile of the total portfolio is improved against its benchmark. Global equity portfolio manager performance should be measured on an unhedged basis in their respective home currency. Some have argued that a fully hedged benchmark such as the MSCI All Country Total Return Index in local currencies should be used to measure the performance of a global equity portfolio manager. We strongly disagree, even though in theory it does not really matter what benchmark is used. MSCI's "total return indexes in local currencies" for global equity aggregates are theoretical in nature. They cannot be replicated in the real world because they are calculated on a daily basis using the previous closing day's exchange rate to calculate foreign equity return10 - such that the "local return" for each foreign equity index is perfectly hedged. Unfortunately this "perfect hedge" is humanly impossible, because as shown in Formula (1) in Appendix 1, only when both the spot rate and forward rate at the time t are equal to the spot rate at time t+1, can the local returns be fully captured! Xiaoli Tang, Associate Vice President xiaolit@bcaresearch.com 1 Perold, A and E. Schulman, 1988, "The free lunch in currency hedging: Implications for investment policy and performance standards", Financial Analyst Journal 44, 45-50. 2 Froot K., 1993, "Currency hedging over long horizons", NBER working paper 4355 3 Black, F., 1989, "Universal hedging: optimizing currency risk and reward in international equity portfolios", Financial Analyst Journal 45, 16-22 4 Campbell, J., K. de Medeiros and L. Viceira, 2010, "Global currency hedging", Journal of Finance LXV, 87-122 5 Gagnon, L., T., McCurdy, and G., Lypny, 1998, " Hedging foreign currency portfolios", Journal of Empirical Finance 5, 197-220 6 Hautsch, N., and J. Inkmann, 2003, "Optimal hedging of the currency exchange risk exposure of dynamically balanced strategic asset allocations", Journal of Asset Management 4, 173-189 7 Brown, C., J., Dark, and W., Zhang, "Dynamic currency hedging for international stock portfolios", 2012, Ph.D. dissertation, University of Melbourn 8 Michenaud, S., and B., Solnik, 2008, "Applying regret theory to investment choices: Currency hedging decisions", Journal of International Money and Finance 27, 677-694 9 Please see BCA Foreign Exchange Strategy Special Report titled "In Search Of A Timing Model", June 22, 2016 available at fes.bcaresearch.com 10 "Note on index calculation in local currency", MSCI Bara Index Calculation Methodologies, p19, May 2010 11 MSCI uses 2 business days as described in "MSCI Index Methodology: MSCI Hedged Indexes", July 2013 Appendix 1 We use one-month forward contracts and re-balance on a monthly basis. The gain or loss of the underlying equity index during the month is not hedged, but converted back to the home currency at the month-end spot rate. Before reliable forward contract rates were available (Jan 2001), we use one-month interest rates instead to calculate hedged returns. Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Please note that for simplification we have ignored the bid-ask spread in all the quotations, and we do not take into account the time lag required to implement a hedge.11 In practice, however, these are valid considerations. Appendix 2: Dynamics Hedging For Six Home Currencies 2.1 The Australian Perspective Correlations: For Aussie investors, foreign currencies in aggregate have a negative correlation with the domestic equity index (especially in the period from 2001), and a mostly positive but low correlation to the unhedged foreign equities. (Chart II-1). So hedging away foreign currency exposure would increase total risk of the global portfolio. This is why a fully hedged portfolio has the highest risk (Chart II-2, Table II-1). Historical Performance: Since 2001, ITTM-based dynamic hedging has produced the highest risk-adjusted return for the global portfolio in AUD. The return profile looks similar to the fully hedged portfolio, but risk is much lower (Table II-1). Over the longer period, the optimal static hedge ratio is about 70%, which is actually quite close to the 50% hedge, as shown in Table II-2. On a five-year rolling basis, as shown in Chart II-2, the ITTM-based dynamic risk/return profile also prevails. Current State: Currently AUD investors should only be hedging their exposure in Swiss francs and U.S. dollars, the two "safe haven" currencies. Actually, our indicators show a close to 100% hedge of the Swiss franc, as shown in Chart II-3, which did hurt the risk/return profile during the GFC period despite an outstanding full-period performance. Table II-1Risk/Return Profile For Global Equity In AUD (2001-2017) Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Table II-2Risk/Return Profile For Global Equity In AUD (1976-2017) Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Chart II-1Australian Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies Australian Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies Australian Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies Chart II-2Australian Perespective: Dynamic Vs. Static Hedging Australian Perespective: Dynamic Vs. Static Hedging Australian Perespective: Dynamic Vs. Static Hedging Chart II-3Australian Perspective: Swiss Index Dynamically Hedged Australian Perspective: Swiss Index Dynamically Hedged Australian Perspective: Swiss Index Dynamically Hedged 2.2 The Canadian Perspective Correlations: For Canadian investors, foreign currencies on aggregate have a negative correlation with the country's domestic equity index, but the correlation with unhedged foreign equities has oscillated in both positive and negative territory. The correlation between Canadian equities and unhedged foreign equities has been always positive, in the range of 0.4-0.8 (Chart II-4). So hedging away foreign currency exposure will increase total risk within a global portfolio. This is why a fully hedged portfolio has the highest risk (Chart II-5, Table II-3 and Table II-4). Historical Performance: Since 2001, the ITTM-based dynamic hedging has produced the highest annualized return for the global portfolio in CAD without significantly increasing volatility from the unhedged scenario. In terms of risk-adjusted return, dynamic hedging has outperformed the best static hedging scenario (40% hedged) by about 46% (Table II-3). On a five-year rolling basis, as shown in Chart II-5, the dynamic risk/return profile also prevails. Current State: Currently Canadian investors should be hedging all foreign currencies except for the Australian dollar. Chart II-6 shows how CAD investors dynamically hedge their exposure to the Swedish krona. Table II-3Risk/Return Profile For Global Equity In CAD (2001-2017) Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Table II-4Risk/Return Profile For Global Equity In CAD (1976-2017) Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Chart II-4Canadian Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies Canadian Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies Canadian Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies Chart II-5Canadian Perspective: Dynamic Vs. Static Hedging Canadian Perspective: Dynamic Vs. Static Hedging Canadian Perspective: Dynamic Vs. Static Hedging Chart II-6Canadian Perspective: Swedish Index Dynamically Hedged Canadian Perspective: Swedish Index Dynamically Hedged Canadian Perspective: Swedish Index Dynamically Hedged 2.3 The Japanese Perspective Correlations: For Japanese investors, correlations among foreign currencies, foreign equities and domestic equities seem to have gone through regime changes since the GFC, as shown in Chart II-7. These regime changes in correlations explain the evolving risk/return profile of the static hedges in Chart II-8. Before the GFC, full hedge and 50% hedge had similar risk profiles, but after the GFC full hedge reduced total risk significantly due to the sharp increase in correlations. Historical Performance: Since 2001, the ITTM-based dynamic hedging has produced the highest risk-adjusted return for the global portfolio in JPY, with a much higher return and slightly higher risk (Table II-5). Fully hedged has the lowest risk in both periods, and 50% is close to the "optimal" static hedge in both periods as well (Table II-5 and II-6). On a five-year rolling basis, as shown in Chart II-8, the ITTM-based dynamic risk/return profile. The 50% static hedge has similar risk profile to the ITTM-based dynamic hedge, but with lower returns. Current State: Currently JPY investors should be only hedging their exposure in Swiss francs and U.S. dollars. Chart II-9 shows how Japanese investors should have hedged CAD exposure. Table II-5Risk/Return Profile For Global Equity In JPY (2001-2017) Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Table II-6Risk/Return Profile For Global Equity In JPY (1976-2017) Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Chart II-7Japanese Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies Japanese Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies Japanese Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies Chart II-8Japanese Perspective: Dynamic Vs. Static Hedging Japanese Perspective: Dynamic Vs. Static Hedging Japanese Perspective: Dynamic Vs. Static Hedging Chart II-9Japanese Perspective: Canadian Index Dynamically Hedged Japanese Perspective: Canadian Index Dynamically Hedged Japanese Perspective: Canadian Index Dynamically Hedged 2.4 The U.S. Perspective Correlations: For U.S. investors, correlations among foreign currencies, foreign equities and domestic equities seem to have gone through regime changes since the GFC, as shown in Chart II-10. These regime changes in correlation explain the evolving risk/return profile of the static hedges in Chart II-11. Before the GFC, full hedge and 50% hedge had similar risk profiles, but after the GFC full hedge exhibited significantly reduced total risk due to the sharp increase in correlations. Historical Performance: Since 2001, the ITTM-based dynamic hedging has produced the highest risk-adjusted return for the global portfolio in USD, with a much higher return and slightly lower risk compared to the 50%, which is the best static hedge for the period (Table II-7). Fully hedged had the lowest risk in both periods, but the return profiles of the static hedges were very similar, supporting the widely held belief that in the long run currency returns are close to zero (Table II-7 and II-8). On a five-year rolling basis, as shown in Chart II-11, the dynamic risk/return profile is close to that of the 50%. Current State: Currently U.S. investors should only be hedging their exposure in euros (Chart II-12). Table II-7Risk/Return Profile For Global Equity In USD (2001-2017) Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Table II-8Risk/Return Profile For Global Equity In JPY (1976-2017) Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Chart II-10U.S. Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies U.S. Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies U.S. Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies Chart II-11U.S. Perspective: Dynamic Vs. Static Hedging U.S. Perspective: Dynamic Vs. Static Hedging U.S. Perspective: Dynamic Vs. Static Hedging Chart II-12U.S. Perspective: EMU Index Dynamically Hedged U.S. Perspective: EMU Index Dynamically Hedged US INVESTOR: EMU INDEX DYNAMIC HEDGE U.S. Perspective: EMU Index Dynamically Hedged US INVESTOR: EMU INDEX DYNAMIC HEDGE 2.5 The Euro Perspective Correlations: For investors that call the euro home currency, the correlation and foreign equities has been positive. The correlation between foreign currencies and domestic equity index, however, has been changing signs over time, currently sitting at near zero! (Chart II-13). This explains the shape of the risk/return profile in Chart II-14 and Table II-9. Historical Performance: Since 2001, the ITTM-based dynamic hedging has produced the highest risk-adjusted return for the global portfolio in euros, which has a higher return and lower risk than the best static hedge of 80% (Table II-9). Over the longer period, the optimal hedge ratio is about 50% hedge, which is actually quite close to those between 40-70%, as shown in Table II-10. On a five-year rolling basis, as shown in Chart II-14, the dynamic risk/return profile definitely prevails. Current State: Currently euro investors should not be hedging any foreign exposure, based on our indicators. Chart II-15 shows how euro investors should have hedged JPY exposure over time since 2001. Table II-9Risk/Return Profile For Global Equity In Euro (2001-2017) Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Table II-10Risk/Return Profile For Global Equity In Euro (1976-2017) Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Chart II-13Domestic And Unhedged Foreign Equities Vs. Foreign Currencies CHART EMU2: DOMESTIC AND UNHEDGED FOREIGN EQUITIES VS. FOREIGN CURRENCIES EURO AREA Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies CHART EMU2: DOMESTIC AND UNHEDGED FOREIGN EQUITIES VS. FOREIGN CURRENCIES EURO AREA Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies Chart II-14Euro Area Perspective: Dynamic Vs. Static Hedging Euro Area Perspective: Dynamic Vs. Static Hedging Euro Area Perspective: Dynamic Vs. Static Hedging Chart II-15Euro area Perspective: Japanese Index Dynamically Hedged Euro area Perspective: Japanese Index Dynamically Hedged Euro area Perspective: Japanese Index Dynamically Hedged 2.6 The British Perspective Correlations: For British investors, correlations between foreign currencies and domestic equities have gone through several regime changes over time in both positive and negative territory, as shown in Chart II-16. The positive correlation between foreign and domestic equities has also increased over time. This would definitely make static hedging worse off (Table II-11 and II-12). Historical Performance: Not surprisingly, since 2001, dynamic hedging has produced the highest risk-adjusted return for the global portfolio in pounds, which has a higher return and lower risk than the best static hedge of 20% (Table II-11). Over the longer period, the optimal hedge ratio is about 90% hedge, Table II-12. On a five-year rolling basis, as shown in Chart II-17, the dynamic risk/return profile prevails, as it shares similar risk as the 50% hedge but with a higher return. Current State: Currently the British investors should not be hedging CAD and Swedish krona, while all six other currencies should be hedged. Chart II-18 shows how U.K. investors should have hedged their AUD exposure over time since 2001. Table II-11Risk/Return Profile For Global Equity In GBP (2001-2017) Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Table II-12Risk/Return Profile For Global Equity In GBP (1976-2017) Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors Chart II-16Domestic And Unhedged Foreign Equities Vs. Foreign Currencies CHART UK2: DOMESTIC AND UNHEDGED FOREIGN EQUITIES VS. FOREIGN CURRENCIES U.K. Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies CHART UK2: DOMESTIC AND UNHEDGED FOREIGN EQUITIES VS. FOREIGN CURRENCIES U.K. Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies Chart II-17Dynamic Vs. Static Hedging CHART UK1: DYNAMIC VS. STATIC HEDGING U.K. Perspective: Dynamic Vs. Static Hedging CHART UK1: DYNAMIC VS. STATIC HEDGING U.K. Perspective: Dynamic Vs. Static Hedging Chart II-18U.K. Perspective: Australian Index Dynamically Hedged U.K. Perspective: Australian Index Dynamically Hedged UK INVESTOR: AU INDEX DYNAMIC HEDGE U.K. Perspective: Australian Index Dynamically Hedged UK INVESTOR: AU INDEX DYNAMIC HEDGE Trades & Forecasts Forecast Summary Core Portfolio Closed Trades

