Market Returns

Highlights The stellar performance in metals over the past year resulted from a combination of favorable demand- and supply-side developments, propelled along, as always, by China's outsized effect on fundamentals. On the demand side, robust global growth is keeping metals consumption strong. On the supply side, environmental reforms in China and the shuttering of mills - as well as supply-side shocks in individual markets - continues to bolster prices. A weak U.S. dollar - which lost 6% of its value in broad trade-weighted terms - further supports these bullish conditions for metal markets. We expect China's winter supply cuts to dominate 1Q18 market fundamentals. As we move toward mid-year, we expect a soft and controlled slowdown in China, brought about by the Communist Party's goals of reducing industrial pollution and pivoting toward consumer-led growth. Although this will moderate demand from the world's top metal consumer, strong growth from the rest of the world will neutralize the impact of this slowdown. Energy: Overweight. Pipeline cracks in the critical Forties system in the North Sea highlight the unplanned-outage risk to oil prices we flagged in recent reports. We remain long Brent and WTI $55/bbl vs. $60/bbl call spreads in 2018, which are up an average of 47%, respectively, since they were recommended in September and October 2017. Base Metals: Neutral. Following a strong 1Q18, a moderate slowdown in China will be offset by growth in the rest of the world (see below). Precious Metals: Neutral. We continue to recommend gold as a strategic portfolio hedge, even though we expect as many as three additional Fed rate hikes next year. Ags/Softs: Underweight. The U.S. undersecretary for trade and foreign agricultural affairs warned farmers this week they "need to have a backup plan in the event the U.S. exits the North American Free Trade Agreement," in an interview with agriculture.com's Successful Farming. No specifics were offered. Canada and Mexico - the U.S.'s NAFTA partners - are expected to account for $21 billon and $19 billion of exports, respectively, based on USDA estimates for FY 2018. These exports largely offset imports of $22 billion and $23 billion, respectively, from both countries. The U.S. runs an ag trade surplus of ~ $23.5 billion annually. Feature Metals had another extraordinary year in 2017. The LME base metal index rallied more than 20% year-to-date (ytd) bringing the index up more than 50% since it bottomed in mid-January 2016 (Chart Of The Week). Chart of the WeekA Great Year For Metals A Great Year For Metals A Great Year For Metals Steel, zinc, copper, and aluminum led the gains. In fact, of the metals we track, iron ore is the only one in negative territory - having lost almost 8% ytd. Nonetheless, it has been on the uptrend recently - gaining ~ 24% since it bottomed at the end of October. Capacity reductions in China, where policymakers mandated inefficient and highly polluting mills and smelters in steel- and aluminum-producing provinces be taken offline, continue to affect the supply side in those metals most. As China churns out less of these commodities, competition for the more limited supply will pull prices for them higher. Nevertheless, a stronger USD - brought about by a more hawkish Fed - likely will cap significant upside gains, and prevent a repeat of this year's exceptional performance. Strong Global Demand Will Neutralize China Slowdown The Chinese economy is beginning to show signs of a slowdown. The Li Keqiang Index - a proxy for China's economic activity - has rolled over. Furthermore, the manufacturing PMI has plateaued following last year's rapid ascent (Chart 2). This deceleration is also evident in China's infrastructure data. Annual growth in infrastructure spending in the first three quarters of the year are below the four-year average. And, although spending grew 15.9% year-on-year (yoy) in the first 10 months of this year, the rate of growth is slower than the four-year average of 19.6% (Chart 3). Chart 2A China Slowdown Is In The Cards... A China Slowdown Is In The Cards... A China Slowdown Is In The Cards... Chart 3...Threatening A Pull Back In Metals Demand ...Threatening A Pull Back In Metals Demand ...Threatening A Pull Back In Metals Demand That said, it is important to point out that this is due to a significant decline in utilities spending growth, which accounts for ~ 20% of infrastructure investments. Investment in utilities grew a mere 2.3% in the first ten months of the year, in contrast with the average 15.7% yoy increase of the previous four years. In any case, the slowdown in China's reflation reflects President Xi Jinping's resolve to shift gears and emphasize quality over quantity in future growth strategies. Now that Xi has consolidated his power, we expect policymakers to build on the momentum from the National Communist Party Congress, and be more effective in implementing reforms going forward. As such, Beijing should be more willing to tolerate slower growth than it has in the past. Nonetheless, we do not anticipate a significant slowdown. More likely than not, policymakers will resort to fiscal stimulus if the economy is faced with notable risks. Consequently, a hard landing in China is not our base case scenario. In any case, strong global demand will neutralize a slowdown in China's metal consumption in 2018. Despite a deceleration in China, the IMF expects global growth to pick up in 2018 (Table 1). The Global PMI is at its highest level since early 2011, supported by strong readings in the Euro Area and the U.S. (Chart 4). In all likelihood, conditions for global metal demand will remain favorable in 2018. Table 1IMF Economic Forecasts China's Supply Cuts Will Tighten Metals In 1Q18; Global Demand Offsets 2H18 Slowdown In China China's Supply Cuts Will Tighten Metals In 1Q18; Global Demand Offsets 2H18 Slowdown In China Chart 4Strong Global Demand Will Neutralize##BR##Impact Of China Slowdown Strong Global Demand Will Neutralize Impact Of China Slowdown Strong Global Demand Will Neutralize Impact Of China Slowdown China Real Estate Will Slow; Major Downturn Not Expected Chart 5Slowing Real Estate Investment Is A Mild Risk Slowing Real Estate Investment Is A Mild Risk Slowing Real Estate Investment Is A Mild Risk We do not foresee significant risks to China's real estate market, which is the big driver of base-metals demand in that economy. Total real estate investment is up 7.8% in the first 10 months of the year - the strongest growth for the period since 2014 (Chart 5). Even so, it is important to note the slowdown in that sector. After growing 9% yoy in 1Q17, growth rates fell to 8% and 7% in 2Q and 3Q17, respectively. In fact, growth in October, the latest month for which data are available, came in at 5.6% yoy - significantly slower than the average monthly yoy rate of 8% in the first nine months of the year. The slowdown in floor-space-started is more pronounced. The area of floor space started grew 5% in the first 10 months of the year, down from an 8% expansion in the same period in 2016. October data showed a yoy as well as month-on-month contraction - 4.2% for the former, and 12.1% for the latter. This is the second yoy contraction in 2017, with July experiencing a 4.9% reduction in floor area started. Similarly, quarterly data shows a significant slowdown from almost 12% yoy growth rates registered in 4Q16 and 1Q17 to the mere 0.4% yoy growth in 3Q17. In addition, the growth rate in commodity building floor-space-under-construction has slowed down to 3.1% yoy in the first 10 months of 2017, down from almost 5% for the same period in the previous two years. Although the data are a reflection of Xi's resolve to tighten control of the real estate market, we do not expect a major downturn that will weigh on metal demand. As BCA Research's China Investment Strategy desk notes, strong demand in the real estate sector, coupled with declining inventories, will prevent a major slowdown in construction activity, even in face of tighter policies.1 A Stronger Dollar Moderates Upside Price Pressures In our modeling of the LME Base Metal Index, we find that currency movements are important determinants of the evolution of metals prices. More specifically, the U.S. dollar is inversely related to the LME base metal index. While U.S. inflation has remained stubbornly low, we expect inflation to start its ascent sometime before mid-2018, allowing the Fed to proceed with its rate-hiking cycle. Given our view that too few hikes are currently priced in for 2018, there remains some upside to the USD. Thus, while dollar weakness has been supportive for metal prices in 2017, a stronger dollar will be a headwind in 2018. A Look At The Fundamentals In terms of supply/demand dynamics in individual metal markets, idiosyncrasies in their current states, and variations in how China's environmental reforms manifest themselves will mean the different metals will follow different trajectories next year. Muted Consumption Mitigated Impact Of Supply Disruptions In Copper Copper production had a bumpy 2017, rocked by sporadic supply disruptions in some of the world's top mines.2 This led to a contraction in world refined production ex-China, which was offset by an increase in Chinese output (Chart 6). Although Chinese refined copper output grew a healthy 6% yoy in the first three quarters, this was nonetheless a slowdown from the 8% yoy expansion for the same period in 2016. Even so, increased Chinese copper production more than offset declines from other top producers. Refined copper production in the rest of the world contracted by 1.5% in the first three quarters, bringing world production growth to 1.3% - significantly slower than the average 2.6% yoy increase witnessed in the same period in the previous two years. The supply-side impact on the overall market was mitigated by a slowdown in consumption. Chinese consumption, which accounts for 50% of global refined copper demand, remained largely unchanged in the first three quarters of the year compared to last year. This follows a yoy increase of ~ 8% in Chinese demand vs. the same period in 2016. Demand from the rest of the world contracted by 0.6% yoy, down from a 2.5% yoy expansion in the same period last year. So, despite supply disruptions, the copper market remained balanced - registering a 20k MT surplus in the first three quarters of this year, following a 230k MT deficit in the same period in 2016. Recently, there is news of capacity cuts in Anhui province - where China's second-largest copper smelter will be eliminating 20 to 30% of its capacity during the winter.3 If the copper market is the next victim of China's environmental reforms, global balances may be pushed to a deficit. Although copper remains well stocked at the major warehouses, an adoption of these winter cuts by other copper producing provinces would weaken refined copper supply and support prices (Chart 7). Chart 6Copper Rallied On Back Of Supply-Side Fears Copper Rallied On Back Of Supply-Side Fears Copper Rallied On Back Of Supply-Side Fears Chart 7Copper Warehouses Are Well Stocked Copper Warehouses Are Well Stocked Copper Warehouses Are Well Stocked Steel Prices Will Remain Elevated Throughout Q1 China's steel sector has undergone significant reforms this year. In addition to the 100-150 mm MT of capacity cuts to be implemented between 2016 and 2020, Beijing has also eliminated steel produced by intermediate frequency furnaces (IFF).4 Even so, Chinese steel production - paradoxically - is at record highs. This comes down to the nature of IFFs, which are illegal and thus not reflected in official crude steel production data. However, growth in steel products - which reflect output from both official as well as illegal steel mills - has been flat (Chart 8). In addition, China's steel exports have come down significantly since last year, reflecting a domestic shortage in the steel industry. November data shows a 34% yoy contraction, and exports for the first 11 months of the year are down more than 30% from the same period last year. We expect Chinese steel production to remain anemic until the end of 1Q18, as mandated winter capacity cuts cap production in major steel-producing provinces. The near-term cutback in production will keep steel prices elevated. The spread between steel and iron ore prices during this period will remain wide as lower steel production translates into muted demand for the ore. This is also consistent with China's inventory data which shows that after falling since August, iron ore stocks have been building up since mid-October - in conjunction with the start of winter steel-capacity cuts. Indonesian Nickel Exports Bearish In Long Run, Not So Much In Near Term Ever since Indonesia's ban on nickel ore exports in 2014, worldwide production has been on the downtrend. In the previous two years, shrinking supply from China - which makes up about a quarter of global output - was the culprit of reduced world output, offsetting increases from the rest of the globe, and causing global production to contract by 0.2% and 0.5%, respectively (Chart 9). Chart 8Falling Exports And Flat Steel Products##BR##Output Reflect Closures In Steel Falling Exports And Flat Steel Products Output Reflect Closures In Steel Falling Exports And Flat Steel Products Output Reflect Closures In Steel Chart 9Deficit And Inventory##BR##Drawdowns Dominate Nickel... Deficit And Inventory Drawdowns Dominate Nickel... Deficit And Inventory Drawdowns Dominate Nickel... However, at 2.5%, the contraction in global output is significantly larger for the first three quarters of this year. What is noteworthy is that it is caused by shrinking production both from China - down ~ 7.5% - as well as from the rest of the world, where output is down ~ 1%. Nevertheless, a decline in demand from China - which accounts for almost half of global consumption - has softened the impact of withering production. Chinese demand for semi refined nickel shrunk 22% in the first three quarters of the year, more than offsetting the 9% growth in demand from the rest of the world. However, there has been a recovery in global demand since June. A 15% yoy growth in the third quarter from consumers ex-China drove a 5% yoy gain in global growth. Despite weak demand in 1H17, the nickel market recorded a deficit in the first three quarters of the year. In fact, nickel has been in deficit for the past two years. Going forward, Indonesia's gradual lifting of the export ban will prop up production. In fact, global yoy production growth has been in the green since June. However, while Indonesian ores are slowly returning to the global market, they remain a fraction of their pre-ban levels. Thus, prices will likely remain under upside pressure in the near term. Record Deficit And Significant Inventory Drawdowns Dominate Aluminum... Aluminum has been in deficit for the past three years. In fact, at 100k MT, the deficit in the first three quarters of 2017 is the largest on record for that period. This is reflected in LME inventory data which has been experiencing drawdowns since April 2014 - Falling from more than 5mm MT to ~ 1mm MT (Chart 10). Strong growth from Chinese producers - which account for more than half the world's primary production - kept global output growth strong, despite a decline from other top producers. However, falling Chinese production in August and September compounded the fall in output from the rest of the world, leading to a 3.5% yoy decline for those two months. In fact, September's Chinese output data marks the lowest production figure since February 2016. On the demand side, global consumption is up 6.2% yoy in the first seven months of 2017, reflecting a general uptrend in both Chinese consumption and, to a lesser extent, a greater appetite for the metal from the rest of the world. However, there has been some weakness from China recently. Chinese demand contracted by 2.9% and 9.6% yoy in August and September. While an 8.2% yoy increase in consumption from the rest of the world offset the August weakness from China, global demand shrunk by 5.8% in September. As with steel, supply-side reforms will dominate and keep aluminum prices elevated in the near term. ... Along With Zinc Demand Global zinc production has been more or less flat this year. The 2.7% decline from Chinese producers, which supply 46% of global zinc slab, was offset by a 2.4% increase in production from the rest of the world. On the demand side, although Chinese consumption - which accounts for almost half of global zinc slab demand - has been flat, strength from the rest of the world supported global demand, which is up 2.3% yoy for the first three quarters of the year (Chart 11). Chart 10...As Well As Aluminum... ...As Well As Aluminum... ...As Well As Aluminum... Chart 11...And Zinc ...And Zinc ...And Zinc Static supply coupled with increased demand has led the zinc market to a deficit of 500k MT - a record for the first three quarters of 2017. The deficit has continued to eat up zinc stocks, which have been in free-fall, since early 2013.   Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Please see BCA Research's China Investment Strategy Weekly Report titled "Chinese Real Estate: Which Way Will The Wind Blow?," dated September 28, 2017, available at cis.bcaresearch.com. 2 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "Copper's Getting Out Ahead Of Fundamentals, Correction Likely," dated August 24, 2017, available at ces.bcaresearch.com. 3 Please see "Chinese Copper Smelter Halts Capacity to Ease Winter Pollution," published on December 7, 2017, available at Bloomberg.com. 4 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "Slow-Down in China's Reflation Will Temper Steel, Iron Ore in 2018,' dated September 7, 2017, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades China's Supply Cuts Will Tighten Metals In 1Q18; Global Demand Offsets 2H18 Slowdown In China China's Supply Cuts Will Tighten Metals In 1Q18; Global Demand Offsets 2H18 Slowdown In China Commodity Prices and Plays Reference Table China's Supply Cuts Will Tighten Metals In 1Q18; Global Demand Offsets 2H18 Slowdown In China China's Supply Cuts Will Tighten Metals In 1Q18; Global Demand Offsets 2H18 Slowdown In China Trades Closed in 2017 Summary of Trades Closed in 2016

