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Dear Client, In addition to this week's regular Weekly Report, you should have also received a Client Note written by my colleague Marko Papic discussing the upcoming U.S. presidential election. Marko argues that the election is now too close to call. Donald Trump's resilience in the polls continues to baffle most observers. Not us. Back in September of 2015, when most pundits were laughing off Trump's chances, we wrote a report arguing that Trump's rhetoric would resonate with voters much more than most people thought possible. That report, entitled "Trumponomics: What Investors Need To Know," is as relevant today as it was back then. Best regards, Peter Berezin Highlights Spare capacity has narrowed substantially within the developed world. Most of the decline in spare capacity is attributable to lackluster supply, rather than stronger demand. Potential GDP growth is likely to remain weak over the coming years. Narrowing output gaps will put upward pressure on inflation. We are long Japanese and German inflation protection. As spare capacity continues to dwindle, forward guidance will become a more effective tool for central banks. At least in this respect, central bankers may find themselves with a few more bullets in their arsenals. Stay long the dollar and position for gradually higher government bond yields. Global equities are highly vulnerable to a near-term correction, owing to a more hawkish Fed and growing U.S. election uncertainty. Once the dust has settled, European and Japanese stocks will outperform their U.S. peers. Feature Spare Capacity Is Dwindling A persistent shortfall of aggregate demand has been the defining feature of the global economic landscape ever since the financial crisis erupted. This chronic lack of spending has kept inflation below target in most developed economies, forcing central banks to adopt ever more radical easing policies. That is starting to change. Spare capacity continues to decline, allowing once dormant supply-side constraints to reimpose themselves. In this week's report, we take stock of where we are in this process. Mind The (Output) Gap The simplest measure of spare capacity is the so-called output gap, which estimates the difference between what economies are actually producing and what they are capable of producing without putting undue upward pressure on inflation. According to the IMF, the output gap for advanced economies has narrowed from a high of 3.8% of GDP in 2009 to 0.8% at present. The OECD's measure shows a similar decline (Chart 1). Chart 1AOutput Gaps Have Narrowed bca.gis_wr_2016_11_04_c1a bca.gis_wr_2016_11_04_c1a Chart 1BOutput Gaps Have Narrowed bca.gis_wr_2016_11_04_c1b bca.gis_wr_2016_11_04_c1b The IMF reckons that the output gap has nearly closed in the U.S. and the U.K. The Fund estimates that Japan's output gap currently stands at 1.5% of GDP. The OECD also sees the U.K. output gap as being fully closed. However, it calculates a smaller output gap for Japan but a larger output gap for the U.S. than the IMF does. Both institutions peg the euro area's output gap at around 1%-to- 1.5%. Not surprisingly, there is a fair bit of variation within continental Europe. The output gap in Germany has fully disappeared, but still stands at 2%-to-3% of GDP in Italy and Spain. Naturally, one should take these numbers with a grain of salt. Output gaps are notoriously difficult to calculate and are subject to large revisions. The OECD, for example, tends to rely on statistical approaches to estimate output gaps.1 These typically involve employing tools such as the so-called "Hodrick-Prescott filter" to smooth out historical GDP data and then treating the resulting trendline as an estimate for potential GDP. Such methods have their uses, but they can go badly awry in situations where GDP is slow to return to its "true" underlying trend. This is a particular worry in the current environment, considering that recoveries following burst asset bubbles tend to be lethargic even in the best of times. The fact that fiscal policy has been fairly tight and monetary policy has been constrained by the zero lower bound has further dampened the recovery. With that in mind, rather than relying on purely statistical techniques, it is useful to measure spare capacity directly. We do this by gauging the extent to which the existing factors of production - labor and capital - are being effectively deployed across the major developed economies. As we argue below, this approach suggests that slack may be modestly higher in Japan than what the IMF and the OECD calculate, and more meaningfully understated in peripheral Europe. The Message From Headline Unemployment Rates Unemployment has been falling in almost all major developed economies (Chart 2). In the U.S. and the U.K., the jobless rate is back to pre-crisis levels. In Germany and Japan, it is below where it was before the Great Recession. As such, it is unlikely that unemployment can decline much in these economies. Chart 2AUnemployment Rates Have Declined bca.gis_wr_2016_11_04_c2a bca.gis_wr_2016_11_04_c2a Chart 2BUnemployment Rates Have Declined bca.gis_wr_2016_11_04_c2b bca.gis_wr_2016_11_04_c2b In contrast, while unemployment rates in peripheral Europe have been trending lower over the past three years, they are still quite high by historical standards. There is some debate over whether they can fall much further. The OECD, for example, contends that Spain is already close to full employment, even though the country's unemployment rate still stands at nearly 20%. We find this implausible. The OECD essentially takes a moving average to calculate structural unemployment rates in various economies. As noted above, this can be highly misleading in circumstances where the forces pushing an economy towards full employment are impaired. In general, this suggests that both the IMF and the OECD estimates of labor market slack in the euro area are too low. This is consistent with a recent ECB research paper, which calculated that the euro area's output gap was 6% of GDP in 2015, a far cry from the European Commission's estimate of 1.1%.2 Disguised Unemployment The unemployment rate is probably the single best measure of labor market slack. However, it can understate the true amount of spare capacity during periods when many people have stopped looking for work, or when those who are employed are not working as much or as intensively as they would like. The nature of this additional labor market slack differs from region to region. In the U.S., it has mainly manifested itself in lower labor force participation rates; whereas in Europe - perhaps in keeping with the more egalitarian nature of European society - it has mainly taken the form of fewer hours worked and a higher incidence of involuntary part-time employment. Chart 3 shows that labor force participation rates among prime-age workers (those between the ages of 25-and-54) in Europe are generally higher now than they were before the financial crisis. In contrast, the share of workers who have part-time jobs but desire full-time employment remains elevated across most of continental Europe (Chart 4). The average annual number of hours worked per employee has also declined in most European economies (Chart 5). Chart 3ALabor Force Participation Rate ##br##Has Risen In Europe, But Fallen In The U.S. bca.gis_wr_2016_11_04_c3a bca.gis_wr_2016_11_04_c3a Chart 3BLabor Force Participation Rate ##br##Has Risen In Europe, But Fallen In The U.S. bca.gis_wr_2016_11_04_c3b bca.gis_wr_2016_11_04_c3b Chart 4AEurope: Higher Incidence Of ##br##Involuntary Part-Time Employment bca.gis_wr_2016_11_04_c4a bca.gis_wr_2016_11_04_c4a Chart 4BEurope: Higher Incidence ##br##Of Involuntary Part-Time Employment bca.gis_wr_2016_11_04_c4b bca.gis_wr_2016_11_04_c4b In the U.S., the prime-age labor force participation rate is still 1.9 points lower than it was in 2007. Part of this is cyclical. As long as the labor market continues to improve, participation rates among prime-age workers should continue to recover. That's the good news. The bad news is that ongoing structural forces are likely to prevent the participation rate from returning back to its pre-crisis levels. Chart 6 shows that labor force participation rates among U.S. prime-aged males has been trending lower since the 1960s. The decline has been particularly acute among less-educated workers. Why this has happened remains a source of intense debate. Conservative commentators have argued that cultural shifts have reduced the social pressure on men to maintain gainful employment. Liberal commentators have contended that falling real wages at the lower end of the skill distribution have reduced the incentive to work. Whatever the reason, it will be difficult to boost labor participation substantially from current levels. At present, 11% of U.S. prime-aged nonparticipants report wanting a job, only modestly higher than before the recession (Chart 7). It is possible that some fraction of those who do not want to work will change their minds - indeed, this year has seen a modest inflow of "disabled" people back into the labor force. Realistically, however, this is unlikely to boost labor participation by more than one percentage point. Chart 5Hours Worked ##br##In Europe Have Declined Slack Around The World Slack Around The World Chart 6U.S.: The Less Educated ##br##Are Shunning The Labor Force Slack Around The World Slack Around The World Chart 7U.S.: Fewer Potential Workers ##br##On The Sidelines bca.gis_wr_2016_11_04_c7 bca.gis_wr_2016_11_04_c7 Chart 8Japan's Underutilized Labor Force bca.gis_wr_2016_11_04_c8 bca.gis_wr_2016_11_04_c8 The incidence of involuntary part-time employment in Japan has returned to where it was prior to the Great Recession. However, in absolute terms, it remains quite high - in fact, nearly as high as in Europe. Japanese full-time employees may also not be as productively engaged as they could be. As evidence, note that output-per-hour in Japan is 37% lower than in the U.S. and 33% lower than in Germany (Chart 8). From this we conclude that there is somewhat more labor market slack in Japan than the headline unemployment rate suggests. Industrial Capacity Utilization Goods-producing sectors typically account for less than a third of GDP in most advanced economies. Nevertheless, because the demand for goods tends to be more volatile than the demand for services, fluctuations in industrial production often account for the bulk of the changes in output gaps. As Chart 9 shows, after a brisk recovery following the financial crisis, the U.S. industrial capacity utilization rate has been trending lower for the past two years. It currently stands at 75.4%, 5.6 percentage points lower than at its pre-recession peak. The Institute for Supply Management's semi-annual capacity utilization survey also suggests that many U.S. manufacturing businesses are operating substantially below potential (Chart 10). Much of the deterioration in U.S. industrial utilization reflects the effects of the energy bust and a stronger dollar. Business capex has decelerated sharply as a consequence of these forces, falling by over two-thirds in the case of energy capex. This should cut into excess capacity. Chart 9U.S.: Industrial Capacity ##br##Utilization Remains Low bca.gis_wr_2016_11_04_c9 bca.gis_wr_2016_11_04_c9 Chart 10U.S.: Less Slack In Services ##br##Than Manufacturing U.S.: Less Slack In Services Than Manufacturing U.S.: Less Slack In Services Than Manufacturing The dearth of new investment elsewhere in the world should also help prop up utilization rates (Chart 11). Industrial utilization is close to its historic average in Europe. Unlike in the case of labor markets, there is not a lot of regional variation in capacity utilization rates across the euro area. If anything, Italian spare capacity is actually closer to its pre-recession level than Germany's. Chart 11AEurope: Idle Industrial Capacity Is Shrinking Europe: Idle Industrial Capacity Is Shrinking Europe: Idle Industrial Capacity Is Shrinking Chart 11BEurope: Idle Industrial Capacity Is Shrinking bca.gis_wr_2016_11_04_c11b bca.gis_wr_2016_11_04_c11b Chart 12Excess Capacity Has Declined In Japan Excess Capacity Has Declined In Japan Excess Capacity Has Declined In Japan Capacity utilization has also returned to its long-term trend in Japan. Encouragingly, the Tankan Factor Utilization Index has risen to its highest level since the early 1990s (Chart 12). Nevertheless, the strong yen is starting to put pressure on Japan's industrial sector. This suggests that further monetary easing from the BoJ will be necessary. Economic And Investment Implications Our analysis suggests that spare capacity has narrowed substantially within the developed world, although for some countries not quite as much as output gap estimates from the IMF and the OECD indicate (particularly in the case of peripheral Europe). Unfortunately, most of the decline in spare capacity is attributable to lackluster supply, rather than faster demand growth (Chart 13). Interestingly, a cyclically-induced withdrawal of workers from the labor market has only played a modest role in explaining the slowdown in potential GDP growth and the resulting decline in output gaps. Instead, most of the deceleration in potential GDP growth stems from lower productivity gains. Chart 13AWeak Supply Growth Has Narrowed Output Gaps bca.gis_wr_2016_11_04_c13a bca.gis_wr_2016_11_04_c13a Chart 13BWeak Supply Growth Has Narrowed Output Gaps bca.gis_wr_2016_11_04_c13b bca.gis_wr_2016_11_04_c13b Some of the decline in productivity growth reflects cyclical factors, especially weak business investment. However, as we have discussed in past reports, much of it reflects structural forces such as declining educational achievement and a shift in focus of internet innovation away from business productivity applications towards consumer services such as social media.3 Looking out, narrowing output gaps will put upward pressure on inflation. We are long Japanese and German inflation protection via the CPI swap market. Governor Kuroda has made it clear that he wants Japanese inflation to rise above 2% to make up for the fact that inflation has perpetually undershot the BoJ's target. The Bundesbank may not want higher inflation, but the ECB's need to reflate Southern Europe all but guarantees such an outcome. As spare capacity continues to dwindle, forward guidance will become a more effective tool for central banks. The essence of forward guidance is the commitment to keeping monetary policy ultra loose even when the economy begins to overheat. If people believe that the central bank will keep the punch bowl filled, this could cause long-term inflation expectations to rise, leading to lower real yields and increased spending today. Such a commitment is likely to be regarded as more credible if people expect it to be carried out over the next few years, rather than at some distant point in the future. The Bank of Japan has already moved in that direction with its pledge to engineer an inflation overshoot by keeping the 10-year JGB yield anchored at zero. Chart 14China: On The Mend, Cyclically China: On The Mend, Cyclically China: On The Mend, Cyclically The U.S. has the smallest output gap, but the highest neutral interest rate, among the major developed economies. This week's FOMC statement strongly hinted at a December rate hike. As we discussed two weeks ago, in addition to one hike this year, we expect the FOMC to hike rates twice next year.4 This should cause the real broad trade-weighted dollar to appreciate by 10% over the next 12 months. A stronger dollar will mitigate some of the upward pressure on U.S. bond yields. Nevertheless, as slack continues to erode and inflation shifts higher, Treasury yields, along with bond yields elsewhere, should continue trending higher. Global equities are currently highly vulnerable to a near-term correction, owing to a more hawkish Fed and growing U.S. election uncertainty. We are currently short the NASDAQ 100 futures as a hedge, a trade that has gained 3.1% since we initiated it. Once the dust has settled, European and Japanese stocks will outperform their U.S. peers. This is partly because U.S. stocks are relatively expensive, but it is also because an ascending dollar will hurt U.S. multinationals. Investors should overweight Japanese and European stocks on a currency-hedged basis within the developed market universe. The outlook for emerging markets is mixed. On the one hand, the recent uptick in Chinese growth - as evidenced by this week's better-than-expected PMI data (Chart 14) - should provide some support to commodity prices and EM assets. On the other hand, a stronger dollar will weigh on commodities, while making it more onerous for some emerging market companies to refinance their dollar-denominated loans. Higher U.S. rates could also reduce the global pool of dollar liquidity, making it difficult for some emerging markets to finance their current account deficits. On balance, a modestly underweight stance towards EM assets is warranted. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 The IMF uses a more ad hoc approach. Desk economists have significant leeway in how they estimate output gaps for their respective economies. Most economists rely on statistical models and production function calculations, intermixed with educated guesswork. 2 Marek Jarocinski, and Michele Lenza, "How Large Is The Output Gap In The Euro Area," ECB Research Bulletin 2016, July 1, 2016. 3 Please see Global Investment Strategy Special Report, "Slower Potential Growth: Causes And Consequences," dated May 29, 2015; and Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com. 4 Please see Global Investment Strategy Weekly Report, "Better U.S. Economic Data Will Cause The Dollar To Strengthen," dated October 14, 2016, available at gis.bcaresearch.com. Strategy & Market Trends* Tactical Trades Strategic Recommendations Closed Trades