Dear Client, I had the pleasure of speaking at BCA's Annual New York conference on Monday, where I offered the following trade recommendations. This week's report is a summary of my remarks. Please note we will be publishing our Q4 Strategy Outlook and monthly tactical asset allocation recommendation table next Wednesday. Best regards, Peter Berezin, Chief Global Strategist Global Investment Strategy Highlights Go short the December 2018 fed funds futures contract. Go long global industrial stocks versus utilities. Go short 20-year JGBs relative to their 5-year counterparts. Feature Trade #1: Go Short The December 2018 Fed Funds Futures Contract The hurricanes are likely to dent activity in the third quarter, but leading economic indicators are pointing to faster growth starting in Q4. This can be seen in a variety of measures, including the Conference Board's LEI (Chart 1). U.S. financial conditions have eased sharply this year, thanks to a decline in government bond yields, narrower credit spreads, a weaker dollar, and rising equity prices. Changes in our FCI lead growth by about 6-to-9 months. If history is any guide, U.S. growth will rise to about 3% in the first half of 2018 (Chart 2). Growth could even temporarily rise above that level if Congress enacts significant unfunded tax cuts, as we expect it will. Chart 1U.S. Leading Economic Indicator Pointing Higher U.S. Leading Economic Indicator Pointing Higher U.S. Leading Economic Indicator Pointing Higher Chart 2Easier Financial Conditions Will Boost U.S. Growth Easier Financial Conditions Will Boost U.S. Growth Easier Financial Conditions Will Boost U.S. Growth Contrary to popular belief, the Phillips curve is far from dead. It has just been dormant for the better part of 30 years because the unemployment rate has hovered along the flat side of the curve. The closest the economy came to overheating was in the late 1990s, but any inflationary pressures back then were choked off by turmoil in emerging markets, a surging dollar, and collapsing commodity prices.1 If U.S. growth accelerates over the next few quarters, the unemployment rate is likely to fall to 3.5% by the end of next year - well below the Fed's end-2018 projection of 4.1%, and even below the low of 3.8% reached in 2000. At that point, the U.S. economy will find itself on the steep side of the Phillips curve (Chart 3). Chart 3U.S. Economy Has Moved Into The 'Steep' Side Of The Phillips Curve Three Tantalizing Trades Three Tantalizing Trades As Chart 4 illustrates, our wage survey indicator - a propriety measures that combines the results of 13 separate employer surveys - is pointing to faster wage growth. Rising wages should boost consumer spending. With the output gap all but extinguished, faster demand growth will lead to higher inflation. This is already being telegraphed by the ISM manufacturing index (Chart 5). Chart 4Survey Data Point To Higher Wage Growth Ahead Survey Data Point To Higher Wage Growth Ahead Survey Data Point To Higher Wage Growth Ahead Chart 5Strong ISM Signaling A Rise In Inflation Strong ISM Signaling A Rise In Inflation Strong ISM Signaling A Rise In Inflation If inflation accelerates, there is little reason why the Fed would not continue raising rates in line with the dots, which call for one more hike in December and three hikes in 2018. That's 100 basis points of hikes between now and the end of next year, considerably more than the 40 bps that the market is currently discounting. We went short the December 2018 fed funds futures contract three weeks ago. The trade has gained 20 basis points so far, but my discussion this morning suggests that it has plenty of juice left. Trade #2: Go Long Global Industrial Stocks Versus Utilities Economists are a bit like stock market analysts - they are generally too optimistic. As a result, they usually end up having to revise their growth estimates down over time. That has not been the case this year: Global growth estimates have been marching higher (Chart 6). Capital spending tends to accelerate in the mature phase of business-cycle expansions, as a growing number of firms realize that they have insufficient capacity to meet rising demand. We are starting to see that now. A variety of indicators - including capital goods orders and capex intention surveys - are pointing to further gains in business spending. This is captured in our model estimates, which project that global capex will grow at the fastest pace in six years (Chart 7). Chart 6Global Growth Estimates Accelerating Despite Stalled U.S. Growth Global Growth Estimates Accelerating Despite Stalled U.S. Growth Global Growth Estimates Accelerating Despite Stalled U.S. Growth Chart 7Global Capex On The Upswing Global Capex On The Upswing Global Capex On The Upswing A burst of capital spending should benefit global industrial stocks. Conversely, rising global yields will hurt rate-sensitive utilities (Chart 8). Industrials are no longer cheap, but relative to utilities, valuations do not seem especially stretched, implying further room for re-rating (Chart 9). Chart 8Higher Bond Yields Will Hurt Utilities Higher Bond Yields Will Hurt Utilities Higher Bond Yields Will Hurt Utilities Chart 9Relative Valuations Are Not Stretched Relative Valuations Are Not Stretched Relative Valuations Are Not Stretched Trade #3: Go Short 20-Year JGBs Relative To Their 5-Year Counterparts The deflationary mindset remains firmly entrenched in Japan. CPI swaps are pricing in inflation of only 0.5% over the next twenty years (Chart 10). Not only do investors expect the Bank of Japan to continue to miss its 2% target, they don't even think that inflation will rise from today's miserly levels. They could be in for a big surprise. Many of the structural drivers of deflation in Japan are fading. Land prices have stopped falling for the first time in 25 years, and bank balance sheets are in good shape (Chart 11). Goods prices are also rising again, thanks in part to a cheaper yen (Chart 12). Profit margins have soared, giving firms the wherewithal to pay their workers more. Chart 10Deflationary Mindset Remains Deeply Entrenched... Deflationary Mindset Remains Deeply Entrenched... Deflationary Mindset Remains Deeply Entrenched... Chart 11A...But Deflationary Pressures Are Abating ...But Deflationary Pressures Are Abating ...But Deflationary Pressures Are Abating Chart 11B ...But Deflationary Pressures Are Abating ...But Deflationary Pressures Are Abating Chart 12ACorporate Pricing Power Has Improved Corporate Pricing Power Has Improved Corporate Pricing Power Has Improved Chart 12B Corporate Pricing Power Has Improved Corporate Pricing Power Has Improved Companies have been reluctant to raise wages, but that may be starting to change. Our wage trend indicator is showing signs of life (Chart 13). As in the U.S., the Phillips curve in Japan tends to become kinked at very low levels of unemployment. Japan's unemployment rate now stands at 2.8%, almost a full percentage point below 2007 levels. As the labor market heats up, companies will have to compete more intensively for a shrinking pool of available workers. This could spark a tit-for-tat cycle where wage hikes by one company lead to hikes by others. Chart 13ATentative Signs of Wage Growth Three Tantalizing Trades Three Tantalizing Trades Chart 13B Three Tantalizing Trades Three Tantalizing Trades Chart 14Demographic Inflection Point? Demographic Inflection Point? Demographic Inflection Point? The government has been hoping for such a bidding war to break out. It will get its wish. The ratio of job openings-to-applicants has soared, and is now even higher than at the peak of the bubble in 1990 (Chart 14). Amazingly, Japan's labor market has tightened over the past few years despite tepid GDP growth and a steady influx of women into the labor force. However, now that female participation in Japan exceeds U.S. levels, this tailwind to labor supply will dissipate. Meanwhile, the retirement of aging Japanese baby boomers will accelerate. The largest number of births in Japan occurred between 1947 and 1949. These workers will reach 70 over the next two years, the age at which most Japanese retire. How should investors play this theme? Considering that inflation is still far from the Bank of Japan's 2% target, it is doubtful that the BoJ will abandon its yield curve targeting regime any time soon. But as inflation expectations begin to rise, ultra long-term yields - which are not subject to the BOJ's cap - will increase. This suggests that shorting 20-year JGBs relative to their 5-year counterparts will pay off in spades. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Is The Phillips Curve Dead Or Dormant?" dated September 22, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights We highlighted last month that investors should remain slightly overweight risk assets, but should also hold safe havens given the preponderance of risks. Some of the risks have since faded and the sweet spot for equities is continuing, but the potential for a correction remains elevated. Geopolitics will no doubt remain a threat for 'risk on' trades, although we may be at peak tensions with respect to North Korea. Our models point to an acceleration in growth in the major economies. Our capital spending indicators suggest that animal spirits are stirring in the business sector. In the U.S., fiscal stimulus is back on the table and investors are looking beyond the negative short-term impact of the hurricanes to the growth-enhancing rebuilding that will follow. It is also positive for the stock-to-bond return ratio that our bullish oil scenario is playing out. Stay long oil-related plays. There is a good chance that this year's downtrend in the dollar and government bond yields is over. The rise in both may be halting, but the risks are to the upside now that disappointments on U.S. growth and inflation have likely ended (notwithstanding the hurricane-distorted economic data in the near term). The Phillips curve is not dead. We do not expect Fed balance sheet normalization on its own to be a major headwind for risk assets. The bigger threat is a sudden and sharp re-assessment of the outlook for interest rates in the major countries. Our base-case view is that inflation will only grind higher in the major countries. It should be slow enough that the associated backup in bond yields does not derail the rally in risk assets, but the danger of a sharper bond market adjustment means that investors should continue to be on the conservative side. Feature It was 'risk on' in financial markets in September, despite a less dovish tone among the major central banks. The reason is that the synchronized global growth outlook continues to gather momentum, supporting the earnings backdrop, but inflation remains dormant in the major countries outside of the U.K. Investors believe that calm inflation readings will allow central banks to proceed cautiously and avoid taking risks with growth, extending the expansion in GDP and earnings. The North Korean situation changes from day to day, but investors appear to be more comfortable with it at the margin. In the U.S., fiscal stimulus is back on the table and investors are looking beyond the negative short-term impact of the hurricanes to the growth-enhancing rebuilding that will follow. Finally, rising oil prices will lift earnings in the energy patch. These developments spurred investors to embrace risk assets and carry trades again in September. However, value is poor and signs of froth are accumulating. For example, equity investors are employing record amounts of margin debt to lever up investments. The Bank for International Settlements highlighted in its Quarterly Review that margin debt outstanding in 2015 was higher than during the dotcom boom (and it has surely increased since then). The global volume of outstanding leveraged loans continues to set new highs even as covenant standards slip. Risk assets are being supported by a three-legged stool: solid earnings growth, low bond yields and depressed bond market volatility. The latter is a reflection of current market expectations that dormant inflation will continue to constrain central bankers. We agree that the economic growth and earnings outlook is positive on a 6-12 month horizon. The main item that could upset the sweet spot for risk assets, outside of a geopolitical event, is an awakening in inflation. This would shatter the consensus view that the bond market will remain well behaved. Markets are priced for little change in the inflation backdrop even in the long term. Our base-case view is that inflation will grind higher in the major countries, although it should be slow enough that the associated backup in bond yields does not derail the rally in risk assets in the next 6-12 months. But the risk of a sharper bond market adjustment means that investors should continue to be conservative (although slightly tilted to risk-over-safety). Getting Used To North Korea It appears that investors are becoming increasingly desensitized to provocation from the rogue state. Our geopolitical experts argued that the risk of a full-out war with the U.S. was less than 10%, but they warned that there could be a market-rattling political crisis or even a military skirmish before Pyongyang returned to the negotiating table. However, we may be at peak tensions now, based on several key developments over the past month. First, both China and Russia, two North Korean allies, have turned up the pressure. China appears to be enforcing sanctions according to Chinese trade data vis-à-vis North Korea (Chart I-1). Both China and Russia have also agreed to reduce fuel supplies. And there is evidence that U.S. and North Korea have held unofficial diplomatic talks behind the scenes. The implication is that North Korea is responding to pressure now that its critical fuel supplies are at risk. Chart I-1China Getting Tougher With NK China Getting Tougher With NK China Getting Tougher With NK We cannot rule out more goading from Kim Jong Un, especially with a busy political calendar in Asia this fall: the Korean Worker's Party's anniversary on October 10, the Chinese midterm leadership reshuffle on October 11-25, Japanese elections on October 22, and Trump's visit to the region in mid-November. Nevertheless, it would require a major provocation (i.e. a direct attack on the U.S. or its allies) for Pyongyang to escalate tensions from current levels. This would require the North to be very reckless with its own strategic assets, given that the U.S. would likely conduct a proportional retaliation against any serious attack. The recent backup in Treasury yields and yen pullback suggest that investors do not think tensions will escalate that far. We agree, but obviously the situation is fluid. Trump Trades Back In Play? U.S. politics have also become more equity-friendly and bond-bearish at the margin. The risk of a debt ceiling standoff has been delayed until December following President Trump's deal with the Democrats. We do not think that this represents a radical shift toward bipartisanship, but it is warning from the President that the GOP had better get cracking on tax legislation. The House Budget committee passed a FY2018 budget resolution in late July that included "reconciliation instructions" for tax legislation. Such a budget resolution approved by the Congress as a whole would allow for tax cuts that are not fully offset by spending cuts, with the proviso that the tax reductions sunset after a defined number of years. It is difficult to see tax legislation being passed before year end, but the first quarter of 2018 is certainly possible. Markets will begin to price in the legislation well before it is passed, which means that the so-called Trump trades are likely to see a revival. In particular, the legislation should favor small caps and boost the dollar. This year's devastating hurricane activity will also lift U.S. growth in 2018. History shows that natural disasters have only a passing effect on the U.S. economy and financial markets. Following the short-term negative economic impact, rebuilding adds to growth with the Federal government footing part of the bill. A 2016 Congressional Budget Office (CBO) report found that federal spending after major hurricanes can add as much as 0.6% to GDP. CBO notes that the lion's share of the economic impact is in the first year after a storm, with most of those expenditures helping victims to obtain food and shelter, fund search and rescue operations, and protect critical infrastructure. Federal outlays for public infrastructure occur after the first year and provide a much smaller lift to GDP (Chart I-2). Chart I-2Federal Government Outlays For Hurricane Relief October 2017 October 2017 Oil: Inventories Are Correcting Chart I-3Oil Inventory Correction To Lift Prices Oil Inventory Correction To Lift Prices Oil Inventory Correction To Lift Prices It is also positive for the stock-to-bond return ratio that our bullish oil scenario is playing out. Our energy strategists highlight that global oil demand is booming, at a time when the U.S. Energy Information Administration (EIA) lowered its estimated shale oil output by 200,000 bpd for the third quarter. This confirms our contention that the EIA has overestimated the pace of the shale production response during 2017. Taken together, these factors helped to improve the global net demand/supply balance by 600,000 bpd. The drawdown in global oil inventories is thus likely to continue (Chart I-3). Looking to next year, crude prices could go even higher with an extension of the OPEC/Russian production cuts beyond March 2018 and continued strong growth in global oil demand. The synchronized global expansion is reflected in rising oil demand from all parts of the world. Soft Industrial Production Readings Won't Last We have highlighted global and regional industrial production as important indicators of both economic growth corporate earnings. It is therefore a little disconcerting that our aggregate for industrial production in the advanced economies has suddenly lost momentum (Chart I-4). We are inclined to fade the recent softening for a few reasons. First, much of it is due to weakness in the U.S. where hurricanes affected the August figures. Second, most of our leading indicators remain very constructive. Chart I-5 present a simple model for real GDP growth for the G4 economies based on our consumer and capital spending indicators. Real