Dear Client, I am currently traveling in Europe visiting clients. This week, in lieu of a regular report, I am sending along a research report written by my colleague at BCA Global Asset Allocation. The topic covers one of the more fascinating "alternative" parts of the fixed income universe - catastrophe bonds. I trust that you will find this report insightful and useful. Best regards, Robert Robis, Senior Vice President Global Fixed Income Strategy Highlights Catastrophe bonds ("cat bonds") have recently been receiving a lot of investor attention because, after this summer's large hurricanes, they are now attractively priced. We explain the mechanics of this market, and analyze cat bonds' historic risk-return characteristics. Cat bonds have historical annualized returns of 7.4%, with volatility of only 3.0%, making them an attractive risk-adjusted investment. However, they are exposed to "cliff risk", creating a return distribution with negative skew and large excess kurtosis. But cat bonds offer interesting portfolio diversification benefits, since financial and economic shocks have minimal impact on cat bond returns. The reinsurance market tends to be cyclical, with premiums rising following a catastrophe and decreasing during a period of calm. Feature Introduction In 1992, Hurricane Andrew caused $17 billion in losses, more than twice the value of the insured property, and forced many insurers into bankruptcy. As the global economy has grown in size since then, the monetary value of insured events has risen steadily. However, increasing regulatory hurdles in the form of higher reserve requirements have led to capacity constraints (Chart 1) in the traditional insurance industry. In 2005, Hurricane Katrina, which caused $108 billion in losses, strengthened the case for the introduction of catastrophe bonds and other insurance-linked securities that helped ease financial burdens in the insurance industry, for several reasons. First, catastrophe bonds give access to the deepest, most liquid, and efficient sources of capital. Second, the securitization of reinsurance capital has created a secondary market where risk exposures can be transferred within the investor community. Third, insurance firms have the ability to move some exposures off their books, thereby allowing them to underwrite larger risks that they would otherwise lack the capacity to cover. According to S&P Global Ratings, the market for cat bonds and other insurance-linked securities is estimated to be about $86 billion. Other insurance-linked securities include industry loss warranties (ILW), collateralized reinsurance contracts, and reinsurance sidecars. Cat bonds are the only insurance-linked securities that publicly trade on a secondary market. The recent increase in natural catastrophes has led to surging supply in the cat bond market. Record issuance in the first and second quarters of 2017 has pushed the size of the outstanding cat bond market to over $30 billion (Chart 2) for the first time. This comes after a period prior to this year with fewer catastrophes and where bond pricing has been stable, which led to increased deal sizes. In this Special Report, we run through the mechanics of the cat bond structure and market. We analyze historical risk-return characteristics (Chart 3) and compare them to other major asset classes. Since insurance-linked securities are known to have very low correlation with other assets, we test their potential diversification benefits within a traditional portfolio. Finally, we analyze their historical performance in periods of financial market stress and rising interest rate environments, which are two of the biggest worries for investors. Our conclusions are that: Chart 1Capacity Constraints A Primer On Catastrophe Bonds A Primer On Catastrophe Bonds Chart 2Record Issuance In 2017 A Primer On Catastrophe Bonds A Primer On Catastrophe Bonds Chart 3Risk-Return Profile Risk-Return Profile Risk-Return Profile The reinsurance market is cyclical, with premiums increasing following a catastrophe and decreasing following a period of calm. Realized volatility in the cat bond market is low. However, returns have a negative skew with an extremely fat-tailed distribution relative to other traditional assets. The addition of cat bonds to a traditional multi-asset portfolio has tremendous diversification benefits. The largest improvement to risk-adjusted returns comes from substituting equities with cat bonds. Financial crises have minimal impact on cat bond returns. However, depending on the magnitude of catastrophe losses, there could be varied regional impacts. Investors can customize the risk-return profile by altering the attachment and exhaustion points, and also by diversifying across trigger types. Mechanics Of Cat Bonds Despite the increasing popularity of cat bonds, their non-conventional structure is understood by only a limited number of investors. A better understanding of the characteristics of this financial instrument makes analyzing risk and return more straightforward. The key features (Chart 4) of a catastrophe bond are as follows. An insurer looking to reduce certain exposures will create a special purpose vehicle (SPV), also known as the issuer, to assist with the transaction. The issuer/SPV sells reinsurance protection to the sponsoring firms and simultaneously issues a cat bond to the investor. The proceeds from the bond sale are managed in a segregated collateral account to generate the floating-rate component of the coupon payable to investors. The fixed component of the coupon is financed through reinsurance premiums paid by the sponsoring firm to the issuer or SPV. Traditionally, cat bonds used a total return swap where a counterparty guaranteed the liquidity and performance of a collateral account. This forced investors and sponsors to rely on the creditworthiness of the swap provider. In 2007, two cat bonds that used Lehman Brothers as a swap counterparty were forced into default because of illiquid collateral assets and mismatched maturities. Nowadays, the assets managed in the collateral account are invested only in U.S. Treasury money market funds or structured notes from the International Bank for Reconstruction and Development (IBRD). The final settlement of the bond is binary: 1) if no trigger event occurs before the bond maturity, the SPV returns the principal to investors along with the final coupon; 2) if a catastrophe hits and the bond is triggered, the principal in the collateral account is used to settle the claims of the sponsoring firms. Cat bonds are typically used to cover a piece of risk exposure in the sponsor's book. For example, a cat bond could cover indemnities exceeding $1 billion up to $1.2 billion, making the bond issue size equal to $200 million. The $1 billion is called the attachment point, and the $1.2 billion is called the exhaustion point, at which point the principal is exhausted and investors are not liable for any further claims. The tranche with the higher attachment point will be of higher quality, but with a lower rate of return. The reinsurance industry is cyclical, which makes contract pricing more volatile than investors might expect. The Rate on Line (Chart 5) index can be seen as a yield on the insurance contracts underwritten in the industry. Market conditions can be split into two phases: Chart 4Mechanics Of Cat Bonds A Primer On Catastrophe Bonds A Primer On Catastrophe Bonds Chart 5Cyclical Reinsurance Premiums Cyclical Reinsurance Premiums Cyclical Reinsurance Premiums Soft Market: Following many years of limited or minor catastrophes, reinsurance premiums are pressured downward and bond prices rise. In these circumstances, demand for cat bonds will be limited as coupon income will be less attractive. Hard Market: A major catastrophe will significantly erode the capital available in the insurance industry, thereby creating a supply shortage that pushes up reinsurance premiums. In these conditions, cat bond issuance will rise, driven by attractive coupon income. Investors can manage the premium cycle by slightly increasing risk at the portfolio level in a softening market (falling premiums) and reducing risk in hardening market (rising premiums). The recent catastrophes should drive up reinsurance premiums, but the sheer weight of money searching for yields in the current environment might make the uplift surprisingly modest compared to the past. Given that cat bonds have a binary payout feature, investors need to understand the trigger type (Table 1) used in the contract. In the early days, most bonds were issued with an indemnity trigger, but the type of trigger (Chart 6) has become more varied over time. The type of trigger used in the cat bond has the following impacts: If the trigger used in the bond takes longer to settle, the investor can be involved in a long drawn-out legal battle with the sponsoring firm looking to settle claims. This could in turn force the bond beyond maturity and keep investor funds locked up at significantly lower rates of return. Table 1Understanding Trigger Types A Primer On Catastrophe Bonds A Primer On Catastrophe Bonds Chart 6Choosing The Right Trigger Type A Primer On Catastrophe Bonds A Primer On Catastrophe Bonds Investors also need to understand the level of basis risk sponsoring firms are exposed to with different trigger types. In the context of cat bonds, basis risk is when the settlement payout from cat bonds differs from the actual portfolio losses incurred by sponsoring firms. If they have basis risk, investors will have to deal with moral hazard, where sponsoring firms will have incentive to underwrite excessive risks. Historical Risk & Return Investing in catastrophe bonds is essentially a "short gamma" strategy, where investors are selling insurance and collecting premium with the hope of options not being triggered during the maturity of the bond. Attractive historical returns (Table 2) have been the result of lower-than-expected principal write-downs given limited catastrophes. In the early years, cat bonds as an asset class were not fully understood by the broader market, creating a "novelty premium" up until 2010. Subsequently, low interest rates have had a profound impact on all traditional assets, making cat bond yields relatively attractive. Realized volatility has been extremely low since the investor collects regular coupons in the absence of a catastrophe that triggers a payout. This makes risk-adjusted returns very attractive compared to other major assets. However, because of the extreme tail risk, there exists a big negative skew along with high excess kurtosis. Cat bonds are exposed to "cliff risk" - the likelihood that the tranche's notional value will be exhausted once settlement claims reach the attachment point. The two main sources of risk that investors need to be mainly concerned about, however, are: 1) insurance risk that cat bonds assume, and 2) credit risk associated with the collateral account. An attractive feature of cat bonds is that poor performance tends to be self-correcting, as seen in the reinsurance cycle. Following a particularly destructive natural disaster, a number of factors such as increased insurance demand, the reduced capacity of insurance firms, and upward revisions to probability models serve to increase insurance premiums and potential returns to insurance-linked securities. For example, after the 2011 Japanese Tohoku earthquake and tsunami, insurance premiums were pushed up by around 50% for earthquake risk and 20% for other catastrophe risk. The likelihood of incurring negative returns is far lower than the chance of benefitting from positive returns. Cat bonds have achieved positive monthly returns 92% of the time (Table 3). The recent hurricane season in the U.S. was the first time returns turned negative on a 12-month basis. Table 2Historical Risk-Return Analysis (January 2002 - November 2017) A Primer On Catastrophe Bonds A Primer On Catastrophe Bonds Table 3Only Fifteen Months Of Negative Returns A Primer On Catastrophe Bonds A Primer On Catastrophe Bonds Finally, there have been many comparisons between cat bonds and high-yield credit. While high-yield debt performance is tied to market and economic cycles lasting about 10 years, that of cat bonds is tied to low probability catastrophes. Frequency of loss in junk bonds is greater than it is for cat bonds. However, the potential principal loss is greater for cat bonds, because they have almost zero recovery value. Diversification & Portfolio Impact Cat bonds' performance is linked to factors such as natural disasters, longevity risk, or life insurance mortality, and not to broader financial market risks. However, in periods of economic stress, markets experience a flight to quality and correlations between risk assets increase. Therefore, the benefits of portfolio diversification dissolve when they are needed most. This is not the case with cat bonds, however, as correlations with other assets (Table 4) have remained stable over time. This makes them a potentially useful diversification instrument in multi-asset portfolios. Table 4Cross-Asset Correlation (January 2002 - November 2017) A Primer On Catastrophe Bonds A Primer On Catastrophe Bonds To test this, we perform a typical portfolio analysis whereby we add cat bonds to a conventional portfolio and investigate the impact on the return and risk of the portfolio (Chart 7). Starting with the most traditional allocation of 60% equities and 40% bonds, we augment the portfolio with a 10% allocation to cat bonds and come up with the following results: Replacing equities with cat bonds leads to the largest reduction in portfolio volatility, and a small decrease in annualized returns. This new portfolio generates equity-like returns, but with a smaller correlation with stocks. Replacing traditional fixed income with cat bonds leads to a large increase to annualized returns, while the impact on volatility is virtually non-existent. The largest positive impact on risk-adjusted returns occurs when cat bonds replace equities, because the reduction in volatility is substantially greater than the increase in returns when cat bonds replace traditional bonds. We also ranked the MSCI All-Country World equity and Bloomberg Barclays Global Aggregate Bond indices from worst to best monthly returns and then overlaid the corresponding cat bond returns for each ranked month (Chart 8). This technique removes randomness from the time series in order to view the relative randomness of the other. We have the following findings: Cat bonds have had only three months that delivered a return less than -2%. These were -2.1% in September 2005 during Hurricane Katrina, -3.6% in March 2011 during the Tohoku earthquake and tsunami in Japan, and -5.8% in September 2017 after the severe hurricanes in Texas, Florida and the Caribbean. Other than catastrophe-related events, cat bond returns have been stable. Cat bonds displayed no reaction when equities had their most negative months. But they tend to have relatively stronger returns when equities also have positive months. Cat bonds performed well in both good and bad months for traditional fixed income. This shows that causes of traditional bond market losses and cat bond principal loss have little or no bearing on one another. Since cat bonds have a large negative skew and high excess kurtosis, investors can potentially lose all their capital if the bonds are triggered. When allocating to cat bonds, investors need to maintain a well-diversified position in order to minimize the risk of complete capital wipeout. This can be done by carefully picking bonds covering different perils (i.e. earthquakes, wind, extreme mortality), regions and trigger types (Chart 9). As a broader range of perils come to the market, investors will find increasing avenues for diversification within the asset class. Investors can also benefit from very low correlations within the cat bond universe, where returns from cat bonds covering a specific peril have no bearing on returns from cat bonds covering another peril. Chart 7Portfolio Diversification A Primer On Catastrophe Bonds A Primer On Catastrophe Bonds Chart 8Attractive Monthly Returns A Primer On Catastrophe Bonds A Primer On Catastrophe Bonds Chart 9Diversifying Across Perils, Coupon Rate And Expected Loss A Primer On Catastrophe Bonds A Primer On Catastrophe Bonds Financial Market Stress Having established that underlying market developments have no bearing on cat bond performance, we want to address two further important questions: 1) do financial crises affect cat bond returns? 2) do natural catastrophes trigger financial crises? Looking at previous global market crisis scenarios dating back to 2008 (Chart 10), we see that cat bonds had positive absolute returns during all crisis periods. The only period with negative cat bond returns was during the 2008 Lehman Brothers' collapse, when the bank was the swap counterparty for two bonds that defaulted. Large natural catastrophes do not affect broader capital markets, but do tend to have a large local impact. In August 2005, Hurricane Katrina, with damages totaling $108 billion, became the costliest hurricane to date in the U.S. The hurricane triggered a cat bond, and the index was down 2.1%, but there was no noticeable lingering impact on the U.S. economy. On the other hand, the earthquake and tsunami in Tohoku on March 11, 2011 had devastating effects. With damages exceeding $300 billion (approximately 5% of Japanese GDP), the cat bond index dropped 3.6%, and Japanese equities collapsed 7.3%. Moreover, a big earthquake in a major city or region such as Tokyo or California could have the capacity to trigger a global recession. Finally, looking at past major catastrophes (Chart 11), we see that existing cat bond prices do not fully recover to their pre-catastrophe levels. Accordingly, picking up bonds at a discount may not generate the expected return as price levels struggle to fully recover. Chart 10Outperformance Across The Board A Primer On Catastrophe Bonds A Primer On Catastrophe Bonds Chart 11Not A Full Recovery Not A Full Recovery Not A Full Recovery Interest Rate & Inflation Hedge Traditional bonds with fixed coupon payments underperform in a rising rate environment. Since cat bonds receive a floating-rate coupon along with the fixed premium, they are largely immune to rising rates. When central banks hike rates, the principal of the bonds invested in money market assets will produce a higher return, thereby offering investors a powerful shield against possible inflation, as well. Since the total coupon received by investors includes a fixed and floating component, cat bonds have a lower modified duration relative to similar maturity traditional bonds. Conclusion Despite their abnormal return distributions, we recommend investors allocate capital from their "alternatives" bucket toward cat bonds. Against a backdrop of low yields and investor complacency, cat bonds are highly attractive given their potential for consistently robust returns and, perhaps most importantly, tremendous diversification benefits. Still, allocations should be relatively small given the illiquid nature of the cat bond market, and diversification among bonds and issuers is critical due to the potential for large losses in the event that a cat bond is triggered. Aditya Kurian, Research Analyst Global Asset Allocation adityak@bcaresearch.com

Highlights Catastrophe bonds ("cat bonds") have recently been receiving a lot of investor attention because, after this summer's large hurricanes, they are now attractively priced. We explain the mechanics of this market, and analyze cat bonds' historic risk-return characteristics. Cat bonds have historical annualized returns of 7.4%, with volatility of only 3.0%, making them an attractive risk-adjusted investment. However, they are exposed to "cliff risk", creating a return distribution with negative skew and large excess kurtosis. But cat bonds offer interesting portfolio diversification benefits, since financial and economic shocks have minimal impact on cat bond returns. The reinsurance market tends to be cyclical, with premiums rising following a catastrophe and decreasing during a period of calm. Feature Introduction In 1992, Hurricane Andrew caused $17 billion in losses, more than twice the value of the insured property, and forced many insurers into bankruptcy. As the global economy has grown in size since then, the monetary value of insured events has risen steadily. However, increasing regulatory hurdles in the form of higher reserve requirements have led to capacity constraints (Chart 1) in the traditional insurance industry. In 2005, Hurricane Katrina, which caused $108 billion in losses, strengthened the case for the introduction of catastrophe bonds and other insurance-linked securities that helped ease financial burdens in the insurance industry, for several reasons. First, catastrophe bonds give access to the deepest, most liquid, and efficient sources of capital. Second, the securitization of reinsurance capital has created a secondary market where risk exposures can be transferred within the investor community. Third, insurance firms have the ability to move some exposures off their books, thereby allowing them to underwrite larger risks that they would otherwise lack the capacity to cover. According to S&P Global Ratings, the market for cat bonds and other insurance-linked securities is estimated to be about $86 billion. Other insurance-linked securities include industry loss warranties (ILW), collateralized reinsurance contracts, and reinsurance sidecars. Cat bonds are the only insurance-linked securities that publicly trade on a secondary market. The recent increase in natural catastrophes has led to surging supply in the cat bond market. Record issuance in the first and second quarters of 2017 has pushed the size of the outstanding cat bond market to over $30 billion (Chart 2) for the first time. This comes after a period prior to this year with fewer catastrophes and where bond pricing has been stable, which led to increased deal sizes. In this Special Report, we run through the mechanics of the cat bond structure and market. We analyze historical risk-return characteristics (Chart 3) and compare them to other major asset classes. Since insurance-linked securities are known to have very low correlation with other assets, we test their potential diversification benefits within a traditional portfolio. Finally, we analyze their historical performance in periods of financial market stress and rising interest rate environments, which are two of the biggest worries for investors. Our conclusions are