Highlights By now, the Kingdom of Saudi Arabia (KSA) and Russia have figured out that if each cuts 500k b/d of production, the revenue enhancement for both will be well worth the foregone volumes. Even without additional cuts from other OPEC and non-OPEC producers - most of whom already have seen output drop as a result of OPEC's market-share war - KSA and Russia benefit. A 1mm b/d cut would accelerate the draw in oil inventories next year, allowing U.S. shale-oil producers to quickly move to replace shut-in output. Importantly, shale producers' marginal costs will then begin to set market prices. Longer term, KSA and Russia would have to manage their production in a way that keeps shale on the margin. Whether they can continue to cooperate over the long term remains to be seen. Energy: Overweight. We are recommending investors go long February 2017 $50 Brent calls vs. short $55 Brent calls, in anticipation of a production cut from KSA and Russia. Base Metals: Neutral. We remain neutral base metals, despite the better-than-expected PMIs for China reported earlier this week. Precious Metals: Neutral. We are moving our gold buy-stop to $1,250/oz from $1,210/oz, expecting higher core PCE inflation. Ags/Softs: Underweight. We are recommending a strategic long position in Jul/17 corn versus a short in July/17 sugar. Feature The options market gives a 43% probability to Brent prices exceeding $50/bbl by the end of this year (Chart of the Week). We think these odds are too low, given our expectation KSA and Russia will announce production cuts of 500k b/d each at the OPEC meeting scheduled for November 30, 2016 in Vienna. Chart of the WeekOptions Probability Brent Exceeds $50/bbl By Year-End Is Less Than 50% Raising The Odds Of A KSA-Russia Oil-Production Cut Raising The Odds Of A KSA-Russia Oil-Production Cut A production cut totaling 1mm b/d - plus whatever additional volumes are contributed by GCC OPEC members - will, in all likelihood, send Brent prices back above $50/bbl by year end. This is a fairly high-conviction call for us: We are putting the odds prices will exceed $50/bbl by year-end closer to 80%. As such, we are opening a Brent call spread, getting long February 2017 $50 Brent calls vs. short $55 Brent calls, in anticipation of this production cut from KSA and Russia.1 There are two simple facts driving our assessment: KSA and Russia are desperate for cash - they're both trying to source FDI, and will continue to need external financing for years. They can't wait for supply destruction to remove excess production from the market, given all they want to accomplish in the next two years. The vast majority of income for these states is derived from hydrocarbon sales - 70% by one estimate for Russia, and 90% for KSA - and both have seen painful contractions in their economies during the oil-price collapse, which forced them to cut social spending, raise fees, issue bonds and sell sovereign equity assets.2 With the exception of KSA, Russia, Iraq and Iran, most of the rest of the producers in the world have seen crude oil output fall precipitously - particularly poorer non-Gulf OPEC states (Chart 2), and market-driven economies like the U.S. (Chart 3). Thus, KSA's insistence that others bear the pain of cutting production has already been realized. Iran and Iraq, which together are producing ~ 8mm b/d, maintain they should be exempt from any production freeze or cut, given their economies are in the early stages of recovering from economic sanctions related to a nuclear program and years of war, respectively. Chart 2GCC OPEC Production Surges, ##br##Non-Gulf OPEC Production Collapses bca.ces_wr_2016_11_03_c2 bca.ces_wr_2016_11_03_c2 Chart 3Russia' Gains Lift Non-OPEC Production;##br## U.S. Declines Continue bca.ces_wr_2016_11_03_c3 bca.ces_wr_2016_11_03_c3 Why Would KSA And Russia Act Now? Neither trusts the other, which is why neither cut production unilaterally to accelerate storage drawdowns. Any unilateral cut would have ceded market share to the arch rival. Both states have gone to great efforts to show they can increase production even in a down market, just to make the point that they would not give away hard-won market share (Chart 4). Chart 4KSA and Russia Devoted##br## Significant Resources to Lift Production bca.ces_wr_2016_11_03_c4 bca.ces_wr_2016_11_03_c4 These states are at polar-opposite ends of the geopolitical spectrum - KSA is supporting Iran's enemies in proxy wars throughout the Middle East, while Russia is supporting Iran and its allies. In the oil markets, they are both going after the same customers in Asia and Europe. Each state had to convince the other it could endure the pain of lower prices, which brought both to the table at Algiers, and allowed their continued dialogue since then to flourish. Globally, the market rebalancing already is mostly - if not completely - done. Excess production has been removed from the market, and very shortly we will see inventory drawdowns accelerate. But, if KSA and Russia leave this process to the market, we may be looking at 2017H2 before stocks start to draw hard. By cutting production now, KSA and Russia accelerate the stock draw and hasten the day when shale is setting the marginal price in the market. While shale now is comfortably in the middle of the global cost curve, it still sits above KSA's and Russia's cost curve, which means the marginal revenue to both will be higher than if their marginal costs are driving global pricing. Both states have a lot they want to do next year and in 2018: Russia is looking to sell 19.5% of Rosneft; KSA is looking to issue more debt and IPO Aramco. Both must convince FDI that the money that's invested in their industries will not be wasted because production has not been reined in. And, they both must keep restive populations under control. Cutting production by 1mm b/d or more would push prices back above $50/bbl, perhaps higher, resulting in incremental income of some $50mm to $75mm per day for KSA and Russia. Viewed another way, the incremental revenue generated annually by higher prices brought on by lower production would service multiples of KSA's first-ever $17.5 billion global debt issue brought to market last month. Both KSA and Russia will be able to lever their production more - literally support more debt issuance - by curtailing production now. KSA will need that leverage to pull off the diversification it is attempting under its Vision 2030 initiative. Russia would be able to do more with higher revenues, as well. Balances Point To Supply Deficit Next Year The meetings - "sideline" and otherwise - in Algiers, Istanbul and Vienna over the past month or so at various producer-consumer conclaves were attended mostly by producers that already have endured painful revenue cutbacks brought on by the OPEC market-share war declared in November 2014. Even those producers that did not endure massive production cuts - e.g., Canada, where oil-sands investments sanctioned prior to the price collapse continue to come on line despite low prices - will see far lower E&P investment activity going forward, given the current price environment. Chart 5Oil Markets Will Go Into Deficit Next Year Oil Markets Will Go Into Deficit Next Year Oil Markets Will Go Into Deficit Next Year Global oil supply growth will be relatively flat this year and next (Chart 5). This will create a physical deficit in supply-demand balances, even with our weaker consumption-growth expectation: We've lowered our growth estimate to 1.30mm b/d this year, and expect 1.34mm b/d growth next year. We revised demand growth lower based on actual data from the U.S. EIA and weaker projections for global growth.3 Among the major producers, only Iran, Iraq, KSA, and Russia increased output yoy. North America considered as a whole is down despite Canada's gains, and will stay down till 2017H2, based on our balances assessments. South America is essentially flat this year and next. The North Sea's up slightly this year, down more than 5% yoy in 2017, while the Middle East ex-OPEC is flat. Lastly, we expect China's production to be down close to 7% this year, and almost 4% next year. Managing The KSA-Russia Production Cut If KSA and Russia can cut 1mm b/d of production, they'd have to actively manage global balances so that the U.S. shale barrel meets the bulk of demand increases, while conventional reserves fill in decline-curve losses. Iran and Iraq together will be up 1mm b/d this year, but only 350k b/d next year. Both states are going to have a tough time attracting FDI to accelerate production gains, although ex-North America, these states probably have a higher likelihood of attracting investment than Non-Gulf OPEC, which is in terrible shape, and will have a hard time funding projects. Recently recovered Libyan and Nigerian output likely is the best they will be able to do until additional FDI arrives.4 At low price levels, even KSA can't realize the full value of the assets it is attempting to sell and the debt it will be servicing (lower prices mean lower rating from rating agencies). This is a worry for KSA, as it looks to IPO 5% of Aramco and issue more debt.5 Without higher prices, they will need to continue to slash spending, cut defense budgets, salaries and bonuses, and begin to levy taxes and fees. Below $50/bbl Brent, Russia faces similar constraints, and cannot expect to realize the full value of the 19.5% share of Rosneft it hopes to sell into the public market. Net, if KSA and Russia can get prices up above $50/bbl by cutting 1mm from their combined production and increase their gross revenues doing so, it's a major win for them. Such a cut would bring forward the global inventory drawdown we presently see picking up steam in 2017H2 without any reductions in production. In addition, because International Oil Companies (IOCs) are limited in terms of capex they can deploy to invest in National Oil Company (NOC) projects, conventional oil reserves will not be developed in the near term due to funding constraints. That, and higher capex being devoted to the U.S. shales, will keep a lid on production growth ex-U.S. Given how we see investment in production playing out over the medium term - i.e., 3 - 5 years - it will fall to the U.S. shales and Iran-Iraq production to find the barrels to meet demand increases and to replace production lost to natural declines. Given that we expect non-Gulf OPEC yoy production in 2017 to be down close to 1.3mm b/d (or -13%), and that we expect Brazil to be flat next year, cutting 1mm b/d from KSA and Russia's near-record levels of production is a bet both states will find worth taking, in order to lift and stabilize prices over the medium term. GCC OPEC production is expected to be up ~ 1% next year, or ~ 150kb/d, so these states have some scope for reducing output, as well. Price Implications If KSA and Russia Cut If we do indeed see KSA and Russia reduce output 1mm b/d as we expect, we expect storage draws will likely accelerate next year, which will flatten WTI and Brent forward curves, and send both into backwardation (Chart 6). We also would expect prices to move toward $55/bbl in the front of the WTI and Brent forward curves, once the storage draws start backwardating these curves. This would be a boon to KSA's and Russia's gross revenues, generating ~ $75mm a day of incremental revenue post-production cuts. Chart 6Expect Backwardation With ##br##A KSA-Russia Production Cut bca.ces_wr_2016_11_03_c6 bca.ces_wr_2016_11_03_c6 Given this expected dynamic, we recommend going long a February 2017 Brent call spread: Buy the $50 Brent call and sell the $55/bbl Brent call. We also recommend getting long WTI front-to-back spreads expecting a backwardation by mid-year or thereabouts: Specifically, we recommend getting long August 2017 WTI futures vs. short November 2017 WTI futures. This scenario also will be bullish for our Energy Sector Strategy's preferred fracking Equipment services companies, HAL and SLCA. ...And if They Fail to Cut Production? If KSA and Russia fail to cut production, and instead freeze it or raise output following the November OPEC meeting, the market will quickly look through their inaction and continue to price to the actual supply destruction we've been observing for the better part of this year. In such a scenario, prices will push into the lower part of our expected $40 to $65/bbl price range for a longer period of time, which not only will prolong the financial stress of OPEC and non-OPEC producers, but will keep the probability of a significant loss of exports from poorer OPEC states elevated. Either way, global inventories will be significantly reduced by the end of 2017, either because of a production cut by KSA and Russia, or because of continued supply destruction brought about by lower prices. Bottom Line: We expect KSA and Russia to announce a 1mm b/d production cut at the upcoming OPEC meeting at the end of this month. This will rally crude oil prices above $50/bbl, and accelerate the drawdown in global storage levels, which will backwardate Brent and WTI forward curves. We recommend getting long Feb17 $50/bbl Brent calls vs. short $55/bbl Brent calls, and getting long Jul17 WTI vs. short Nov17 WTI futures in anticipation of these cuts. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com SOFTS Sugar: Downgrade To Strategically Bearish, Look To Go Long Corn Vs. Sugar We downgrade our strategic sugar view from neutral to bearish, as we expect a much smaller supply deficit next year. We also downgrade our tactical sugar view from bullish to neutral, as prices have already surged over 120% since last August. We expect corn to outperform sugar in 2017. Brazil will likely increase its imports of cheaper U.S. corn-based ethanol. We look to long July/17 corn versus July/17 sugar if the price ratio drops to 17 (current: 17.94). If the position gets filled, we suggest a 5% stop-loss to limit the downside risk. Sugar prices have rallied more than 120% since last August on large supply deficits and an extremely low global stock-to-use ratio (Chart 7). Falling acreage and unfavorable weather have reduced sugarcane supplies from major producing countries Brazil, India, China and Thailand. Chart 7Sugar Tactically Neutral, Strategically Bearish bca.ces_wr_2016_11_03_c7 bca.ces_wr_2016_11_03_c7 Tactically, We Revise Our Sugar View From Bullish To Neutral. Sugar prices are likely to stay high over next three to six months on tight supplies. The global sugar stock-to-use ratio is at its lowest level since 2010 (Chart 7, panel 3). Inventories in India and China fell to a six-year low while inventories in the European Union (EU) were depleted to all-time lows. These three regions together accounted for 36.7% of global sugar consumption last year. However, we believe prices will have limited upside over next three to six months. Despite tight inventories, India and China likely will not increase imports. India currently has a 40% tax on sugar imports, and the government also imposed a 20% duty on its sugar exports in June to boost domestic supply. China started an investigation into the country's soaring sugar imports in late September. The probe will last six months, with an option to extend the deadline. In the meantime, other sugar importers likely will reduce or delay their sugar purchases because of currently high prices. Lastly, speculative buying is running out of steam, as traders already are deeply long sugar - net speculative positions as a percentage of total open interest is sitting at record-high levels (Chart 7, panel 4). Strategically, We Downgrade Our Sugar View From Neutral To Bearish. Assuming normal weather conditions across major producing countries next year, we believe the global sugar market will have a much smaller supply deficit over a one-year time horizon. Although sugar prices in USD terms reached their highest level since July 2012, prices in other currencies actually rose to all-time highs (Chart 8). Record high sugar prices in these countries will encourage planting and investment, which will consequently result in higher sugar production, especially in Brazil, India and Thailand. This year, due to adverse weather during April-September, the USDA has revised down its sugarcane output estimates for Brazil and Thailand by 3.2% and 7.1%, respectively. Assuming a return of normal weather next year, we expect sugarcane output in these two countries to recover. Farmers in China and India have cut their sown acreage for sugarcane this year on extremely low prices late last year and early this year. With prices up significantly in the latter half of this year, we expect sugar output in these two countries to rebound on acreage recovery as well. In addition, Brazilian sugar mills have clearly preferred producing sugar over ethanol so far this year on surging global sugar prices. According to the Brazilian Sugarcane Industry Association (UNICA), for the accumulated production until October 1, 2016, 46.31% of sugarcane was used to produce sugar, a considerable increase from 41.72% for the same period of last year. We expect this trend to continue in 2017, adding more sugar supply to the global market. Moreover, as the market becomes more balanced next year, speculators will likely unwind their huge long positions, which may accelerate a price drop sometime next year (Chart 7, panel 4). Where China Stands In The Global Sugar Market? China is the world's biggest sugar importer, the third-largest consumer and the fifth-biggest producer, accounting for 14.2% of global imports, 10.3% of global consumption and 4.9% of global production, respectively (Chart 9, panel 1). Chart 8Sugar Supply Will Increase In 2017 bca.ces_wr_2016_11_03_c8 bca.ces_wr_2016_11_03_c8 Chart 9Chinese Sugar Imports May Slow Chinese Sugar Imports May Slow Chinese Sugar Imports May Slow Sugar production costs are much higher in China than in Brazil and Thailand, due to higher wages and low rates of mechanization. Falling sugar prices in 2011-2015 further