GDP growth will continue to accelerate for the G4 economies as a group according to the model. Our aggregate consumer indicator appears to have peaked at a high level, but the capex indicator is blasting off. The bullish capital spending reading is unanimous across the major economies (Chart I-6). Chart I-4Animal Spirits Are Stirring... Animal Spirits Are Stirring... Animal Spirits Are Stirring... Chart I-5...Contributing To Stronger G4 Economic Growth ...Contributing To Stronger G4 Economic Growth ...Contributing To Stronger G4 Economic Growth Chart I-6Capital Goods Indicators Are Surging Capital Goods Indicators Are Surging Capital Goods Indicators Are Surging The Eurozone is particularly strong on both the consumer and business fronts, suggesting that euro strength has not undermined growth. Conversely, the U.K. is at the weak end of the spectrum based on the drop in its consumer spending indicator. This is the main reason why we do not believe the Bank of England will be able to make good on its warning of a rate hike this year (see below). Robust capital goods imports for our 20-country aggregate supports the view that animal spirits are stirring in boardrooms in the advanced economies (Chart I-4, third panel). These imports and our capital spending indicators suggest that the small pullback in advanced-economy industrial production will not last, purchasing managers' indexes will remain elevated, and the acceleration in global export activity is just getting started. Even U.S. small business sector has shifted into a higher gear in terms of hiring and capital spending according to the NFIB survey. These trends will favor industrial stocks, especially versus utilities. Central Banks Shedding Dovish Feathers The synchronized global growth pickup is also reflected in our Central Bank Monitors, which are all near or above the zero line (Chart I-7). The Monitors gauge pressure on central banks to adjust policy. Current readings are consistent with the relatively more hawkish tone by central bankers in Canada, the U.S., the Eurozone and the U.K. Chart I-7Central Bank Monitors Support Less Dovish Policymakers Central Bank Monitors Support Less Dovish Policymakers Central Bank Monitors Support Less Dovish Policymakers The violent reaction in the gilt market to the Bank of England's hint that it could hike rates in the next few months highlights the vulnerability of bond markets to any shift by central bankers in a less dovish direction. In this case, we do not believe the BoE will be able to follow through with its rate hike plan. The leading economic indicators are softening and inflation is about to roll over now that the pound has bottomed. In contrast, bunds are quite vulnerable to a more hawkish tilt at the European Central Bank (ECB). Eurozone policymakers confirmed at their September meeting that they plan to announce in October a reduction in the asset purchase program, to take effect in 2018. The ECB revised up its growth forecast for 2017, and left the subsequent two years unchanged. The inflation forecast was trimmed by 0.1 percentage points in 2018 and 2019. The fact that this year's surge in the euro was not enough to move the needle much on the ECB's projections speaks volumes about the central bank's confidence in the current European economic expansion, as well as its comfort level with the rising currency. Our fixed income strategists believe that the full extent of ECB tapering is not yet fully discounted in the European bond market. Phillips Curve: It's Not Dead, Just Resting Chart I-8U.S. Inflation U.S. Inflation U.S. Inflation Turning to the Fed, the bond market did not get the dovish tone it was expecting from September's FOMC meeting. Policymakers left a December rate hike on the table, as Chair Yellen downplayed this year's lagging inflation data as well as the impact of the hurricanes on the economy. Not surprisingly, the odds of a December rate hike have since jumped to 70%. The Fed announced its plan to begin shrinking its balance sheet beginning in October. In the press conference, Yellen tried to disassociate balance sheet policy from the rate outlook. Balance sheet adjustment will be on autopilot, such that short-term interest rates will be the Fed's main policy instrument going forward. While the Fed plans to deliver another rate increase in December, it will require at least a small rise in inflation. Policymakers were no doubt pleased that annual CPI core inflation edged up in August and the 3-month rate of change has moved back to 2% (Chart I-8). The CPI diffusion index also moved above the zero line, indicating that the soft patch in the inflation data may be over, although the diffusion index for the PCE inflation data fell back to the zero line. Table I-1 presents the major contributors to the 0.9 percentage point decline in the year-over-year headline CPI inflation rate since February. Energy accounts for the majority of the decline, at 0.6 percentage points. New cars, shelter, medical services and wireless telephone services account for the remainder. The deflationary wireless price effect is now unwinding, but medical services is a wildcard and our shelter model suggests that this large part of the CPI index will probably not help to lift inflation this year. Thus, higher inflation must come largely from non-shelter core services, which is the component most closely correlated with wages. Investors remain unconvinced by Yellen's assertion that the soft patch in the inflation data reflects transitory factors. Indeed, market-based long-term inflation expectations remain well below the Fed's target, and they even fell a little following the FOMC meeting. Table I-1Contribution To Change In Headline ##br##Inflation (February -August, 2017) October 2017 October 2017 One FOMC member is becoming increasingly alarmed by the market's disbelief that the Fed will hit the 2% target even in the long run (Chart I-9). In a recent speech, Governor Brainard noted that both market-based and survey evidence on inflation expectations have drifted lower in the post-Lehman years. More recently, long-term inflation breakeven rates and CPI swaps have been surprisingly sticky in the face of the rebound in oil prices. In the Fed's view, monetary policy can be used effectively in response to shifts in the cyclical drivers of inflation. However, if inflation expectations were to become unanchored, then inflation's long-run trend would be altered and monetary policy would become less effective. Japan is a glaring example of what could be the endpoint. Brainard's fears have not yet affected the FOMC consensus, which is loath to throw the Phillips curve model into the dust bin just yet. We agree that the Phillips curve is not dead. Peter Berezin, Chief Strategist for the BCA Global Investment Strategy Service, argued in a recent Special Report that the often-cited reasons for why the Phillips curve has become defunct - decreased union bargaining power, a more globalized economy, and technological trends - are less convincing than they appear. The Fed simply has to be patient because the U.S. is only now reaching the kinked part of the Phillips Curve (Chart I-10). Chart I-9Worrying Trends For The FOMC Worrying Trends For The FOMC Worrying Trends For The FOMC Chart I-10U.S. Wage Growth Accelerates Once The Unemployment Rate Falls Below 5% (1997-2017) October 2017 October 2017 Moreover, our global fixed income team has made the case that the global output gap must be taken into consideration.1 Chart I-11 presents the percentage of OECD economies that have an unemployment rate below the NAIRU rate, along with inflation in the services and goods sectors of the developed markets. While the correlation between this global NAIRU indicator and realized inflation rates declined in the years after the recession, the linkages have improved over the past couple of years. The fact that the global NAIRU indicator is only now back to pre-Lehman levels suggests that inflationary pressure could finally be near an inflection point. Market expectations for the path of real GDP growth and the unemployment rate are roughly in line with the FOMC's central tendency forecast. However, the wide gulf between the FOMC and the market on the path of interest rates remains a potential catalyst for a correction in risk assets if market rates ratchet higher. Fed balance sheet runoff could also be problematic in this regard. QE Unwind: How Much Of A Risk? Many investors equate the surge in asset prices in the years after the Great Financial Crisis with central bank largesse. Won't a reversal of this policy be negative for both bonds and stocks? Fed balance sheet runoff, together with ECB tapering and less buying by the Bank of Japan, will certainly change the supply/demand backdrop for the G4 government bond markets in 2018. We have updated our projection for the net flow of government bonds available to the private sector, taking into consideration the supply that is absorbed by central banks and other official institutions (Chart I-12). The top panel shows that the net supply of Treasurys to the private sector never contracted in recent years, but the bottom panel highlights that the net supply of G4 government bonds as a group was negative for 2015, 2016 and 2017. Central banks and other official buyers had to bid-away bonds from the private sector during these years. Chart I-11Global Slack Matters Global Slack Matters Global Slack Matters Chart I-12Major Swing In Government ##br##Bond Supply In 2018 October 2017 October 2017 We project that the net supply will swing from a contraction of almost $600 billion in 2017 to a positive net flow of almost US$200 billion next year. The Fed's projected runoff accounts for most of the swing. The supply/demand effect might push up term premia a little. Nonetheless, as discussed in this month's Special Report beginning on page 19, the balance sheet unwind is not the key threat to bonds and stocks. Rather, the main risk is the overly benign central bank outlook that is priced into the bond market. Real 5-year bond yields, five years forward, are still extremely depressed because the market has discounted negative real short-term interest rates out to 2022 in the U.S. and 2026 in the Eurozone (Chart I-13). Chart I-13Real Forward Short-Term Rates Real Forward Short-Term Rates Real Forward Short-Term Rates Time For The Nikkei To Shine Equity bourses took September's backup in bond yields in stride. Indeed, the S&P 500 and Nikkei broke to new highs during the month. The Euro Stoxx 50 also sprang to life, although has not yet reached fresh highs in local currency terms. The solid earnings backdrop remains a key support for the market. We highlighted our EPS forecasts in last month's report. Nothing of significance has changed on this front. The latest data suggest that operating margins may be peaking, but the diffusion index does not suggest an imminent decline (Chart I-14). Meanwhile, our upbeat economic assessment discussed above means that top line expansion should keep EPS growing solidly into the first half of 2018 at the global level. EPS growth will likely decelerate toward the end of next year to mid-single digits. Chart I-14Operating Margins Approaching A Peak? Operating Margins Approaching A Peak? Operating Margins Approaching A Peak? We still see a case for the Nikkei to outperform the S&P 500, at least in local currencies. Japan is on the cheap side according to our top-down indicator (Chart I-15). Japanese earnings are highly geared to economic growth at home and abroad. Japanese EPS is in an uptrend versus the U.S. in both local and common currencies (Chart I-16). We do not expect to see a peak in EPS growth until mid-2018, a good six months after the expected top in the U.S. Moreover, an Abe win in the October 22 election would mean that policy will remain highly reflationary in absolute terms and relative to the U.S. Chart I-15Valuation: Japan Cheap To The U.S., But Not Europe Valuation: Japan Cheap To The U.S., But Not Europe Valuation: Japan Cheap To The U.S., But Not Europe Chart I-16Japanese Earnings Outperforming The U.S. Japanese Earnings Outperforming The U.S. Japanese Earnings Outperforming The U.S. European stocks are a tougher call. On the plus side, the economy is flying high and there are no warning signs that this is about to end. There is hope for structural reform in France after Macron's election win this year. We give Macron's proposed labor market reforms high marks because they compare favorably with those of Spain and Germany, which helped to diminish structural unemployment in those two countries. Many doubt that Macron's reforms will see the light of day, but our geopolitical team believes that investors are underestimating the chances. The German election in September poured cold water on recent enthusiasm regarding accelerated European integration. This is because Merkel will likely have to deal with a larger contingent of Euroskeptics in the grand coalition that emerges in the coming months. However, we do not expect political developments in Germany to be a headwind for the Eurozone stock market. On the negative side, European stocks do not appear cheap to the U.S. after adjusting for the structural discount (Chart I-15). Moreover, this year's euro bull phase will take a bite out of earnings. As noted in last month's Overview, euro strength so far this year will lop three to four percentage points off of EPS growth by the middle of next year. Our model suggests that this will be overwhelmed by the robust economic expansion at home and abroad, but profit growth could fall to 5%, which is likely to be well short of that in the U.S. and Japan (local currency). Still, a lot of the negative impact of the currency on profits may already be discounted as forward earnings have been revised down. On balance, we remain overweight European stocks versus the U.S. (currency hedged). However, it appears that Japan has more latitude to outperform. Dollar: Finally Finding A Floor? Chart I-17Has The Dollar Found Bottom? Has The Dollar Found Bottom? Has The Dollar Found Bottom? The Fed's determination to stick with the 'dot plot' may have finally placed a floor under the dollar. Before the September FOMC meeting, the market had all but priced out any rate hikes between now and the end of 2018. Both the U.S. economic surprise index and the inflation surprise index have turned up relative to the G10 (Chart I-17). The dollar has more upside if we are past the period of maximum bond market strength and moving into in a window in which U.S. economic and inflation surprises will 'catch up' with the other major economies. Technically, investors appear to be quite short the dollar, especially versus the euro. Bullish sentiment on the euro is highlighted by the fact that the currency has deviated substantially from the interest rate parity relationship. Euro positioning is thus bullish the dollar from a contrary perspective. Nonetheless, our currency experts are more bullish the dollar versus the yen. Given that inflation expectations have softened in Japan and wage growth is still lacking, the Bank of Japan will have to stick with its zero percent 10-year JGB target. The yen will be forced lower versus the dollar as the U.S. yield curve shifts up. We also like the loonie. The Bank of Canada (BoC) pulled the trigger in September for the second time this year, lifting the overnight rate to 1%. Policymakers gave themselves some "wiggle room" on the outlook, but more tightening is on the way barring a significant slowdown in growth, another spike in the C$, or a housing meltdown. The statement said that the loonie's rise partly reflected the relative strength of the Canadian economy, which implies that it is justified by the fundamentals. It does not appear that the C$ has reached a "choke point" in the eyes of the central bank. Investment Conclusions: We highlighted in our last issue that investors should remain slightly overweight risk assets, but should also hold safe haven assets given the preponderance of risks. Some of the risks have since faded and the sweet spot for risk assets is continuing. We remain upbeat on global economic growth and earnings. Nonetheless, both stocks and bonds remain vulnerable to any upside surprises on inflation, especially in the U.S. While the positive trends in stock indexes and corporate bond spreads should continue over the coming 6-12 months, there is a good chance that this year's downtrend in the dollar and government bond yields is over. The rise in both may be halting, but the risks are to the upside now that disappointments on U.S. growth and inflation have likely ended (notwithstanding the hurricane-distorted economic data in the near term). The Phillips curve is not dead, which means that it is only a matter of time before inflation begins to find a little traction. Higher oil prices will also provide a tailwind for headline inflation. Geopolitics will no doubt remain a threat for 'risk on' trades, but we may be past the worst in terms of North Korean tension. We also do not expect Fed balance