that: Chart 1Capacity Constraints A Primer On Catastrophe Bonds A Primer On Catastrophe Bonds Chart 2Record Issuance In 2017 A Primer On Catastrophe Bonds A Primer On Catastrophe Bonds Chart 3Risk-Return Profile Risk-Return Profile Risk-Return Profile The reinsurance market is cyclical, with premiums increasing following a catastrophe and decreasing following a period of calm. Realized volatility in the cat bond market is low. However, returns have a negative skew with an extremely fat-tailed distribution relative to other traditional assets. The addition of cat bonds to a traditional multi-asset portfolio has tremendous diversification benefits. The largest improvement to risk-adjusted returns comes from substituting equities with cat bonds. Financial crises have minimal impact on cat bond returns. However, depending on the magnitude of catastrophe losses, there could be varied regional impacts. Investors can customize the risk-return profile by altering the attachment and exhaustion points, and also by diversifying across trigger types. Mechanics Of Cat Bonds Despite the increasing popularity of cat bonds, their non-conventional structure is understood by only a limited number of investors. A better understanding of the characteristics of this financial instrument makes analyzing risk and return more straightforward. The key features (Chart 4) of a catastrophe bond are as follows. An insurer looking to reduce certain exposures will create a special purpose vehicle (SPV), also known as the issuer, to assist with the transaction. The issuer/SPV sells reinsurance protection to the sponsoring firms and simultaneously issues a cat bond to the investor. The proceeds from the bond sale are managed in a segregated collateral account to generate the floating-rate component of the coupon payable to investors. The fixed component of the coupon is financed through reinsurance premiums paid by the sponsoring firm to the issuer or SPV. Traditionally, cat bonds used a total return swap where a counterparty guaranteed the liquidity and performance of a collateral account. This forced investors and sponsors to rely on the creditworthiness of the swap provider. In 2007, two cat bonds that used Lehman Brothers as a swap counterparty were forced into default because of illiquid collateral assets and mismatched maturities. Nowadays, the assets managed in the collateral account are invested only in U.S. Treasury money market funds or structured notes from the International Bank for Reconstruction and Development (IBRD). The final settlement of the bond is binary: 1) if no trigger event occurs before the bond maturity, the SPV returns the principal to investors along with the final coupon; 2) if a catastrophe hits and the bond is triggered, the principal in the collateral account is used to settle the claims of the sponsoring firms. Cat bonds are typically used to cover a piece of risk exposure in the sponsor's book. For example, a cat bond could cover indemnities exceeding $1 billion up to $1.2 billion, making the bond issue size equal to $200 million. The $1 billion is called the attachment point, and the $1.2 billion is called the exhaustion point, at which point the principal is exhausted and investors are not liable for any further claims. The tranche with the higher attachment point will be of higher quality, but with a lower rate of return. The reinsurance industry is cyclical, which makes contract pricing more volatile than investors might expect. The Rate on Line (Chart 5) index can be seen as a yield on the insurance contracts underwritten in the industry. Market conditions can be split into two phases: Chart 4Mechanics Of Cat Bonds A Primer On Catastrophe Bonds A Primer On Catastrophe Bonds Chart 5Cyclical Reinsurance Premiums Cyclical Reinsurance Premiums Cyclical Reinsurance Premiums Soft Market: Following many years of limited or minor catastrophes, reinsurance premiums are pressured downward and bond prices rise. In these circumstances, demand for cat bonds will be limited as coupon income will be less attractive. Hard Market: A major catastrophe will significantly erode the capital available in the insurance industry, thereby creating a supply shortage that pushes up reinsurance premiums. In these conditions, cat bond issuance will rise, driven by attractive coupon income. Investors can manage the premium cycle by slightly increasing risk at the portfolio level in a softening market (falling premiums) and reducing risk in hardening market (rising premiums). The recent catastrophes should drive up reinsurance premiums, but the sheer weight of money searching for yields in the current environment might make the uplift surprisingly modest compared to the past. Given that cat bonds have a binary payout feature, investors need to understand the trigger type (Table 1) used in the contract. In the early days, most bonds were issued with an indemnity trigger, but the type of trigger (Chart 6) has become more varied over time. The type of trigger used in the cat bond has the following impacts: If the trigger used in the bond takes longer to settle, the investor can be involved in a long drawn-out legal battle with the sponsoring firm looking to settle claims. This could in turn force the bond beyond maturity and keep investor funds locked up at significantly lower rates of return. Table 1Understanding Trigger Types A Primer On Catastrophe Bonds A Primer On Catastrophe Bonds Chart 6Choosing The Right Trigger Type A Primer On Catastrophe Bonds A Primer On Catastrophe Bonds Investors also need to understand the level of basis risk sponsoring firms are exposed to with different trigger types. In the context of cat bonds, basis risk is when the settlement payout from cat bonds differs from the actual portfolio losses incurred by sponsoring firms. If they have basis risk, investors will have to deal with moral hazard, where sponsoring firms will have incentive to underwrite excessive risks. Historical Risk & Return Investing in catastrophe bonds is essentially a "short gamma" strategy, where investors are selling insurance and collecting premium with the hope of options not being triggered during the maturity of the bond. Attractive historical returns (Table 2) have been the result of lower-than-expected principal write-downs given limited catastrophes. In the early years, cat bonds as an asset class were not fully understood by the broader market, creating a "novelty premium" up until 2010. Subsequently, low interest rates have had a profound impact on all traditional assets, making cat bond yields relatively attractive. Realized volatility has been extremely low since the investor collects regular coupons in the absence of a catastrophe that triggers a payout. This makes risk-adjusted returns very attractive compared to other major assets. However, because of the extreme tail risk, there exists a big negative skew along with high excess kurtosis. Cat bonds are exposed to "cliff risk" - the likelihood that the tranche's notional value will be exhausted once settlement claims reach the attachment point. The two main sources of risk that investors need to be mainly concerned about, however, are: 1) insurance risk that cat bonds assume, and 2) credit risk associated with the collateral account. An attractive feature of cat bonds is that poor performance tends to be self-correcting, as seen in the reinsurance cycle. Following a particularly destructive natural disaster, a number of factors such as increased insurance demand, the reduced capacity of insurance firms, and upward revisions to probability models serve to increase insurance premiums and potential returns to insurance-linked securities. For example, after the 2011 Japanese Tohoku earthquake and tsunami, insurance premiums were pushed up by around 50% for earthquake risk and 20% for other catastrophe risk. The likelihood of incurring negative returns is far lower than the chance of benefitting from positive returns. Cat bonds have achieved positive monthly returns 92% of the time (Table 3). The recent hurricane season in the U.S. was the first time returns turned negative on a 12-month basis. Table 2Historical Risk-Return Analysis (January 2002 - November 2017) A Primer On Catastrophe Bonds A Primer On Catastrophe Bonds Table 3Only Fifteen Months Of Negative Returns A Primer On Catastrophe Bonds A Primer On Catastrophe Bonds Finally, there have been many comparisons between cat bonds and high-yield credit. While high-yield debt performance is tied to market and economic cycles lasting about 10 years, that of cat bonds is tied to low probability catastrophes. Frequency of loss in junk bonds is greater than it is for cat bonds. However, the potential principal loss is greater for cat bonds, because they have almost zero recovery value. Diversification & Portfolio Impact Cat bonds' performance is linked to factors such as natural disasters, longevity risk, or life insurance mortality, and not to broader financial market risks. However, in periods of economic stress, markets experience a flight to quality and correlations between risk assets increase. Therefore, the benefits of portfolio diversification dissolve when they are needed most. This is not the case with cat bonds, however, as correlations with other assets (Table 4) have remained stable over time. This makes them a potentially useful diversification instrument in multi-asset portfolios. Table 4Cross-Asset Correlation (January 2002 - November 2017) A Primer On Catastrophe Bonds A Primer On Catastrophe Bonds To test this, we perform a typical portfolio analysis whereby we add cat bonds to a conventional portfolio and investigate the impact on the return and risk of the portfolio (Chart 7). Starting with the most traditional allocation of 60% equities and 40% bonds, we augment the portfolio with a 10% allocation to cat bonds and come up with the following results: Replacing equities with cat bonds leads to the largest reduction in portfolio volatility, and a small decrease in annualized returns. This new portfolio generates equity-like returns, but with a smaller correlation with stocks. Replacing traditional fixed income with cat bonds leads to a large increase to annualized returns, while the impact on volatility is virtually non-existent. The largest positive impact on risk-adjusted returns occurs when cat bonds replace equities, because the reduction in volatility is substantially greater than the increase in returns when cat bonds replace traditional bonds. We also ranked the MSCI All-Country World equity and Bloomberg Barclays Global Aggregate Bond indices from worst to best monthly returns and then overlaid the corresponding cat bond returns for each ranked month (Chart 8). This technique removes randomness from the time series in order to view the relative randomness of the other. We have the following findings: Cat bonds have had only three months that delivered a return less than -2%. These were -2.1% in September 2005 during Hurricane Katrina, -3.6% in March 2011 during the Tohoku earthquake and tsunami in Japan, and -5.8% in September 2017 after the severe hurricanes in Texas, Florida and the Caribbean. Other than catastrophe-related events, cat bond returns have been stable. Cat bonds displayed no reaction when equities had their most negative months. But they tend to have relatively stronger returns when equities also have positive months. Cat bonds performed well in both good and bad months for traditional fixed income. This shows that causes of traditional bond market losses and cat bond principal loss have little or no bearing on one another. Since cat bonds have a large negative skew and high excess kurtosis, investors can potentially lose all their capital if the bonds are triggered. When allocating to cat bonds, investors need to maintain a well-diversified position in order to minimize the risk of complete capital wipeout. This can be done by carefully picking bonds covering different perils (i.e. earthquakes, wind, extreme mortality), regions and trigger types (Chart 9). As a broader range of perils come to the market, investors will find increasing avenues for diversification within the asset class. Investors can also benefit from very low correlations within the cat bond universe, where returns from cat bonds covering a specific peril have no bearing on returns from cat bonds covering another peril. Chart 7Portfolio Diversification A Primer On Catastrophe Bonds A Primer On Catastrophe Bonds Chart 8Attractive Monthly Returns A Primer On Catastrophe Bonds A Primer On Catastrophe Bonds Chart 9Diversifying Across Perils, Coupon Rate And Expected Loss A Primer On Catastrophe Bonds A Primer On Catastrophe Bonds Financial Market Stress Having established that underlying market developments have no bearing on cat bond performance, we want to address two further important questions: 1) do financial crises affect cat bond returns? 2) do natural catastrophes trigger financial crises? Looking at previous global market crisis scenarios dating back to 2008 (Chart 10), we see that cat bonds had positive absolute returns during all crisis periods. The only period with negative cat bond returns was during the 2008 Lehman Brothers' collapse, when the bank was the swap counterparty for two bonds that defaulted. Large natural catastrophes do not affect broader capital markets, but do tend to have a large local impact. In August 2005, Hurricane Katrina, with damages totaling $108 billion, became the costliest hurricane to date in the U.S. The hurricane triggered a cat bond, and the index was down 2.1%, but there was no noticeable lingering impact on the U.S. economy. On the other hand, the earthquake and tsunami in Tohoku on March 11, 2011 had devastating effects. With damages exceeding $300 billion (approximately 5% of Japanese GDP), the cat bond index dropped 3.6%, and Japanese equities collapsed 7.3%. Moreover, a big earthquake in a major city or region such as Tokyo or California could have the capacity to trigger a global recession. Finally, looking at past major catastrophes (Chart 11), we see that existing cat bond prices do not fully recover to their pre-catastrophe levels. Accordingly, picking up bonds at a discount may not generate the expected return as price levels struggle to fully recover. Chart 10Outperformance Across The Board A Primer On Catastrophe Bonds A Primer On Catastrophe Bonds Chart 11Not A Full Recovery Not A Full Recovery Not A Full Recovery Interest Rate & Inflation Hedge Traditional bonds with fixed coupon payments underperform in a rising rate environment. Since cat bonds receive a floating-rate coupon along with the fixed premium, they are largely immune to rising rates. When central banks hike rates, the principal of the bonds invested in money market assets will produce a higher return, thereby offering investors a powerful shield against possible inflation, as well. Since the total coupon received by investors includes a fixed and floating component, cat bonds have a lower modified duration relative to similar maturity traditional bonds. Conclusion Despite their abnormal return distributions, we recommend investors allocate capital from their "alternatives" bucket toward cat bonds. Against a backdrop of low yields and investor complacency, cat bonds are highly attractive given their potential for consistently robust returns and, perhaps most importantly, tremendous diversification benefits. Still, allocations should be relatively small given the illiquid nature of the cat bond market, and diversification among bonds and issuers is critical due to the potential for large losses in the event that a cat bond is triggered. Aditya Kurian, Research Analyst Global Asset Allocation adityak@bcaresearch.com

Highlights Chart 12017 Bond Returns 2017 Bond Returns 2017 Bond Returns Treasuries sold off for the third consecutive month in November (Chart 1), and with Congress about to deliver tax cuts and core inflation showing signs of bottoming, the bond bear market is poised to shift into a higher gear. At the moment, the biggest upside risk for bonds is that the Fed continues its hawkish posturing but inflation refuses to comply. That combination would put downward pressure on TIPS breakeven inflation rates and cause the yield curve to flatten further. A flat yield curve increases the odds of a risk-off episode in equities and credit spreads, with a consequent flight into the safety of Treasuries. We do not think the Fed will get it wrong and expect TIPS breakevens to widen alongside rising inflation, easing the flattening pressure on the yield curve. Investors should maintain a below-benchmark duration stance and an overweight allocation to spread product on a 6-12 month investment horizon.   Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 3 basis points in November, dragging year-to-date excess returns down to 285 bps. The average index option-adjusted spread widened 2 bps on the month and now sits at 97 bps. Spreads gapped wider early in the month but then reversed course, ending November not far from where they began. In other words, investment grade corporate bonds remain extremely expensive. We calculate that Baa-rated spreads can only tighten another 39 bps before reaching the most expensive levels since 1989. This represents 3 months of historical average spread tightening. Corporate bonds are essentially a carry trade at this stage of the cycle, but should continue to deliver positive excess returns to Treasuries until inflation pressures mount and the credit cycle comes to an end. We expect the credit cycle will end sometime in 2018.1 Last week's profit data showed that our measure of EBITD increased at an annualized rate of 4% in Q3 (Chart 2), solidly above zero but significantly slower than the 12% registered in Q2. If corporate debt grows by more than 4% in the third quarter, our measure of gross leverage will tick higher (panel 4). As we have shown in prior reports, this would bring the end of the credit cycle closer.2 Quarterly corporate debt growth has averaged just under 6% (annualized) since 2012, so higher leverage in Q3 is likely (Table 3). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* A Higher Gear A Higher Gear Table 3BCorporate Sector Risk Vs. Reward* A Higher Gear A Higher Gear High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 2 basis points in November, dragging year-to-date excess returns down to 578 bps. The index option-adjusted spread widened 6 bps on the month, and currently sits at 349 bps. Excess returns were negative in November for only the fourth month since spreads peaked in February 2016. In a recent Special Report we argued that last month's sell-off would prove fleeting, but also cautioned that excess returns are likely to be low between now and the end of the credit cycle.3 The report flagged five reasons why investors might be nervous about their high-yield allocations. The two most important being that spreads are very tight and the yield curve is very flat. Tight spreads imply that investors should not expect much in the way of further capital gains, insofar as much further spread tightening would lead to historically expensive valuations. In a baseline scenario where spreads remain flat, we forecast excess returns to junk of 246 bps (annualized) (Chart 3). An inverted yield curve signals that investors believe the Fed will be forced to cut rates in the future. This makes it an excellent indicator for the end of the credit cycle. When the yield curve is very flat investors are more inclined to view any negative development as a signal that the cycle is about to turn. This leads to more frequent sell-offs. A period of curve steepening led by higher inflation would mitigate the risk. MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 4 basis points in November, bringing year-to-date excess returns up to 35 bps. The conventional 30-year zero-volatility MBS spread was flat on the month, as a 2 bps widening in the option-adjusted spread (OAS) was offset by a 2 bps decline in the compensation for prepayment risk (option cost). Agency MBS OAS continue to look reasonably attractive, especially relative to Aaa-rated credit. And with the pace of run-off from the Fed's balance sheet already well telegraphed, there is no obvious catalyst for further OAS widening. In addition, mortgage refinancings are unlikely to spike any time soon. This will ensure that nominal MBS spreads remain capped at a low level (Chart 4). If bond yields rise during the next 6-12 months, as we expect, then higher mortgage rates will be a drag on refinancings. However, as we showed in a recent report, even if rates move lower, the coupon and age distribution of outstanding mortgages has made refi activity much less sensitive to rates than in the past.4 All in all, with OAS more attractive than they have been for several years, Agency MBS are an alluring alternative for investors looking to scale back exposure to corporate bonds. We anticipate shifting some of our recommended spread product allocation out of corporate bonds and into MBS once we are closer to the end of the credit cycle, likely sometime in 2018. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 28 basis points in November, bringing year-to-date excess returns up to 221 bps. Foreign Agencies and Local Authorities outperformed the Treasury benchmark by 39 bps and 34 bps, respectively. Meanwhile, Sovereign bonds delivered a stellar 93 bps of outperformance. Domestic Agency bonds outperformed by 4 bps, while Supranationals underperformed by 1 bp. We continue to hold a negative view of USD-denominated Sovereign debt. Not only is valuation unattractive compared to similarly-rated U.S. corporate bonds (Chart 5), but historically, periods of sovereign bond outperformance have coincided with falling U.S. rate hike expectations.5 Our Global Fixed Income Strategy team flagged similar concerns in a recent Special Report on the merits of USD-denominated EM debt (both corporate and sovereign).6 The recent moderation in Chinese money and credit growth also heightens the risk of near-term Sovereign underperformance.7 We remain overweight Local Authorities and Foreign Agencies. Year-to-date, those sectors have delivered 256 bps and 402 bps of excess return, respectively, and continue to offer attractive spreads after adjusting for credit rating, duration and spread volatility. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 19 basis points in November (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio moved sharply higher in November, with short maturities bearing the brunt of the sell-off. But even after November's weakness, the average M/T yield ratio remains below its average post-crisis level, and long maturities continue to offer a significant yield advantage over short maturities. Both the Senate and House have already passed their own versions of a tax bill, which now just need to be reconciled before new tax legislation is signed into law. Judging from the two versions of the bill, the following will likely occur: The Muni tax exemption will be maintained, the top marginal tax rate will remain close to its current level, the corporate tax rate will be reduced substantially, the state & local income tax deduction will be at least partially eliminated, the tax exemption for private activity bonds might be removed, and advance refunding of municipal bonds will be outlawed or severely restricted. Last month's poor Muni performance was driven by a surge in supply (Chart 6), almost certainly issuers trying to get their advance refundings done before the passage of the final bill. Given that the other provisions in the bill should not have a major impact on yield ratios (any negative impact from lower corporate tax rates should be mitigated by stronger household demand stemming from the removal of the state & local tax deduction), this back-up in yield ratios could present a tactical buying opportunity in Munis once the bill is passed. Stay tuned.   Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-flattened in November, as investors significantly bid up the expected pace of Fed rate hikes but did not correspondingly increase their long-dated inflation expectations. The sharp upward adjustment in rate hike expectations means that investors are now positioned for 69 bps of rate hikes during the next 12 months (Chart 7). Similarly, the July 2018 fed funds futures contract is now priced for 52 bps of rate hikes between now and next July. Even if the Fed lifts rates in line with its dots, we would only see 75 bps of rate hikes between now and next July. Since there are strong odds that the Fed will proceed more gradually, this week we close our short July 2018 fed funds futures position for an un-levered profit of 21 bps. In a Special Report published last week, we presented several scenarios for the slope of the 2/10 yield curve based on different combinations of Fed rate hikes and future rate hike expectations.8 We also noted that the positive correlation between long-maturity TIPS breakeven inflation rates and the slope of the nominal 2/10 yield curve has remained intact this cycle. We conclude that the 2/10 slope will steepen modestly in the first half of 2018, before transitioning to flattening once TIPS breakevens level-off at a higher level. With the 2/5/10 butterfly spread now discounting some mild curve flattening (panel 4), investors should remain long the 5-year bullet versus the duration-matched 2/10 barbell.   TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 15 basis points in November, bringing year-to-date excess returns up to -84 bps. The 10-year TIPS breakeven inflation rate fell 2 bps on the month and, at 1.86%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. As was detailed in last week's Special Report, one of our key views for 2018 is that core inflation will resume its gradual cyclical uptrend, causing long-maturity TIPS breakeven inflation rates to return to their pre-crisis trading range between 2.4% and 2.5%.9 A wide range of indicators, such as our own Pipeline Inflation Indicator and the New York Fed's Underlying Inflation Gauge, already suggest that TIPS breakevens are biased wider (Chart 8). Even more encouragingly, both year-over-year core CPI and core PCE inflation have printed higher in each of the last two months. But even if inflation remains stubbornly low, we think any downside in long-maturity breakevens will prove fleeting. We are quickly approaching an inflection point where if inflation does not rise, the Fed will have to adopt a more dovish policy stance. A sufficiently dovish policy response would limit any downside in breakevens. According to our model, the 10-year TIPS breakeven inflation rate is currently trading in-line with other financial market variables - oil, the trade-weighted dollar and the stock-to-bond total return ratio (panel 2). ABS: Neutral Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 11 basis points in November, bringing year-to-date excess returns up to 92 bps. Aaa-rated ABS outperformed the Treasury benchmark by 10 bps and non-Aaa ABS outperformed by 30 bps. The index option-adjusted spread (OAS) for Aaa-rated ABS tightened 3 bps on the month and, at 31 bps, it remains well below its average pre-crisis trading range. The value proposition in Aaa-rated ABS is not what it once was. At 31 bps, the average index OAS is only 1 bp greater than the average OAS for a conventional 30-year Agency MBS. Agency CMBS are even more attractive, offering an index OAS of 44 bps. Further, the credit cycle is slowly turning against consumer debt. Delinquency rates are rising, albeit off a very low base, but this has caused banks to start tightening lending standards on consumer credit (Chart 9). Tight bank lending standards typically coincide with wider spreads. Importantly, while lending standards are tightening they are not yet very restrictive in absolute terms. In response to a special question from the July 2017 Fed Senior Loan Officer's Survey, banks reported (on net) that lending standards are tighter than the midpoint since 2005 for subprime auto and credit card loans, but are still easier than the midpoint since 2005 for credit card and auto loans to prime borrowers. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 1 basis point in November, dragging year-to-date excess returns down to 180 bps. The index option-adjusted spread (OAS) for non-agency Aaa-rated CMBS widened 3 bps in November, but is still about one standard deviation below its pre-crisis average (Chart 10). With spreads at such low levels in an environment of tightening commercial real estate (CRE) lending standards and falling CRE loan demand, we continue to view the risk/reward trade-off in non-Agency CMBS as quite unfavorable. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 15 basis points in November, bringing year-to-date excess returns up to 112 bps. The index OAS for Agency CMBS tightened 2 bps on the month but, at 44 bps, the sector continues to offer an attractive spread pick-up relative to other low-risk spread product. The Aaa-rated consumer ABS OAS is only 31 bps, and the OAS on conventional 30-year Agency MBS is a mere 30 bps. Such an attractive spread pick-up in a sector that benefits from Agency backing is surely worth grabbing. Treasury Valuation Chart 11Treasury Fair Value Models Treasury Fair Value Models Treasury Fair Value Models The current reading from our 2-factor Treasury model (based on Global PMI and dollar sentiment) pegs fair value for the 10-year Treasury yield at 2.81% (Chart 11). Our 3-factor version of the model (not shown), which also incorporates the Global Economic Policy Uncertainty Index, places fair value at 2.79%. The Global Manufacturing PMI edged higher once more in November, up to 54 from 53.5 in October. It is now at its highest level since March 2011. Meanwhile, sentiment toward the dollar remains significantly less bullish than it was in 2015 and 2016 (bottom panel). A higher PMI reading and less bullish dollar sentiment both lead to a higher fair value in our model. At the country level, both the Eurozone and Japanese PMIs ticked higher in November. The Eurozone PMI broke above 60 for the first time since April 2000. The U.S. and Chinese PMIs both moved modestly lower. For further details on our Treasury models please refer to U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 11, 2016, available at usbs.bcaresearch.com. At the time of publication the 10-year Treasury yield was 2.39%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report, "2018 Key Views: Implications For U.S. Fixed Income", dated November 28, 2017, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Won't Back Down", dated September 26, 2017, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, "Junk Bond Jitters", dated November 21, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching: Yet Another Update", dated October 10, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Living With The Carry Trade", dated October 17, 2017, available at usbs.bcaresearch.com 6 Please see Global Fixed Income Strategy Special Report, "Examining The Role Of EM Hard Currency Debt In Global Bond Portfolios", dated October 31, 2017, available at gfis.bcaresearch.com 7 Please see China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of China's Business Cycle", dated November 30, 2017, available at cis.bcaresearch.com 8 Please see U.S. Bond Strategy Special Report, "2018 Key Views: Implications For U.S. Fixed Income", dated November 28, 2017, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Special Report, "2018 Key Views: Implications For U.S. Fixed Income", dated November 28, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

As we near the end of an impressive year for equities, the relationship between price growth and earnings growth and how to best position a portfolio for 2018 bears some reflection. The purpose of this report, rather than take a position on inflation or growth, is to create a roadmap such that investors can allocate according to their expectations for both and also avoid potential pitfalls and embrace likely winners. Diagram 1Four Quadrants Of Earnings And Inflation Equity Sector Winners And Losers When Inflation Climbs; A Deeper Dive Equity Sector Winners And Losers When Inflation Climbs; A Deeper Dive In framing our analysis, we will focus on the top half of a well-known growth/inflation matrix presented in Diagram 1 below (stay tuned for a follow-up Special Report when we examine the sector impacts of deflation). We have used S&P 500 earnings as our measure of growth for two reasons: first, they lead GDP and IP growth and second, they are most relevant in a discussion of S&P 500 sector allocations. While inflation and earnings growth tend to move together, this has not always been the case. We have identified six time periods in which inflation has been visibly rising (shaded in Chart 1) and compared it with S&P 500 EPS growth. The mean reverting nature of S&P 500 earnings growth makes discerning a pattern difficult but, more often than not, there is a positive correlation with rising inflation. Over the last 60 years S&P 500 earnings growth has averaged 7.6%, while core PCE prices increased on average by 3.3%. As shown in Table 1 below, S&P 500 earnings outpaced core inflation in four periods (indeed, they grew much faster) and fell behind in two periods. We thus place 1965-1971 and 1998-2002 in the top-left quadrant of our matrix (Stagflation) and 1973-1975, 1976-1981, 1987-1989 and 2003-2006 in the top-right (Boom Times). It is important to qualify that, for the purposes of this report, we are considering all periods in which inflation is increasing, not necessarily periods when it is elevated on an absolute basis. Chart 1Earnings And Inflation Usually Move Together... Earnings And Inflation Usually Move Together... Earnings And Inflation Usually Move Together... Table 1...But Not Always Equity Sector Winners And Losers When Inflation Climbs; A Deeper Dive Equity Sector Winners And Losers When Inflation Climbs; A Deeper Dive In our examination of inflation and sector winners last year1, we presented Table 2 below, now modified to tie sector earnings growth to relative share price performance. Breaking down sector performance in boom and bust periods is revealing. The first and most obvious observation is that stock performance tracks earnings growth in all periods, implying that fundamentals lead valuation, as they should. The second observation is that empirical evidence supports sector allocation theory in inflationary boom/bust periods. Table 2Sector Performance When Inflation Rises Equity Sector Winners And Losers When Inflation Climbs; A Deeper Dive Equity Sector Winners And Losers When Inflation Climbs; A Deeper Dive In theory, the best performing stocks in a stagflation environment would have low economic sensitivity but high pricing power. This is borne out with S&P health care being the top performing sector both from an earnings growth and, predictably, relative stock performance perspective. By contrast, the top performing boom time stocks should be the most economically sensitive yet still stores of value. In these periods, the top overall performer was energy which checks all the boxes. This year, we are expanding our analysis to the GICS2 sectors which have shared the same cyclical return profile as their GICS1 peers (Table 3). In the inflationary busts, defensive stocks including healthcare equipment and food & beverage outperformed. As expected, the inflationary booms saw traditional cyclical indices including energy and transportation outperform. Table 3GICS2 Sector Performance When Inflation Rises Equity Sector Winners And Losers When Inflation Climbs; A Deeper Dive Equity Sector Winners And Losers When Inflation Climbs; A Deeper Dive In the next section, we will take a deeper look at three of the GICS2 top and two bottom quartile performers when inflation is rising. Energy - (Currently Overweight) The S&P energy index has been a stellar performer in all six high inflation periods we have examined and has the highest average return of all GICS2 sectors. This is logical, considering the sector's revenue, profit and share price leverage to the underlying commodity. During periods of high inflation, all stores of value tend to increase and oil is no exception. An additional tailwind for energy prices with inflation is the associated elevated industrial production; the current synchronized global growth backdrop should sustain a healthy level of demand for energy. Keep in mind oil prices are an excellent gauge of global growth. In the context of a falling rig count and contracting oil stocks (Chart 2), energy prices and stocks seem likely to remain well bid, underpinning our overweight recommendation on the S&P energy index. Transportation - (Currently Overweight) Transportation can largely be summarized as S&P railroads (currently overweight) and S&P air freight & logistics (currently overweight) which together comprise 75% of the index. The index has been a very strong performer in periods of rising inflation, driven by coincident accelerating global trade volumes (Chart 3). Historically, global industrial production and both rail and air freight EPS have moved in tandem as relatively fixed supply drives pricing power firmly on the side of logistics providers (Chart 3). This pricing power allows the transportation to mitigate the usually coincidentally highly volatile energy price via oil surcharges, offsetting what is typically the largest input cost. Together, firming volumes and pricing gains support an outsized earnings outlook and our overweight recommendation in transportation. Chart 2Inflation, IP And Oil Prices Move Together Inflation, IP And Oil Prices Move Together Inflation, IP And Oil Prices Move Together Chart 3Rising Inflation Is A Boon To Global Trade Volume Rising Inflation Is A Boon To Global Trade Volume Rising Inflation Is A Boon To Global Trade Volume Health Care Equipment - (Currently Neutral) The S&P health care equipment index has consistently been an outperformer in each of the six high inflation impulse periods we analyzed. This is all the more interesting, considering it is the least cyclical of the top quartile relative performers. Health care equipment sales are largely driven by new facility construction which is, in turn, driven at least in part by consumer spending on health care. Consumer health care expenditure has a demonstrated propensity to follow (with significantly greater amplitude) overall inflation (Chart 4). Further, health care equipment is highly levered to global demand; the latter clearly rises hand in hand with inflation and should be EPS accretive to the former. Elevated relative valuations offsetting the positive operating environment keep us on the sidelines. Chart 4Health Care Spending Tracks Inflation Health Care Spending Tracks Inflation Health Care Spending Tracks Inflation Automotive - (Currently Underweight) Returns in the S&P automotive index are by far the most consistently negative when inflation is rising. Rising interest rates driving the costs of ownership higher, combined with the rational avoidance of a depreciating asset when stores of value are preferable, have historically impaired light vehicle sales as inflation climbs. In fact, the two have a tight negative correlation (Chart 5). In an industry where margins are razor thin at the best of times and fixed costs are relatively high, a shrinking top line implies significant profit contraction. Add on a highly geared balance sheet in a rising rate environment and the ingredients are all in place for underperformance. The current environment echoes this analysis; inventories are still elevated despite manufacturer incentives hitting their highest level in history and seven-year auto loans becoming the norm, something unheard of in previous cycles. Chart 5Inflation And Auto Sales Are Inversely Correlated Inflation And Auto Sales Are Inversely Correlated Inflation And Auto Sales Are Inversely Correlated Utilities - (Currently Underweight) Utilities, as the prototypical defensive sector, have unsurprisingly performed poorly as inflation is rising. Rising inflation expectations go hand in hand with rising bond yields (Chart 6); as a fixed-income proxy, utilities are likely to be subject to the same drubbing as the bond market when yields rise. Further, surging global trade is a notable boon to the three outperformers previously highlighted with their exceptional international exposure; utilities are a domestic-only investment and are bound to underperform. Overall, we recommend an underweight position in utilities. Chart 6Inflation Is A Headwind To Fixed Income Proxies Inflation Is A Headwind To Fixed Income Proxies Inflation Is A Headwind To Fixed Income Proxies Chris Bowes, Associate Editor U.S. Equity Strategy chrisb@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Equity Sector Winners And Losers When Inflation Climbs," dated December 5, 2016, available at uses.bcaresearch.com.