reduced the profitability of Chinese sugar producers. As a result, the sugarcane-sown area in China has dropped 24% in three years, resulting in a huge supply deficit (Chart 9, panel 2). Because domestic prices are much higher than global prices, the country has boosted its imports rapidly in recent years (Chart 9, panel 3). We believe, in the near term, the recently announced investigation into surging sugar imports will slow the inflow of sugar into the country, which will be negative for global sugar prices. In the longer term, the sugarcane-sown area in China will recover on elevated sugar prices, indicating the country's production is set to rebound, which likely will reduce its sugar imports. This is in line with our strategic bearish view. Chart 10Corn Is Likely To Outperform Sugar In 2017 bca.ces_wr_2016_11_03_c10 bca.ces_wr_2016_11_03_c10 Risks To Our Sugar View In the near term, sugar prices could rally further on negative weather news or if the USDA revises down its estimates of global sugar production and inventories. Prices also could go down sharply if speculators unwind their huge long positions before the year end. We will re-evaluate our sugar view if one of these risks materializes. In the long term, if adverse weather occurs and damages the Brazilian sugarcane yield outlook for next season, which, in general starts harvesting next April, we may upgrade our bearish view to bullish. How To Profit From The Sugar Market? In the softs market, we continue to prefer relative-value trades to outright positions. With regards to sugar, we look to go long corn vs. short sugar, as we expect corn to outperform sugar in 2017. Both sugar and corn are used in ethanol production. Ethanol is also a globally tradable commodity. While sugar prices rose to four-year highs, corn prices fell to seven-year lows, resulting in a significant increase in Brazilian sugar-based ethanol production costs and a considerable drop in U.S. corn-based ethanol production costs. We believe the current high sugar/corn price ratio is unlikely to sustain itself, as Brazil will likely increase its imports of cheaper U.S. corn-based ethanol (Chart 10, panels 1, 2 and 3). In addition, global ethanol importers will also prefer buying U.S. corn-based ethanol over Brazilian sugar-based ethanol. Eventually, this should bring down the sugar/corn price ratio to its normal range. Therefore, we look to long July/17 corn versus July/17 sugar if the price ratio drops to 17 (current: 17.94) (Chart 10, panel 4). If the position gets filled, we suggest a 5% stop-loss to limit the downside risk. In addition to the risks related to the fundamentals, this pair trade also faces the risk of a steep contango in the corn futures curve, and a steep backwardation in the sugar futures curve. The July/17 corn prices are 6.2% higher than the nearest futures prices and July/17 sugar prices are 5.2% lower than the nearest sugar futures prices. Long Wheat/Short Soybeans Relative Trade On another note, our long Mar/17 wheat/short Mar/17 soybeans relative trade was stopped out at a 5% loss on October 26. We still expect wheat to outperform soybeans over next three to six months. We will re-initiate this relative trade if the ratio drops to 0.41 (current: 0.426) (Chart 10, bottom panel). Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com 1 The Feb17 options expire 22 December 2016, three weeks after the OPEC meeting. 2 Please see Commodity & Energy Strategy Weekly Report "Ignore The KSA - Russia Production Pact, Focus Instead On The Need For Cash," dated September 8, 2016, available at ces.bcaresearch.com. 3 The IMF expects slightly slower global GDP growth this year (3.1%), and a slight pick-up next year (3.4%). Please see "Subdued Demand, Symptoms and Remedies," in the October 2016 IMF World Economic Outlook. 4 Please see "OPEC Special-Case Nations Add 450,000 Barrels in Threat to Deal," by Angelina Rascouet and Grant Smith, published by Bloomberg news service November 2, 2016. 5 Please see Commodity & Energy Strategy Weekly Report "Desperate Times, Desperate Measures: Aramco And The Saudi Security Dilemma," dated January 14, 2016, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Closed Trades

Highlights The RMB will continue to drift lower against a broadly stronger dollar, but the risk of chaotic depreciation is very low. The TWD will likely remain strong in the near term, mostly due to the unyielding strength in the JPY, but it should depreciate both against the dollar and in trade-weighted terms over the medium-to-long term. Hong Kong's currency peg will not be challenged, and will rise along with the greenback, but this will prove to be deflationary for its economy and asset prices. Feature The broad trend in the U.S. dollar will remain the dominant global macro force in the near term, which in turn will dictate the performances of the three currencies in the Greater China region. Historically these currencies have had a lower "beta" - i.e. systematically lower volatility than most of their global peers. This week we review the unique driving forces behind these currencies and the cyclical dynamics of their respective economies. In a nutshell, the fundamentals of these currencies are stronger than most of their global counterparts, which diminishes the odds of outsized depreciation. Therefore, they will remain "low-beta" plays, and may even appreciate in trade-weighted terms as the dollar strengthens. The RMB: Drifting With The Flow The USD/CNY has now approached 6.8, the level at which the RMB was essentially pegged to the dollar post the global financial crisis until late 2010 (Chart 1). This has raised speculation that the People's Bank of China (PBoC) may once again soft-peg the RMB around current levels to the U.S. dollar. While there is no doubt that the PBoC will maintain tight control over the exchange rate, it is impossible to predict how the central bank intends to control it in the near term. We suspect the path of least resistance is for the RMB to continue to drift lower against a broadly stronger dollar, but the risk of chaotic depreciation is very low. First, much of the RMB's valuation froth has been cleansed through a combination of nominal depreciation and lower inflation. The RMB's 12% depreciation against the dollar since its all-time peak in January 2014 has erased all the gains since 2010 and has weakened the currency by over 10% in real effective terms since its historical high in mid-2015 - non-trivial moves for a tightly managed currency. Our models suggest that the RMB is no longer overvalued either against the dollar or in real effective terms, as discussed in recent reports.1 Similarly the trade-weighted RMB has been oscillating around a well-defined uptrend in the past decade, and it depreciation since last year has pushed the currency from a two-sigma overshoot above its long-term trend to a two-sigma undershoot (Chart 2). Chart 1Will The RMB Be Re-pegged? Will The RMB Be Re-pegged? Will The RMB Be Re-pegged? Chart 2The RMB And Long Term Trend The RMB And Long Term Trend The RMB And Long Term Trend Second, most market participants have focused squarely on the destabilizing impact of the RMB depreciation, but have ignored the reflationary benefits of a weaker currency. For a large open economy, the exchange rate matters materially. The RMB's 10% depreciation in trade-weighted terms has significantly boosted profit margins of Chinese exporters. Even though export prices measured in dollar terms are still declining, they have increased sharply in RMB terms, boosting profits as well as overall industrial activity (Chart 3). The most recent readings of purchasing managers' surveys released early this week confirm that the manufacturing sector has continued to recover, and currency weakness may be an important factor behind the regained strength (Chart 4). In the near term, the performance of the USD/CNY is largely dictated by the dollar's trend, but the downside of the RMB should be self-limiting, as the reflationary impact of a weaker exchange rate will help boost Chinese growth, which in turn will reduce downward pressure on the Chinese currency. Chart 3A Weaker RMB Helps Exporters' Profits A Weaker RMB Helps Exporters' Profits A Weaker RMB Helps Exporters' Profits Chart 4A Weaker RMB Leads Cyclical Recovery A Weaker RMB Leads Cyclical Recovery A Weaker RMB Leads Cyclical Recovery Finally, the risk of major RMB depreciation largely hinges on whether China would suffer massive capital flight that depletes its foreign exchange reserves. The risk certainly cannot be ignored, but the odds are low for now. The lion's share of China's capital outflows in the past two years have been attributable to Chinese firms paying back borrowings in foreign currencies. Therefore, the pressure for capital outflows will diminish as foreign debts are paid back (Chart 5). In addition, we expect Chinese regulators to strengthen capital account restrictions. Early this week, the authorities further tightened regulations for residents purchasing overseas insurance products. It is likely they will further crack down on administrative loopholes to hinder capital outflows. Bottom Line: Expect further weakness in the RMB/USD, but odds of material depreciation are low. The Strong TWD Will Hurt In contrast to the RMB, the Taiwanese dollar has in fact appreciated both against the dollar and in trade-weighted terms so far this year, likely due to the strong Japanese yen (Chart 6). Taiwan competes with Japan in similar value-added segments in the global supply chain, and therefore their currencies have historically been closely correlated. In this vein, the Bank of Japan's failed attempts to further weaken the yen against the dollar has also effectively boosted the Taiwanese currency. Chart 5Chinese Companies Rushed To##br## Pay Back Foreign Debt Greater China Currencies: An Overview Greater China Currencies: An Overview Chart 6TWD And JPY: Joined At The Hip TWD And JPY: Joined At The Hip TWD And JPY: Joined At The Hip From a valuation perspective, the TWD appears cheap based on standard purchasing power parity assessment. Nonetheless, with exports accounting for over 50% of Taiwan's GDP, a strong currency is neither desirable nor affordable. Similar to Japan, Taiwan's headline consumer price inflation has been uncomfortably low, rising by a mere 0.33% in September from a year ago. Meanwhile, the rising TWD will continue to depress corporate sector pricing power. Wholesale prices of manufactured goods, after briefly moving into positive territory earlier this year, have crashed back into deflation in recent months alongside the strong TWD (Chart 7, top panel). Furthermore, the untimely strength in the exchange rate may short-circuit Taiwan's nascent growth recovery that has been budding in recent months. Export orders, after rising at an above 8% annual rate in previous months, have already begun to roll over, and will likely come under further downward pressure inflicted by the exchange rate (Chart 7, bottom panel). Furthermore, overall inventory levels in the economy have been rising in recent years. Chart 8 shows that manufacturers' inventory-to-shipment ratio has increased notably since 2011. The combination of a potential slowdown in new orders and elevated inventory levels bodes poorly for industrial production and overall business activity. Chart 7A Strong TWD Is Deflationary A Strong TWD Is Deflationary A Strong TWD Is Deflationary Chart 8Inventory Level Has Been Rising Inventory Level Has Been Rising Inventory Level Has Been Rising To be sure, with its chronic current account surplus and an outsized foreign exchange reserve, Taiwan is much better equipped than most of its global and EM peers to deal with external turmoil. As a large net creditor nation, the risk of a typical balance-of-payment crisis and chaotic currency depreciation is not in the cards. The problem for Taiwan is that the TWD has become unduly strong, which could lead to quick growth deterioration and in turn sow the seeds for currency depreciation. Bottom Line: In the near term we expect the TWD to remain strong, mostly due to the unyielding strength in the JPY, but it should depreciate both against the dollar and in trade-weighted terms over the medium- to long term. We will be looking for opportunities to short the TWD/USD in the coming months. The HKD Peg Will Remain Solid The Hong Kong dollar has remained remarkably strong against the dollar in recent months, despite the broad dollar bull market (Chart 9). In the spot market, the HKD/USD has been hovering around the stronger end of the convertibility undertaking. In the forward market, the HKD non-deliverable forward (NDF) contract's premium over the dollar has widened notably in recent weeks. We suspect stronger demand for the HKD is mainly from the mainland, as it is viewed as an alternative to the greenback. Furthermore, the RMB cash accumulated in Hong Kong in previous years is being unwound (Chart 10). RMB deposits at Hong Kong banks have almost halved in the past year, but remain elevated. They may continue to be converted back into HKD supporting its exchange rate. Chart 9The HKD Still Faces Upward Pressure The HKD Still Faces Upward Pressure The HKD Still Faces Upward Pressure Chart 10HK RMB Deposits May Continue To Unwind HK RMB Deposits May Continue To Unwind HK RMB Deposits May Continue To Unwind More fundamentally, compared with the late 1990s' episode when the HKD was under furious speculative attack, the HKD's current valuation is substantially cheaper. In 1997 when the Asian crisis erupted, the Hong Kong economy had just gone through a massive inflationary boom, which dramatically pushed up its real effective exchange rate (Chart 11). This in of itself created acute deflationary pressure, which had to be corrected by either nominal exchange rate depreciation or domestic price declines. By defending the currency peg, the Hong Kong authorities opted for price deflation to realign the then-overvalued HKD. This time around, Hong Kong's real effective exchange rate is just above its all-time low, and there are no clear signs that the economy is facing strong deflationary pressures that would call for meaningful exchange rate adjustment. Similar to China and Taiwan, a strong HKD pegged to a rising USD is not ideal for the Hong Kong economy due to its heavy dependence on external demand, particularly from the mainland. Already, mainland tourism to Hong Kong has begun to moderate, and average spending among foreign tourists has dropped significantly in the past few years - at least partially attributable to the strong HKD (Chart 12). More importantly, further HKD strength will continue to tighten Hong Kong's monetary conditions, which fundamentally matters for its asset prices. As discussed in detail in previous reports,2 tightening monetary conditions are particularly bearish for real estate prices, which are already in "bubble" territory. The downside in Hong Kong stocks should be limited due to their deeply depressed valuation parameters. Chart 11The HK Dollar Is Not Expensive The HK Dollar Is Not Expensive The HK Dollar Is Not Expensive Chart 12Tourists' Spending And Exchange Rate Tourists" Spending And Exchange Rate Tourists" Spending And Exchange Rate Bottom Line: Hong Kong's currency peg will not be challenged, and the trade-weighted HKD will rise along with the greenback, but this will prove to be deflationary for its economy and asset prices. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Can The RMB Withstand More Fed Rate Hikes?", dated September 1, 2016; and China Investment Strategy Weekly Report, "The RMB's Near-Term Dilemma And Long-Term Ambition", dated October 20, 2016, available at cis.bcaresearch.com 2 Please see China Investment Strategy Weekly Report, "Hong Kong: From Politics To Political Economy", dated September 8, 2016, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights Chile's economy is headed for recession. Facing strong external and domestic headwinds, any policy stimulus will be too late to prevent the impending contraction in economic activity. Investors should receive 3-year interest swaps and stay short CLP / long USD. South Africa's cyclical and structural outlook remains bleak. Banks have been selling foreign assets and repatriating capital which has helped the rand to appreciate. However, as this capital repatriation tapers, the rand will enter a renewed bear market. Stay short the rand versus the U.S. dollar and long MXN / short ZAR. Feature Chile: Stimulus Will Arrive Too Late To Prevent Recession Chart I-1Chile: From Stagflation To Recession? Chile: From Stagflation To Recession? Chile: From Stagflation To Recession? The stagflationary environment in Chile over the past two years - a combination of sluggish growth and high inflation - will give way to outright recession (Chart I-1). As economic activity downshifts further, we are doubtful that policymakers will be able to push through stimulus measures in time, and of sufficient size, to stave off recession. On the fiscal front, the government is unlikely to preemptively engage in a significant spending push. The deceleration in economic activity will soon translate into lower fiscal revenue at a time when the fiscal deficit is already quite wide, at 2.8% of GDP. Furthermore, a renewed fall in copper prices (more on this below) means mining revenue will also be weaker than currently expected, inflicting substantial damage on the government's budget. Meanwhile, monetary policy is unlikely to become stimulative in the near term. Having concluded a two-year battle to tame sticky core inflation, the central bank is unlikely cut interest rates too fast. Besides, as the current term of Central Bank President Rodrigo Vergara ends in December, chances of a new rate cut cycle before he is replaced are low. On the whole, the lack of imminent policy stimulus means economic growth is set to fall much further. Investors can profit by receiving 3-year swap rates (Chart I-2). Although the central bank will be late to cut rates, long-term interest rates will fall because Chilean growth is facing strong headwinds on several fronts: Copper prices have failed to rally amid the reflation trade of the past nine months, and are set to drop to new lows as Chinese property construction and demand for industrial metals contracts anew (Chart I-3). As a result, copper exports will continue to act as a serious drag on Chilean growth (Chart I-4). Chart I-2Receive 3-Year Interest ##br##Rate Swaps In Chile Receive 3-Year Interest Rate Swaps In Chile Receive 3-Year Interest Rate Swaps In Chile Chart I-3China's Industrial Metals ##br##Demand To Contract China's Industrial Metals Demand To Contract China's Industrial Metals Demand To Contract Chart I-4Exports Will Remain ##br##A Drag On Growth Exports Will Remain A Drag On Growth Exports Will Remain A Drag On Growth Capital expenditures will contract, partially due to very downbeat business confidence owing to the uncertain political environment created by the government's reforms agenda since 2014 (Chart I-5, top panel). As discussed in detail in our December 2014 Special Report on Chile,1 from a big-picture perspective, these reforms have shifted the structure of the economy toward higher government expenditures at the expense of the private sector. This has severely eroded business confidence. In addition, the downturn in the housing market will gain momentum, further depressing activity (Chart I-5, bottom panel). Meanwhile, employment growth has been weak and income growth has been decelerating steadily - and we foresee further downside ahead (Chart I-6). Importantly, the economy's credit impulse is now turning negative (Chart I-7). Higher delinquencies in turn will force banks to curtail lending going forward. Chart I-5Chile: Capex To Remain Weak Chile: Capex To Remain Weak Chile: Capex To Remain Weak Chart I-6Chile: Labor Market Will Weaken Further Chile: Labor Market Will Weaken Further Chile: Labor Market Will Weaken Further Chart I-7Negative Credit Impulse##br## Will Weigh On Growth Negative Credit Impulse Will Weigh On Growth Negative Credit Impulse Will Weigh On Growth Finally, narrow (M1) money supply growth, a very good leading indicator for economic activity, is now decelerating sharply (Chart I-8). Consistently, our marginal propensity to consume proxy points to weak spending and lower consumer price inflation (Chart I-9). Chart I-8Chile: Narrow Money Growth, ##br##Economic Activity And Inflation Chile: Narrow Money Growth, Economic Activity And Inflation Chile: Narrow Money Growth, Economic Activity And Inflation Chart I-9Consumption Is Set ##br##To Decelerate Further Consumption Is Set To Decelerate Further Consumption Is Set To Decelerate Further The economy has developed considerable downward momentum. Any policy stimulus is likely to come too late to prevent the economy from falling into recession. Therefore, local interest rates in Chile are headed to new lows. An economic recession and lower copper prices are clearly bearish for the Chilean peso, and we maintain that its 8.5% rally this year versus the U.S. dollar will be followed by new lows (Chart I-10). Turning to equities, lower interest rates will help only marginally as equity valuations are not cheap (Chart I-11). Moreover, as Chilean banks account for 20% of the MSCI market cap and, while they are better run and more conservative than many others in the EM, they are not immune to a decelerating credit and business cycle. Besides, this bourse's Latin American consumer plays will also likely disappoint. As such, dedicated EM investors should stay neutral on Chilean stocks relative to the EM equity benchmark (Chart I-12). Chart I-10Chilean Peso Valuation Chilean Peso Valuation Chilean Peso Valuation Chart I-11Chilean Equities Are At Fair Value Chilean Equities Are At Fair Value Chilean Equities Are At Fair Value Chart I-12Chilean Equities: Stay ##br##Neutral Relative To EM Benchmark Chilean Equities: Stay Neutral Relative To EM Benchmark Chilean Equities: Stay Neutral Relative To EM Benchmark Lastly, as highlighted in our recent in-depth Special Report on EM corporate credit,2 credit investors should stay long Chilean and Russian corporate debt versus China. Chilean corporate credit will likely outperform Chinese corporate credit, as the latter is more frothy - overbought and expensive. Bottom Line: The Chilean economy is heading into recession, and policymakers will be late with stimulus to prevent it. Fixed-income investors should receive 3-year interest rate swaps. Dedicated EM equity investors should maintain a neutral stance on the Chilean bourse versus the EM equity benchmark. Stay short CLP / long USD. Santiago E. Gomez Associate Vice President santiago@bcaresearch.com South Africa: Flows Versus Fundamentals Chart II-1Improving Trade Has Helped The ZAR Improving Trade Has Helped The ZAR Improving Trade Has Helped The ZAR The South African rand has rallied since the start of the year on the back of an improving trade balance (Chart II-1) and strong capital inflows. However, it is facing a key technical resistance level, as are many other EM assets. We expect these resistance levels to hold for EM risk assets in general and the South African rand in particular. The underlying reasons behind our outlook center around our expectations of a stronger U.S. dollar, rising U.S. and G7 bond yields and a relapse in commodities prices. This is in addition to a lack of cyclical recovery and poor structural fundamentals in South Africa. A well-known explanation as to how South Africa has been able to finance its wide current account deficit is that there have been strong foreign portfolio inflows stemming from the global search for yield. What is less known is that South African banks have in the past year been selling foreign assets and repatriating capital back into South Africa (Chart II-2). Over the past 12 months, this repatriation of capital has amounted to US$ 6.5 billion, which effectively allowed the country to fund 50% of its current account deficit. While there is no doubt that this repatriation of capital has aided the rally in the rand and domestic bonds, it remains to be seen whether these flows will continue. Our suspicion is that with South African banks' holdings of foreign bonds dropping from US$ 18 billion in December 2015 to US$ 12 billion at the end of June 2016, and G7 bond yields rising, the speed of capital repatriation will likely slow. In the meantime, fundamentals in South Africa remain weak: The household sector, which accounts for 60% of GDP, has been sluggish. Private consumption growth has been anemic and credit growth to households has been falling rapidly (Chart II-3). Chart II-2South Africa: Banks Have Been ##br##Repatriating Capital Enormously South Africa: Banks Have Been Repatriating Capital Enormously South Africa: Banks Have Been Repatriating Capital Enormously Chart II-3South African ##br##Consumption Is Anemic South African Consumption Is Anemic South African Consumption Is Anemic The corporate sector is not painting a reassuring picture either. South African firms are not investing; real gross fixed capital formation is contracting (Chart II-4, top panel) and business confidence is at an all-time low (Chart II-4, bottom panel). The ongoing dynamic of persistently high wage growth - despite negative productivity growth - only reinforces the gloomy outlook as it creates downward pressure on corporate profit margins, or upward pressure on inflation (Chart II-5). Chart II-4Contracting Capex And ##br##Record-Low Business Confidence Contracting Capex And Record-Low Business Confidence Contracting Capex And Record-Low Business Confidence Chart II-5Toxic Structural Dynamics: Contracting ##br##Productivity And High Wage Growth Toxic Structural Dynamics: Contracting Productivity And High Wage Growth Toxic Structural Dynamics: Contracting Productivity And High Wage Growth Along with renewed weakness in the rand, higher wage growth will raise interest rate expectations. The fixed-income market is currently discounting no policy rate hikes during the next 12 months making it vulnerable to potential depreciation in the rand. In addition to a poor economic backdrop, uncertainty regarding economic policy is considerable. Chart II-6South Africa's Central ##br##Bank's Liquidity Injections South Africa's Central Bank's Liquidity Injections South Africa's Central Bank's Liquidity Injections First, fiscal policy will not be market friendly. The poor performance of the ANC in the last municipal elections shows the ANC is clearly losing support from the population. This will lead President Zuma and ANC to adopt even more populist policies. This is bearish for both the fiscal accounts and the structural growth outlook. As such, this will cap the upside in the rand and put a floor under domestic bond yields. Second, the central bank will not defend the exchange rate if the latter comes under selling pressure anew. In fact, monetary policy remains somewhat unorthodox. Specifically, the Reserve Bank of South Africa continues to inject liquidity into the system to cap interbank rates (Chart II-6). This will facilitate ZAR depreciation. Investment Conclusions Stay short the rand versus the U.S. dollar. Three weeks ago we also initiated a long MXN / short ZAR trade, and this trade remains intact as the MXN is oversold and the ZAR is overbought. Dedicated EM equity investors should maintain a neutral allocation to South African stocks. On the back of a fragile and deteriorating consumer sector, we recommend staying short general retailer stocks. Their share prices seem to be breaking down despite the rebound in the rand and a drop in domestic bond yields (Chart II-7). Policy uncertainty and pressure for populist policies is still an overarching issue for South Africa, especially compared to Russia. As such we suggest fixed income investors continue to underweight South African sovereign credit within the EM sovereign credit universe (Chart II-8), and maintain the relative trade of being long South African CDS / short Russian CDS. Chart II-7Stay Short South ##br##African General Retailers Stay Short South African General Retailers Stay Short South African General Retailers Chart II-8Stay Underweight South ##br##African Credit And Short Rand Stay Underweight South African Credit And Short Rand Stay Underweight South African Credit And Short Rand Stephan Gabillard, Research Analyst stephang@bcaresearch.com 1 Please refer to the Emerging Markets Strategy & Geopolitical Strategy Special Report titled, "Chile: A New Economic Model?," dated December 3, 2014 available at ems.bcaresearch.com 2 Please refer to the Emerging Markets Strategy Special Report titled, "EM Corporate Health Is Flashing Red," dated September 14, 2016. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

GAA DM Equity Country Allocation Model The model significantly reduced the weight of France by six percentage points due to change in liquidity condition, the other downgrade, albeit much smaller, was the U.S. All other countries had been upgraded as a result, with Germany being the largest beneficiary. Japan and U.K. remain the two largest underweights (Table 1). Table 1Model Allocation Vs. Benchmark Weights GAA Model Updates GAA Model Updates As shown in Table 2 and Chart 1, Chart 2 and Chart 3, the overall model outperformed the MSCI World benchmark by 27 basis points (bps) in October, driven completely by the Level 2 model (as U.K and Australia underperformed the euro area). The Level 1 model was in line with the benchmark. Since going live, the overall model performed slightly better than its benchmark. Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. Table 2Performance (Total Returns In USD) GAA Model Updates GAA Model Updates Chart 1GAA DM Model Vs. MSCI World bca.gaa_sa_2016_11_01_c1 bca.gaa_sa_2016_11_01_c1 Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) bca.gaa_sa_2016_11_01_c2 bca.gaa_sa_2016_11_01_c2 Chart 3GAA Non U.S. Model (Level 2) bca.gaa_sa_2016_11_01_c3 bca.gaa_sa_2016_11_01_c3 Table 3Allocations GAA Model Updates GAA Model Updates Table 4Performance Since Going Live GAA Model Updates GAA Model Updates Chart 4Overall Model Performance bca.gaa_sa_2016_11_01_c4 bca.gaa_sa_2016_11_01_c4 For more details on the models, please see the January 29th, 2016 Special Report "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model". http://gaa.bcaresearch.com/articles/view_report/18850 GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of October 31, 2016. The momentum component has shifted Financials from underweight to overweight. For mode details on the model, please see the Special Report "Introducing the GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Patrick Trinh, Senior Analyst patrick@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com

Highlights Defaults: The default outlook is improving alongside a brighter forecast for economic growth. The corporate default rate will fall from 5.4% to close to 4% during the next 12 months. Valuation: The low starting point for spreads means the risk/reward trade-off in junk bonds remains poor, despite a more encouraging default outlook. Strategy: In addition to a poor longer run risk/reward trade-off, the risk of a Fed rate hike in December makes us extremely cautious on junk in the near term. Maintain a maximum underweight allocation to high-yield and await a better entry point for spreads in the New Year. Feature This year's rally in High-Yield has been nothing short of impressive. The average spread on the Barclays High-Yield index has narrowed to 467bps from a February high of 839bps, and excess junk returns have now recovered all the ground lost since the mid-2014 peak (Chart 1). Chart 1Back In The Black bca.usbs_sr_2016_11_01_c1 bca.usbs_sr_2016_11_01_c1 When considering the potential for further spread tightening we first observe that, despite this year's rally, the average junk spread remains 144bps above the cycle lows reached in June 2014. However, the credit cycle is also two years older, corporations are more highly levered and the default rate has started to increase. The dramatic sell-off and subsequent recovery in the price of oil has also had a large impact on junk bond performance since mid-2014, but now that the average spread on energy debt is within 100bps of the overall index (Chart 1, bottom panel), its influence will be much smaller going forward. In this week's report we consider the potential for further junk bond outperformance through three different analytical approaches. We conclude that: Junk spreads already discount a significant improvement in capacity utilization Junk spreads do not adequately reflect the risks from higher implied equity volatility Although the outlook for default losses has improved, current spreads do not offer adequate compensation Growth Rebound Is In The Price As we anticipated,1 last Friday's preliminary Q3 GDP print exceeded expectations. Further, we expect that a number of headwinds which have held back U.S. growth in 2016 will give way next year, generating 2.5% - 3% real GDP growth in 2017.2 This should bode well for junk bond performance, except that a relatively large growth acceleration has already been incorporated into high-yield spreads. Of all economic indicators high-yield spreads correlate most closely with capacity utilization (Chart 2), which bottomed in March of this year shortly after the peak in junk spreads. But capacity utilization has not kept pace with the tightening in junk spreads since then. Historically, a 100bps tightening in junk spreads during a 12-month period has coincided with a 0.4% improvement in capacity utilization. This would suggest that even if junk spreads remain flat, capacity utilization should reach 77.2% by next February (Chart 2, bottom panel). While industrial production will continue to improve, in large part because of rebounds in the oil price and rig count (Chart 3), it will be difficult for any rebound to surpass the expectations that have already been baked into the high yield market. Chart 2Junk Spreads & Capacity Utilization bca.usbs_sr_2016_11_01_c2 bca.usbs_sr_2016_11_01_c2 Chart 3Drag From Energy Has Dissipated bca.usbs_sr_2016_11_01_c3 bca.usbs_sr_2016_11_01_c3 The Risk From Rising Vol Is Understated Another well-known correlation is between junk spreads and the VIX. As was observed by Robert Merton in 1974,3 corporate bond investors effectively bear the risk from equity investors who own portfolio insurance against downside tail risk (see Box). In other words, an increase in the price of volatility can be thought of as a transfer of default risk from equity holders to bondholders. Unusually, junk spreads have tightened during the past three months while the price of volatility (VIX) has risen (Chart 4). Box - Merton Model Of Corporate Debt Robert Merton pointed out that holding a corporate bond is equivalent to holding a risk-free security plus a short put option on the value of the assets of the corporation. For a corporation with zero default risk, the option is worthless and the bondholder owns a risk-free security. However, the closer a corporation comes to default, the put option (which the bondholder is short and the equity holder is long) increases in value. If the value of assets of the corporation falls below the value of the debt outstanding, then the equity holders are better off defaulting on the debt than repaying it. The act of defaulting on debt is analogous to exercising the put option in that the shareholders put the assets of the corporation to the debt holders rather than repay the debt. Higher volatility increases the value of this put option, effectively reducing the value of corporate debt relative to equity. In other words, higher asset price volatility increases the risk of default. Similarly, a drop in volatility makes default less likely and so increases the value of corporate debt. Although asset volatility and equity volatility are not identical, they are