sheet normalization to be a major headwind for risk assets. Nonetheless, the anticipated swing the supply of G4 government bonds to private investors would serve to add to selling pressure in the fixed-income space if inflation is rising in the U.S. and/or Europe at the same time. In other words, the risk relates more to expected policy rates than the Fed's balance sheet. Stay overweight stocks versus bonds, long oil related plays, slightly short in duration in the fixed income space, and long inflation protection. We also recommend returning to long positions on the U.S. dollar. Mark McClellan Senior Vice President The Bank Credit Analyst September 28, 2017 Next Report: October 26, 2017 1 Please see BCA Global Investment Strategy Weekly Report, "Is The Phillips Curve Dead Or Dormant?" dated September 22, 2017, available at gis.bcaresearch.com II. Liquidity And The Great Balance Sheet Unwind Liquidity is the lifeblood of the economy and financial markets, but it is a slippery concept that means different things to different people. Liquidity falls into four categories: monetary, balance sheet, financial market transaction liquidity, and funding liquidity. Overall liquidity conditions are reasonably constructive for risk assets at the moment. Financial market and balance sheet liquidity are adequate. Monetary policy is extremely easy, although the low level of money and credit growth underscores that the credit channel of monetary policy is still somewhat impaired. Funding liquidity is as important as monetary liquidity for financial markets. It has recovered from the Great Financial Crisis (GFC) lows, but it is far from frothy. Unwinding the Fed's balance sheet represents a risk to investors because QE played such an important role in reducing risk premia in financial markets. The unwind should not affect transactions liquidity or balance sheet liquidity. It should not affect the broad monetary aggregates either. The bond market's reaction will be far more important than balance sheet shrinkage. As long as the Fed can limit the bond market damage via forward guidance, then funding liquidity should remain adequate and risk assets should take the Fed's unwind in stride. It will be a whole different story, however, if inflation lurches higher. The technical impact of balance sheet unwind on the inner workings of the credit market is very complicated. Asset sales could lead to a shortage of short-term high-quality assets, unless it is offset with increased T-bill issuance. However, a smaller balance sheet could, in fact, improve funding liquidity to the extent that it frees up space on banks' balance sheets. Liquidity has been an integral part of BCA's approach to financial markets going back to the early days of the company under the tutelage of Editor-in-Chief Hamilton Bolton from 1949 to 1968. Bolton was ahead of his time in terms of developing monetary indicators to forecast market trends. Back then, the focus was on bank flows such as the volume of checks cashed because capital markets were still developing and most credit flowed through the banking system. Times changed, monetary policy implementation evolved and financial markets became more important and sophisticated. When money targeting became popular among central banks in the 1970s, central bank liquidity analysis focused more on the broader monetary aggregates. These and other monetary data were used extensively by Anthony Boeckh, BCA's Editor-in-Chief from the 1968 to 2002, to forecast the economy and markets. He also highlighted the importance of balance sheet liquidity (holdings of liquid assets), and its interplay with rising debt levels. Martin Barnes continued with these themes when writing about the Debt Supercycle in the monthly Bank Credit Analyst. "Liquidity" is a slippery concept, and it means different things to different people. In this Special Report, we describe BCA's approach to liquidity and highlight its critical importance for financial markets. We provide a list of indicators to watch, and also outline how the pending shrinkage of the Fed's balance sheet could affect overall liquidity conditions. A Primer On Liquidity We believe there are four types of liquidity that are all interrelated: Central Bank Liquidity: Bank reserves lie at the heart of central bank liquidity. Reserves are under the direct control of the central bank, which are used as a tool to influence general monetary conditions in the economy. The latter are endogenous to the system and also depend on the private sector's desire to borrow, spend and hold cash. Bullish liquidity conditions are typically associated with plentiful bank reserves, low interest rates and strong growth in the monetary aggregates. Balance Sheet Liquidity: A high level of balance sheet liquidity means that plenty of short-term assets are available to meet emergencies. The desire of households, companies and institutional investors to build up balance sheet liquidity would normally increase when times are bad, and decline when confidence is high. Thus, one would expect strong economic growth to be associated with declining balance sheet liquidity, and vice versa when the economy is weak. Of course, deteriorating balance sheet liquidity during good times is a negative sign to the extent that households or business are caught in an illiquid state when the economy turns down, jobs are lost and loans are called. Financial Market Transaction Liquidity: This refers to the ability to make transactions in securities without triggering major changes in prices. Financial institutions provide market liquidity to securities markets through their trading activities. Funding Liquidity: The ability to borrow to fund positions in financial markets. Financial institutions provide funding liquidity to borrowers through their lending activities. The conditions under which these intermediaries can fund their own balance sheets, in turn, depend on the willingness of banks and the shadow banking system to interact with them. The BIS definition of funding liquidity is a broad concept that captures a wide range of channels. It includes the capacity of intermediaries that participate in the securitization chain to access the necessary funding to originate loans, to acquire loans for packaging into securities, and finance various kinds of guarantees. The availability and turnover of collateral for loans is also very important for generating funding liquidity, as we discuss below. These types of liquidity are interrelated in various ways, and can positively or negatively reinforce each other. It is the interaction of these factors that determines the economy's overall ease of financing. See Box II-1 for more details. BOX II-1 How Liquidity Is Inter-Related Central bank liquidity, which is exogenously determined, is the basis for private liquidity creation (the combination of market transaction and funding liquidity). The central bank determines the short-term risk-free rate and the official liquidity that is provided to the banking system. If the central bank hikes rates or provides less official liquidity, appetite for private lending begins to dry up. Private sector liquidity is thus heavily influenced by monetary policy, but can develop a life of its own, overshooting to the upside and downside with swings in investor confidence and risk tolerance. Financial market liquidity and funding liquidity are closely interrelated. When times are good, markets are liquid and funding liquidity is ample. But when risk tolerance takes a hit, a vicious circle between market transaction and funding liquidity develops. The BIS highlights the procyclical nature of private liquidity, which means that it tends to exhibit boom-bust cycles that generate credit excesses that are followed by busts.1 The Great Financial Crisis of 2008 is a perfect example. The Fed lifted the fed funds rate by 400 basis points between 2004 and 2006. Nonetheless, the outsized contraction in private liquidity, resulting from the plunge in asset prices related to U.S. mortgage debt, was a key driver of the crash in risk asset prices. Liquidity Indicators: What To Watch (1) Monetary Liquidity Key measures of central bank liquidity include the monetary base and the broad money aggregates, such as M1 and M2 (Chart II-1). Central banks control the amount of reserves in the banking system, which is part of base money, but they do not control the broad monetary aggregates. The latter is determined by the desire to hold cash and bank deposits, as well as the demand and supply of credit. Box II-2 provides some background on the monetary transmission process and quantitative easing. BOX II-2 The Monetary Transmission Process And Qe Before the Great Recession and Financial Crisis, the monetary authorities set the level of short-term interest rates through active management of the level of bank reserves. Reserves were drained as policy tightened, and were boosted when policies eased. The level of bank reserves affected banks' lending behavior, and shifts in interest rates affected the spending and investment decisions of consumers and businesses. Of course, it has been a different story since the financial crisis. Once short-term interest rates reached the zero bound, the Fed and some other central banks adopted "quantitative easing" programs designed to depress longer-term interest rates by aggressively buying bonds and thereby stuffing the banking system with an excessive amount of reserves. Many feared the onset of inflation when QE programs were first announced because investors worried that this would contribute to a massive increase in credit and the overall money supply. Indeed, there could have been hyper-inflation if banks had gone on a lending spree. But this never happened. Banks were constrained by insufficient capital ratios, loan losses and intense regulation, while consumers and businesses had no appetite for acquiring more debt. The result was that the money multiplier - the ratio of broad money to the monetary base - collapsed (top panel in Chart II-1). Bank lending standards eventually eased and credit demand recovered. Broad money growth has been volatile since 2007 but, despite quantitative easing, it has been roughly in line with the decade before. The broad aggregates lost much of their predictive power after the 1980s. Financial innovation, such as the use of debit cards and bank machines, changed the relationship between broad money on one hand, and the economy or financial markets on the other. Despite the structural changes in the economy, investors should still keep the monetary aggregates and the other monetary indicators discussed below in their toolbox. While the year-to-year wiggles in M2, for example, have not been good predictors of growth or inflation on a one or two year horizon, Chart II-2 shows that there is a long-term relationship between money and inflation when using decade averages. Chart II-1The Monetary Aggregates The Monetary Aggregates The Monetary Aggregates Chart II-2Long-Run Relationship Between M2 And Inflation October 2017 October 2017 Other monetary indicators to watch: M2 Divided By Nominal GDP (Chart II-3): When money growth exceeds that of nominal GDP, it could be interpreted as a signal that there is more than enough liquidity to facilitate economic activity. The excess is then available to purchase financial assets. Monetary Conditions Index (Chart II-3): This combines the level of interest rates and the change in the exchange rate into one indicator. The MCI has increased over the past year, indicating a tightening of monetary conditions, but is still very low by historical standards. Dollar Based Liquidity (Chart II-3): This includes Fed holdings of Treasurys and U.S. government securities held in custody for foreign official accounts. Foreign Exchange Reserves (Chart II-3): Central banks hold reserves in the form of gold, or cash and bonds denominated in foreign currencies. For example, when the People's Bank of China accumulates foreign exchange as part of its management of the RMB, it buys government bonds in other countries, thereby adding to liquidity globally. Interest Rates Minus Nominal GDP Growth (Chart II-4): Nominal GDP growth can be thought of as a proxy for the return on capital. If interest rates are below the return on capital, then there is an incentive for firms to borrow and invest. The opposite is true if interest rates are above GDP growth. Currently, short-term rates are well below nominal GDP, signaling that central bank liquidity is plentiful. Chart II-3Monetary Indicators (I) Monetary Indicators (I) Monetary Indicators (I) Chart II-4Monetary Indicators (II) Monetary Indicators (II) Monetary Indicators (II) (2) Balance Sheet Liquidity Chart II-5 presents the ratio of short-term assets to total liabilities for the corporate and household sectors. It is a measure of readily-available cash or cash-like instruments that make it easier to weather economic downturns and/or credit tightening phases. The non-financial corporate sector is in very good shape from this perspective. The seizure of the commercial paper market during the GFC encouraged firms to hold more liquid assets on the balance sheet. However, the uptrend began in the early 1990s and likely reflects tax avoidance efforts. Households are also highly liquid when short-term assets are compared to income. Liquidity as a share of total discretionary financial portfolios is low, but this is not surprising given extraordinarily unattractive interest rates. The banking system is being forced to hold more liquid assets under the new Liquidity Coverage Ratio requirement (Chart II-6). This is positive from the perspective of reducing systemic risk, but it has negative implications for funding liquidity, as we will discuss below. Chart II-5Balance Sheet Liquidity Balance Sheet Liquidity Balance Sheet Liquidity Chart II-6Bank Balance Sheet Liquidity Bank Balance Sheet Liquidity Bank Balance Sheet Liquidity (3) Financial Market Transaction Liquidity: Transactions volumes and bid-ask spreads are the main indicators to watch to gauge financial market transaction liquidity. There was a concern shortly after the GFC that the pullback in risk-taking by important market-makers could severely undermine market liquidity, leading to lower transaction volumes and wider bid-ask spreads. The focus of concern was largely on the corporate bond market given the sharply reduced footprint of investment banks. The Fed's data on primary dealer positioning in corporates shows a massive decline from the pre-crisis peak in 2007 (Chart II-7). This represents a decline from over 10% of market cap to only 0.3%. The smaller presence of dealers could create a liquidity problem for corporate debt, especially if market-making dealers fail to adequately match sellers with buyers during market downturns. Yet, as highlighted by BCA's Global Fixed Income Strategy team, corporate bond markets have functioned well since the dark days of the Lehman crisis.2 Reduced dealer presence has not resulted in any unusual widening of typical relationships like the basis between Credit Default Swaps and corporate bond spreads. Other market participants, such as Exchange Traded Funds, have taken up the slack. Daily trading volume as a percent of market cap has returned to pre-Lehman levels in the U.S. high-yield market, although this is not quite the case for the investment-grade market (Chart II-8). Chart II-7Less Market Making Less Market Making Less Market Making Chart II-8Corporate Bond Trading Volume Corporate Bond Trading Volume Corporate Bond Trading Volume That said, it is somewhat worrying that average trade sizes in corporates are smaller now compared to pre-crisis levels - perhaps as much as 20% smaller according to estimates by the New York Fed. This is likely the result of the reduced risk-taking by the dealers and the growing share of direct electronic trading. Thus, it may feel like liquidity is impaired since it now takes longer to execute a large bond trade, even though transaction costs for individual trades have not been increasing. The bottom line is that financial market liquidity is not as good as in the pre-Lehman years. This is not a problem at the moment, but there could be some dislocations in the fixed-income space during the next period of severe market stress when funding liquidity dries up. (3) Funding Liquidity: There are few direct measures of funding liquidity. Instead, one can look for its "footprint" or confirming evidence, such as total private sector credit. If credit is growing strongly, it is a sign that funding liquidity is ample. Box II-3 explains why international credit flows are also important to watch for signs of froth in lending. BOX II-3 The Importance Of International Credit Flows The BIS highlights that swings in international borrowing amplify domestic credit trends. Cross border lending tends to display even larger boom-bust cycles than domestic credit, as can be seen in the major advanced economies in the lead up to the GFC, as well as some Asian countries just before the Asian crisis in