Highlights Agricultural markets are informationally efficient for the most part, which is to say that at any given time, prices already reflect most public information available to traders, and a lot of private information as well. Even so, we believe markets are underestimating the Fed's resolve in normalizing interest-rate policy next year - particularly when it comes to the number of rate hikes we are likely to see - and thus are underestimating the likelihood of lower grain prices in 2018. Energy: Overweight. Oil markets will emerge from their suspended animation following OPEC 2.0's Vienna meeting today. Our Brent and WTI call spreads in May, July and December 2018 - long $55/bbl calls vs. short $60/bbl calls - are up an average 50.2%. Our long Jul/18 WTI vs. short Dec/18 WTI trade anticipating steepening backwardation is up 13.3%. Base Metals: Neutral. China's refined zinc imports were up 145% yoy to 61,355 MT in October, based on customs data. Metal Bulletin noted tight domestic supplies accounted for the increase. Precious Metals: Neutral. Gold is breaking away from its attachment to $1,280/oz., as the USD weakens. Our long gold portfolio hedge is up 5.2% since inception May 4, 2017. Ags/Softs: Neutral. Global financial conditions will become increasingly important to grain prices going forward, a trend we explore below. Feature Record output and ending stocks will ensure that ag markets remain well supplied globally next year. While we see risks as balanced in the upcoming year, and remain neutral ags generally, we believe markets are underestimating the Fed's resolve when it comes to normalizing interest rates, and thus underestimate upside USD potential. This means the likelihood of lower grain prices also is being underestimated. Weather will add volatility to the mix, as well. We believe the fundamentals supporting the assessment of record output and season-ending stocks-to-use ratios are fully reflected in prices. However, financial conditions - particularly USD strength next year - are not being fully priced by markets. This makes grains, in particular, vulnerable to the downside. Financial conditions driving ag markets: Fed policy & real rates: we expect U.S. financial conditions to tighten, and for the Fed to hike rates once more this year, and up to three more times in 2018.1 FX rates: With higher U.S. policy rates next year, the USD is likely to strengthen. This will weaken grain prices generally. Wheat, in particular, is most vulnerable to a strengthening USD and a weakening of the currencies of some of the commodity's top exporters - the European Union, Russia, and Australia. We've narrowed down the fundamental factors to look out for in 2018 as follows: Strong demand amid an extension of supply cuts by the OPEC 2.0 coalition will support oil prices in 2018. Higher energy prices will increase profit-margin pressure in ag markets through input and shipping costs. Weather risks from La Nina threaten to curb yields this winter, especially in Argentina and Brazil, which will add volatility to prices. Policy shifts in Argentina, China, and Brazil will influence farmers' planting decisions in the upcoming crop year. A Look Back At 2017 Chart of the WeekGrains Outperformed Softs This Year Grains Outperformed Softs This Year Grains Outperformed Softs This Year As predicted in our 2017 outlook, grains reversed their 2016 underperformance vis-à-vis softs this year, and outperformed them.2 While prices for sugar, coffee, and cotton were up 28%, 8%, and 12% in 2016, they have since declined by 21%, 8%, and 2%, respectively. In fact, sugar - our top ag in 2016 - took the biggest hit this year (Chart of the Week). On the other hand, as a complex, grains currently stand at largely the same level as the beginning of last year. However, there are some idiosyncrasies within the class. The two worst performing grains last year - rice and wheat - have been the strongest performers so far this year. Rice rallied 30% year-to-date (ytd) on the back of tighter supplies, completely reversing its 19% decline in 2016. Similarly, wheat, which lost 13% of its value last year, is up a modest 3% ytd. On the other hand, soybeans surrendered its title as the most profitable grain in 2016. After gaining 14% last year, its fate turned and it fell 3% ytd. Finally, out of the lot, corn is the only ag we cover that has fallen in both years consecutively, by a minor 1.9% in 2016, and an additional 4.4% so far this year. A Recap Of Long Term Trends According to the International Grains Council's November estimates, grains production is projected to come down this crop year. With an increase in consumption, this will ultimately lead to a 5.2% decline in ending stocks - the first drawdown in five years. Despite the year-on-year (y-o-y) decline, grain inventories are expected to stand at their second highest level on record (Table 1). Table 1Grain Production Down While Consumption Inches Higher Global Financial Conditions Will Drive Grain Prices In 2018 Global Financial Conditions Will Drive Grain Prices In 2018 The decline in expected grain ending stocks is mainly driven by corn, which - despite a large upwards revision to U.S. yields in the most recent WASDE - is expected to experience a 3.6% decline in production. This, together with a boost in consumption, leads to a 13.6% fall in ending stocks - the first drawdown since the 2010/11 crop year. The decline in corn expectations reflects a shift in the planting preferences of some of the major producers. The U.S., Brazil, Argentina, and China are the top soybean and corn exporters - accounting for 78% and 49% of global soybean and corn area harvested in the 2016/17 crop year, respectively. What is significant in the current cycle is that farmers in these countries are moving away from planting corn and towards more soybeans (Chart 2). China, which accounted for 19% of global corn area harvested and 6% of global soybean area harvested in 2016/17, is leading this change. While corn area harvested fell by an average 4.2% in the 2015 and 2016 crop years, soybean area harvested gained 9.8% during that period. Similarly, in Brazil, which accounted for 10% and 28% of global corn and soybean area harvested in 2016/17, respectively, corn area harvested by farmers has been growing at a much slower rate than soybean area harvested, with the former expanding by 16.4% and the latter by 39.6% since 2010/11. Likewise, harvested area in the U.S., which accounted for 18% and 29% of global corn and soybean area harvested, respectively, shrunk by 0.9% in the case of corn, and expanded by 21.3% in the case of soybeans since 2010/11. The exception to this rule is Argentina. Argentine farmland accounted for 3% and 15% of global corn and soybean area harvested in 2016/17, respectively. Since 2010/11, both corn area harvested as well as soybean area harvested increased by roughly the same level - 1.6 Mn Ha for the former and 1.5 Mn Ha for the latter - representing a 44.4% and 8.6% increase in area harvested for corn and soybeans, respectively. However, this is due to export policies, which in effect, encourage corn production over soybeans. As we discuss below, soybean export tariffs will be phased out in the coming years, likely changing the incentives structure for Argentine farmers. This trend is mirrored in production data, with global soybean output gaining 32% since 2010/11, compared to a 25% increase in global corn production. However, this shift is in large part due to demand patterns which also favor soybeans to corn. Over the same period, global soybean consumption increased by 36%, compared to 24% in the case of corn (Chart 3). Chart 2Farmers Favor Soybeans Over Corn... Farmers Favor Soybeans Over Corn... Farmers Favor Soybeans Over Corn... Chart 3...As Do Consumers ...As Do Consumers ...As Do Consumers In fact, at 28%, global soybean stock-to-use ratios are significantly more elevated than that of corn, which stand at 19%. Furthermore, while soybeans are expected to record a 3.9mm MT surplus by the end of the current crop year, corn is projected to experience a 17.7mm MT deficit. Powell's Fed And Dollar Movements Our modelling of ags reveals that U.S. financial factors are important determinants of agriculture commodity price developments.3 Fed policy decisions and their impact on real rates have a direct effect on ag commodity prices, as well as an indirect effect through the exchange rate channel (Chart 4). Chart 4Fed Policy Drives Ag Markets Fed Policy Drives Ag Markets Fed Policy Drives Ag Markets While U.S. inflation has remained stubbornly low, forcing the Fed to slow down their interest rate normalization process, the anticipation - and eventual acceleration - of the Fed tightening cycle will weigh on ag prices. However, thanks in part to softer-than-expected inflation readings coming out of the U.S. this year, the USD broad trade-weighted index (TWIB) has weakened by 6.8% since the beginning of the year. In terms of the impact of real rates, monetary policy impacts agriculture markets through the following channels: The Fed's interest-rate normalization process will, all else equal, increase borrowing costs for farmers, and discourage investments in general - impacting both agricultural investments as well as outlays in research and development. Tighter credit also leads to a slowdown in growth which - ceteris paribus - depresses consumption and demand for goods and services generally, and agricultural commodities specifically. Finally, real rates have an indirect effect on agricultural commodity prices through its effect on the U.S. dollar. Higher U.S. rates encourage investment in U.S. bonds and entail a strengthening of the U.S. dollar making U.S. exports less competitive vis-à-vis those of its international competitors. Since commodities are priced in U.S. dollars while costs are priced in local currencies, a weakening of the domestic currency vis-à-vis the dollar would increase profitability for farmers selling in international markets. This can incentivize farmers to plant more, despite depressed global ag prices, which increases supply. As our modelling reveals, the net effect is an inverse relationship, whereby easier monetary policy is generally more favorable for agriculture markets. The Fed Will Remain Behind The Inflation Curve Our U.S. Bond Strategy team expects the Fed to remain behind inflation, in which case the USD will remain weak in the beginning of next year. The 2/10 Treasury curve is flat highlighting the market's belief that the Fed will continue with interest rate normalization despite below target levels of inflation.4 Since this would be a huge error on the part of new Chairman Powell, our U.S. bond strategists believe that the Fed will avoid such a policy mistake. Consequently, if inflation does not pick up soon, the Fed will be forced to turn dovish. In any case, U.S. monetary policy will "fall behind the curve." This means that the U.S. dollar will remain weak until inflation starts to tick higher, and the Fed can resume its interest rate normalization process. In fact, our bond strategists find that there is a resemblance between the current cycle and that of the late 1990s where the unemployment rate significantly undershot its natural level before inflation started to accelerate. Thus, they find it significant that most of the indicators that predicted the 1999 increase in inflation are now positive. This reinforces our faith that inflation will soon rebound, allowing the Fed to fall behind the curve and simultaneously hike rates at a pace of one more hike this year, and three more in 2018.5 In terms of the future path of the U.S. dollar, our foreign exchange strategists argue interest rate differentials will be a more significant determinant of dollar dynamics going forward. They expect inflation will start its ascent sometime before the end of 1H2018, which would lift the interest rate curve and the dollar. Our expectation is that inflation will bottom towards the end of this year/beginning of next, giving room for the Fed to proceed with its anticipated rate-hiking cycle, resulting in two to three hikes next year. Markets are pricing one to two rate hikes next year, which means our out-of-consensus rates call could cause the USD to rally far more than what markets have priced in to the USD TWIB. Following a 4.4% appreciation in trade weighted terms in 2016, the U.S. dollar has depreciated by 6.8% so far this year. The U.S. accounts for a larger share of global exports of corn and soybeans than rice and wheat, which means a strengthening of the USD TWIB will likely have a bigger impact on wheat and rice, in which the U.S. faces greater international competition for market share (Table 2). Table 2Wheat & Rice Vulnerable To USD Dynamics Global Financial Conditions Will Drive Grain Prices In 2018 Global Financial Conditions Will Drive Grain Prices In 2018 This is, in fact, in line with the price behavior that we have observed. Wheat and rice prices fell the most in 2016 as the U.S. dollar appreciated, and have outperformed soybeans and corn so far this year, as the U.S. dollar depreciated. Thus, in the absence of supply shocks that affect a particular grain, changes in the U.S. dollar going forward will have a greater impact on rice and wheat than on corn and soybeans. Keep An Eye On The Brazilian Real Of the major ag exporters, Brazil is most vulnerable to USD depreciation risk. Poor productivity trends have made our foreign exchange strategists single out the Brazilian Real (BRL) as one of the most expensive currencies they track. While they expect the BRL to depreciate over a one- to two-year horizon, the current strength in EM asset prices means that the BRL is likely to remain at its current level in the near term. However, given that the BRL provides an high carry, it will likely move sideways until U.S. interest rate expectations adjust to a rebound in inflation - which we expect toward the end of this year, or beginning of next. Brazil is a major ag producer - making up 45%, 44%, 27%, 23% and 12% share of the global export pies for soybeans, sugar, coffee, corn and cotton, respectively. Thus, a weaker BRL vis-à-vis the USD is a major downside risk to these commodity prices. Downside FX Risks Will Keep Wheat Prices Depressed Chart 5Downside FX Risks For Wheat Exporters Downside FX Risks For Wheat Exporters Downside FX Risks For Wheat Exporters In addition to the risks from an overvalued BRL, our foreign exchange strategists have highlighted the EUR, RUB, and AUD as currencies that are at risk of falling back to their fair value in the near term. Given that these regions are major wheat exporters, this would weigh on the grain's price as exports increase (Chart 5).6 On the back of expectations that the European Central Bank will adopt a significantly less aggressive monetary policy than the Fed, our foreign exchange strategists expect the EUR to weaken toward the end of the year and beginning of next. Given that Europe is a major wheat exporter - making up ~20% of global exports - a weaker EUR would make European wheat more attractive, weighing on prices in 2018. The currencies of other major exporters could be drawn in different directions in the near term. Our FX strategists see the Russian Rouble (RUB) as overvalued and at risk of weakening when U.S. inflation starts accelerating late this year or early next. However, higher oil prices would push up the ruble's fair value, correcting some of its overvaluation. As with the EUR, the wheat market is most vulnerable to a weaker RUB since Russia accounts for 14% of global wheat exports. Likewise, Australia - another major wheat exporter which accounts for 10% of world exports - has been identified as having an expensive currency. It is at risk of a depreciation over the next 24 months, but could rally if iron ore markets turn higher. Some Additional (Potential) Fundamental Forces Among the news and noise in the ags sphere, we see higher oil prices and La Nina as the most significant near-term risks to current supply/demand dynamics. Longer term, shifting policies in China, Argentina, and Brazil will become more relevant in determining the trajectory of ag markets. Our Out-Of-Consensus Call On Oil Is Bullish For Ags Chart 6Higher Energy Prices Upside Risk Higher Energy Prices Upside Risk Higher Energy Prices Upside Risk We expect oil prices will tread higher next year - averaging $65/bbl for Brent and $63/bbl for WTI - on the back of stronger demand and an extension of the OPEC 2.0 coalition's supply restrictions.7 This will support ag commodity prices. Higher oil prices affect ags by increasing input costs and global shipping prices. In addition, the supply of ocean-going transport for grains is tight. The Baltic Dry index, a measure of the global cost of shipping dry goods, and has been on the uptrend this year, as freight costs have more than doubled since mid-February, mostly on the back of a slowdown in shipping transportation supply (Chart 6). La Nina: A Literal Tailwind? Against a backdrop of falling stocks-to-use ratios in the corn and soybean markets, weather will add volatility to prices into 1H2018. In the near term La Nina, which is predicted to continue through the 2017-18 Northern Hemisphere winter, threatens to curb agricultural output. This phenomenon affects weather and rainfall, causing floods and droughts, by cooling the Pacific Ocean. Australia's Bureau of Meteorology recently pegged the chance of a La Nina at 70%, expecting it to last from December to at least February. However, this season's La Nina is forecast to be weak and weather conditions are expected to neutralize in 1Q2018.8 In the case of ags, the greatest threat from La Nina is the risk of droughts in Brazil and Argentina which could hurt the regions soybean, corn, sugar, and cotton harvests. Furthermore, excess rainfall in Australia and Colombia threaten wheat, cotton, and sugar yields in the former and coffee output in the latter. Furthermore, the weather phenomenon raises chances of a potential drought in the U.S. Midwest.9 However, it is noteworthy that by the time La Nina hits, much of the harvest in the Northern Hemisphere will have been completed. So the main risk will be to harvests in the Southern Hemisphere. Gradualismo In Argentina, Stockpiling In China, And Ethanol In Brazil 1. Since taking office late 2015, Argentine President Mauricio Macri has reversed his predecessor's unfavorable agricultural policies - allowing the Argentine peso to float, and eliminating export taxes on wheat and corn. Marci's Gradualismo reforms have been successful - incentivizing plantings and leading to record harvests (Chart 7). While a 30% export tax remains on soybeans - Argentina's main cash crop - it is down from 35% under the presidency of Macri's predecessor. Further cuts to soybean export taxes have been delayed in order to finance the country's fiscal deficit, however they are expected to resume next year with a 0.5pp reduction/month for the next two years. This would stimulate soybean plantings, if it materializes. Argentine farmers produce 18% of global soybean output, and account for 9% of global soybean exports. The change in export policy, as it unfolds, will thus weigh on soybean prices as Argentine farmers increase their soybean acreage in the coming crop years. 