closely related. Therefore, declining equity implied volatility is positive for corporate bonds since it reduces the value of the implicit short put option embedded in corporate debt. This divergence is not sustainable, and the near-term risks clearly favor a convergence via wider spreads rather than a lower VIX. A Trump victory in this month's election would obviously surprise markets and prompt a flight to safety. But the polling data suggest this is a low probability event. More likely is that the VIX rises in anticipation of a Fed rate hike in December. This process could begin as early as tomorrow afternoon, if the Fed teases a December rate hike in the statement from this week's meeting. We anticipate a December rate hike and would expect investors to bid up the price of vol between now and then. As a rate hike becomes more likely, investors will become increasingly worried about a repeat of last year when a Fed rate hike precipitated a large sell-off in risk assets. The trend in equity volatility is also biased higher in the longer run. While it is impossible to accurately forecast all of the wiggles in the VIX index, its long-run underlying trend tends to be driven by corporate health and monetary conditions (Chart 5). Chart 4Higher Vol A Near-Term Risk bca.usbs_sr_2016_11_01_c4 bca.usbs_sr_2016_11_01_c4 Chart 5Long Run Vol Drivers bca.usbs_sr_2016_11_01_c5 bca.usbs_sr_2016_11_01_c5 Easier monetary conditions tend to reduce investor risk aversion and send the VIX lower. But easy money also encourages the corporate sector to take on debt. Initially, a virtuous circle is created between a lower VIX and a re-levering corporate sector. To the extent that corporate credit growth fuels aggregate demand, risk aversion will decline even further leading to even lower volatility. Eventually, the virtuous circle is broken when either monetary conditions are tightened or leverage increases so much that investors question the sustainability of corporate balance sheets. Chart 5 suggests that the current level of the VIX does not reflect the reality of tightening monetary conditions or deteriorating corporate balance sheets. Bottom Line: A sizeable improvement in capacity utilization and persistently cheap equity volatility are required to sustain junk spreads at current levels. A Brighter Outlook For Defaults Around this time last year we called the beginning of the default cycle,4 and our view remains that we are one year into a prolonged grind higher in corporate defaults. Typically, once corporate defaults start to trend higher they do not peak until the next recession and we do not expect this cycle to be any different. This is because firms tend not to engage in voluntary de-leveraging. Rather, they tend to continue to add leverage until the economy forces retrenchment upon them. One exception to this trend is the small increase and subsequent reversal in defaults that occurred in the mid-1980s (Chart 6). In this instance it was not an improvement in corporate balance sheets that caused the uptrend in defaults to reverse. Instead, it was a dramatic easing of monetary conditions that gave banks the necessary confidence to keep the credit taps open, despite worsening corporate health. This episode can be contrasted with the mid-1990s cycle when corporate health continued to deteriorate but monetary conditions did not ease. This resulted in a persistent grind higher in defaults. Chart 6Defaults Will Moderate Next Year, But Long-Run Uptrend Is Still Intact Defaults Will Moderate Next Year, But Long-Run Uptrend Is Still Intact Defaults Will Moderate Next Year, But Long-Run Uptrend Is Still Intact In our view, the current cycle has the most in common with the mid-1990s. Corporate balance sheets are deteriorating and no monetary relief should be expected with the Fed in the midst of a rate hike cycle, albeit a shallow one. However, the prolonged nature of the recovery also means that the rise in corporate defaults will also be shallow and drawn out, with some fluctuations around an upward trend. Chart 7The Reason For Low Recoveries bca.usbs_sr_2016_11_01_c7 bca.usbs_sr_2016_11_01_c7 On that note, we forecast that the default rate will moderate during the next twelve months. Our default rate model is shown in the top panel of Chart 6. This model is based on industrial production growth, corporate profit growth, times-interest earned and lending standards. We forecast that both industrial production and corporate profit growth will improve next year, in large part due to the end of the drag from falling oil prices. The red line in the top panel of Chart 6 shows the Moody's baseline forecast for future defaults. This forecast calls for the default rate to be 4.09% during the next 12 months, down from 5.4% during the past 12 months. This forecast is consistent with our own base case expectation that calls for a return to modestly positive growth in both industrial production and corporate profits (on the order of 5% annualized). The thick grey line in the top panel of Chart 6 shows what the default rate would be in a pessimistic scenario where industrial production and corporate profit growth are held flat at current levels. This forecast has the default rate rising to 6.5% during the next 12 months. In order to forecast default losses we also need a forecast for the recovery rate. In the past we have modeled recoveries using the output from our default rate model. This simple observation that recoveries tend to fall when defaults rise, and vice-versa, had been sufficient to capture the major swings in recoveries, but has not performed well during the current cycle (Chart 7). In fact, recoveries have lagged well below levels that would be expected given the number of corporate defaults we have seen. The reasons for the low recovery rate are not well known, but we have collected some bottom-up data that may offer a partial explanation. The bottom two panels of Chart 7 show the Tobin's Q and net debt-to-assets ratio for the bottom decile of firms in our sample going back to 1990.5 We note that the Tobin's Q - the ratio of market value to replacement value of a firm's assets - has fallen to recessionary levels. Meantime, while net debt-to-assets is in a clear uptrend, it does not appear stretched relative to the early stages of past default cycles. This suggests that low recoveries are not the result of too much debt being supported by too few assets, but are the result of a low market value being placed on the assets in question. More fundamentally, we suspect that low recovery rates are actually explained by the divergence between the monetary and credit cycles (Chart 8). In past cycles, Fed tightening has tended to occur alongside a deterioration in corporate health. However, in this cycle corporate balance sheet re-leveraging is well advanced compared to monetary tightening. If we accept the premise that defaults themselves are caused by tighter money and tightening lending standards, while recoveries are more related to the state of corporate balance sheets at the time of default, then it makes sense that recoveries would be lower in this cycle since corporate balance sheets had been aggressively levering-up for several years before monetary conditions began to tighten and defaults started to rise. Chart 8The Diverging Credit And Monetary Cycles bca.usbs_sr_2016_11_01_c8 bca.usbs_sr_2016_11_01_c8 In both our baseline and pessimistic forecasts we assume that the recovery rate increases somewhat (from 28% to 35%), but remains low relative to where we would expect it to be based on the default rate alone. Adding it all up, our base case scenario calls for default losses of 266bps during the next 12 months. This results from a default rate of 4.09% and a recovery rate of 35%. Our pessimistic scenario calls for default losses of 423bps during the next 12 months. This results from a default rate of 6.5% and a recovery rate of 35%. The Default-Adjusted Spread & Expected Returns Individually, neither the average junk spread nor future default losses offer much explanatory power when it comes to forecasting high-yield returns. Rather, it is the combination of both - the default-adjusted spread - that explains the bulk of variation in junk returns. The top panel of Chart 9 shows 12-month high-yield returns in excess of duration-matched Treasuries alongside the average option-adjusted spread from the Barclays index, advanced by 12 months. The chart shows that there is some correlation between today's average junk spread and excess returns during the following 12 months, but the correlation is very weak. Chart 9Default-Adjusted Spread Predicts Lower Excess Returns Default-Adjusted Spread Predicts Lower Excess Returns Default-Adjusted Spread Predicts Lower Excess Returns The second panel of Chart 9 adjusts the average junk spread by realized default losses. Here we see a much stronger correlation. In fact, the starting spread on the High-Yield index less realized default losses during the next 12 months explains more than 50% of the variation in excess junk returns. This means that with knowledge of today's junk spread and an accurate forecast of future default losses, we can have a reasonably good idea about what excess junk returns will be during the next year. The bottom panel shows the results of a regression of excess junk returns versus the default-adjusted spread. It also shows what the default-adjusted spread implies in term of excess junk returns using both our base case and pessimistic default loss scenarios. In our base case scenario where the default rate improves during the next year, excess junk returns are predicted to be close to zero. In other words, the anticipated improvement in defaults is not sufficient to offset the low level of starting spreads. In our pessimistic scenario, where the default rate rises to 6.5%, excess returns during the next 12 months are predicted to be deeply negative. Bottom Line: The default outlook is improving alongside a brighter outlook for economic growth, but wider spreads are still required to make the risk/reward trade-off in junk bonds attractive. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching", dated September 13, 2016, available at usbs.bcaresearch.com 2 Please see The November 2016 Bank Credit Analyst, dated October 27, 2016, available at bca.bcaresearch.com 3 Merton, Robert C. 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates." Journal of Finance 29, pp. 449-470. 4 Please see U.S. Bond Strategy Weekly Report, "The Rising Risk Of Corporate Default", dated October 20, 2015, available at usbs.bcaresearch.com 5 We create a sample consisting of all the firms included in either the Barclays Corporate or High-Yield index (excluding financials) for which bottom-up data are available from Bloomberg. Data are retrieved on a quarterly basis and the sample is adjusted once per year based on changes in the composition of the Barclays indexes. The lowest sample size in any quarter is 53 firms, the largest is 101. On average, the sample size is 68 firms. Fixed Income Sector Performance Recommended Portfolio Specification

Highlights A poor fundamental backdrop for high yield is being offset by easy monetary conditions. A prolonged shallow uptrend in corporate defaults - and therefore spreads - is most likely. The relative performance of equities versus corporate credit has not been distorted by monetary policy: the high-yield debt market will remain a reliable indicator for equity market vulnerability. A December rate hike will not be problematic for the residential real estate market. Plenty of pent-up demand for housing exists, and this will provide long-term support, so long as the labor market remains robust. Feature High-yield (HY) corporate bond spreads have dramatically narrowed throughout 2016 (Chart 1). This trend should not go unnoticed, since beyond being an important asset class in its own right, we have long viewed the high-yield debt market as an early warning system for equities. The current message suggests an all-clear for stocks. Chart 1Dramatic Spread Narrowing In 2016, But... bca.usis_wr_2016_10_31_c1 bca.usis_wr_2016_10_31_c1 We have had a cautious stance on U.S. high yield since August 2015, based on the view that corporate balance sheet health has deteriorated to the point where defaults would continue to rise on a cyclical basis. This week, we explore whether this remains the right strategy, and also whether junk bond spreads are still a relevant leading indicator for the equity market. Our answer to both questions is: Yes. In our view, the HY comeback can be explained by three main factors. First, the recovery in energy-related junk bonds has led the rally, as rising oil prices have helped diminish the default risks among U.S. shale issuers. Second, the 2015 spike in junk bond yields - mainly due to contagion from energy-sector bankruptcy fears - created tactical value in high-yield. Throughout most of 2016, we have seen an unwinding of these previously oversold positions. And third, the high-yield market benefits from an ongoing and intense search for yield in a world of unattractive higher-quality interest rates. Looking ahead, the first two forces are unlikely to play much of a role in the outcome for junk bonds. Oil prices are likely to trade in narrow range, allowing energy-related company fundamentals to stabilize. The rally in junk bonds over the past several months has removed any perceived value in this sector. Thus, it is only the search for yield/accommodative monetary policy that still supports a narrowing in spreads. Over time, we believe junk bond performance will once again be aligned with balance sheet fundamentals, i.e. high-yield spreads will gradually widen. A Review Of Our HY Indicators Our fixed income strategists have developed three key indicators to gauge major turning points in corporate spreads (Chart 2): Corporate Health Monitor (CHM): An aggregate indicator of non-financial corporate balance sheet health. The CHM deteriorated further in the second quarter, and has reached levels that historically tend to only be seen during recessions. Of the indicator's six components, most of the weakness has occurred in measures of corporate profitability (Chart 3). One caveat is that our measure of leverage in the CHM remains low, but this understates the risks because it measures total debt as a percent of market value of equity. Leverage looks decidedly worse if measured using net debt/book value. Chart 2Key Corporate Credit Indicators Key Corporate Credit Indicators Key Corporate Credit Indicators Chart 3Corporate Health Monitor Components Corporate Health Monitor Components Corporate Health Monitor Components C&I bank lending standards: A Fed survey that measures how easy/difficult it is for the corporate sector to access bank loans. According to this gauge, banks have already been tightening credit conditions for the past three quarters. Deviation in monetary conditions from equilibrium: We use our Monetary Conditions Index (MCI), which incorporates movements in both the dollar and interest rates. Due to a very accommodative Fed, monetary conditions remain very easy according to this measure. At present, two of these three indicators are sending negative signals for corporate spreads. Our corporate health monitor is decidedly bearish, as are lending standards. Indeed, focusing on corporate balance sheets and fundamental credit quality metrics would almost unanimously lead investors to recognize that the credit cycle is in its late stages and to expect spreads to move wider. After all, spreads have widened in every episode of deteriorating balance sheet health since the mid-1990s. Or to put it more simply, a default cycle - leading to spread widening - has occurred each time that year-on-year profit growth has gone negative since 1984 (Chart 4). Chart 4Profit Contraction Spells Trouble For Junk Bonds Profit Contraction Spells Trouble For Junk Bonds Profit Contraction Spells Trouble For Junk Bonds Our Bank Credit Analyst service came to the same conclusion earlier this year. In a Special Report, our colleagues analyzed financial ratios for 770 companies from across the industrial and quality spectrum. Their work uncovered that the corporate re-leveraging cycle is far more advanced than is widely believed and that key financial ratios and overall corporate health look only mildly better excluding the troubled energy and materials sectors. Of course, there is an important salve this cycle at work and it is captured in our third indicator - monetary policy. As shown in Chart 2, easy monetary conditions have never persisted for this long and low rates have driven a colossal search for yield, causing high-yield bonds to become ever more divorced from fundamentals. This divergence between corporate bond spreads and balance sheet fundamentals is likely to persist for as long as monetary conditions remain supportive. Adding it up, a poor fundamental backdrop for high-yield is being offset by easy monetary conditions. This combination argues for a cautious long-term bias toward lower-quality corporate credit because a prolonged shallow uptrend in corporate defaults (and spreads) is most likely. Nimble investors may look to tactically buy junk bonds when spreads overshoot our forecast of default losses, although such an opportunity is not present at the moment (Chart 5). The equity market is suffering from the same dynamic. Chart 5No Value Here No Value Here No Value Here Will Junk Bond Yields Still Warn Of Stock Bear Markets? Junk bond yields have long been one of our early warning indicators for equity bear markets. Since the 1980s, junk yields (shown inverted in Chart 6) have consistently broken out to new highs 3-6 months before stock bear markets take hold. This is because in a typical cycle, junk yields tend to respond more quickly to an erosion in corporate health fundamentals and/or a credit event. Chart 6Junk Bonds Provide Early Warning For Stocks Junk Bonds Provide Early Warning For Stocks Junk Bonds Provide Early Warning For Stocks Chart 7Typical Behavior Here bca.usis_wr_2016_10_31_c7 bca.usis_wr_2016_10_31_c7 But, as we note above, in the current cycle, the reaction to worsening corporate health fundamentals has been far more subdued than historical relationships would have predicted, due to the salve effect of easy monetary policy. If corporate bonds are in a "bubble", does it mean that the behavior of junk bond spreads will no longer be an early predictor of stocks returns? We believe corporate bonds will still be a useful timing tool for equities. If equities are experiencing the same divorcing from fundamentals, courtesy of central bank largesse, then it stands to reason that what pops the bond bubble will also burst the equity balloon. The search for yield has affected the behavior of investors, and therefore returns, in a fairly systematic way. Due to the current extended period of ultra-low interest rates and central bank asset purchases, government bond prices have been pushed sky high (yields have sunk to rock-bottom lows). As a shortage of government bonds has taken hold, investors have sought to invest in "Treasury-like" products, first seeking out the safest corporate bonds, but eventually reaching further out on the risk spectrum to include high-yield bonds and (dividend yielding) stocks. Indeed, asset prices of all stripes have been distorted by the search for yield, which has fueled a broad inflation in all asset classes. The behavior of stocks relative to corporate bonds is telling (Chart 7). Since 2010, and until very recently, stocks outperformed junk bonds on a total return basis. Junk bonds outperformed investment-grade bonds over roughly the same period (although junk underperformed investment-grade in most of 2015 due to the collapse in energy prices and related energy company defaults). This is exactly what has occurred during every recovery phase since the 1980s. Over the past forty years, investment-grade bonds tended to outperform junk bonds and equities during economic recessions. Junk bonds beat equities during the early phases of recovery (i.e. when economic growth turns positive) and for as long as companies continue to repair balance sheets. And equity returns trump both investment-grade and high-yield corporate bonds when our Corporate Health Monitor is deteriorating, i.e. in the latter half of the economic cycle, such as now. This suggests that the relative performance of equities versus corporate credit has not been distorted by monetary policy. One key takeaway is that, although very easy monetary conditions mean that corporate credit performance is becoming divorced from fundamentals, monetary policy has had a similar effect on equity prices (we have written at length in past reports about equity market performance diverging from profit indicators). As in past cycles, once the monetary cover fades, it is most likely that corporate credit markets will once again respond most quickly to balance sheet fundamentals. The bottom line is that we believe the high-yield debt market will remain a reliable indicator for equity market vulnerability. The current message is that a bear market in stocks will be averted, although as we have written in recent reports, earnings disappointments amid dollar strength represent a potential trigger for a near-term correction. Housing Outlook: Room To Expand Over the past quarter, residential real estate data has been slightly disappointing. September housing starts slipped to the bottom end of the range that has held this year and are only marginally above year-ago levels. House price inflation, as measured by the Case Shiller index, is negative on a 3-month basis. Despite this mild disappointment, we continue to believe the housing market is a relative bright light and will continue to be a significant positive contribution to GDP growth. Most indicators show that the housing market continues to recover along the typical path of the classic boom/bust real estate cycle (Chart 8). Chart 8Housing And Its History bca.usis_wr_2016_10_31_c8 bca.usis_wr_2016_10_31_c8 Chart 9First-Time Homebuyers Entering The Market First-Time Homebuyers Entering The Market First-Time Homebuyers Entering The Market Moreover, both supply and demand conditions are supportive of further construction activity and upward pressure on house prices over the next several quarters. On the demand side, household formation and a pick-up in interest from first-time buyers are the largest positives. Household formation: The number of households being formed is the most basic measure of marginal new demand for housing units. Household formation was suppressed during the Great Recession and early recovery years, because very poor job prospects and restricted access to credit sorely limited prospective new households from entering both the rental and ownership market. From 2007-2013, the annual household formation rate was 625,000, compared to over 1.1 million in the pre-crisis period.1 Now that the unemployment rate is at 5% and job security is improving, household formation rates are accelerating, particularly among young adults who have hitherto delayed moving out on their own. Monthly numbers are choppy, but household formation could easily run on average at 1.1 million per year for the next few years, simply to make up for muted rates post-housing crisis. First-time buyers: After years of putting off purchases, first-time buyers appear to be finally coming back to the housing market (Chart 9). According to the National Association of Realtors, the proportion of first-time homebuyers for existing home sales has reached its highest mark since July 2012 (34%). But there is still room for this share to improve, as prior to 2007, first-time homebuyers averaged about 40% of total purchases. Once again, persistent income gains and job security will be the driving factors behind first-time homebuyers' decisions. Could a Fed interest rate rise slow housing demand? We don't think so. Mortgage payments relative to income will remain well below their long-term average even if rates are increased by 200bps, an extreme case scenario. Even under this scenario, housing affordability would still be above average, conservatively assuming that income is held constant (Chart 10). Income and employment prospects will continue to trump mortgage rates for consumers making housing decisions; the current employment backdrop is positive for continued housing market activity. Chart 10December Rate Hike Won't Bother The Housing Market bca.usis_wr_2016_10_31_c10 bca.usis_wr_2016_10_31_c10 Chart 11Supply Is Tight bca.usis_wr_2016_10_31_c11 bca.usis_wr_2016_10_31_c11 From a supply perspective, conditions remain ripe for more robust construction activity. As Chart 11 shows, the supply of new homes remains low both in absolute, and in terms of months of supply. The bottom line is that we do not fear that a December rate hike will be particularly onerous for the residential real estate market. Plenty of pent-up demand for housing still exists, and this will provide long-term support, so long as the labor market remains robust, as we expect. The recent soft patch in housing will give way to stronger home building activity in the coming months, helping to boost real GDP growth in 2017. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 The State Of the Nation's Housing 2016, Joint Centre For Housing Studies of Harvard University http://jchs.harvard.edu/research/publications/state-nations-housing-2016

Recommended Allocation Monthly Portfolio Update Monthly Portfolio Update Central Banks Still In The Driving Seat Markets continue to obsess about every move from the three major DM central banks. With two of them (the Fed and the ECB) likely to withdraw accommodation cautiously over the coming 12 months, the upside for risk assets is limited. The Fed is signaling that it will probably hike in December and the futures market is pricing in a 70% probability of that happening (roughly the probability one month before the rate rise in December last year). Inflation expectations have picked up recently (Chart 1) and core PCE inflation ticked up to 1.7% in August, within "hailing distance", as Fed vice-chair Stanley Fischer put it, of the Fed's 2% target. There is a political angle, too: having forecast four rate rises for the year, the Fed would endanger its credibility (and risk an audit from Congress) if it failed to deliver even one. At the same time, with growth in the Eurozone running a little above trend, the ECB is likely to announce in December an extension to its asset purchase program beyond March 2017 but eventually at a slower pace (a "tapering"). Reflecting these factors, government bond yields have moved up in recent months (Chart 2), and the trade-weighted dollar has strengthened by 4% since mid-August. None of these moves are good for risk assets, which have consequently moved sideways since August. But neither do they presage a big selloff since central banks will err on the side of caution. Inflation in the U.S. is unlikely to jump: wage growth will be kept under control by a gradual rise in the participation rate, which will prevent unemployment falling much further (Chart 3). The Fed's leaders continue to sound dovish. Janet Yellen even raised the question in a recent speech of "whether it might be possible to reverse these adverse supply-side effects [from the 2007-9 Global Financial Crisis] by temporarily running a 'high-pressure economy'", though she emphasized this was a suggestion for further economic research not her view. More practically, the FOMC will have a more dovish tilt in 2017, as the three regional Fed presidents who voted for a hike in September rotate out. Chart 1Have Inflation Expectations Bottomed? bca.gaa_mu_2016_10_31_c1 bca.gaa_mu_2016_10_31_c1 Chart 2Bond Yields Moving Higher bca.gaa_mu_2016_10_31_c2 bca.gaa_mu_2016_10_31_c2 Chart 3Core Workers Reentering The Labor Force bca.gaa_mu_2016_10_31_c3 bca.gaa_mu_2016_10_31_c3 Meanwhile, economic data remain somewhat sluggish. The U.S. manufacturing and non-manufacturing ISMs both rebounded sharply in September, suggesting that the very weak August prints were, as we suggested, an anomaly. Q3 U.S. real GDP growth come in at 2.9%, but the New York Fed's NowCast points to a slowdown to 1.4% in Q4. The Citi Economic Surprise Index (Chart 4) has also turned down again recently, with notable weakness in consumer spending and housebuilding. We expect this sluggish pace to continue through 2017: consumption should hold up as wage rises come through, but it is hard to forecast a strong recovery in capex, given the low capacity utilization rate (Chart 5), even if investment in the mining and energy sectors bottoms out next year. Eurozone growth could stutter too. It is driven substantially by credit growth, but historically European banks have tended to curtail lending after their share prices have fallen, as has been the case recently (Chart 6). Chinese growth has stabilized (at least in the GDP data, which seems to come in regularly at 6.7%, bang in the middle of the government's target range), thanks to the government's reflation policy from earlier this year. While the Chinese authorities have now reined back a little on stimulus, given their worries about the run-up in house prices,1 they offer an option since they would undoubtedly reflate again should growth slow. Chart 4Data Surprising Negatively Again bca.gaa_mu_2016_10_31_c4 bca.gaa_mu_2016_10_31_c4 Chart 5Hard To See More CAPEX Indeed bca.gaa_mu_2016_10_31_c5 bca.gaa_mu_2016_10_31_c5 Chart 6Share Prices Influence Lending bca.gaa_mu_2016_10_31_c6 bca.gaa_mu_2016_10_31_c6 All this suggests that returns from investment assets will be low, but positive, over the coming 12 months. With economic growth anemic but stable, bond yields prone to drift up, and equities expensive (but not as expensive as bonds), we expect risk-adjusted returns from the major asset classes to be broadly similar. We continue to recommend therefore a neutral weighting between bonds and equities, and suggest that investors look to pick up extra return through tilts to investment-grade corporate credit, inflation-linked over nominal bonds, and alternative assets such as real estate and private equity. Equities: Our preference remains for U.S. equities over European ones in USD terms. The dollar is likely to strengthen further, and the worst is not over for Eurozone banks - the time to buy into them will be at the point of maximum pain, which may come if German or Italian banks have to be bailed out by their governments. We continue to recommend a small (currency-hedged) overweight on Japan. The Bank of Japan's new policy to cap 10-year government bond yields at 0% has worked so far: the yen has weakened to JPY 104 to the dollar and equities have risen moderately. We expect further fiscal or wage-control measures from the government to give inflation an extra push. We remain wary of EM equities: earnings growth is negative, loan growth has started to slow (with the credit impulse having a high correlation with earnings and economic growth), and there is still little sign of structural reform. Some sectors in EM - notably IT and Healthcare - are attractive, however. Fixed Income: U.S. Treasury bond yields are likely to rise further - our model suggests fair value is a little below 2% (Chart 7) - and so we remain underweight duration. A moderate pickup in inflation suggests that TIPs will outperform nominal bonds (as described in detail in our recent Special Report).2 We lowered our recommendation in high-yield corporate debt to neutral last month because, at 65 BPs, the default-adjusted spread no longer offers sufficient return to justify the risk. At the start of the year it was 400 BPs (Chart 8). We continue to like investment-grade debt, where the spread over government bonds is 120 BPs in the U.S. and 100 BPs in the Eurozone, higher than at any point in 2005-2006 during the last expansion. Chart 7Treasury Yields Could Rise Further bca.gaa_mu_2016_10_31_c7 bca.gaa_mu_2016_10_31_c7 Chart 8Junk No Longer Offers Enough Return Junk No Longer Offers Enough Return Junk No Longer Offers Enough Return Currencies: We expect the U.S. dollar to continue to appreciate given the differential in growth and monetary conditions between the U.S. and other developed economies. The dollar looks expensive, but is nowhere near the over-bought levels it got to at the peak of previous rallies in 1985 and 2002 (Chart 9). China seems likely to allow a further weakness of the RMB against the dollar, repegging it to a trade-weighted currency basket. This could push down other emerging market currencies too particularly if, like Brazil recently, they try to cut rates to boost growth. Chart 9USD Not As Overvalued As In The Past bca.gaa_mu_2016_10_31_c9 bca.gaa_mu_2016_10_31_c9 Commodities: Oil has probably overshot in the short-term on expectations that Saudi Arabia and Russia will cap, or even cut, production. We think this talk has been overhyped and that the OPEC meeting in November could prove a disappointment. Nonetheless, we still see the equilibrium level for crude over the next two years at USD 50 a barrel, the marginal cost for U.S. shale producers. Industrial commodities are likely to fall further (they peaked in June) if we are right that the dollar appreciates. We continue to like gold as an inflation hedge, but short-term are nervous because it, too, is negatively correlated with the dollar. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see China Investment Strategy "Housing Tightening: Now And 2010" dated October 13, 2016, available at cis.bcaresearch.com 2 Please see Global Asset Allocation Special Report "TIPS For Inflation-Linked Bonds," dated October 28, 2016, available at gaa.bcaresearch.com Recommended Asset Allocation Model Portfolio (USD Terms)