the late 1990s (Chart II-9). When times are good, banks and the shadow banking system draw heavily on cross-border sources of funds, such that international credit expansion tends to grow faster during boom periods than the credit granted domestically by banks located in the country. Since G4 financial systems intermediate a major share of global credit, funding conditions within the G4 affect funding conditions globally, as BIS research shows.3 This research also demonstrates that financial cycles have become more highly correlated across economies due to increased financial integration. Booms in credit inflows from abroad are also associated with a low level of the VIX, which is another sign of ample funding liquidity conditions (Chart II-10). These periods of excessive funding almost always end with a financial crisis and a spike in the VIX. Chart II-9International Credit Is Highly Cyclical International Credit Is Highly Cyclical International Credit Is Highly Cyclical Chart II-10International Credit Booms Lead Spikes In The VIX International Credit Booms Lead Spikes In The VIX International Credit Booms Lead Spikes In The VIX Other measures of funding liquidity to watch include: Chart II-11Market Measures Of Funding Liquidity Market Measures Of Funding Liquidity Market Measures Of Funding Liquidity Libor-OIS Spread (Chart II-11): This is a measure of perceived credit risk of LIBOR-panel banks. The spread tends to widen during periods of banking sector stress. Spreads are currently low by historical standards. However, libor will be phased out by 2021, such that a replacement for this benchmark rate will have to be found by then. Bond-CDS Basis (Chart II-11): The basis is roughly the average difference between each bond's yield spread to Treasurys and the cost of insuring the bond in the CDS market. Arbitrage should keep these two spreads closely aligned, but increases in funding costs tied to balance sheet constraints during periods of market stress affect this arbitrage opportunity, allowing the two spreads to diverge. The U.S. high-yield or investment grade bond markets are a good bellweather, and at the moment they indicate relatively good funding liquidity. FX Basis Swap (Chart II-11): This is analogous to the bond-CDS basis. It reflects the cost of hedging currencies, which is critically important for international investors and lending institutions. The basis swap widens when there is financial stress, reflecting a pullback in funding liquidity related to currencies. The FX swap basis widened during the GFC and, unlike other spreads, has not returned to pre-Lehman levels (see below). Bank Leverage Ratios (Chart II-12): The ratio of loans to deposits is a measure of leverage in the banking system. Banks boost leverage during boom times and thereby provide more loans and funding liquidity to buy securities. In the U.S., this ratio has plunged since 2007 and shows no sign of turning up. Primary Dealers Securities Lending (Chart II-13): This is a direct measure of funding liquidity. Primary dealers make loans to other financial institutions with the purpose of buying securities, thereby providing both funding liquidity and market liquidity. Historically, shifts in dealer lending have been correlated with bid-ask spreads in the Treasury market. Securities lending is also correlated with the S&P 500, although it does not tend to lead the stock market. Dealer loans soared prior to 2007, before collapsing in 2008. Total loans have recovered, but have not reached pre-crisis highs, consistent with stricter regulations that forced the deleveraging of dealer balance sheets. Chart II-12U.S. Bank Leverage U.S. Bank Leverage U.S. Bank Leverage Chart II-13Securities Lending And Margin Debt bca.bca_mp_2017_10_01_s2_c13 bca.bca_mp_2017_10_01_s2_c13 NYSE Margin Debt (Chart II-13): Another direct measure of funding liquidity. The uptrend in recent years has been steep, although it is less impressive when expressed relative to market cap. Bank Lending Standards (Chart II-14): These surveys reflect bank lending standards for standard loans to the household or corporate sectors, but their appetite for lending for the purposes of securities purchases is no doubt highly correlated. Lending standards tightened in 2016 due to the collapse in oil prices, but they have started to ease again this year. Table II-1 provides a handy list of liquidity indicators split into our four categories. Taking all of these indicators into consideration, we would characterize liquidity conditions in the U.S. as fairly accommodative, although not nearly as abundant as the period just prior to the Lehman event. Monetary conditions are super easy, while balance sheet and financial market liquidity are reasonably constructive. In contrast, funding liquidity, while vastly improved since the GFC, is still a long way from the pre-Lehman go-go years according to several important indicators such as bank leverage. Moreover, the Fed is set to begin the process of unwinding the massive amount of monetary liquidity provided by its quantitative easing program. Chart II-14Bank Lending Standards Bank Lending Standards Bank Lending Standards Table II-1Liquidity Indicators To Watch October 2017 October 2017 Fed Balance Sheet Shrinkage: What Impact On Liquidity? Given that the era of quantitative easing has been a positive one for risk assets, it is unsurprising that investors are concerned about the looming unwind of the Fed's massive balance sheet. For example, Chart II-15 demonstrates the correlation between the change in G4 balances sheets and both the stock market and excess returns in the U.S. high-yield market. Chart II-16 presents our forecast for how quickly the Fed's balance sheet will contract. Following last week's FOMC meeting we learned that balance sheet reduction will begin October 1. For the first three months the Fed will allow a maximum of $6 billion in Treasurys and $4 billion in MBS to run off each month. Those caps will increase in steps of $6 billion and $4 billion, respectively, every three months until they level off at $30 billion per month for Treasurys and $20 billion per month for MBS. Chart II-15G4 Central Bank Balance Sheets G4 Central Bank Balance Sheets G4 Central Bank Balance Sheets Chart II-16Fed Balance Sheet Fed Balance Sheet Fed Balance Sheet We have received no official guidance on the level of bank reserves the Fed will target for the end of the run-off process. However, New York Fed President William Dudley recently recommended that this level should be higher than during the pre-QE period, and should probably fall in the $400 billion to $1 trillion range.4 In our forecasts we assume that bank reserves will level-off once they reach $650 billion. In that scenario the Fed's balance sheet will shrink by roughly $1.4 trillion by 2021. The level of excess reserves in the banking system will decline by a somewhat larger amount ($1.75 trillion). In terms of the impact of balance sheet shrinkage on overall liquidity conditions, it is useful to think about the four categories of liquidity described above. (1) Monetary Liquidity The re-absorption of excess reserves will mean that base money will contract (i.e. the sum of bank reserves held at the Fed and currency in circulation). However, we do not expect this to have a noticeable impact on the broader monetary aggregates, credit growth, the economy or inflation, outside of any effect it might have on the term premium in the bond market. The reasoning is that all those excess reserves did not have a major impact on growth and inflation when they were created in the first place. This was because the credit channel of monetary policy was blocked by a lack of demand (private sector deleveraging) and limited bank lending capacity (partly due to regulation). Banks were also less inclined to lend due to rising loan losses. Removing the excess reserves should have little effect on banks' willingness or ability to make new loans. In terms of asset prices, some investors believe that when the excess reserves were created, a portion of it found its way out of the banking system and was used to buy assets directly. That is not the case. The excess reserves were left idle, sitting on deposit at the Fed. They did not "leak" out and were not used to purchase assets. Thus, fewer excess bank reserves do not imply any forced selling. Nonetheless, the QE program certainly affected asset prices indirectly via the portfolio balance effect. Asset purchases supported both the economy and risk assets in part via a weaker dollar and to the extent that the policy lifted confidence in the system. But most importantly, QE depressed long-term interest rates, which are used to discount cash flows when valuing financial assets. QE boosted risk-seeking behavior and the search for yield, partly through the signaling mechanism that convinced investors that short-term rates would stay depressed for a long time. The result was a decline in measures of market implied volatility, such as the MOVE and VIX indexes. Could Bond Yields Spike? The risk is that the portfolio balance effect goes into reverse as the Fed unwinds the asset purchases. The negative impact on risk assets will depend importantly on the bond market's response. As highlighted in the Overview section, there will be a sharp swing in the flow of G4 government bonds available to the private sector, from a contraction of US$800 billion in 2017 to an increase of US$600 billion in 2018. Focusing on the U.S. market, empirical estimates suggest that the Fed's shedding of Treasurys could boost the 10-year yield by about 80 basis points because the private sector will require a higher term premium to absorb the higher flow of bonds. However, the impact on yields is likely to be tempered by two factors: Banks are required by regulators to hold more high-quality assets than they did in the pre-Lehman years in order to meet the new Liquidity Coverage Ratio. The BCA U.S. Bond Strategy service argues that growing bank demand for Treasurys in the coming years will absorb much of the net flow of Treasurys that the Fed is no longer buying.5 As the FOMC dials back monetary stimulus it will be concerned with overall monetary conditions, including short-term rates, long-term rates and the dollar. If long-term rates and/or the dollar rise too quickly, policymakers will moderate the pace of rate hikes and use forward guidance to talk down the long end of the curve so as to avoid allowing financial conditions to tighten too quickly. Thus, the path of short-term rates is dependent on the dollar and the reaction of the long end of the curve. It is difficult to estimate how it will shake out, but the point is that forward guidance will help to limit the impact of the shrinking Fed balance sheet on bond yields. Indeed, the Fed is trying hard to sever the link in investors' minds between balance sheet policy and signaling about future rate hikes, as highlighted by Chair Yellen's Q&A session following the September FOMC meeting. The bottom line is that the impact on monetary liquidity of a smaller Fed balance sheet should be minimal, although long-term bond yields will be marginally higher as a result. That said, much depends on inflation. If the core PCE inflation rate were to suddenly shift up to the 2% target or above, then bond prices will be hit hard, the VIX will surge and risk assets will sustain some damage. The prospect of a more aggressive pace of monetary tightening would undermine funding liquidity, compounding the negative impact on risk assets. (2) Funding Liquidity Chart II-17Tri-Party Repo Market Has Shrunk Tri-Party Repo Market Has Shrunk Tri-Party Repo Market Has Shrunk By unwinding its balance sheet, the Fed will be supplying securities into the market and removing cash. This will be occurring at a time when transactions in the tri-party repo market have fallen to less than half of their peak in 2007 due to stricter regulation (Chart II-17). This market has historically been an important source of short-term funding, helping to meet the secular rise in demand for short-term, low-risk instruments, largely from non-financial corporations, asset managers and foreign exchange reserve funds. If the Fed drains reserves from the system and T-bill issuance does not increase substantially to compensate, a supply shortage of short-maturity instruments could develop. We can see how this might undermine the Fed's ability to shift short-term interest rates higher under its new system of interest rate management, where reverse repos and the interest rate paid on reserves set the floor for other short-term interest rates. However, at the moment we do not see the risk that fewer excess reserves on its own will negatively affect funding liquidity. Again, any impact on funding liquidity would likely be felt via a sharp rise in interest rates and pullback in the portfolio balance effect, which would occur if inflation turns up. But this has more to do with rising interest rates than the size of the Fed's balance sheet. Indeed, balance sheet shrinkage could actually improve funding liquidity provided via the bilateral repo market, securities-lending, derivatives and prime brokerage channels. These are important players in the collateral supply chain. A recent IMF working paper emphasizes that collateral flows are just as important in credit creation as money itself.6 Collateral refers to financial instruments that are used as collateral to fund positions, which can be cash or cash-like equivalents. Since pledged collateral can be reused over and over, it can generate significantly more total lending than the value of the collateral itself. The Fed's overnight reverse-repo facility includes restrictions that the collateral accessed from its balance sheet can only be used in the tri-party repo system. Thus, the Fed's presence in the collateral market has reduced the "velocity of collateral." Table II-2 shows that the reuse rate of collateral, or its velocity, has fallen from 3.0 in 2007 to 1.8 in 2015. Table II-2Collateral Velocity October 2017 October 2017 The combination of tighter capital regulations and Fed asset purchases has severely limited the available space on bank balance sheets to provide funding liquidity. Regulations force banks to carry more capital for a given level of assets. Fed asset purchases have forced a large portion of those assets to be held as reserves, limiting banks' activity in the bilateral repo market. There is much uncertainty surrounding this issue, but it appears that an unwind the Fed's balance sheet will free up some space on bank balance sheets, possibly permitting more bilateral repo activity and thus a higher rate of collateral velocity. It may also relieve concerns about a shortage of safe-haven assets. Nonetheless, we probably will not see a return of collateral velocity to 2007 levels because stricter capital regulations will still be in place. What About Currency Swaps? Some have argued that this removal of cash could also lead to an appreciation of the U.S. dollar. In particular, Zoltan Pozsar of Credit Suisse has observed a correlation between U.S. bank reserves and FX basis swap spreads.7 There is also a strong correlation between FX swap spreads and the U.S. dollar (Chart II-18). Chart II-18FX Basis Swap And Reserves FX Basis Swap And Reserves FX Basis Swap And Reserves One possible chain of events is that, as the Fed drains cash from the market, there will be less liquidity in the FX swap market. Basis swap spreads will widen as a result, and this will cause the dollar to appreciate. In this framework, the unwinding of the Fed's balance sheet will put upward pressure on the U.S. dollar. However, it is also possible that the chain of causation runs in the other direction. The BIS has proposed a model8 where a stronger dollar weakens the capital positions of bank balance sheets. This causes them to back away from providing liquidity to the FX swap market, leading to wider basis swap spreads. In this model, a strong dollar leads to wider basis swap spreads and not the reverse. If this is the correct direction of causation, then we should not expect any impact on the dollar from the unwinding of the Fed's balance sheet. At the moment it is impossible to tell which of the above two theories is correct. All we can do is monitor the correlation between reserves, FX basis swap spreads and the dollar going forward. Conclusions: Overall liquidity conditions are reasonably constructive for risk assets at the moment. Financial market and balance sheet liquidity are adequate. Monetary policy is extremely easy, although the low level of money and credit growth underscores that the credit channel of monetary policy is still somewhat impaired and/or constrained relative to the pre-Lehman years. Funding liquidity has recovered from the Great Financial Crisis lows, but it is far from frothy. More intense regulation means that funding liquidity will probably never again be as favorable for risk assets as it was before the crisis. But, hopefully, efforts by the authorities to reduce perceived systemic risk mean that funding liquidity may not be as quick to dry up as was the case in 2008, in the event of another negative shock. Unwinding the Fed's balance sheet represents a risk to investors because QE played such an important role in reducing risk premia in financial markets. However, we believe that the bond market's reaction will be far more important than balance sheet shrinkage. As long as the Fed can limit the bond market damage via forward guidance, then risk assets should take the Fed's unwind in stride. It will be a whole different story, however, if inflation lurches higher. The technical impact of balance sheet unwind on the inner workings of the credit market is very complicated and difficult to forecast. Asset sales could lead to a shortage of short-term high-quality assets. However, this is more a problem in terms of the Fed's ability to raise interest rates than for funding liquidity. A smaller balance sheet could, in fact, improve funding liquidity to the extent that it frees up space on banks' balance sheets. Mark McClellan Senior Vice President The Bank Credit Analyst Ryan Swift Vice President U.S. Bond Strategy 1 D. Domanski, I. Fender and P. McGuire, "Assessing Global Liquidity," BIS Quarterly Review (December 2011). 