2. Although we will likely get more clarity regarding Chinese ag policies with the release of China's Number 1 Central document - which for the past 14 years has focused on agriculture - in February, we expect Beijing to continue incentivizing soybean farming over corn. China's soybean inventory levels stand significantly lower than its notoriously massive stocks of corn, wheat, and cotton (Chart 8). Chart 7Argentine Reforms Will Raise Soybean Exports Argentine Reforms Will Raise Soybean Exports Argentine Reforms Will Raise Soybean Exports Chart 8China's Soybean Stocks Are Relatively Low China's Soybean Stocks Are Relatively Low China's Soybean Stocks Are Relatively Low As such, China's top corn producing province - Heilongjian - cut the subsidy for corn farmers by 13 percent this year. Farmers there now receive 8.90 yuan/hectare of corn, down from the 10.26 yuan/hectare they received last year. This compares with subsidies for soybean farmers which at 11.56 yuan/hectare is much higher. According to the China National Grain and Oils Information Center, corn acreage in Heilongjiang is down 9.3 percent in 2016/17. However, with corn prices in China increasing, the higher subsidy for soybeans may not be sufficient. Nonetheless, according to a report by the Brazilian state Mato Grosso's official news agency, over the next five years the Chinese commodities trader COFCO intends to almost double its soybean imports from the Brazilian grains state. This means that China's demand for soybeans will drive the market in the near term as they look to buildup soybean reserves and bring down their corn stocks.10 Chart 9Higher Oil Prices Incentivize Ethanol Over Sugar Higher Oil Prices Incentivize Ethanol Over Sugar Higher Oil Prices Incentivize Ethanol Over Sugar 3. Ethanol Demand will raise the opportunity costs of bringing sugar and corn to market. In addition to the direct effect of higher oil prices on ag commodities in general, our forecast of increasing prices will pressure sugar prices indirectly through the ethanol channel in Brazil. Since July, Brazil's state-controlled oil company, Petrobras, has shifted its pricing policy allowing gasoline and diesel prices to follow those of international oil markets. As a result, the gasoline-ethanol price gap is widening.11 This will revive demand for the biofuel, which will cause mills to divert sugarcane away from the sweetener in favor of producing more ethanol (Chart 9). In fact, according to UNICA - the Brazilian sugarcane industry association - mills in the country's center-south region - from which 90% of Brazil's sugar output is derived - are favoring ethanol production over sugar. Data for the first half of October shows that 46.5% of sugarcane was diverted to producing sugar, down from 49.6% in the same period last year. However, in the near term, increased production from the EU amid their scrapping of domestic sugar production quotas will likely keep the global market in balance.12 Global sugar supply is forecast to remain strong on the back of supplies from Thailand, Europe and India. There are reports that ethanol producers in Brazil are evaluating the adoption of "corn-cane flex" ethanol plants.13 However this is a longer run risk which would increase demand for corn, and reduce demand for sugar. Bottom Line: Financial conditions will drive ag prices in 2018. The Fed's resolve to normalize interest rates - more so than markets expect - will keep a lid on prices. This will offset risks from higher energy prices. Nonetheless, some weather induced volatility is likely into 1Q2018. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 In fact, our Global Investment Strategists expect the Fed to hike rates in December 2017, and again four more times in 2018. Please see BCA Research's Global Investment Strategy Weekly Report titled "A Timeline For the Next Five Years: Part I," dated November 24, 2017, available at gis.bcaresearch.com. 2 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "2017 Commodity Outlook: Grains & Softs," dated December 22, 2016, available at ces.bcaresearch.com. 3 A 1% move in the USD TWI is associated with a 1.4% change in the CCI Grains & Oilseed Index, in the opposite direction. Similarly, a 1pp move in 5-year real rates is associated with a 18% change in the CCI Grains & Oilseed Index, in the opposite direction. The adjusted R2 is 0.84. 4 Please see BCA Research's U.S. Bond Strategy Portfolio Allocation Summary titled "Into The Fire," dated November 7, 2017, available at usbs.bcaresearch.com. 5 Please see BCA Research's U.S. Bond Strategy Weekly Report titled "The Fed Will Fall Behind The Curve," dated October 24, 2017, available at usbs.bcaresearch.com. 6 Please see BCA Research's Foreign Exchange Strategy Weekly Report titled "Updating Our Long-Term Fair Value Models," dated September 15, 2017, available at fes.bcaresearch.com. 7 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "Oil Balances Continue To Point To Higher Prices," dated November 23, 2017, available at ces.bcaresearch.com. 8 El Nino/Southern Oscillation (ENSO) alternates between warm ("El Nino") and cool ("La Nina") phases, impacting global precipitation and temperatures. These episodes are identified by looking at temperatures in the "Nino region 3.4" whereby readings of at least 0.5 degrees Celsius above or below seasonal average for several months would qualify as an El Nino or La Nina. 9 La Nina is often associated with wet conditions in eastern Australia, Indonesia, the Philippines, Thailand, and South Asia. It usually leads to increased rainfall in northeastern Brazil, Colombia, and other northern parts of South America, and drier than normal conditions in Uruguay, parts of Argentina, coastal Ecuador and northwestern Peru. The effect on the U.S. and Canada tends to be milder since they are located further away from the heart of ENSO, on the other hand it has the greatest impact on countries around the Pacific and Indian Oceans. 10 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "Ags in 2017/18: Move To Neutral," dated October 5, 2017, available at ces.bcaresearch.com. 11 Flex-fuel vehicles in Brazil means that ethanol demand is not constrained by a "blending wall". Thus ethanol is a substitute for gasoline- rather than a complement to, as in the U.S. 12 France, Belgium, Germany and Poland reportedly have the capacity to ramp up sugar beet production. 13 Please see "Brazil mills eye corn-cane flex plant to extend production cycle," dated November 7, 2017, available at reuters.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Global Financial Conditions Will Drive Grain Prices In 2018 Global Financial Conditions Will Drive Grain Prices In 2018 Commodity Prices and Plays Reference Table Trade Recommendation Performance In 3Q17 Global Financial Conditions Will Drive Grain Prices In 2018 Global Financial Conditions Will Drive Grain Prices In 2018 Trades Closed in 2017 Summary of Trades Closed in 2016

Highlights Higher Treasury Yields: As core inflation returns to the Fed's target in 2018 the 10-year TIPS breakeven inflation rate will rise by at least 50 basis points and the nominal 10-year Treasury yield will move above 2.80%. This is substantially higher than the 1-year forward rate of 2.49%. Maintain a below-benchmark portfolio duration stance. TIPS Over Nominal Treasuries: TIPS will outperform nominal Treasury securities in 2018 as long-maturity TIPS breakeven inflation rates widen alongside rising core inflation. The passage of tax cuts in the first half of next year would speed up the adjustment in breakevens. Curve Steepeners, Then Flatteners: The slope of the yield curve is positively correlated with TIPS breakeven inflation rates. Look for mild curve steepening in the first half of 2018 as breakevens widen, transitioning to flattening once breakevens level-off around mid-year. The Cyclical Sweet Spot Comes To An End: The cyclical sweet spot of solid growth and low inflation that has been driving the outperformance of spread product will come to an end in 2018. The catalyst will be higher inflation. We will start paring exposure to spread product once long-maturity TIPS breakeven inflation rates approach our target range of 2.4% to 2.5%, probably in the middle of next year. A Year Of Low Returns: Spreads are not that far from all-time expensive levels, meaning there is limited room for spread compression at this late stage of the credit cycle. Excess returns from spread product will be very similar to carry in 2018 - at least until inflation rises and it is time to prepare for a sustained period of spread widening. Feature BCA's Outlook for 2018 was published last week.1 That report laid out the macroeconomic themes that will impact markets during the next year. In this week's report we expand on those themes and discuss what they mean for U.S. fixed income markets specifically. We identify five key implications. Implication 1: Higher Yields One important theme for 2018 will be the resumption of the cyclical uptrend in inflation. As was stated in the Outlook: The historical evidence still suggests that once the labor market becomes tight, inflation eventually does accelerate. A broad range of data indicates that the U.S. labor market is indeed tight and the Atlanta Fed's wage tracker is in an uptrend, albeit modestly. Two other factors consistent with an end to disinflation are the lagged effects of dollar weakness and a firming in oil prices. Non-oil import prices have now moved decisively out of deflationary territory while oil prices in 2017 have averaged more than 20% above year-ago levels. Rising inflation mustn't necessarily translate into higher yields, but the Treasury market is not currently priced for the possibility that core inflation will ever re-gain the Fed's 2% target. Chart 1 shows the nominal 10-year Treasury yield split into its two main components: Chart 110-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components The compensation for future inflation - proxied by the 10-year TIPS breakeven inflation rate. The real 10-year Treasury yield - proxied by the 10-year TIPS yield. As has been stated repeatedly in this publication, in an environment where realized inflation is well-anchored around the Fed's 2% target the 10-year TIPS breakeven inflation rate has historically traded in a range between 2.4% and 2.5% (Chart 1, top panel). The 10-year TIPS breakeven inflation rate currently sits at 1.84%. This means that by the time core inflation returns to the Fed's 2% target, a feat we think will be achieved in 2018, the 10-year TIPS breakeven inflation rate will impart 56 to 66 basis points of upside to the nominal 10-year Treasury yield. It is possible that any increase in the compensation for inflation protection could be offset by falling real yields. However, it is highly unlikely that the 10-year real yield would decline while the Fed is hiking rates, unless there is a sharp downward adjustment in our 12-month Fed Funds Discounter2 (Chart 1, panel 2). On that front, the market is currently priced for between two and three rate hikes during the next 12 months. This expectation could be revised even higher in the near-term as inflation recovers, but that faster pace of rate hikes is unlikely to be sustained for any significant period of time. All in all, the discounter appears not that far from its fair value, meaning that the 10-year real yield should impart some modest additional upside to the 10-year nominal yield on a 6-12 month horizon. To summarize, if core inflation returns to the Fed's target in 2018, then the nominal 10-year Treasury yield will move into a range between 2.90% and 3.00% (Chart 1, bottom panel), conservatively assuming no additional upside or downside from real yields. This is substantially above the 1-year forward rate of 2.49%, and we therefore advocate a below-benchmark portfolio duration stance. The Importance Of Synchronized Growth It was also observed in the Outlook that, according to the IMF, the median output gap for 20 advanced economies will shift from -0.1% in 2017 to +0.3% in 2018. If these forecasts pan out, then 2018 will also be the first year since the recession that more than 50% of those 20 economies have output gaps in positive territory. Meanwhile, the IMF estimates that the U.S. output gap has been essentially closed since 2015 (Chart 2). In other words, the U.S. has been leading the global economic recovery for the past few years but this is now starting to change. The rest of world is quickly catching up and the global economic recovery is now much more synchronized. This is critically important for U.S. bond yields because it lessens the impact of foreign inflows. For example, when U.S. growth was far outpacing growth in the rest of the world in 2014 and 2015, any increase in U.S. Treasury yields also widened the spread between U.S. yields and yields in the rest of the world. The wider gap encouraged foreign inflows to the U.S. bond market and limited how high U.S. yields could rise. Now, with the global economic recovery more synchronized, U.S. yields will have to increase by much more to have the same impact on the spread between U.S. yields and yields in the rest of the world. In our view this is an extremely bond-bearish development that often goes under-appreciated. Our 2-factor Treasury model attempts to quantify the impact of synchronized global growth on the U.S. 10-year Treasury yield (Chart 3). The model uses Global Manufacturing PMI as its proxy for global growth, and bullish sentiment toward the U.S. dollar as a proxy for the synchronization of the global recovery - a less synchronized recovery should lead to increased bullishness toward the dollar and vice-versa. The model's current reading pegs fair value for the 10-year Treasury yield at 2.69%. Chart 2Rest of World Playing Catch-Up Rest of World Playing Catch-Up Rest of World Playing Catch-Up Chart 32-Factor Treasury Model 2-Factor Treasury Model 2-Factor Treasury Model Bottom Line: As core inflation returns to the Fed's target in 2018 the 10-year TIPS breakeven inflation rate will rise by at least 50 basis points and the nominal 10-year Treasury yield will move above 2.80%. This is substantially higher than the 1-year forward rate of 2.49%. Maintain a below-benchmark portfolio duration stance. Implication 2: TIPS Over Nominal Treasuries It should be obvious that if the forecasts in the prior section pan out then TIPS will substantially outperform nominal Treasury securities as breakeven inflation rates widen in 2018. In our opinion the low level of long-maturity TIPS breakeven inflation rates represents the greatest source of medium-term value in U.S. bond markets. Chart 4Breakevens Biased Wider Breakevens Biased Wider Breakevens Biased Wider In addition, a wide range of indicators, such as our own Pipeline Inflation Indicator and the New York Fed's Underlying Inflation Gauge, already suggest that breakevens are biased wider (Chart 4). With the Fed engaged in a rate hike cycle, evidence of price pressures in the realized inflation data will be required before breakevens see significant upside. Our base case forecast is that the 10-year TIPS breakeven rate will reach our target range of 2.4% to 2.5% around the same time that core PCE inflation reaches 2%, probably in the middle of next year. However, there is one political risk that could speed up that adjustment. Namely, if Congress manages to pass tax cuts in the first half of 2018. From the Outlook: The U.S. tax system is desperately in need of reform [...]. However, the economy does not need stimulus from net tax giveaways given that it is operating close to potential. That would simply boost demand relative to supply, create overheating, and give the Fed more reason to get aggressive. The Republican's initial tax plan has some good elements of reform such as cutting back the personal mortgage interest deduction, eliminating some other deductions and making it less attractive for companies to shift operations overseas. However, many of these proposals are unlikely to survive the lobbying efforts of special interest groups. The net result probably will be tax giveaways without much actual reform. [...] There inevitably will be contentious negotiations in Congress but we assume that the Republicans will eventually come together to pass some tax cuts by early next year. Fiscal stimulus from tax cuts at this late stage of the cycle would be very inflationary, and judging by the sharp increase in TIPS breakevens that followed President Trump's election last November, the market has already figured this out. The passage of a tax bill early next year would no doubt speed up the return of long-maturity TIPS breakevens to our target range. Bottom Line: TIPS will outperform nominal Treasury securities in 2018 as long-maturity TIPS breakeven inflation rates widen alongside rising core inflation. The passage of tax cuts in the first half of next year would speed up the adjustment in breakevens. Implication 3: Curve Steepeners, Then Flatteners Another recommendation that follows from rising inflation is that the yield curve will steepen as long-maturity TIPS breakeven inflation rates rise. We have previously observed that changes in the slope of the 2/10 Treasury curve are positively correlated with changes in the 5-year/5-year forward TIPS breakeven inflation rate. Crucially, this positive correlation remains intact even when the Fed is hiking rates.3 In the current rate hike cycle (which started in December 2015) we observe that monthly changes in the 2/10 nominal Treasury slope have been positively correlated with monthly changes in the 5-year/5-year forward TIPS breakeven rate in 22 out of 24 months (Chart 5). It stands to reason that we should expect the yield curve to steepen as TIPS breakevens rise. Chart 52/10 Nominal Treasury Slope Vs. TIPS Breakeven Inflation Rate 5-Year/5-Year Forward ##br##(December 2015 - Present) Implications For U.S. Fixed Income Implications For U.S. Fixed Income However, we caution that curve steepening is probably only a story for the first half of 2018. Steepening will transition to flattening once long-dated TIPS breakevens reach our 2.4% to 2.5% target range, and in the meantime, there is a limit to how steep the yield curve can get. Let's assume that the Fed's median projection of a 3% terminal fed funds rate is reasonably accurate. It follows that the 10-year Treasury yield is unlikely to rise much above 3% before the end of the recovery. We can also calculate what the 2-year Treasury yield will be under different scenarios for the fed funds rate and the 2-year/fed funds slope. The latter can be thought of as simply the number of rate hikes the market expects during the subsequent two years. With these assumptions we can craft scenarios for where the 2/10 Treasury slope will be under different conditions, and these scenarios are presented in Table 1. The shaded cells in Table 1 are the scenarios that cause the 2/10 Treasury slope to steepen from its current level of 59 bps. Table 1Scenarios For The Number Of Fed Rate Hikes By ##br##The Time That Inflation Returns To Target Implications For U.S. Fixed Income Implications For U.S. Fixed Income For example, by the time that inflation recovers to the Fed's 2% target, the nominal 10-year Treasury yield will most likely be in a range between 2.8% and 3.25%. If the Fed only delivers two rate hikes between now and then it is very likely that the yield curve will steepen. This is shown in the section of Table 1 labelled "2 Rate Hikes". However, if the Fed lifts rates four times between now and the time that inflation returns to target, then it is much more likely that the 2/10 curve will flatten. These scenarios are shown in the top three rows of Table 1. The message is that the order of events matters. In our base case scenario, inflation starts to recover early next year and long-dated TIPS breakeven inflation rates reach our 2.4% to 2.5% target by mid-2018. At that point it is quite likely that the Fed will have only hiked rates a couple of times and the curve will have steepened. More rapid rate hikes, however, would severely limit the amount of potential steepening. We continue to advocate positioning for 2/10 steepening via a long position in the 5-year bullet versus a short position in the duration-matched 2/10 barbell. At present, the 2/5/10 butterfly spread is priced for 4 bps of 2/10 curve flattening during the next six months, so even mild curve steepening will lead to outperformance during that timeframe.4 We will shift from curve steepeners to flatteners once TIPS breakevens return to our target range. Bottom Line: The slope of the yield curve is positively correlated with TIPS breakeven inflation rates. Look for mild curve steepening in the first half of 2018 as breakevens recover, transitioning to flattening once breakevens re-normalize around mid-year. Implication 4: The Cyclical Sweet Spot Comes To An End From the Outlook: The perfect environment for markets has been moderate economic growth, low inflation and easy money. [...] We are assuming that growth is strong enough to encourage central banks to keep moving away from hyper-easy policies, setting up for a collision with markets. If growth slows enough that recession fears spike, then that also would be bad for risk assets. Sustaining the bull market requires a goldilocks growth outcome of not too hot and not too cold. Chart 6The "Fed Put" Is Still In Place The "Fed Put" Is Still In Place The "Fed Put" Is Still In Place This publication has named that goldilocks environment the "cyclical sweet spot" for risk assets. Essentially, as long as inflation is below the Fed's target, the Fed must respond to any economic weakness (or tightening of financial conditions) by adopting a more accommodative policy stance. The market knows that this "Fed put" is in place and that makes it very difficult to get a meaningful sell-off. In fact, the last major sell-off in corporate credit (in 2014/15) only occurred because the market assumed that the Fed would not deviate from its projected rate hike path even though commodity prices were plunging, causing defaults in certain exposed industry groups. Notice in Chart 6 that our 24-month Fed Funds Discounter stayed flat as spreads widened. Spreads only tightened in early 2016 after the Fed capitulated. So under what conditions will the "Fed put" disappear? Logically, if inflation were much higher the Fed would be less inclined to support markets at any sign of trouble. This is the reason that, while we remain overweight spread product versus Treasuries for now, we expect the cyclical sweet spot for spreads will come to an end next year. Long-maturity TIPS breakeven inflation rates approaching our target range of 2.4% to 2.5% will be the first signal that it is time to pare exposure. The importance of supportive monetary policy for spread product performance is also evident when looking at our three favorite credit cycle indicators (Chart 7). Historically, three conditions must be met before a sustained period of spread widening can occur. Chart 7Credit Cycle Indicators Credit Cycle Indicators Credit Cycle Indicators Our Corporate Health Monitor must be in "deteriorating health" territory (Chart 7, panel 2). Fed policy must be restrictive. This can be proxied by an inverted yield curve, or a real fed funds rate above its estimated equilibrium level (Chart 7, panels 3 & 4). Bank Commerical & Industrial lending standards must be in "net tightening" territory (Chart 7, bottom panel). For the time being only corporate health is sending a negative signal, but once inflation recovers we will be at increasing risk of monetary conditions turning restrictive. Tighter lending standards tend to follow restrictive monetary policy with a short lag. Bottom Line: The cyclical sweet spot of solid growth and low inflation that has been driving the outperformance of spread product will come to an end in 2018. The catalyst will be higher inflation. We will start paring exposure to spread product once long-maturity TIPS breakeven inflation rates approach our target range of 2.4% to 2.5%, probably in the middle of next year. Implication 5: A Year Of Low Returns From the Outlook: Our estimates indicate that a balanced portfolio will deliver average returns of only 3.3% a year over the coming decade, or 1.3% after inflation. That is down from the 4% and 1.9% nominal and real annual returns that we estimated a year ago, reflecting the current more adverse starting point for valuations. Heading into 2018 almost all U.S. spread product sectors are indeed faced with a more adverse starting point for valuations. Chart 8 compares today's option-adjusted spread (OAS) with the OAS at the end of 2016 for seven major spread products. With the exception of MBS, all sectors currently have lower spreads than at they did at the beginning of 2017. Chart 8Less Value In Spread Product Implications For U.S. Fixed Income Implications For U.S. Fixed Income Starting valuation is only one component of excess returns. Capital gains/losses from the change in spreads is the other. However, the deeper we move into the credit cycle the less room there is for further spread compression. In fact, we have previously calculated that the average spread for the investment grade Corporate bond index can only tighten another 35 bps before it reaches all-time expensive levels. This represents only 3 months of historical average spread tightening. The same calculation for the High-Yield index shows that the spread can only tighten another 145 bps, representing 4 months of average tightening.5 In other words, there is not much potential for spread compression at this late stage of the credit cycle and excess returns will be very similar to carry in 2018 - at least until inflation rises and it is time to prepare for a sustained period of spread widening. Chart 9 shows annualized 2017 year-to-date excess returns for each sector alongside projected excess returns for 2018 under two scenarios. The "flat spread" scenario assumes that spreads stay flat at current levels, while the "optimistic" scenario assumes that spreads tighten to all-time expensive valuation levels. Chart 92018 Excess Return Projections Implications For U.S. Fixed Income Implications For U.S. Fixed Income For investment grade corporate bonds even this extremely optimistic scenario would only provide excess returns of 363 bps, just 121 bps above this year's likely returns. For High-Yield, the optimistic scenario would provide excess returns of 637 bps, a mere 148 bps above this year's likely returns. For consumer ABS and domestic Agency bonds, the projections from our optimistic scenario do not even surpass this year's likely excess returns. Bottom Line: Spreads are not that far from all-time expensive levels, meaning there is limited room for spread compression at this late stage of the credit cycle. Excess returns from spread product will be very similar to carry in 2018 - at least until inflation rises and it is time to prepare for a sustained period of spread widening. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see Outlook 2018, "Policy And The Markets: On A Collision Course", dated November 20, 2017, available at bca.bcaresearch.com 2 Our 12-month Fed Funds Discounter measures the number of rate hikes priced into the overnight index swap curve for the next 12 months. 3 Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com 4 For further details on our yield curve models and how we calculate the amount of steepening/flattening priced into the butterfly spread please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com 5 These numbers refer to the spread tightening necessary to reach all-time lows on the 12-month breakeven spread for each index. We calculate the 12-month breakeven spread as OAS divided by duration. Fixed Income Sector Performance

Highlights We are exploring the key FX implications of the views presented in BCA's 2018 annual outlook. The dollar is likely to experience some upside in the first half of 2018, but then weaken as U.S. monetary policy becomes increasingly onerous. The euro should mirror these dynamics, bottoming toward 1.1 in mid-2018. The yen could continue to weaken for most of 2018. But as markets begin to collide with policy, the second half of 2018 should be friendlier to the yen as potential risk-off events emerge. Risk-off events should also support the CHF versus the EUR. The GBP will remain victim to Brexit negotiations. It is cheap, but on a risk adjusted basis, potentially elevated expected returns will come at the price of heavy volatility. The commodity currencies and the Scandinavian currencies will suffer when global volatility picks up. Feature Key Views From The Outlook This past Monday we sent you BCA's Annual Outlook, exploring the key macroeconomic themes that we expect will shape 2018. This year, the discussion between BCA's editors and Mr. X, and his daughter, Ms. X, yielded the following key views:1 The environment of easy money, low inflation and healthy profit growth that has been so bullish for risk assets will start to change during the coming year. Financial conditions, especially in the U.S., will gradually tighten as decent growth leads to building inflation pressures, encouraging central banks to withdraw stimulus. With U.S. equities at an overvalued extreme and investor sentiment overly optimistic, this will set the scene for an eventual collision between policy and the markets. The conditions underpinning the bull market will erode only slowly, which means that risk asset prices should continue to rise for at least the next six months. However, long-run investors should start shifting to a neutral exposure. Given our economic and policy views, there is a good chance that we will move to an underweight position in risk assets during the second half of 2018. The U.S. economy is already operating above potential and thus does not need any boost from easier fiscal policy. Any major tax cuts risk overheating the economy, encouraging the Federal Reserve to hike interest rates and boosting the odds of a recession in 2019. This is at odds with the popular view that tax cuts will be good for the equity market. A U.S. move to scrap NAFTA would add to downside risks. For the second year in a row, the IMF forecasts of economic growth for the coming year are likely to prove too pessimistic. The end of fiscal austerity has allowed the euro area economy to gather steam and this should be sustained in 2018. However, the slow progress in negotiating a Brexit deal with the EU poses a threat to the U.K. economy. China's economy is saddled with excessive debt and excess capacity in a number of areas. Any other economy would have collapsed by now, but the government has enough control over banking and other sectors to prevent a crisis. Growth should hold above 6% in the next year or two, although much will depend on how aggressively President Xi pursues painful reforms. The market is too optimistic in assuming that the Fed will not raise interest rates by as much as indicated in their "dots" projections. There is a good chance that the U.S. yield curve will become flat or inverted by late 2018. Bonds are not an attractive investment at current yields. Only Greece and Portugal currently have 10-year government bond real yields above their historical average. Corporate bonds should outperform governments, but a tightening in financial conditions will put these at risk in the second half of 2018. The euro area and Japanese equity markets should outperform the U.S. over the next year reflecting their better valuations and more favorable financial conditions. Developed markets should outperform the emerging market index. Historically, the U.S. equity market has led recessions by between three and 12 months. If, as we fear, a U.S. recession starts in the second half of 2019, then the stock market would be at risk from the middle of 2018. The improving trend in capital spending should favor industrial stocks. Our other two overweight sectors are energy and financials. The oil price will be well supported by strong demand and output restraint by OPEC and Russia. The Brent price should average $65 a barrel over the coming year, with risks to the upside. We expect base metals prices to trade broadly sideways but will remain highly dependent on developments in China. Modest positions in gold are warranted. Relative economic and policy trends will favor a firm dollar in 2018. Unlike at the start of 2017, investors are significantly short the dollar which is bullish from a contrary perspective. Sterling is quite cheap but Brexit poses downside risks. The key market-relevant geopolitical events to monitor will be fiscal policy and mid-term elections in the U.S., and reform policies in China. With the former, the Democrats have a good chance of winning back control of the House of Representatives, creating a scenario of complete policy gridlock. A balanced portfolio is likely to generate average returns of only 3.3% a year in nominal terms over the next decade. This compares to average returns of around 10% a year between 1982 and 2017. Essentially, global economic growth remains robust, which opens a window for global policy makers to abandon their ultra-easy policy stance. Asset markets will have to ultimately adjust to this gradual tightening in global policy. This will be an environment where risk in DM economies should perform well in the first half of the year. However, as policy becomes increasingly constraining, risk assets are likely to fare more poorly in the second half of 2018. Implications For The FX Markets What are the key implications of these views for currency markets? The USD is likely to perform well in the first half of 2018. BCA believes that U.S. inflation should gather steam during the first two to three quarters of 2018. This suggests the Fed will be able to follow the path described by the dot plots - something interest rate markets are not ready for (Chart I-1). As investors are short the USD, upside risk to U.S. interest rates should result in a higher dollar (Chart I-2). Chart I-1BCA Sees Upside To Rates BCA Sees Upside To Rates BCA Sees Upside To Rates Chart I-2The Dollar Is A Pariah The Dollar Is A Pariah The Dollar Is A Pariah The euro is likely to continue to behave as the anti-dollar. The euro is currently over-owned and vulnerable to negative surprises. While the European economy remains very strong, growing at a 2.5% pace on an annual basis last quarter, inflation is set to ebb as our core CPI diffusion index has sharply decelerated (Chart I-3). This means that contrary to the U.S., the upside risk is limited in the European OIS curve. The divergence in our inflation forecast between the U.S. and the euro area should thus be translated in a lower EUR/USD in the first half of 2018. A target around 1.1 on EUR/USD makes sense for mid-2018. The euro is unlikely to find much downside beyond these levels, as it would be trading at a more than 15% discount to its purchasing-power-parity equilibrium - a level often associated with bottoms. Moreover, investors are still cyclically underweight European assets, which points to pent-up buying power in favor of the euro (Chart I-4). Chart I-3Dissipating Inflation Pressures##br## In Europe Dissipating Inflation Pressures In Europe Dissipating Inflation Pressures In Europe Chart I-4Portfolio Rebalancing Toward Europe ##br##Key To A Higher Euro Portfolio Rebalancing Toward Europe Key To A Higher Euro Portfolio Rebalancing Toward Europe Key To A Higher Euro The picture for the yen is likely to be buffeted by two factors. The Japanese economy seems to be on the mend. The recent decoupling between the Nikkei and the yen is very interesting (Chart I-5). The strength of Japanese stocks could highlight that Japan's domestic economy is gaining momentum, and is less in need of massively easy policy. Thus, the Bank of Japan may be moving away from the apex of its easy policy. Moreover, the rising probability of growing fiscal stimulus could further diminish the need for easy monetary policy. This is a consequence of Abe winning yet another supermajority, which raises the likelihood that he will begin campaigning on a referendum to amend the Japanese constitution. Despite this, the BoJ will still maintain among the loosest policy settings in the world. Moreover, USD/JPY remains closely correlated with Treasury yields and Treasury/JGB spreads (Chart I-6). BCA anticipates both these variables to continue to trend in a yen-negative fashion. If BCA's view that risk assets could peak during the second half of 2018 is correct, bond yields may peak around that time frame as well. Since the yen is trading at a massive discount (Chart I-7), mid-year may well prove a massive buying opportunity for yen bulls, especially if the U.S. yield curve ends 2018 in a near-flat state. Chart I-5Nikkei Trying To Tell Us Something Nikkei Trying To Tell Us Something Nikkei Trying To Tell Us Something Chart I-6Yen Still A Function Of T-Notes Yen Still A Function Of T-Notes Yen Still A Function Of T-Notes Chart I-7Yen Is Cheap Yen Is Cheap Yen Is Cheap The Swiss franc continues to trade at a 5% premium to its PPP fair-value against the euro. This means the Swiss National Bank will maintain very easy policy that will promote CHF weakness. However, the fight will remain difficult; once Switzerland's prodigious net international investment position of 130% of GDP is taken into account, the trade-weighted CHF trades in line with fair value (Chart I-8). Thus, the CHF will continue to behave as a funding, or risk-off, currency. So long as global market volatility remains well contained, EUR/CHF will experience appreciating pressure. If asset markets peak in the second half of 2018, EUR/CHF is likely to depreciate, which will prompt renewed intervention by the SNB to mitigate any deflationary impact of a stronger CHF. The pound does look very cheap, trading at an 18% discount against the USD (Chart I-9). However, Brexit remains a key problem. Brexit is about limiting immigration into the U.K., the key force that has generated the U.K.'s economic outperformance over the past 15 years (Chart I-10). Without higher trend growth than its neighbors, England will see its equilibrium real neutral rate fall, limiting the upside to the Bank of England's cash rate. As FDI into the U.K. is succumbing to the heightened level of uncertainty, a falling neutral rate means it will be more difficult to finance Britain's current account deficit of 5% of GDP. Thus, the pound is cheap for a reason. Until negotiations with the EU progress, the pound will continue to offer limited reward and plenty of volatility. Chart I-8CHF: Not What It May Seem CHF: Not What It May Seem CHF: Not What It May Seem Chart I-9GBP: A Value Trap? GBP: A Value Trap? GBP: A Value Trap? Chart I-10U.K. Trend Growth And Neutral Rate Will Fall U.K. Trend Growth And Neutral Rate Will Fall U.K. Trend Growth And Neutral Rate Will Fall Commodity currencies are at a difficult juncture. The AUD, CAD, and NZD could begin the year on a firm tone, if global growth remains robust in the early innings of 2018. However, they will suffer if global volatility rises, which seems unavoidable if markets and policy indeed collide in the second half of 2018 (Chart I-11). The pain for commodity currencies could be compounded by the fact that China looks set to start some potentially painful reforms. The AUD is the worst placed of the three as it is the most expensive, while the CAD is the best placed, as BCA's commodity strategists remain more positive on the energy complex than on the base metals market. Shorting AUD/JPY may prove to be a great hedge for investors who are long risk assets. The Scandinavian currencies are at an interesting juncture as well. Both the NOK and the SEK are extremely cheap on a trade-weighted basis and against the euro (Chart I-12). While strong oil prices should help the NOK, and the overheating Swedish economy should prompt investors to price in policy tightening by the Riksbank, neither of these fundamentals are lifting their respective currencies. The strength in EUR/SEK and EUR/NOK is likely to reverse in the first half of 2018. However, if BCA is correct that markets could begin to feel the pain from gradual tightening in global policy in the second half of 2018, the historically very cyclical Scandinavian currencies should only enjoy a short-lived rally against the euro. Chart I-11The End Of The Great Carry##br## Trade Is Coming The End Of The Great Carry Trade Is Coming The End Of The Great Carry Trade Is Coming Chart I-12Scandies Should Rally##br## In Early 2018 Scandies Should Rally In Early 2018 Scandies Should Rally In Early 2018 Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 The full report, The Bank Credit Analyst, titled "2018 Outlook - Policy And The Markets: On A Collision Course", dated November 20, 2017, is available at fes.bcaresearch.com Forecasts Forecast Summary

Highlights When it meets in Vienna at the end of this month, OPEC 2.0 will look through the pipeline leaks in South Dakota, which are expected to take some 500k b/d of Canadian crude shipments to the U.S. off the market until repairs are done at the end of November. While this will provide an unexpected assist in draining U.S. inventories, it truly is a transitory event (no pun intended). The larger issue for prices is gauging market expectations going into the OPEC 2.0 meeting at the end of this month. We believe the market is giving high odds to the coalition extending its 1.8mm b/d production cut to cover all of 2018 at its Vienna meeting. This is without doubt the result of the synchronized messaging coming from the leaders of OPEC 2.0, the Kingdom of Saudi Arabia (KSA) and Russia. Based on our balances models, an extension of the cuts to end-June - our base case - will draw OECD stocks down below their five-year average by mid-2018 (Chart of the Week). An executed extension to end-December 2018 would produce even sharper draws. This leaves the only material risk to prices a failure to extend the cuts on Nov. 30, or a reduction in the cuts themselves. Of the two, a failure to extend the cuts is the only material downside risk we see going into the Vienna meetings. Should OPEC 2.0 fail to extend its production cuts at month-end, and cause the markets to sell, we would view it as a buying opportunity: a Mar/18 expiry runs counter to OPEC 2.0's strategy. Energy: Overweight. Our Brent and WTI call spreads in May, July and December 2018 - long $55/bbl calls vs. short $60/bbl calls - are up an average 41.4%, since they were recommended in September and October. Our long Jul/18 WTI vs. short Dec/18 WTI trade initiated November 2, 2017 in expectation of steepening backwardation is up 27.7%. Base Metals: Neutral. A weaker USD is providing a tailwind for copper, which is up ~ 2% over the past week. Our U.S. Bond Strategy desk expects the Fed to remain behind the inflation curve, which will translate into lower real rates and continue to support base metals.1 Precious Metals: Neutral. Gold continues to trade on either side of $1,280/oz, hardly budging following the upheaval in KSA. U.S. financial conditions - particularly a weaker USD - are driving gold. Our long gold portfolio hedge is up 4.2% since inception May 4, 2017. Ags/Softs: Neutral. Updated projections of record-high yields from U.S. corn farmers is behind the upward revision to 2017/2018 corn ending stocks in the November WASDE. This led to a massive increase - by 7.56mm MT - in U.S. corn output, which was partially offset by an increase in expected world demand and a downward adjustment to global beginning stocks. Corn prices were down more than 3% in the week following the revisions, but have since regained 2.5%. Feature Markets appear to be pricing in an extension of OPEC 2.0's production cuts to end-2018 when the producer group meets in Vienna at the end of the month around OPEC's regularly scheduled meeting. Our updated balances suggest a sharp sell-off triggered by market disappointment in OPEC 2.0 would represent a buying opportunity, particularly in 2H18. We continue to expect Brent to average $65/bbl next year in our base case (OPEC 2.0 cuts extended to end-June), with WTI trading $2/bbl under that. An extension of OPEC 2.0's cuts to end-December could lift our 2018 Brent forecast as much as $5/bbl, although the Brent-WTI spread likely would widen to $4 to $5/bbl, if this occurs. We do not believe additional cuts are in the offing. Nor do we expect an even-more-dramatic announcement of cuts being extended beyond 2018. We are deliberately keeping our base case more conservative than the apparent market expectation of an extension to end-2018. This suggests markets will be disappointed with anything less than an extension of the OPEC 2.0 cuts to end-June. Given our balances modeling, we believe any disappointment in the market's expectation that leads to a sell-off would represent a buying opportunity, since a Mar/18 expiry – the current terminus of the OPEC 2.0 production cuts, defeats the coalition's strategy of reducing OECD inventories. Under our base case, inventories draw to their five-year average levels by mid-year 2018 (Chart of the Week). In our updated balances model, we have a 100k b/d downward revision in expected U.S. oil-shale output for 2018 tightening the supply side for next year. The U.S. EIA has repeatedly revised its historical estimated shale production lower in recent months, and late-2017 rig counts have deteriorated slightly, which have shifted our historical production curve lower as well. On the demand side, we expect growth of ~ 1.65mm b/d on average in 2017 - 18. These assumptions give an upward bias to our 2018 price forecasts for Brent and WTI crude oil (Chart 2). Chart of the WeekSupply-Demand Balances##BR##Point Toward Tight Markets Supply-Demand Balances Point Toward Tight Markets Supply-Demand Balances Point Toward Tight Markets Chart 2Balances Are Tightening,##BR##Giving An Upward Bias To Prices Balances Are Tightening, Giving An Upward Bias To Prices Balances Are Tightening, Giving An Upward Bias To Prices Inventory Draw Could Be Sharper Chart 3Extending OPEC 2.0 Cuts To End-December##BR##Will Result In Sharper Draws Extending OPEC 2.0 Cuts To End-December Will Result In Sharper Draws Extending OPEC 2.0 Cuts To End-December Will Result In Sharper Draws An extension of the OPEC 2.0 cuts to end-Dec/18 would translate to a deeper storage draw than our end-June base case expectation (Chart 3). The Keystone pipeline leaks referenced above also provide an unanticipated assist in drawing down inventories, by temporarily removing ~ 500k b/d from the market in the 2H of November. While we have modeled price-induced additions to U.S. shale-oil output next year in our base case, an extension of OPEC 2.0's cuts to end-December likely will accelerate this production increase as additional production is added in 2H18. This will tend to temper price hikes, but not arrest them, given the differential storage draws we expect of 127 mm bbls. As we have noted, an extension of the OPEC 2.0 production cuts to the end of 2018 could lift Brent and WTI prices by as much as $5/bbl. However, given the still-insufficient pipeline take-away in the U.S. shale basins, we would expect higher production would widen the Brent - WTI price spread to $4 to $5/bbl next year. Practically, if the extension of the production cuts pushes Brent to $70/bbl, we're more inclined to expect WTI prices to average ~ $65/bbl next year. EM Continues To Lead Growth In Oil Demand EM oil demand strength continues to be the dominant feature of the oil market this year, and, we expect, into next year. We are modeling a 1.13mm b/d and 1.22mm b/d increase in EM demand this year and next, respectively. This accounts for 75% and 77% percent of global growth in 2017 and 2018 (Table 1). DM demand, which we proxy with OECD oil consumption, is expected to average 47.5mm b/d over the two-year interval, an average gain of 490k b/d over the interval, vs. 1.18 mm b/d gain in EM oil demand. Table 1BCA Global Oil Supply - Demand Balances (mm b/d) Oil Balances Continue To Point To Higher Prices Oil Balances Continue To Point To Higher Prices China and India account for slightly more than one-third of the 52mm b/d of consumption we are modeling for non-OECD demand over this period, and ~50% of the non-OECD demand growth from 2016 to 2018. The indicators we use to confirm or refute the demand trends we see - EM imports and global PMIs - continue to support the global-growth theme we've noted throughout the year, particularly in the EM markets (Charts 4 and 5). Chart 4EM Trade Volumes Remain Strong,##BR##Supporting The Global Growth Hypothesis EM Trade Volumes Remain Strong, Supporting The Global Growth Hypothesis EM Trade Volumes Remain Strong, Supporting The Global Growth Hypothesis Chart 5Global Manufacturing Activity##BR##Remains Robust Global Manufacturing Activity Remains Robust Global Manufacturing Activity Remains Robust Continue Watching The Fed EM oil demand and import volumes are highly dependent on Fed policy, which is of particular concern now, because the U.S. central bank is trying to carry out its rate-normalization policy (Chart 6). Still, as our colleagues on the U.S. Bond Strategy desk note, "To avoid policy failure the Fed must allow inflation to reach its 2% target before the onset of the next recession. This means it will soon fall behind the inflation curve." This will be bullish for trade, since as we've shown in the past, U.S. monetary policy has a huge effect on trade.2 For the near term - into 1H18 - fundamentals will dominate the evolution of price: Supply, demand and inventories will matter more than U.S. monetary policy effects on the USD and real rates. Nonetheless, should the hawks in the Fed carry the day, we would expect a strengthening of the USD, which, all else equal, would act as a headwind to oil prices next year. For the time being, a weaker USD is reinforcing stronger prices brought about by tighter fundamentals, particularly in the Brent market (Chart 7). Chart 6Continue Watching The Fed Continue Watching The Fed Continue Watching The Fed Chart 7A Weaker USD Provides A Slight Tailwind A Weaker USD Provides A Slight Tailwind A Weaker USD Provides A Slight Tailwind Bottom Line: Markets are expecting OPEC 2.0 to extend its 1.8mm b/d production cut to end-2018. We are deliberately using a more conservative extension to end-June in our balances modeling, which produce 2018 Brent and WTI prices forecasts of $65/bbl and $63/bbl. An executed extension of the OPEC 2.0 cuts to end-December 2018 likely would add as much as $5/bbl to Brent prices, and perhaps $2/bbl to WTI prices, which would widen the Brent - WTI spread to $4 to $5/bbl on average next year. Fundamentals will continue to dominate the evolution of prices into 2018 - supply growth (falling), demand growth (rising), and inventories (falling) will drive prices. For the moment a weaker USD is supportive for commodities generally, particularly oil and copper. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com 1 Please see "The Fed Will Fall Behind The Curve," published October 24, 2017, by BCA Research's U.S. Bond Strategy. It is available at usbs.bcaresearch.com. 2 Please see footnote 1 above. U.S. monetary policy effects on EM oil demand and trade volumes, and the feedback loop back to the key indicators used by the Fed, have been a recurrent theme in our research. Please see, e.g., "Strong EM Trade Volumes Will Support Oil," published June 8, 2017, by BCA Research's Commodity & Energy Strategy. It is available at ces.bcaresearch.com. Our line of research recently found support in IMF research published earlier this month; please see "Global Trade and the Dollar," published by the IMF November 13, 2017. The IMF research is available at http://www.imf.org/en/Publications/WP/Issues/2017/11/13/Global-Trade-and-the-Dollar-45336?cid=em-COM-123-36197 Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Oil Balances Continue To Point To Higher Prices Oil Balances Continue To Point To Higher Prices Commodity Prices and Plays Reference Table Trade Recommendation Performance In 3Q17 Oil Balances Continue To Point To Higher Prices Oil Balances Continue To Point To Higher Prices Trades Closed in 2017 Summary of Trades Closed in 2016