"That as the only possible policy in our day for a conqueror to pursue is to leave the wealth of a territory in the complete possession of the individuals inhabiting that territory, it is a logical fallacy and an optical illusion in Europe to regard a nation as increasing its wealth when it increases its territory, because when a province or state is annexed, the population, who are the real and only owners of the wealth therein, are also annexed, and the conqueror gets nothing." 1 Norman Angell's "The Great Illusion" posited in the early 1910s that war would be futile for developed nations, especially given the rising importance of economic and financial ties. Nevertheless, the arms race from the late-1800s gained momentum and eventually led to the Great War, dealing a devastating blow to his arguments. The European armament dynamics of the late-19th century/early 20th century are eerily reminiscent of the current post-Great Recession global arms race. Back then Germany, Austria-Hungary and Italy on one side, and Britain, France and Russia on the other, were fiercely trying to outpace each other in military expenditures. The crumbling Ottoman Empire along with the newly created smaller states in Greece, Serbia, Bulgaria and Romania were also eager weapons purchasers. Today, a fresh military expenditure-related development pops up almost daily. Not only are the U.S. and China boosting military spending, but also Japan, Australia, India, Vietnam, Saudi Arabia, Turkey, Russia, etc (Chart 1).2 The list goes on and on. The driving factor is "multipolarity," i.e. the emergence of multiple competing great powers, which BCA's Geopolitical Strategy service has shown to be a key investment theme.3 Chart 1U.S. Defense Spending Is More Than The Rest Of The World Combined Brothers In Arms Brothers In Arms While we are not arguing that WWIII will erupt in the coming years, the purpose of this Special Report is to identify the winning global equity sectors from the intensifying global arms race (Chart 2): global defense stocks come atop of our list, but also global space-related equities and cyber security firms would be beneficiaries of the secular increase in military outlays. On a regional basis, the U.S. defense stocks are the only game in town, but undiscovered Chinese, and to a lesser extent Russian, defense stocks are intriguing as are Israeli defense and tech stocks (please refer to the Appendix below for ticker symbols). Chart 2Intensifying Global Arms Race bca.gtss_sr_2016_10_28_c2 bca.gtss_sr_2016_10_28_c2 Late 19th/Early 20th Century: Militarism, Globalization & Finance Back in the late-1800s, the ascendancy of Germany was challenging the hegemony of Britain, fueling a European-wide arms race. Smaller newly formed states were also on the hunt for the latest and greatest weaponry. During the Balkan Wars of 1912-13 airplanes were deployed in combat for the very first time, highlighting the importance of new technology. Behind this explosive European rearmament were a few large British companies (Vickers Sons & Maxim Ltd, Armstrong and Whitworth, and Coventry Ordnance Works). "By 1905, its capital of £7.4 million ranked Vickers sixth amongst British companies; Armstrong Whitworth, with 5.3 million pounds capital was eleventh".4 Basil Zaharoff, who acted as general representative for business abroad for Vickers,5 was reputedly one of the richest men in the world.6 Moreover, globalization was on the rise in the late 19th century, as evidenced by global imports as a percentage of GDP (Chart 3). Industrialization coupled with imperialism and the colonization of Asia and sub-Saharan Africa along with population growth and rising demand for commodities were key drivers behind the jump in 19th century globalization. Finally, all of this was made possible by cross-boarder finance. Trade finance and credit growth skyrocketed in the late-1800s and the rising interconnectedness of global financial centers was most evident in the 1907 stock market panic that originated in the U.S., but spread like wildfire to the rest of the world. Chart 3Twin Peaks Of Globalization? Twin Peaks Of Globalization? Twin Peaks Of Globalization? Chart 4Heeding The Early 1960s Parallel bca.gtss_sr_2016_10_28_c4 bca.gtss_sr_2016_10_28_c4 What About The 1960s? The idea of militarily outspending opponents was very evident in the early-1960s when U.S. defense spending surged by 20% on a year-over-year basis (Chart 4), bolstering demand once again for military contractors. The mutually assured destruction (MAD) doctrine of military strategy and national security policy declared overtly in the early-1960s by U.S. defense secretary Robert McNamara and the Space Race competition between the Cold War rivals also have striking similarities with today, as far as investment implications are concerned. Parallels With Today China's ascendency to a world power large enough to challenge the hegemony of the U.S. is a sea change.7 The rearmament of East Asia is reminiscent of late 19th and early 20th century Europe and involves Japan, Australia, South Korea, Vietnam and India. All of the Middle East, along with Turkey and Russia, are on a structural military spending spree. European NATO fringe states are also arming furiously (Chart 5), trying to thwart Russia's regional ambitions. In the U.S., despite the Budget Control Act of 2011 (sequestration), the CBO projects that defense spending will rise gradually from $586 billion in 2015 to $739 billion by 2026 (Chart 6). This is before any push for a fiscal spending thrust that both presidential candidates have proposed, which would include increased defense outlays. While as a percentage of GDP defense spending may drift sideways, in absolute terms it will likely rise, and thus boost demand for defense contractors. Chart 5Stealthy Rise In Defense Outlays bca.gtss_sr_2016_10_28_c5 bca.gtss_sr_2016_10_28_c5 Chart 6CBO Estimates New Defense Spending Highs bca.gtss_sr_2016_10_28_c6 bca.gtss_sr_2016_10_28_c6 Globalization has hit an apex recently (Chart 3).8 The world is still licking its wounds from the recent GFC, where U.S. financials stocks were so intertwined with their global peers that the crisis effectively brought down to its knees the global financial system and gave birth to unorthodox monetary policy that Central Banks are still currently deploying. Global Rearmament Beneficiaries If our hypothesis that a global arms race will continue to heat up in coming years pans out, then owning global defense stocks as a structural bet will pay handsome dividends. The global push away from austerity and toward more fiscal spending should also support aggregate defense demand. Thus, there are high odds that global defense stocks are primed to deliver absolute positive returns, irrespective of where the broad global equity market drifts in the next five years. Similar to Vickers and Armstrong and Whitworth making impressive stock market strides early last century, global defense stocks should continue to be high flyers. The early-1960s U.S. aerospace & defense (A&D) stocks are the only close stock market parallel we have come across in our analysis (given data constraints) and comparing this index's available metrics of that era with today is in order. A big pushback to the U.S. Equity Strategy service's constructive view on the U.S. defense index (since the late-2015 inception) has been that the valuations of these stocks are already full, leaving no valuation cushion for any mishaps (Chart 7). True, defense stocks are on the expensive side, but not if they manage to grow into their valuations, as we expect. Relative performance was up over 100% in a span of four years in the 1960s (Chart 8), as U.S. aerospace & defense industrial production (IP) swelled to a 20% per annum clip with utilization rates running at 95% (Chart 8). A&D factories were humming, racing to fulfill orders as U.S. military expenditures were thriving (Chart 4). Chart 7Buy Global Defense Stocks Buy Global Defense Stocks Buy Global Defense Stocks Chart 8In The 1960s A&D Factories Were Humming... bca.gtss_sr_2016_10_28_c8 bca.gtss_sr_2016_10_28_c8 This demand surge translated into a jump in sector sales momentum (Chart 4), and given the industry's high operating leverage, earnings and book values soared. From trough to peak, sector EPS rose more than 400%, margins expanded from sub 2% to nearly 8%, and book value doubled (Chart 9). That stellar performance justified initial valuation premiums at the time. Using that period as a guide would imply that there is ample upside left for relative performance of the global defense index (that is a pure play on global defense spending). For comparison consistency, we use U.S. A&D figures. Currently, U.S. A&D IP is contracting, with resource utilization running at 80%. U.S. A&D relative performance has risen a mere 30% since the Great Recession (Chart 10). Chart 9...Boosting The Allure Of ##br## A&D Stocks bca.gtss_sr_2016_10_28_c9 bca.gtss_sr_2016_10_28_c9 Chart 10If History At Least Rhymes, ##br## There Is Still Ample Upside... bca.gtss_sr_2016_10_28_c10 bca.gtss_sr_2016_10_28_c10 Likely, the advance is still in the early innings, and analysts have been very slow to upgrade their EPS estimates accentuating the apparent overvaluation. Importantly, 5-year forward relative EPS growth estimates are deep in negative territory which is very perplexing given the upward trajectory of industry demand (Chart 11). Given that we only have access to data for MSCI All-Country World aerospace & defense long-term EPS expectations the caveat is that some of the poor expectations and performance could be because of the waning aerospace delivery cycle. Unlike the deteriorating health of the broad corporate sector, profit margins are expanding and net debt-to-EBITDA is a comfortable 1.2x. Similarly, interest coverage ratio is near an all-time high of 8x (Chart 12), while the overall markets EBIT/interest expense ratio is half that. Chart 11...Especially ##br## Given Depressed Analysts' Expectations ...Especially Given Depressed Analysts' Expectations ...Especially Given Depressed Analysts' Expectations Chart 12Defense ##br## Wins Championships Defense Wins Championships Defense Wins Championships Global defense sector return on equity (ROE) is almost 30% and rising (Chart 13), whereas global non-financial corporate (NFC) ROE is hitting multi-year lows, with the U.S. NFC ROE plumbing all-time lows (Chart 14). Free cash flow is also growing briskly and the industry is making greenfield investments, with capex growing 9.5% year-over-year, the mirror image of the global NFC sector that is pruning capital outlays (middle and bottom panels, Chart 13). Chart 13Defense Flexing ##br## Its Muscles... Defense Flexing Its Muscles... Defense Flexing Its Muscles... Chart 14...Vs. The Atrophy In The U.S. ##br## Non-Financial Corporate Sector bca.gtss_sr_2016_10_28_c14 bca.gtss_sr_2016_10_28_c14 On the valuation front, modest overvaluation exists, as portrayed by the high relative price-to-cash flow and price-to-book multiples. However, the global defense stocks forward P/E ratio and EV/EBITDA multiple are on an even keel with the broad market (Chart 15), and if our thesis that a secular uptrend in defense-related demand looms proves accurate, then these stocks are not expensive, but on the contrary still represent a buying opportunity. Chart 15Mixed Signals On The Relative Valuation Front Mixed Signals On The Relative Valuation Front Mixed Signals On The Relative Valuation Front Chart 16Defense Is The Best Offense bca.gtss_sr_2016_10_28_c16 bca.gtss_sr_2016_10_28_c16 The Rise In Terrorism, Global Space Race And Cyber Security Threat The unfortunate structural increase in terrorist activity will also embolden governments around the world to step up defense spending (top panel, Chart 16).9 The latter tends to move in long cycles. U.S. defense industry revenues have already begun to outpace those of the overall S&P 50010, and a prolonged upturn lies ahead, based on the message from the previous upcycle. From a cyclical perspective, the defense capital goods shipments-to-inventories ratio is outpacing the overall manufacturing sector (second panel. Chart 16), reinforcing the case for ongoing earnings outperformance. The same also holds true in Europe. Western European terrorist attacks have increased, heralding further relative gains for the euro area aerospace & defense index (bottom panel, Chart 16). Beyond the disastrous spike in terrorism, the global space race is also gaining traction, with China spearheading the charge. There is a good chance that China will attain geosynchronous orbit satellites (residing more than 20,000 miles above the earth), challenging U.S. space dominance. India's space aspirations are grand and it is slowly and stealthily rising up the ranks on the space race. Moreover, as more countries aim to have manned space missions, that translates into higher space budgets and thus firming demand for space-related expenditures (Chart 17). Chart 17Space, The Final Frontier Brothers In Arms Brothers In Arms Finally, the number of cyber-attacks is also on the rise globally. Defending against attacks is a challenge. Not only does the cyber space domain definition remain elusive, but tracking hackers down is also increasingly difficult given the vastest of the internet, lack of global uniform policing methods and physical country borders. Crudely put, it is a lot easier for a Chinese or Russian hacker to deal a blow, for example, to U.S. nuclear infrastructure rather than physically deliver an attack. All of this suggests that investment in anti-hacking and counter cyber-attack capabilities is necessary around the globe in order to thwart cyber-terrorism. Risks To Our View While there is conceivably a risk that China will abruptly halt its intense militarization and make a U turn in its long-term strategy of becoming a military superpower, we assign a very low probability to such a turn of events. The global push for more fiscal spending may not materialize, which would be a risk to our sanguine global defense spending view. As Paul Volcker and Peter Peterson recently opined in a NY Times article11 - offering a different view from the always-articulate Larry Summers - prudent and fiscally responsible spending is in order given the excessive debt-to-GDP ratio that is probing war-like levels (Chart 18). This excessive debt overhang is not only a U.S. phenomenon, but also a global one spanning both advanced and emerging economies. Chart 18Excessive Debt Is A Risk To Bullish View On Global Defense Stocks Excessive Debt Is A Risk To Bullish View On Global Defense Stocks Excessive Debt Is A Risk To Bullish View On Global Defense Stocks One final risk is that the world will enter a prolonged peace phase and global terrorism will get quashed, with conflicts dying down in the Middle East, Russia reining in its imperialistic ambitions and China ceasing to stir the waters in the South and East China Seas. We would also assign low odds to this optimistic "no conflict phase" scenario, but it would indeed be welcome. Investment Conclusion Factors are falling into place for a structural outperformance period in the global defense index. The early-1900s and early-1960s parallels, coupled with the trifecta of terrorism, space race and cyber security all point to upbeat demand for defense-related goods and services. Expressing this buoyant view can be done from a bottom up perspective. The Appendix below highlights all the companies in the global defense index we track from Datastream and the alternative one from Bloomberg. An investable proxy is the U.S. aerospace & defense index as the U.S. dominates global A&D indexes and aerospace outfits also sport significant defense corporate segments (please see the Appendix below for relevant tickers). There are also three fairly liquid ETFs mimicking the U.S. A&D index: ITA:US, PPA:US & XAR:US. Moreover, below are a few more speculative investment ideas. Given China's dominance of global defense spending (ex-U.S.) we are confident that Chinese A&D stocks will also be eagerly sought after and deliver alpha in the coming years (please refer to the Appendix below for a list of China plays). If one has the resilience and the stomach to invest in Russian equities given high political and currency risk, then Russian A&D stocks may be a desirable vehicle. Russia remains a massive weapons exporter with a large sphere of influence. We would not underestimate the returns in local currency of some Russian A&D stocks (the Appendix below lists some Russian A&D listed firms). Finally, Israel A&D and IT companies either listed on NASDAQ or domestically in Tel Aviv offer some great opportunities for investors that can handle riskier investments. Not only Israel's geography, but also its intense IT/military focus and entrepreneurial culture imply that a number of these companies will be long-term winners (please see the Appendix below for relevant tickers). While most of the drones, space-related, and highly specialized IT companies are private, there is a drone and an anti-hacking ETF (IFLY:US & HACK:US). On the space front, we are tracking an index that comprises a number of space-related constituents that we show in the Appendix below. Nevertheless, most of these companies are categorized under A&D. Bottom Line: We are initiating a structural overweight in the global defense index with a longer-than-usual five year secular investment horizon. The re-rating phase in this index is still in the early innings. The re-rating phase in this index is still in the early innings. We also reiterate our overweight in the BCA U.S. defense index (LMT, GD, RTN, NOC, LLL). Anastasios Avgeriou, Vice President Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Angell, Norman (1911), The Great Illusion: A Study of the Relation of Military Power in Nations to their Economic and Social Advantage, (3 ed.), New York and London: G.P. Putnam’s & Sons. 2 Please see BCA Geopolitical Strategy Monthly Report, “The Great Risk Rotation,” dated December 11, 2013, available at gps.bcaresearch.com 3 Please see BCA Geopolitical Strategy Monthly Report, “Multipolarity And Investing,” dated April 9, 2014, available at gps.bcaresearch.com 4 Angell, Warren, Kenneth (1989), Armstrongs of Elswick: Growth In Engineering And Armaments To The Merger with Vickers, London, The Macmillan Press Ltd. 5 http://www.oxforddnb.com/index/38/101038270/ 6 https://www.britannica.com/biography/Basil-Zaharoff 7 Please see BCA Geopolitical Strategy Special Report, “Sino-American Conflict: More Likely Than You Think, Part II,” dated November 6, 2015, available at gps.bcaresearch.com 8 Please see BCA Geopolitical Strategy, “The Apex Of Globalization - All Downhill From Here,” in Monthly Report, “Winter Is Coming,” dated November 12, 2014, available at gps.bcaresearch.com 9 Please see BCA Geopolitical Strategy Special Report, “A Bull Market For Terror,” dated August 5, 2016, available at gps.bcaresearch.com 10 Please see U.S. Equity Strategy Weekly Report, “Wobbling,” dated December 7, 2015, available at uses.bcaresearch.com 11 http://www.nytimes.com/2016/10/22/opinion/ignoring-the-debt-problem.html?_r=0 Appendix Table A1BI Global Defense Primes Competitive Peers Brothers In Arms Brothers In Arms Table A2World Defense Index (DS: DEFENWD) Brothers In Arms Brothers In Arms Table A3S&P 500 Aerospace & Defense Index ##br## (S5AERO Index) Brothers In Arms Brothers In Arms Table A4China ##br## Aerospace & Defense Brothers In Arms Brothers In Arms Table A5Russia & Israel Aerospace & Defense Brothers In Arms Brothers In Arms Table A6Kensho Space Index Brothers In Arms Brothers In Arms