2 Please see BCA Global Fixed Income Strategy Weekly Report, "Global Interest Rate Strategy For The Remainder Of 2017," dated July 18, 2017, available at gfis.bcaresearch.com 3 E. Cerutti, S. Claessens and L. Ratnovski, "A Primer on 'Global Liquidity'," CEPR Policy Portal (June 8, 2014). 4 William C. Dudley, "The U.S. Economic Outlook and the Implications for Monetary Policy," Federal Reserve Bank of New York (September 07, 2017). 5 Please see BCA U.S. Bond Strategy Weekly Report, "The Great Unwind," dated September 19, 2017, available at usbs.bcaresearch.com 6 M. Singh, "Collateral Reuse and Balance Sheet Space," IMF Working Paper (May 2017). 7 Alexandra Scaggs, "Where would you prefer your balance sheet: Banks, or the Federal Reserve?" Financial Times Alphaville (April 13, 2017). 8 S. Avdjiev, W. Du, C. Koch, and Hyun S.Shin, "The dollar, bank leverage and the deviation from covered interest parity," BIS Working Papers No.592 (Revised July 2017). III. Indicators And Reference Charts Equity indexes in the U.S. and Japan broke out to new highs in September. European stocks surged as well. Investors embraced risk assets in the month on a solid earnings backdrop, strong economic indicators, continuing low inflation and revived hopes for fiscal stimulus in the U.S. and Japan, among other factors. Our indicators do not warn of any near-term stumbling blocks for the bull market. Our monetary indicator continues to hover only slightly on the restrictive side. Our equity composite technical indicator may be rolling over, but it must fall below zero to send a 'sell' signal. The speculation index is elevated, but bullish equity sentiment is only a little above the long-term mean. Meanwhile, the S&P 500 tends to increase whenever the 12-month forward EPS estimate is rising. The latter is in a solid uptrend that should continue based on the net revisions ratio and the earnings surprise index. Valuation remains poor, but has not yet reached our threshold of overvaluation. Our new Revealed Preference Indicator (RPI) continued on its bullish equity signal in August for the second consecutive month. We introduced the RPI in the July report. It combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Our Willingness-to-Pay (WTP) indicators are also bullish on stocks for the U.S., Europe and Japan. These indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. The U.S. and Japanese WTPs are trending sideways, and Europe could be rolling over. While this is a little worrying because they indicate that flows into equity markets have moderated recently, the indicators have to clearly turn down to provide a bearish signal for stocks. Flows into the U.S. appear to be more advanced relative to Japan and the Eurozone, suggesting that there is more "dry powder" available to buy the latter two markets than for the U.S. market. Oversold conditions for the U.S. dollar are being worked off, but our technical indicator is still positive for the currency. The greenback looks expensive based on PPP, but is less so on other measures. We are positive in the near term. Our composite technical indicator for U.S. Treasurys is at neutral. Bond valuation is also at neutral based on our long-standing model. However, other models that specifically incorporate global economic factors suggest that the 10-year Treasury is still more than 30 basis points on the expensive side. Stay below benchmark in duration. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-10U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

Highlights Dear Client, We will not be publishing next week, as BCA Research's Investment Conference is being held in New York City. We will be back the following week with a Special Report on global agricultural markets, and a recap on the performance of our 3Q17 recommendations. Kind regards, Robert P. Ryan, Chief Commodity Strategist Commodity & Energy Strategy Our new supply-demand balances indicate OPEC 2.0 will have to extend its production cuts to June 2018 to meaningfully reduce global oil inventories, even with demand growth exceeding 1.60mm b/d this year and 1.70mm b/d next year. This will lift average Brent prices to ~ $59/bbl and WTI to just under $57.50/bbl next year. We continue to expect Brent to trade to $60/bbl by year-end 2017, and for WTI to trade ~ $3.00/bbl under that. Higher prices will incentivize higher production from U.S. shale operators. This is a risk OPEC 2.0 will have to manage, as it develops a modus operandi that allows it to co-exist with shale and still maintain adequate revenues for its member states. Energy: Overweight. We are taking profit on our Brent options positions at today's close, since December options will have only three weeks to trade when we return. These positions, recommended in May and June, were up 116.3% on average by Tuesday's close. We will initiate positions in May and December 2018 Brent call spreads, going long the $55/bbl strike vs. short the $60/bbl strike at tonight's close. Base Metals: Neutral. Our tactical COMEX copper short is up 5.5% since inception on September 7. Precious Metals: Neutral. Our long COMEX Gold hedge is up 6.2% since it was initiated May 4, 2017. We are retaining the position as a strategic portfolio hedge. Ags/Softs: Underweight. Corn is having a tough time holding a bid following last week's USDA's Crop Report, which called for higher production and ending stocks, and lower prices. We will be updating our global ags assessment in a Special Report October 5. Feature OPEC 2.0 will have to extend its 1.8mm b/d production cuts to end-June 2018, in order to bring global inventories closer to levels it considered necessary to clear the market when it embarked on its 1.8mm b/d production-cutting Agreement at the end of last year, based on our most recent supply-demand balances modeling (Chart of the Week). Chart of the WeekOPEC 2.0 Needs To Extend Cuts,##BR##To Reduce Global Inventories OPEC 2.0 Needs To Extend Cuts, To Reduce Global Inventories OPEC 2.0 Needs To Extend Cuts, To Reduce Global Inventories As a result, our base case for balances reflects the OPEC 2.0 Agreement being extended to end-June (Chart 2). As we noted in our assessment last week, compliance with the OPEC 2.0 production-cutting Agreement remains high.1 All told, we see global production growing 0.83mm b/d this year, and 2.13mm b/d next year, based on our expectation of the OPEC 2.0 Agreement being extended to end-June. On the demand side, our most recent assessment of global demand leads us to expect growth of 1.62mm b/d this year and 1.72mm b/d in 2018 (Table 1). Chart 2Base Case For BCA Oil Supply-Demand Balances Reflects June 2018 Expiry Of OPEC 2.0 Cuts Base Case For BCA Oil Supply-Demand Balances Reflects June 2018 Expiry Of OPEC 2.0 Cuts Base Case For BCA Oil Supply-Demand Balances Reflects June 2018 Expiry Of OPEC 2.0 Cuts Table 1BCA Global Oil Supply - Demand Balances (mm b/d) OPEC 2.0 Will Extend Cuts To June 2018 OPEC 2.0 Will Extend Cuts To June 2018 Fundamentals Point To Higher Oil Prices Based on our latest assessment of the global oil market, we believe OPEC 2.0 will fall short of reducing visible inventories back to their 5-year average levels if the coalition's production-cutting agreement expires at end-March 2018 (Chart of the Week, top panel). In fact, we believe that the Agreement will have to be extended to at least June 2018 - assuming no change in OPEC 2.0 country-specific production quotas - in order to draw OECD inventories down to their 5-year average levels (Chart of the Week, middle panel). An extension of the cuts to December 2018 would push OECD commercial inventories closer to levels originally targeted by OPEC 2.0 when its Agreement was reached at the end of last year. There is a higher risk prices will exceed the upper end of the range we assume WTI will trade in - $45/bbl to $65/bbl - with greater frequency next year, given we expect WTI prices will average slightly less than $57.50/bbl and Brent prices will average just under $59.00/bbl. Given the draws we expect in global inventories, the likelihood the WTI forward curve trades in backwardation next year also is elevated. We expect Brent to continue to trade in backwardation next year, which we believe will benefit OPEC 2.0 member states, since it allows them to realize higher spot prices - against which term contracts mostly are written - and will limit the volume of hedging U.S. shale producers can effect. Given our updated balances, we re-estimated our oil fundamentals models, accounting for the higher demand we expect (Chart 3), and continued production restraint by OPEC 2.0 on the supply side (Chart 4). These are markedly different to the EIA's estimates. Chart 3BCA Expecting Stronger Oil Demand Than EIA BCA Expecting Stronger Oil Demand Than EIA BCA Expecting Stronger Oil Demand Than EIA Chart 4Oil Supply Evolution Under Different Scenarios Oil Supply Evolution Under Different Scenarios Oil Supply Evolution Under Different Scenarios Using these fundamental inputs, we derived forecasts for the WTI and Brent prices.2 The four scenarios we analyzed are: Expiry of OPEC 2.0 Agreement in March 2018; Expiry of OPEC 2.0 Agreement in June 2018; Expiry of OPEC 2.0 Agreement in December 2018; The U.S. EIA Short-term Energy Outlook (STEO) supply-demand assumptions. The estimated results are presented in Table 2 and Chart 5. Table 2Fundamentally Derived##BR##Price Expectations OPEC 2.0 Will Extend Cuts To June 2018 OPEC 2.0 Will Extend Cuts To June 2018 Chart 5Oil Prices Will Lift As OPEC 2.0##BR##Agreement Restricts Supply Oil Prices Will Lift As OPEC 2.0 Agreement Restricts Supply Oil Prices Will Lift As OPEC 2.0 Agreement Restricts Supply Interestingly, the 4Q17 WTI futures curve appears to be priced much closer to Scenario No. 4, the EIA's assumptions. This is something we have observed in the past - i.e., the market has a tendency to price to the EIA's supply-demand balances, in the short term. As far as we can tell, the EIA's estimates assume less steep cuts than we do, and appear to be projecting visible inventories will begin to rise starting next month - (Chart 6). Chart 6EIA Assumes OECD Inventories Will Rise EIA Assumes OECD Inventories Will Rise EIA Assumes OECD Inventories Will Rise Under the EIA scenario, the average WTI futures price for 4Q17 is $50.40/bbl. Under BCA Base Case Scenario, which assumes the OPEC 2.0 Agreement will be extended to end-June, we estimated WTI prices would average $54.00/bbl over the same period. For 2018, the divergence between the EIA and BCA base cases is even more dramatic: Under the EIA's assumptions, our fundamental model estimates WTI prices will average $45.55/bbl in 2018, while under our new base case scenario, which projects the OPEC 2.0 deal will be extended through June, we estimate WTI prices will average $57.44/bbl next year. In its September Short-Term Energy Outlook (STEO), the EIA substantially lowered its U.S. shale production growth estimates for this year. Our colleagues at BCA's Energy Sector Strategy highlight this revision in this week's report, noting that 3Q17 U.S. onshore production levels will be 540k b/d higher yoy, versus an earlier expectation of a 730k b/d increase. This represents a ~ 25% reduction in the yoy growth rate. In addition, EIA's forecasted 3Q17 quarter-on-quarter oil production growth was cut by 40%, with sequential production growth now estimated at 197k b/d.3 The EIA's estimate now is more in line with BCA's assessment. These revisions will be supportive of prices, once market participants realize the EIA's scaling back on its growth expectations. BCA Lifts Estimate Of Demand Growth In our revised supply-demand balances, we expect 2017 global oil consumption will increase 1.62mm b/d, while 2018 demand will be up 1.72mm b/d. This reflects the strong growth reported by the OECD, which we noted last week, and the IMF.4 Strong growth momentum also can be seen in the continued performance of world trade volumes (Chart 7). The trade expansion is led by EM economies, with EM Asia, Latin America and Central Europe all posting yoy growth of ~ 10% at mid-year. EM also drives most of global oil-demand growth (Chart 8).5 Chart 7Global Growth Reflected##BR##In Increased Trade Volumes Global Growth Reflected In Increased Trade Volumes Global Growth Reflected In Increased Trade Volumes Chart 8EM Import Volumes##BR##Remain Strong EM Import Volumes Remain Strong EM Import Volumes Remain Strong Our expectation is EM oil demand will grow 1.20mm b/d this year and 1.30mm next year, accounting for the bulk of the 1.62mm and 1.72mm of overall demand growth we expect in 2017 and 2018, respectively. We will continue to follow demand trends in EM closely, particularly China and India, given its importance to overall global oil demand growth. Backwardation Will Persist In Brent, Arrive Sooner In WTI The direct implication of our results is backwardation will become more pronounced going forward. In the Brent market, the forward curve is backwardated to the end of 1Q18 then pretty much flattens out, based on mid-week settlements. In the WTI curve forwards, WTI futures carry to June 2018 then backwardate slightly to the beginning of 4Q19. We expect both to backwardate next year as storage draws and markets tighten. We have maintained OPEC 2.0 member states would benefit from a strategy under which they manage production and storage in such a way as to backwardate Brent and WTI curves. This would allow member states to realize higher revenues from spot prices, which are referenced in long-term supply contracts and are received on outright spot sales, and limit the amount of hedging U.S. shale producers can do: Lower deferred prices are not as profitable for producers, since they result in less revenue per barrel hedge in the future. Upward-sloping forward curves - i.e., contango market structures - allow producers to hedged at higher prices in the future, providing higher revenues, assuming the starting point is the same as in a backwardated market. We expect that as 2017 winds down and we approach the end of 1Q18, it will become apparent to OPEC 2.0's leadership their production-cutting agreement needs to be extended in order to drain global storage and get prices to lift. This is particularly true for the Kingdom of Saudi Arabia (KSA), which most likely will IPO Saudi Aramco, the state-owned oil company toward the end of next year. If OPEC 2.0's production-management agreement is not extended and inventories do not draw sufficiently to lift prices and backwardate the Brent forward curve, KSA most likely will have to push its IPO into 2019. Given the country's keen desire to raise funds to support its diversification away from its oil dependency, we believe its leaders would prefer to get the funds raised by the IPO in the door and begin allocating them. Bottom Line: OPEC 2.0 will extend the expiry of its production-cutting agreement from end-March to end-June 2018. This will force global inventories to fall to levels closer to those expected when the coalition agreed to jointly manage production at the end of last year. Demand growth will exceed 1.60mm b/d this year and 1.70mm b/d next year. This, along with the extension of the OPEC 2.0 cuts to end-June, will lift average Brent prices to ~ $59/bbl and WTI to just under $57.50/bbl next year. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Hurricane Recovery Obscures OPEC 2.0's Forward Guidance," published September 14, 2017. It is available at ces.bcaresearch.com. 2 We estimate WTI and Brent prices for the balance of 2017 and 2018 with respect to their fundamentals. The adjusted R2 for the WTI and the Brent regressions are 0.89 and 0.92, respectively. 3 Please see BCA Research's Energy Sector Strategy Weekly Report "A Funny Thing Happened On The Way To The "Shalepocalypse," published September 20, 2017. It is available at nrg.bcaresearch.com. 4 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Hurricane Recovery obscures OPEC 2.0's Forward Guidance," published September 14, 2017. It is available at ces.bcaresearch.com. See also "A Firming Recovery," in the IMF's World Economic Outlook Update published July 24, 2017. We use IMF global GDP growth estimates as an input to our oil-demand modelling. 5 We have found EM imports to be a good explanatory variable for oil and base metals demand, as well as inflation in the U.S. and EU. Please see, e.g., BCA Research's Commodity & Energy Strategy Weekly Report "Trade And Commodity Data Point To Higher Inflation," published July 27, 2017. It is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table OPEC 2.0 Will Extend Cuts To June 2018 OPEC 2.0 Will Extend Cuts To June 2018 Trades Closed in 2017 Summary of Trades Closed in 2016

Highlights Bitcoin and other virtual currencies have sold off sharply in recent days. However, as the turn of the millennium dotcom boom and bust illustrates, wild swings in asset prices can sometimes mask important structural changes that new technologies have unleashed on the global economy. If the proliferation of virtual currencies continues, it will have real macroeconomic effects. Globally, the volume of currency in circulation - the largest component of base money - has grown by 5.5% year-over-year. However, the growth rate would be 7% if virtual currencies were included in the tally. The indirect increase in global liquidity coming from virtual currencies should provide a modest boost to spending. This is somewhat bearish for bonds but bullish for equities. The implications for gold and the dollar are mixed. Governments derive significant "seigniorage revenue" from their ability to issue fiat currency. This is likely to impede the widespread adoption of virtual currencies, ultimately capping their prices. Feature Bitcoin And Beyond The price of bitcoin has been extremely volatile lately, falling by more than 10% last week after the Chinese government announced a ban on so-called Initial Coin Offerings. The downdraft continued into this week, spurred on by JPMorgan CEO Jamie Dimon's description of bitcoin as a "fraud." The recent selloff followed a dizzying ascent which saw the price of the upstart currency surpass $5000 earlier this month (Chart 1). Despite the pullback, one thousand dollars of bitcoin purchased in July 2010 would still be worth $58 million today. Such mind-boggling returns have caught the public's attention. There were more Google searches for "bitcoin" in August and September than for "Donald Trump" (Chart 2). Public appetite is so high that the Bitcoin Investment Trust, though officially an open-ended vehicle, has traded as high as twice its net asset value in recent months. Chart 1Bitcoin Prices: It's Been A Wild Ride So Far Bitcoin Prices: It's Been A Wild Ride So Far Bitcoin Prices: It's Been A Wild Ride So Far Chart 2President Trump: Bitcoin Is More Popular Than You! President Trump: Bitcoin Is More Popular Than You! President Trump: Bitcoin Is More Popular Than You! Other virtual currencies have also seen staggering returns. Ethereum is still up more than 3000% year-to-date, giving it a market cap of $23 billion. Dogecoin, a currency that was started "as a joke" according to its founders, commands a market cap of $114 million. Wider Effects? The run-up in bitcoin prices bears a close resemblance to classic bubbles (Chart 3). Yet, as the turn of the millennium dotcom boom and bust illustrates, wild swings in asset prices can sometimes mask important structural changes that new technologies have unleashed on the global economy. This raises the question of whether the explosion in virtual currencies is relevant for the broader investment community, including those investors who would never consider buying bitcoin. We would answer yes, albeit in a limited form thus far. The market capitalization of all virtual currencies currently stands at $120 billion (Chart 4). Globally, there is about $6 trillion in currency outstanding, so the value of virtual currencies is now 2% that of traditional cash and currency. That's not huge, but it's no longer trivial either. Chart 3Bitcoin Bubble? Bitcoin Bubble? Bitcoin Bubble? Chart 4Virtual Currencies: Market Cap Is Now Non-Trivial Bitcoin's Macro Impact Bitcoin's Macro Impact The importance of virtual currencies increases if we look at rates of change. The global stock of currency in circulation has risen by 5.5% over the past 12 months. However, if we add virtual currencies to the mix, the rate of growth jumps to 7%. The contribution of virtual currencies to the rate of growth of the broad money supply - which includes such items as bank deposits - is still fairly small. However, economists focus on currency in circulation for a reason: It is the largest component of base money (also known as "high-powered" money). The stock of base money helps determine the total money supply through the magic of the money multiplier and fractional reserve banking. The Monetary Hot Potato For the time being, the macro impact of virtual currencies has been constrained by the fact that most people are buying them as a store of value, rather than as a medium of exchange. It is no coincidence that up until recently, a disproportionately large amount of demand for virtual currencies has come out of China, an economy that suffers from a plethora of savings and a dearth of safe investable assets (Chart 5). In addition to squirrelling away their wealth in overpriced condos, the Chinese are now snapping up bitcoins. Chart 5Bitcoin Trading Volume By Top Three Currencies Bitcoin's Macro Impact Bitcoin's Macro Impact Over time, the public may begin to regard virtual currencies as legitimate substitutes for dollars, euros, yen, and yuan. This could lead people to want to hold fewer of these traditional currencies, causing them in turn to either spend their excess cash holdings or deposit them in commercial banks. The first outcome would obviously be inflationary, but so would the second if rising deposit inflows caused banks to increase lending. What would happen if people began transacting more in virtual currencies? At that point, the Fed and other central banks would need to decide whether to take some traditional paper money out of circulation in order to make room for the growing share of private virtual currencies. The merits of doing so would depend on the state of the business cycle.1 When inflation is low, as it is today in most of the world, central banks would gladly welcome anything that boosts spending and liquidity. Indeed, in some ways, the issuance of private currencies could have similar effects to helicopter drops of money. However, if inflation were to accelerate too rapidly, central banks would have to begin withdrawing their own currencies from circulation, or push for the withdrawal of private currencies. Governments Want Their Cut Chart 6U.S. Seigniorage Revenue U.S. Seigniorage Revenue U.S. Seigniorage Revenue The former outcome would not please the fiscal authorities. When the U.S. Treasury issues a $100 bill, it gains the ability to buy $100 of goods and services with it. The government's cost is whatever it pays to print the bill, which is close to zero. This so-called "seigniorage revenue" is quite large, averaging close to $70 billion per year for the U.S. government alone over the past decade (Chart 6). Why would the U.S. or any other country that issues its own currency want to part with this revenue? The answer is that it wouldn't. Instead, governments are likely to introduce their own competitors to bitcoin. The blockchain technology on which bitcoin is built is ingenious but completely within the public domain. Central banks are already thinking about how to issue their own virtual currencies. The creation of such parallel electronic currencies would allow people to send funds to one another and purchase goods and services without the need for an intermediary, a potentially negative development for banks and other financial institutions. These government-sponsored virtual currencies are unlikely to offer the full anonymity of bitcoin, but for most people, that may not be such a bad thing. As our Technology Sector Strategy service has emphasized, private virtual currencies suffer from numerous deficiencies which expose their users to fraud.2 When thieves stole 6% of all outstanding bitcoins from the Mt. Gox exchange in 2014, the victims had nothing to fall back on. A government-sponsored virtual currency could at least offer some protection to its holders, thereby making it more valuable to use. It would also allow central banks to fulfill their responsibilities as lenders of last resort. The Free Banking Era in the U.S., which at one point saw 8000 different currencies in circulation, experienced multiple banking crises. A world with myriad private currencies all competing with one another would be similarly unstable. Bitcoin: A Solution In Search Of A Problem? Chart 7The Boom In Cryptocurrencies Bitcoin's Macro Impact Bitcoin's Macro Impact This gets to a more fundamental issue, which is that bitcoin often comes across as a solution in need of a problem. People can already transfer money fairly easily when it is legal to do so. If the main practical advantage of bitcoin is to overcome capital controls and empower tax cheats, junkies, and hackers, it is hard to see how this does not beget a government crackdown. Ironically, the "mining" of additional bitcoins requires significant investment in specialized computers and dollops of electricity. Virtual currencies may exist in bits and bytes, but real resources must be expended to create them. In contrast, governments can create money with simply the stroke of a pen. Granted, if governments used this power to devalue the value of money - as they have periodically done from time to time - the virtues of bitcoin as a store of value would become more evident. The algorithms that power bitcoin limit the total number of coins that can ever be created to 21 million. Bitcoin is not the only game in town, however. Dozens of competitors have sprung up (Chart 7). While each may cap the number of coins in circulation, collectively they represent a potentially significant (and possibly unlimited) addition to the monetary base. Thus, it is not clear how well virtual currencies would perform as inflation hedges compared to more traditional instruments such as gold and land, let alone modern hedges such as inflation-linked securities. Investment Conclusions The role that money plays in modern economies is one of those things that people tend to tie themselves into pretzels thinking about. It's actually not that complicated. For the most part, inflation occurs when the demand for goods and services outstrips the supply of goods and services. Outside of extreme situations, the choice of monetary regime does not affect the supply-side of the economy (that's determined by productivity and the size of the labor force, neither of which central banks have much control over). Thus, it really is just a question of how the monetary regime affects aggregate demand. As noted above, there are reasons to think that the proliferation of virtual currencies will boost the demand for goods and services, either through the wealth effect channel (people who acquired bitcoin in its early days feel richer today), or via the currency substitution channel (if people start transacting in bitcoin, they may try to dispose of their excess dollars, euros, yen, and yuan either by spending them or depositing them in banks, leading to higher loan growth). Neither of these effects is terribly significant right now, but both have the potential to increase in importance over time. At some point, governments will take steps to rein in virtual currencies. However, until then, their existence is likely to spur inflation in the fiat currencies in which most prices are measured. That's bad for high-quality government bonds, but potentially good for stocks. The implications for gold are mixed. On the one hand, if the growth of virtual currencies translates into an increase in the global money supply and rising inflation, that is good for bullion. On the other hand, if people see bitcoin as a competitor to gold as a store of value, they may wish to hold less of the yellow metal. The dollar could lose out from the proliferation of virtual currencies if central banks allocate some of their USD reserves into these new currencies. However, it is doubtful this will happen to any significant degree since most central banks are likely to see virtual currencies as unwanted competitors to their own monies. In the meantime, stronger global demand growth could put disproportionately more upward pressure on U.S. inflation, given that the U.S. is closer to full employment than most economies. This could cause the Fed to raise rates more aggressively than it otherwise would, leading to a firmer dollar. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 To appreciate this point, ponder the question of who suffers when someone goes shopping with counterfeit currency. If the economy is operating at full potential, the answer is that everyone else suffers because they have to pay higher prices for the things that they buy. However, if there are plenty of idle workers, the additional spending is unlikely to raise prices. Rather, it will translate into higher output and income. 2 Please see Technology Sector Strategy, "Blockchain and Cryptocurrencies," dated May 5, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights U.S. product inventories - particularly gasoline and distillates - will show sharp declines over the balance of September, as refining capacity continues to trail demand in the wake of Hurricane Harvey. U.S. crude inventories will accumulate as refineries slowly come back on line. This will keep the Brent vs. WTI spreads and crack spreads elevated, as refiners outside the U.S. Gulf scramble for crude (Chart of the Week).1 Global product storage facilities will be drained to more normal levels responding to this imbalance. It is understandable that the significance of the increased frequency of messaging from OPEC 2.0's leadership re its willingness to extend production cuts beyond March 2018 would be secondary to hurricane recovery. Nonetheless, we advise investors to stay focused on OPEC 2.0's evolution, particularly next year, as it develops a modus operandi for providing forward guidance to markets and investors. Energy: Overweight. Brent futures are backwardated to January 2018, reflecting a tight market as refiners, particularly in Europe, scramble for barrels to meet U.S. and Latin American product demand. We remain long Brent and WTI $50/bbl vs. $55/bbl call spreads in Dec/17, which are up 183.8% and 30.2%, respectively, since inception. Base Metals: Neutral. Our tactical COMEX copper short initiated last week is up 3.4%. Precious Metals: Neutral. The Dec/17 COMEX Gold contract gapped lower earlier in the week, as a strengthening USD, and a 15 - 0 vote Monday by the UN Security Council to adopt sanctions proposed by the U.S. against N. Korea took some of the luster off the metal. Our long strategic portfolio hedge is up 8.0% since it was initiated May 4, 2017. Ags/Softs: Underweight. Grains appear to be finding support around current levels. We are bearish, but do not advise shorting the complex, especially with erratic weather as a backdrop. Feature Chart of the WeekBrent - WTI Spread,##BR##Cracks Reflect Refining Scramble Brent - WTI Spread, Cracks Reflect Refining Scramble Brent - WTI Spread, Cracks Reflect Refining Scramble The Kingdom of Saudi Arabia (KSA) and Russia, the putative leaders of what we've dubbed OPEC 2.0, are taking every opportunity to signal their willingness to consider an extension of their production-cutting agreement beyond March 2018, when it is scheduled to expire.2 We believe this to be part and parcel of an evolving forward guidance strategy, which KSA and Russia will deploy to signal their production intentions over the near term. This is consistent with our view such a strategy is necessary to keep the producer coalition durable, and to work out an even larger plan to begin messaging firms and institutions allocating capital to oil and natural gas markets globally. This is critical for KSA, which will be looking to IPO Saudi ARAMCO next year, and Russia, which is preparing for elections in March and still relies heavily on hydrocarbon exports to fund its government.3 The last thing either needs is out-of-control oil production tanking the market, as it almost did at the beginning of 2016. Other members of the OPEC 2.0 coalition seeking foreign direct investment (FDI) - e.g., Gulf Arab producers and non-OPEC states like Mexico and Kazakhstan - benefit from an oil-production-management framework as well. The significance of OPEC 2.0's emerging forward guidance strategy could be lost amid the devastation of hurricanes Harvey and Irma, which is understandable. But it will be critical to understanding the coalition's