Highlights With inflation probably having bottomed, especially in the U.S., investors are starting to worry about inflation tail-risk and wonder whether inflation-linked bonds (ILBs) are an efficient way to hedge this risk. This Special Report explains how ILBs work in different countries and analyzes their performance characteristics over time. We find that ILBs, a rapid growing asset class, can be a beneficial addition to a balanced global portfolio even though recent history does not show as strong portfolio diversification benefits as a longer history. The lower nominal duration of ILBs is a useful feature for portfolio duration management. ILBs have proven to be a good inflation hedge in a rising inflationary environment, but they underperform nominal bonds in a disinflationary environment. As such, the balance between ILBs and nominal bonds should be managed tactically based on an investor's views on inflation dynamics and valuation. Overweight U.S. TIPS; avoid U.K. linkers. Australian TIBS are a cheap yield enhancer, but higher yielding Mexican Udibonos are a dangerous yield trap. Feature BCA's view is that the 35-year bull market in bonds is ending and that the path of least resistance for bond yields globally is up.1 Even though the level of inflation in the U.S. is still below the Fed's target of 2%, we think it's clear that U.S. inflation has bottomed for this cycle. Globally, loose monetary policy together with the likelihood of more fiscal stimulus, present the risk of higher inflation down the road. Global Asset Allocation has recommended investors to overweight U.S. TIPS (Treasury Inflation Protected Securities) relative to nominal U.S. government bonds throughout 2016. Many clients have asked for details on how TIPS work, whether there are similar securities in other countries, and how ILBs fit into a balanced global portfolio. In this Special Report, we take a detailed look at inflation-linked bond markets globally and recommend some strategies for asset allocators to use them to help navigate a world of low returns and possibly higher inflation. 1. What Are Inflation-Linked bonds (ILBs)? Inflation Protection: Inflation-linked bonds are designed to hedge inflation risk by indexing the bonds' principal to the official inflation index in the issuer country. While the methodology and what the bonds are called differ from country to country, the underlying concept is the same: the holders of ILBs will get the stated real return even in an inflationary environment since both the nominal face value and the nominal coupon payments change based on an official inflation measure. Deflation Floor: In the case of sustained deflation such that the final nominal face value falls below the initial face value, however, the repayment of principal at maturity is guaranteed in the majority of the countries, but not, for example, in the U.K., Canada, Brazil, or Mexico (Table 1). Table 1Basic Information Of Global ILB Markets TIPS For Inflation-Linked Bonds TIPS For Inflation-Linked Bonds Inflation Measure: ILBs are linked to actual inflation with a time lag. As shown in Table 1, the inflation measure used varies slightly by country: in the U.S. it's the non-seasonally adjusted CPI; in the U.K. it's the retail price index (RPI); while in the euro area, France and Italy both have ILBs linked to local CPI ex tobacco and EU HICP ex tobacco, with the former primarily for domestic retail investors. The time lag is three months in most countries, but can vary from one to eight months as shown in Table 1. A Rapidly Growing Asset Class: The earliest recorded ILBs were issued by the Commonwealth of Massachusetts in 17802 during the Revolutionary War. Finland introduced indexed bonds in 1945, Israel and Iceland in 1955. Brazil introduced its indexed bonds in 1964 and has become the largest ILB market in the emerging markets and the third largest globally. When the U.K. issued its first "linkers", it originally used eight months of inflation lag to make sure the next coupon payment is known at the current coupon payment date. In 1991 Canada issued its first ILBs and the "Canadian Model", which uses a three-month lag to the inflation index and calculates a daily index ratio using linear extrapolation, has been adopted widely since; even the U.K. adopted it in 2005. The largest ILB market now is the U.S. TIPS with a market cap of USD 1.2 trillion. TIPS were first issued in 1997, using the Canadian model. Chart 1 shows the evolution of the ILB markets globally. Since the Bloomberg Barclays Universal Government Inflation-linked Bond Index was constructed in July 1997, the market cap has increased to over USD 3.2 trillion from a mere USD 145 million at the end of 1997. It's worth noting that the actual amount of ILBs outstanding globally is slightly larger than this because not all debts are included in the index.3 Even though many countries have issued ILBs, and emerging markets (EM) grew very fast in the 2000s, the global market is still dominated by the top three countries (the U.S., U.K., and Brazil) with a combined share of 70% of global market cap. Chart 1ILBs: A Fast Growing Asset Class bca.gaa_sr_2016_10_28_c1 bca.gaa_sr_2016_10_28_c1 Chart 2U.S. BEI Vs. Inflation Expectations bca.gaa_sr_2016_10_28_c2 bca.gaa_sr_2016_10_28_c2 Country Differentiation: Nominal government bonds come with different features in different countries, and the same is true with ILBs. Table 2 shows that even though the U.S. accounts for 43.6% of the developed markets (DM) index in terms of market cap, it contributes only 28.8% to overall duration while the U.K. accounts for 53% of the overall duration, because the U.K. linkers have much longer duration than the U.S. TIPS. The Canadian real return bonds (RRBs) have the second longest average duration at 16 years. Table 2Key Features of the Bloomberg Barclays Government ILB Indexes* TIPS For Inflation-Linked Bonds TIPS For Inflation-Linked Bonds 2. How Do ILBs Compare To Nominal Bonds? Break-Even Inflation (BEI) And Inflation Expectations: The difference between the yield on a nominal bond and the yield on a comparable ILB (a comparator) is defined as the BEI, the market-based inflation rate at which an investor is indifferent between holding a real or a nominal bond. If realized inflation over an ILB's life turns out to be higher than the BEI at purchase, then holding the ILB is better than holding its nominal counterpart. BEI on its own is not an accurate gauge of inflation expectations, because it is the sum of inflation expectations, the inflation risk premium, and the liquidity premium. One of the long-term inflation expectation measures that the U.S. Fed keeps track of is the five-year forward five-year inflation calculated using the Fed's own fitted yield curves.4 Even this measure, however, contains the inflation term premium and the relative supply/demand of 10-year BEI vs 5-year BEI. Three important observations from Chart 2 for investors to pay attention to when assessing the inflation outlook are: U.S. breakeven inflation rates have been consistently below the Fed's inflation target of 2% since 2014 (panel 4); The CPI swaps markets priced in a much higher inflation rate than the TIPS market and the Fed's measure derived from fitted curves (panels 2 & 3), largely caused by the supply and demand imbalance in the inflation swaps market: there is excess demand to receive inflation, but no natural regular payer of inflation other than the U.S. Treasury via TIPS, therefore a higher fixed rate has to be paid to receive inflation; The 10-year inflation expectation from the Cleveland Fed's model5 (panel 1), exhibits very different behavior from the other measures. It has been below the 2% target since 2011. This model attempts to combine survey-based inflation expectations and that derived from the CPI swaps market. It's intended to be a "superior" measure of inflation expectations from a monetary policy perspective.6 For investors, however, it's advisable to take into account all these measures when assessing inflation dynamics. Duration and Yield Beta: Duration is measured as the bond price change in relation to the yield change. Chart 3 shows that ILBs have higher duration than their nominal counterparts. These two durations, however, are not directly comparable because ILB duration is related to "real yield" while nominal bond duration is related to "nominal yield". The conversion from one to another is not straightforward because the relationship between real and nominal yields can be complex.7 In practice, however, we can run a simple regression to get ILB's yield beta to change in nominal yield.8 Some practitioners simply assume 0.5 in the emerging market.9 Our research shows that in the developed market the relationship between real yield and nominal yield can vary over different time periods and in different countries, but the moving 3-year and 5-year yield betas are always less than 1 and mostly above 0.5, which is the full sample average.(Chart 4). This is a useful feature for duration management and curve positioning. For example, everything else being equal, 1) replacing nominal government bonds with comparable ILBs can reduce portfolio duration, and 2) replacing a short-dated nominal bond with a longer-dated ILB could maintain the same duration. Chart 3Average Government Bond Duration Average Government Bond Duration Average Government Bond Duration Chart 4ILBs' Yield Beta TIPS For Inflation-Linked Bonds TIPS For Inflation-Linked Bonds Total Return: By design, ILBs should do well in an inflationary environment and they should outperform their nominal bonds when realized inflation is higher than the break-even inflation rate. How have ILBs performed in the real world? Unfortunately, we do not have a long enough data history to cover different inflation cycles. Chart 5 confirms that in nominal terms ILBs outperform their nominal counterparts when inflation rate trends higher. What's interesting, however, is that it is disinflation, rather than deflation, that hurts ILBs the most. Within the available data history, only 2009 experienced a brief deflation scare globally, yet the rebound in ILBs actually led economies out of the deflationary environment. Over the long run, U.K. linkers have underperformed nominal gilts since their first issuance in 1981 when inflation was running at 12%. Since 1997 when the Bloomberg/Barclays ILB indexes were constructed, however, ILBs have performed slightly better than their nominal comparable bonds in most countries, with the exception of the euro area where ILBs have fared slightly worse (Chart 5). Risk-Adjusted Return: On a risk-adjusted basis, the available data history shows that ILBs performed slightly better in the U.S. and Australia, and also the DM aggregate on a hedged basis, but slightly worse in the euro area, the U.K. and Canada. It's worth emphasizing, however, that in either case the difference is not significant (Table 3). Chart 5ILB Performance Vs Inflation ILB Performance Vs Inflation ILB Performance Vs Inflation Table 3ILBs Approximately Equal To Nominal Bonds TIPS For Inflation-Linked Bonds TIPS For Inflation-Linked Bonds 3. What's The Role Of ILBs In A Balanced Portfolio? Bridgewater Associate showed that adding ILBs to a balanced euro zone stock/bond portfolio significantly improved the efficient frontier over the very long run, from 1926 to 2010.10 Since there were no ILBs in the early part of that history, ILB returns were calculated based on inflation. Our research, based on data from the Bloomberg/Barclays Inflation-Linked Government Bond Index with a much shorter history, however, does not yield the same results, probably because the much shorter recent history does not include any highly inflationary periods from which ILBs benefit the most. Table 4 shows the statistics of replacing a certain portion of the nominal bonds with comparable ILBs in a DM 60/40 stocks/bonds portfolio. On a standalone basis, the hedged USD DM ILBs are less volatile and have the best risk-adjusted return of 1.3 in the sample period (Portfolio 8). When combined with equities, however, the nominal bonds are a slightly better diversifier than the ILBs. Why? The answer lies in the correlation. Chart 6 shows that the ILBs have much higher correlation with equities than the nominal bonds do with equities. This makes sense because equities could rise in an inflationary environment if the higher inflation were driven by stronger growth, while inflation is always bad for nominal bonds. Again, the differences in risk-adjusted returns are not significant, varying from 0.77 to 0.7 (Portfolios 2-6) in line with the findings in Section 2. Table 4Balanced Global Portfolio Statistics* TIPS For Inflation-Linked Bonds TIPS For Inflation-Linked Bonds Chart 6Global Stocks-Bonds Correlations bca.gaa_sr_2016_10_28_c6 bca.gaa_sr_2016_10_28_c6 4. Inflation Has Bottomed BCA's Fixed Income Strategy team has written extensively about the outlook for U.S. and global inflation.11 We concur with their view that, even though inflation in most DM countries is still below the targets set by their central banks (Chart 7), in most countries it has probably bottomed (top three panels in Chart 7), and especially in the U.S., where all indicators point to rising wage pressures as labor market slack diminishes (Chart 8). Chart 7Inflation Still Below Target Inflation Still Below Target Inflation Still Below Target Chart 8Accelerating Wage Pressure bca.gaa_sr_2016_10_28_c8 bca.gaa_sr_2016_10_28_c8 5. Investment Implications Overweight U.S. TIPS Over Nominal Treasuries: We have shown that ILBs outperform comparable nominal bonds in a rising inflation environment and have argued that inflation has bottomed in the U.S. These views support our recommendation to overweight U.S. TIPS relative to nominal U.S. Treasuries. In addition, our TIPS valuation models (Chart 9) show that breakeven inflation rates in the U.S. are still below fair values based on underlying economic and financial drivers. Being the largest ILB market with a market cap of over USD 1.2 trillion, TIPS are very easy to trade. Currently, only five-year TIPS have a negative yield, so there are plenty of opportunities for investors to preserve real purchasing power by holding longer maturity TIPS. Avoid U.K. Linkers: The U.K. linkers market is the second largest after the U.S., with a market cap of about USD 810 billion. Unfortunately, these linkers are among the most expensively priced real return bonds, with negative yields at all maturities (Chart 10, panel 3). For example, 10-year linkers are currently yielding -1.98%, which means that investors are guaranteed to lose 18% of real purchasing power in 10 years by holding the bonds to maturity. Granted, the U.K. linkers have always traded at a premium to U.S. TIPS and many other ILB markets due to the nature of the U.K. pension schemes which link pension liabilities to inflation (CPI or RPI). With insatiable appetite from pension funds, demand greatly exceeds what the linkers and inflation swaps markets can supply. U.K. real yields have been driven lower and lower, causing an increasing funding gap which in turns drives yield further down.12 In addition, our fair value model (Chart 10, panels 1 and 2) shows that the U.K. linkers' current breakeven rates are above fair value. The collapse in the linkers' yields after the Brexit vote is also consistent with a skyrocketing in the CPI swaps rate, indicating that the probable rise in inflation due to the collapse of the GBP has now largely been priced in (panel 4). Investors who are not constrained by U.K. pension regulations should avoid U.K. linkers. Chart 9Overweight U.S. TIPS bca.gaa_sr_2016_10_28_c9 bca.gaa_sr_2016_10_28_c9 Chart 10Avoid U.K. Linkers bca.gaa_sr_2016_10_28_c10 bca.gaa_sr_2016_10_28_c10 Yield Enhancement From Australia, Not From Mexico: The U.S. TIPS market is liquid but yields are low, albeit higher than U.K. linkers. Among the smaller markets with higher yields, we prefer Australian Treasury Indexed Bonds (TIBS) over Mexican Udibonos, even though the 10-year Udibonos have a higher yield of 2.8% compared to the 10-year TIBS yield of 0.62%. As shown in Chart 11 and Chart 12, the Australian TIBS are very cheap while the Mexican Udibonos are very expensive. The BEI in Mexico is above the central bank's target of 3% while in Australia it's still at the lower end of the target range of 2-3%. Chart 11 Australian TIBS: A Cheap Yield Enhancer bca.gaa_sr_2016_10_28_c11 bca.gaa_sr_2016_10_28_c11 Chart 12 Mexico ILBS: Too Expensive Mexico ILBS: Too Expensive Mexico ILBS: Too Expensive 6. ETFs Some of our clients always want to know if there are ETFs for the asset classes we cover. For ILBs, the most liquid ETF is the iShares TIPS Bond ETF with an AUM of USD 19 billion and an expense ratio (ER) of 20 bps. For non-U.S. global ILBs, the SPDR Citi International Government Inflation-Protected Bond ETF has an AUM of USD 620 million and an expense ratio of 50bps. The Appendix on page 14 gives a sample list of the exchange traded ILB funds. For more information about ETFs, please see BCA's newly launched Global ETF Strategy service. AppendixSample List Of ILB ETFs*** TIPS For Inflation-Linked Bonds TIPS For Inflation-Linked Bonds Xiaoli Tang Associate Vice President xiaolit@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "The End of the 35-year Bond Bull Market," July 5, 2016, available at gis.bcaresearch.com. 2 Robert Shiller, "The Invention of Inflation-Linked Bonds in Early America," NBER Working Paper 10183, December 2003. 3 Barclays Index Methodology, July 17, 2014. 4 Refet S. Gurkaynak et al., "The TIPS Yield Curve and Inflation Compensation," May 2008, Federal Reserve publication. 5 Joseph G Haubrich et al., "Inflation Expectations, Real Rates, and Risk Premia: Evidence from Inflation Swaps," Working Paper 11-07, March 2011, Federal Reserve Bank Of Cleveland. 6 Joseph G. Haubrich And Timothy Bianco, "Inflation: Nose, Risk, and Expectations," Economic Commentary, June 28, 2010, Federal Reserve Bank Of Cleveland. 7 Francis E. Laatsch and Daniel P. Klein, "The nominal duration of TIPS bonds," Review of Financial Economics 14 (2005). 8 Mattheu Gocci, "Understanding the TIPS Beta," University of Pennsylvania, 2013. 9 Thor Schultz Christensena and Eva Kobeja, "Inflation-Linked Bond from emerging markets provide attractive yield opportunities," Danske Capital, May 2015. 10 Werner Kramer, "Introduction to Inflation-Linked Bonds," Lazard Asset Management, 2012.