strategy regarding how it intends to manage its own production, now that U.S. shale is the marginal barrel in the world, even after Hurricane Harvey disrupted production and refining in Texas, and U.S. crude and product exports from the Gulf. Thus far, OPEC 2.0 continues to deliver on its production cuts, and global demand - which we expect will dip by less than 1mm b/d over the next few weeks due to the hurricanes - remains strong. In a month or two, we expect hurricane recovery efforts will restore lost refining capacity and product demand. As rebuilding goes into high gear, we expect product demand to get a significant boost. OPEC 2.0 Maintains Discipline We will be updating our oil supply/demand balances next week, but so far it appears KSA and Russia are honoring their commitments to restrain production. This allows them to maintain credibility with their respective OPEC and non-OPEC allies within OPEC 2.0, and with the market in general (Chart 2). KSA, in particular, has led the way among OPEC members of the coalition, according to a tally done by S&P Global's Platts, which put KSA's average crude oil production over the January - August 2017 period at 9.97mm b/d vs. its quota of 10.06mm b/d. This is up slightly over the 9.93mm b/d average production for January - June 2017 reported by JODI. KSA's August production reported in the September OPEC Monthly Oil Market Report was 9.95mm b/d. For the January - August 2017 period, Russia's total crude and liquids production averaged 11.22mm b/d, according to U.S. EIA estimates. For the May - August period, it averaged 11.16mm b/d, putting total output 300k b/d below its October 2016 level, against which OPEC 2.0 benchmarks. Russia committed to reducing output by 300k b/d under the OPEC 2.0 Agreement as part of an overall effort to remove 1.8mm b/d of production from the market to end-March 2018. Russia's crude oil production averaged 10.38mm b/d over the January - June 2017 period, according to JODI data, vs. an October level of 10.51mm b/d. For 2Q17, Russia's average production reported to JODI was 10.31mm b/d, or 200k b/d below its Oct/16 output. Overall OPEC compliance of members with quotas was 112% of agreed volumes last month, meaning OPEC members with quotas under the OPEC 2.0 Agreement are producing 630k b/d below agreed volumes, according to Platts.4 Seven of the OPEC states still covered by the Agreement are producing below quota. Iraq leads in over-production at 4.46mm b/d on average in the January - August period, or 82k b/d over quota. Overall, however, production discipline is holding (Chart 3, panel 2). Chart 2KSA, Russia Leading##BR##OPEC 2.0 By Example KSA, Russia Leading OPEC 2.0 By Example KSA, Russia Leading OPEC 2.0 By Example Chart 3Production Discipline, Strong Demand##BR##Will Continue To Support Prices Production Discipline, Strong Demand Will Continue To Support Prices Production Discipline, Strong Demand Will Continue To Support Prices Bottom Line: OPEC 2.0's forward guidance to markets, firms and institutions allocating capital in the energy sector has featured frequent re-statements of the coalition's leaders' willingness to extend their production cuts if inventories have not drawn sufficiently by March 2018, when their Agreement is due to expire. We believe this reflects the desire of OPEC 2.0's leadership to maintain the coalition as a long-term production-coordinating body. This will allow the major oil producing nations to communicate production plans and allay investor fears of out-of-control production in the future. Global Demand Will Remain Strong We have noted repeatedly global economic growth has been firing on all cylinders, which will keep global oil demand robust for at least the balance of 2017, and likely into 2018 (Chart 3, panel 3). This is particularly evident in global trade data, which we also will be updating next week.5 Global economic data continue to support this thesis: All 46 countries monitored by the OECD are on track to grow this year, the first time this has happened since 2007, according to BCA's Global Investment Strategy (GIS).6 In addition, BCA's Global Investment Strategy notes U.S. growth projections have been broadly stable, but these likely will be revised higher. The easing in U.S. financial conditions since the start of the year should boost real GDP growth over the next few quarters, which, along with the expected boost to product demand coming on the back of hurricane-recovery efforts, will continue to be bullish for refined product demand. Global Product Inventory Draws Will Accelerate OPEC 2.0's efforts to draw global inventories - particularly in the OECD - received an unexpected assist from hurricanes Harvey and Irma. We expect the trend of drawdowns seen over the past few months to accelerate (Chart 4). This will return global product inventories to more normal levels, and, with crude oil inventories accumulating, favor refiners as they scramble to meet demand. Our colleagues at BCA's Energy Sector Strategy upgraded U.S. refiners last week to overweight in line with their view Harvey has the "potential to finally normalize bloated refined product inventories. Over two weeks since the hurricane made landfall, the industry still has 1.0 MMb/d of refining capacity shut down (5 refineries), 2.15 MMb/d of capacity not operating but working on restarting operations (6 refineries), and 1.4 MMb/d of capacity operating below full capacity (5 refineries). Over the past 16 days, at least 55 million barrels of refined product have not been generated, which will result in increased crude inventories and shrinking refined product inventories, benefitting refiners" (Chart 5).7 Chart 4OECD Oil Inventory Declines Will Accelerate OECD Oil Inventory Declines Will Accelerate OECD Oil Inventory Declines Will Accelerate Chart 5Refinery Outages From Harvey Persist Hurricane Recovery Obscures OPEC 2.0's Forward Guidance Hurricane Recovery Obscures OPEC 2.0's Forward Guidance Over the short term, Brent crude - and related streams pricing off Brent - and products will remain bid, keeping refiner crack spreads elevated, as operations return to normal, and Florida emerges from the economic damage and dislocations caused by Irma. Typically, product demand falls immediately after severe storms, and recovers as rebuilding begins and progresses. We will be updating our balances model next week to reflect the effects of hurricanes and the continued indications of strong global growth. Bottom Line: Demand for refined products will dip slightly - likely less than 1% of global demand - as hurricane-ravaged markets recover. As rebuilding progresses, product demand likely will be boosted. This will drain OECD product inventories in the short term, providing an unexpected assist to OPEC 2.0's efforts to bring global stocks down to five-year average levels. This evolution will favor refiners, as well. OPEC 2.0's forward guidance to markets continues to evolve. In recent weeks, it has featured frequent re-statements of the coalition's leaders' willingness to extend their production cuts if inventories have not drawn sufficiently by March 2018. We believe this messaging is designed to allay fears of another production-free-for-all of the sort that threatened to take global benchmark crude oil prices below $20/bbl last year. It is too early to expect OPEC 2.0 will replace the original OPEC Cartel. But, we believe KSA and Russia are signaling their common desire to make OPEC 2.0 a durable feature of budgeting and investment considerations over the medium term. Actions speak louder than words, in this regard. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 A "crack spread" refers to the difference in refined-product prices and crude oil prices. It takes its name from the "cracking" long-chain hydrocarbon bonds in crude oil required to produce refined products like gasoline and diesel fuel. The Brent - WTI spread is the price difference in USD/barrel ($/bbl) between the global benchmark crudes. 2 Please see, for example, "Saudi Arabia Says It's Open to Another OPEC Cuts Extension," updated on bloomberg.com September 11, 2017; "Saudi, UAE agree extension of oil cuts may be considered - statement," published on the same day on reuters.com's U.K. service; and "Russia's Novak says to consider extension of oil cut deal if glut persists" published on reuters.com September 6, 20107. We have repeated noted markets are looking for OPEC 2.0 to provide forward guidance, if the principals to the deal intend to maintain a durable coalition. Please see, e.g., "KSA's Tactics Advance OPEC 2.0's Agenda," published by BCA Research's Commodity & Energy Strategy Weekly Report August 10, 2017, and available at ces.bcaresearch.com. 3 The U.S. CIA estimates Russia exported 5.1mm b/d of crude oil in 2016, roughly half of crude production. This squares with exports reported by the Joint Organizations Data Initiative (JODI), a transnational agency headquartered in Riyadh, Saudi Arabia. Last year, Russia also exported 223 billion cubic meters of natural gas. KSA exported 7.65mm b/d of crude oil last year, according to JODI, or close to 75% of KSA's production. 4 Please see S&P Global Platts OPEC Guide published September 7, 2017, online. 5 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Trade And Commodity Data Point To Higher Inflation," published on July 27, 2017. It is available at ces.bcaresearch.com. 6 Please see BCA Research's Global Investment Strategy Weekly Report "Central Bank Showdown," published on September 8, 2017. It is available at gis.bcaresearch.com. 7 Please see BCA Research's Energy Sector Strategy Weekly Report "Rebalancing Recommendations," published on September 13, 2017. It is available at nrg.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Hurricane Recovery Obscures OPEC 2.0's Forward Guidance Hurricane Recovery Obscures OPEC 2.0's Forward Guidance Trades Closed in 2017 Summary of Trades Closed in 2016

Dear Client, I have been visiting clients in Europe this week, so today's report is somewhat shorter than usual. We will be back next week with an exciting Special Report on the macro effects of bitcoin and other virtual currencies. Best regards, Peter Berezin, Chief Global Strategist Global Investment Strategy Highlights Global growth remains strong and broad-based. U.S. GDP growth will accelerate over the next few quarters thanks to the easing in financial conditions so far this year. The market is pricing in only 20 basis points in cumulative rate hikes between now and the end of next year. This is far too low. Go short the Dec-2018 fed funds futures contract. The euro has strengthened more this year than one would have expected based solely on the change in interest rate differentials. Positioning shifts are the likely culprit. In real terms, the terminal rate in the U.S. based on 5-year, 5-year forward OIS rates is currently only 13 bps higher than in the euro area. We will automatically open a tactical short EUR/USD position if the euro moves above $1.22 any time over the next three weeks. Feature Global Economy Firing On All Cylinders The global economy continues to chug along. All 46 countries monitored by the OECD are on track to grow this year, the first time this has happened since 2007. Usually, economists are too optimistic about growth prospects. This has not been the case over the past 12 months. Consensus global growth estimates for 2017 and 2018 have marched higher during this time, led by the euro area, Japan, and a number of emerging economies (Chart 1). U.S. growth projections have been broadly stable, but these too are likely to be revised higher. Both the manufacturing and non-manufacturing ISM indices improved in August. The same goes for core capital goods orders, consumer confidence, retail sales, and homebuilder sentiment. The employment report was on the weak side, but it was probably distorted by seasonal factors - August payrolls have now fallen short of expectations for seven years in a row, a suspiciously long streak. Hiring intention surveys and perceptions of job availability both remain strong. The net share of households who see jobs as "plentiful" as opposed to "hard to get" rose further in August. It is now well above its pre-recession peak (Chart 2). Chart 1Higher And Higher Higher And Higher Higher And Higher Chart 2A Healthy U.S. Labor Market A Healthy U.S. Labor Market A Healthy U.S. Labor Market A Healthy U.S. Labor Market A Healthy U.S. Labor Market Fed Rate Expectations Are Too Dovish The Treasury market remains oblivious to these developments, focusing only on the failure of inflation to rise. This could prove to be a fatal mistake. Inflation is a highly lagging indicator. It typically does not peak until well after a recession has begun and does not bottom until well after it has ended (Chart 3). Trying to infer the true level of economic slack from today's inflation rate is like trying to read the speedometer of an automobile when there is a 30-second delay between what the dial says and when you step on the accelerator. Many market participants and a number of Fed officials have argued that interest rates are already close to neutral, implying little need for further rate hikes. We agree that the neutral rate is lower than in the past, but their argument misses a crucial point. Even if the Fed knew what the level of the neutral rate is - which, of course, it doesn't - it would still need to get the timing right. If the Fed waits too long to bring rates up to neutral, the unemployment rate will end up falling below NAIRU. This could force the Fed to raise rates more aggressively than it (or the markets) would like. Such an outcome now looks increasingly likely. The easing in U.S. financial conditions since the start of the year should boost real GDP growth over the next few quarters (Chart 4). This could cause the unemployment rate to fall to 3.5% by next summer, leaving it below its 2000 lows and more than a full point below most estimates of NAIRU. If this were to happen, it would prompt the Fed to turn up the hawkish rhetoric. Chart 3Inflation Is A Lagging Indicator Central Bank Showdown Central Bank Showdown Chart 4Easing Financial Conditions In The U.S. Bode Well For Growth Easing Financial Conditions In The U.S. Bode Well For Growth Easing Financial Conditions In The U.S. Bode Well For Growth The market is not giving enough weight to such an outcome. The December-2018 fed funds futures contract is pricing in only 20 basis points in cumulative rate hikes between now and the end of next year. That is much too low. We recommend that clients short this contract and are initiating a new tactical trade to this effect. ECB Will Take It Easy In contrast to the U.S., euro area financial conditions have tightened this year. During his press conference, Mario Draghi expressed confidence in the growth outlook, but acknowledged the risks to the region from a stronger currency. He noted that "the recent volatility in the exchange rate represents a source of uncertainty which requires monitoring with regard to its possible implications for the medium-term outlook for price stability." As we predicted last week, the ECB trimmed its 2018 inflation forecast from 1.3% to 1.2%, and its 2019 forecast from 1.6% to 1.5%. Chart 5 shows the market's estimate of the gap in terminal interest rates between the U.S. and the euro area using 5-year, 5-year forward OIS rates. The gap has narrowed by around 50 bps since the start of the year. However, EUR/USD has strengthened more than one would have expected based solely on the movement in interest rate differentials. Specifically, the market now expects U.S. five-year yields to be 78 basis points higher in 2022 than in the euro area. This is precisely the same gap that prevailed last October. Yet, EUR/USD was $1.10 back then. Today, it is $1.20. Shifts in positioning help explain why the euro has strengthened so much. Traders were heavily short the euro at the start of this year. Today, they are heavily long (Chart 6). Looking out, with few euro shorts left, EUR/USD is likely to trade off the interest rate gap between the two regions. Chart 5U.S. Vs. Euro Area: Interest Rate Gap Has Narrowed U.S. Vs. Euro Area: Interest Rate Gap Has Narrowed U.S. Vs. Euro Area: Interest Rate Gap Has Narrowed Chart 6Euro Positioning: From Deeply Short To Long Euro Positioning: From Deeply Short To Long Euro Positioning: From Deeply Short To Long Chart 7Fiscal Policy Is More Stimulative In The U.S. Central Bank Showdown Central Bank Showdown In real terms, the terminal rate in the U.S. is currently only 13 bps higher than in the euro area. That seems rather low to us. Trend growth is faster in the U.S., the banking system is in better shape, and fiscal policy is more stimulative (Chart 7). All this suggests that the real neutral rate is substantially higher in the U.S. As such, we will automatically open a tactical short EUR/USD position if the euro moves above $1.22 at any time over the next three weeks, with a stop of $1.24 and a year-end target of $1.15. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades