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Dear Client, This week, I am currently on the road visiting clients across Europe. We are sending you an abbreviated weekly report as well as a Special Report from our Geopolitical Strategy team entitled “U.S. Election: Final Forecast & Implications”. Not only does this report encompass a detailed analysis of the upcoming U.S. presidential election and its implications for the future of U.S. politics, it also introduces GPS’s poll-plus model, a model which currently forecasts a Clinton victory. I trust you will find this piece very informative. Best regards, Mathieu Savary, Vice President Foreign Exchange Strategy Highlights The U.S. dollar is consolidating its recent gains, but it offers more upside in the months ahead A Trump victory would supercharge any dollar strength, but is likely to hurt the dollar in the long-term. In Japan, no more fiscal drag and a tightening in the labor market will ultimately result in a lower yen, courtesy of higher inflation expectations and falling real rates. The Australian labor market points to weaknesses in the domestic economy. Any EM turmoil could launch an AUD bear phase. Feature The U.S. dollar continues to consolidate its recent gains. While the dollar is expensive, it still offers upside potential. Monetary divergences remain in favor of the U.S. economy. U.S. labor market slack is disappearing and the rising share of salaries and wages in the national income pie is likely to further support consumption. Shifting the distribution of economic gains toward workers signifies that the middle class is gaining ground relative to households at the summit of the income ladder. This process should help consumption because the middle class has a much higher marginal propensity to consume than the top 1% (Chart I-1). If consumption growth remains healthy, job creation is likely to fan additional wage pressures, creating a virtuous circle for U.S. households and consumption. This virtuous cycle is likely to help the Fed increase rates over the next two years, providing a source of support for the dollar (Chart I-2). Chart I-1Shifting Income To The Middle Class Will Support Consumption bca.fes_wr_2016_10_28_s1_c1 bca.fes_wr_2016_10_28_s1_c1 Chart I-2A Virtuous Cycle For The Dollar A Virtuous Cycle For The Dollar A Virtuous Cycle For The Dollar In terms of the presidential election outcome, the shift of the median voter to the left signifies that redistributionist policies are likely to become an ever growing part of the U.S. political discourse. This reality is likely to provide another source of support for the U.S. dollar, at least for now. While a Clinton victory will not halt these trends, a Trump victory would likely supercharge any dollar bull market. While vague in details, Trump's economic plan involves much more infrastructure spending financed with debt issuance, i.e. a large amount of fiscal stimulus that would remove the need for any dovish tilt to the Fed's stance. Moreover, by raising the specter of protectionism, a Trump victory could revive inflationary forces in the U.S. economy. Protectionism, while negative for profits, would decrease the trade deficit, temporarily lifting U.S. GDP. Since the supply side of the economy has been hampered by tepid levels of investment (Chart I-3), we could see a situation where demand is in excess of supply. This would prompt an even more hawkish Fed. However, although a Trump victory would be a dream for dollar bulls, caution is warranted. In the long-term, a Trump administration implies a falling fair value for the dollar. For one, by lifting inflation, a Trump victory would hurt the PPP value of the greenback. Second, a Trump victory would also ultimately lead to a degradation of the USD's role as the global reserve currency, making the -40% of GDP net international investment position of the U.S. more difficult to sustain (Chart I-4). Finally, by shielding the economy from the competitive pressures of globalization, a Trump victory would likely result in a deterioration of U.S. productivity vis-à-vis the rest of the world. Chart I-3Low Capital Stock Growth Would Crystalize The##br## Inflationary Effect Of A Trump Presidency bca.fes_wr_2016_10_28_s1_c3 bca.fes_wr_2016_10_28_s1_c3 Chart I-4The Dollar Needs Its ##br##Reserve-Currency Status bca.fes_wr_2016_10_28_s1_c4 bca.fes_wr_2016_10_28_s1_c4 Yen Signs pointing toward a strong wave of yen weakness are slowly coming together. In recent years, the yen has closely followed real rates differentials (Chart I-5). With the BoJ guaranteeing a limit on the upside for nominal rates, any improvement in the economy is likely to cause inflation expectations to increase, and thus real rates, to fall. What are the signals pointing toward higher inflation expectations and a lower yen? First, the labor market is tightening. The job-opening-to-applicants ratio is at a 15 year high and employment growth remains healthy (Chart I-6). Meanwhile, the participation rate of women in the labor force is at all-time highs, and at 73.5%, the employment-to-population ratio for prime-age women is already above U.S. levels. In fact, it is at similar levels to those experienced in the U.S. during the boom years of the late 1990s. Thus, the declining likelihood that more women will enter the labor force eliminates a wage-suppressing factor. Chart I-5USD/JPY: A Function Of##br## Real Rate Differentials USD/JPY: A Function Of Real Rate Differentials USD/JPY: A Function Of Real Rate Differentials Chart I-6Japan: Female Labor Participation Now Exceeds ##br##The U.S. Japanese Wages Can Now Rise bca.fes_wr_2016_10_28_s1_c6 bca.fes_wr_2016_10_28_s1_c6 Second, the Japanese shipment-to-inventory ratio is improving. Thanks to lean-inventory techniques, this ratio tends to be most elevated at the bottom of economic slowdowns, reflecting depressed sales rather than bloated inventories. Historically, growing shipments relative to inventories are associated with rising inflation expectations (Chart I-7). Third, the drag from fiscal policy is dissipating. Budget tightening is leveling off, lifting a big brake on domestic demand (Chart I-8). Moreover, we expect fiscal stimulus to gather momentum in 2017, especially in the form of wage policy. This provides an additional support for Japanese inflation expectations. If no further fiscal stimulus comes to fruition in Japan, we expect USD/JPY to rally toward 110-115 in the next 18-months. If aggressive fiscal stimulus and a wage policy are implemented, the upside for USD/JPY could be much greater, in the order of 120 or more. Chart I-7Japanese Shipment-To-Inventory##br## Ratio And CPI Expectations Japanese Shipment-To-Inventory Ratio And CPI Expectations Japanese Shipment-To-Inventory Ratio And CPI Expectations Chart I-8The Dissipating Japanese ##br##Fiscal Drag USD, JPY, AUD: Where Do We Stand? USD, JPY, AUD: Where Do We Stand? Yet, while the cyclical outlook for the yen is bearish, the shorter-term outlook is more nuanced. Any EM-selloff triggered by tightening global liquidity conditions could prompt downward pressures on Japanese inflation expectations. This would mechanically lift Japanese real rates and the yen. Hence, we recommend investors sell the yen on a long-term basis but hedge this position by buying JPY volatility over the next 3-6 months. Australian Dollar The Australian dollar is at a tricky spot. Technically, the AUD has been forming a tapering wedge, a pattern that often heralds a large move in this currency. How will this pattern resolve itself? We expect a bearish outcome. The domestic economy is displaying some worrying signs. Not only is full-time employment contracting, but so are total hours worked (Chart I-9). This is likely to weigh on household income and on consumption. This is especially problematic as Australian gross fixed capital formation continues to contract at a 4.5% annual pace. The result is that inflationary pressures in Australia will be kept at bay. In the process, the RBA could adopt a more dovish bias. Chart I-9Australian Domestic Conditions ##br##Are Deteriorating bca.fes_wr_2016_10_28_s1_c9 bca.fes_wr_2016_10_28_s1_c9 Chart I-10Australian Exports To ##br##China Are Still Falling... Australian Exports To China Are Still Falling... Australian Exports To China Are Still Falling... Additionally, despite a stabilization in Chinese growth, Chinese imports from Australia continue to contract (Chart I-10). Not only has this happened as iron ore prices have rebounded, but also, as economic conditions have improved in EMs that are highly levered to the Chinese cycle (Chart I-11). Our expectation is that the Chinese industrial sector is likely to experience a slowdown in the months ahead, courtesy of a falling fiscal impulse (Chart I-12), which begs a question: What does the future hold for Australian exports? Chart I-11...Despite Rising Taiwanese##br## Industrial Production bca.fes_wr_2016_10_28_s1_c11 bca.fes_wr_2016_10_28_s1_c11 Chart I-12Tightening Global Liquidity Is A Headwind##br## For EM Financial Conditions And Growth Tightening Global Liquidity Is A Headwind For EM Financial Conditions And Growth Tightening Global Liquidity Is A Headwind For EM Financial Conditions And Growth Finally, our bullish U.S. dollar stance is a tough hurdle for commodity prices to overcome (Chart I-13). Weakness in commodities would represent a negative terms-of-trade shock for Australia and the AUD. Moreover, the PBOC continues to use a lower RMB as an engine of reflation, and we stand by our bearish JPY forecast. Because of these two developments KRW, SGD, and TWD, are very likely to experience further downside. Historically, Asian currency weakness correlates closely with a weak AUD (Chart I-14). Chart I-13Commodities And The Dollar:##br## Joined At The Hip bca.fes_wr_2016_10_28_s1_c13 bca.fes_wr_2016_10_28_s1_c13 Chart I-14AUD Performs Poorly When ##br##Asian Currencies Sell Off bca.fes_wr_2016_10_28_s1_c14 bca.fes_wr_2016_10_28_s1_c14 We are already shorting AUD/USD in the context of a short commodity currencies trade. We are considering buying EUR/AUD, as the euro is less sensitive to the dollar, EM spreads, and commodity prices versus the AUD. Also, EUR/AUD is more attractive from a valuation perspective, trading 5% below its PPP fair value. This cross is also supported by a favorable balance-of-payments backdrop, with the euro area registering a 7.7% of GDP current-account differential relative to Australia. Buying EUR/AUD represents a way for investors to bet on a weaker AUD while decreasing their exposure to the U.S. dollar risk factor. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 bca.fes_wr_2016_10_28_s2_c1 bca.fes_wr_2016_10_28_s2_c1 Chart II-2USD Technicals 2 bca.fes_wr_2016_10_28_s2_c2 bca.fes_wr_2016_10_28_s2_c2 Policy Commentary: "There are risks of hanging around zero too long. And if the economy can withstand [a hike], I think it's appropriate to move" - Philadelphia Fed President Patrick Harker (October 26, 2016) Report Links: Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 The Euro Chart II-3EUR Technicals 1 bca.fes_wr_2016_10_28_s2_c3 bca.fes_wr_2016_10_28_s2_c3 Chart II-4EUR Technicals 2 bca.fes_wr_2016_10_28_s2_c4 bca.fes_wr_2016_10_28_s2_c4 Policy Commentary: "In the euro area, we have a long way to go before we exhaust the productivity improvements that have already taken place in the U.S" - ECB President Mario Draghi (October 25, 2016) Report Links: Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 The Yen Chart II-5JPY Technicals 1 bca.fes_wr_2016_10_28_s2_c5 bca.fes_wr_2016_10_28_s2_c5 Chart II-6JPY Technicals 2 bca.fes_wr_2016_10_28_s2_c6 bca.fes_wr_2016_10_28_s2_c6 Policy Commentary: "Since the employment situation has continued to improve, no further easing of monetary policy may be necessary... at any rate, I would like to discuss this thoroughly with other board members at our monetary policy meeting" - BoJ Board Member Yutaka Harada (October 12, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 British Pound Chart II-7GBP Technicals 1 bca.fes_wr_2016_10_28_s2_c7 bca.fes_wr_2016_10_28_s2_c7 Chart II-8GBP Technicals 2 bca.fes_wr_2016_10_28_s2_c8 bca.fes_wr_2016_10_28_s2_c8 Policy Commentary: "Our judgment in the summer was that we could have seen another 400,000-500,000 people unemployed over the course of the next few years...So we're willing to tolerate a bit of overshoot in inflation over the course of the next few years in order to avoid that situation, to cushion the blow" - BOE Governor Mark Carney (October 14, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9AUD Technicals 1 bca.fes_wr_2016_10_28_s2_c9 bca.fes_wr_2016_10_28_s2_c9 Chart II-10AUD Technicals 2 bca.fes_wr_2016_10_28_s2_c10 bca.fes_wr_2016_10_28_s2_c10 Policy Commentary: "We have never thought of our job as keeping the year-ended rate of inflation between 2 and 3 percent at all times...Given the uncertainties in the world, something more prescriptive and mechanical is neither possible nor desirable" - RBA Governor Philip Lowe (October 17, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 bca.fes_wr_2016_10_28_s2_c11 bca.fes_wr_2016_10_28_s2_c11 Chart II-12NZD Technicals 2 bca.fes_wr_2016_10_28_s2_c12 bca.fes_wr_2016_10_28_s2_c12 Policy Commentary: "There are several reasons for low inflation - both here and abroad. In New Zealand, tradable inflation, which accounts for almost half of the CPI regimen, has been negative for the past four years. Much of the weakness in inflation can be attributed to global developments that have been reflected in the high New Zealand dollar and low inflation in our import prices" - RBNZ Assistant Governor John McDermott (October 11, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 bca.fes_wr_2016_10_28_s2_c13 bca.fes_wr_2016_10_28_s2_c13 Chart II-14CAD Technicals 2 bca.fes_wr_2016_10_28_s2_c14 bca.fes_wr_2016_10_28_s2_c14 Policy Commentary: ""Given the downgrade to our outlook, Governing Council actively discussed the possibility of adding more monetary stimulus at this time, in order to speed up the return of the economy to full capacity" - BoC Governor Stephen Poloz (October 19, 2016) Report Links: Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Swiss Franc Chart II-15CHF Technicals 1 bca.fes_wr_2016_10_28_s2_c15 bca.fes_wr_2016_10_28_s2_c15 Chart II-16CHF Technicals 2 bca.fes_wr_2016_10_28_s2_c16 bca.fes_wr_2016_10_28_s2_c16 Policy Commentary: "We don't have a fixed limit for growing the balance sheet; it's a corollary of our foreign exchange market interventions - which we conduct to fulfill our price stability mandate" - SNB Vice-President Fritz Zurbruegg (October 25, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 bca.fes_wr_2016_10_28_s2_c17 bca.fes_wr_2016_10_28_s2_c17 Chart II-18NOK Technicals 2 bca.fes_wr_2016_10_28_s2_c18 bca.fes_wr_2016_10_28_s2_c18 Policy Commentary: "A period of low interest rates can engender financial imbalances. The risk that growth in property prices and debt will become unsustainably high over time is increasing. With high debt ratios, households are more vulnerable to cyclical downturns" - Norges Bank Governor Oystein Olsen (October 11, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 bca.fes_wr_2016_10_28_s2_c19 bca.fes_wr_2016_10_28_s2_c19 Chart II-20SEK Technicals 2 bca.fes_wr_2016_10_28_s2_c20 bca.fes_wr_2016_10_28_s2_c20 Policy Commentary: "[On Sweden's financial stability]...it remains an issue because we are mismanaging out housing market. Our housing market isn't under control in my view" - Riksbank Governor Stefan Ingves (October 17, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Dazed And Confused - July 1, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

The Tactical Asset Allocation model can provide investment recommendations which diverge from those outlined in our regular weekly publications. The model has a much shorter investment horizon - namely, one month - and thus attempts to capture very tactical opportunities. Meanwhile, our regular recommendations have a longer expected life, anywhere from 3-months to a year (or longer). This difference explains why the recommendations between the two publications can deviate from each other from time to time. Highlights Chart 1Model Weights bca.gis_taami_2016_10_28_c1 bca.gis_taami_2016_10_28_c1 In October, the model outperformed global equities in USD and local-currency terms; it also outperformed the S&P 500 in local-currency terms, while performing in line with the S&P in USD terms. For November, the model trimmed its allocation to cash and stocks and boosted its weighting in bonds (Chart 1). The model increased its weighting in French, Dutch, and Swedish stocks at the expense of the U.S., Japan, Germany, Switzerland, New Zealand, and Emerging Asia. Within the bond portfolio, allocation to New Zealand and the U.K. was increased, while the allocation to U.S., Australian and Spanish paper was reduced. The risk index for stocks deteriorated in October, while the bond risk index improved noticeably. Feature Performance In October, the recommended balanced portfolio gained 0.6% in local-currency terms, and was down 1% in U.S. dollar terms (Chart 2). This compares with a loss of 1.4% for the global equity benchmark, and a 1% loss for the S&P 500 index. Given that the underlying model is structured in local-currency terms, we generally recommend that investors hedge their positions, though we do provide recommendations from time to time. The higher allocation to EM stocks in October was timely, but the boost to bonds was a drag on the model's performance. Weights The model cut its allocation to stocks from 67% to 66% and increased its bond weighting from 21% to 26%. The allocation to cash was decreased from 12% to 8%, while commodities remain excluded from the portfolio (Table 1). The model reduced its allocation to New Zealand equities by 3 points, Emerging Asia by 2 points and U.S., Japan, Germany and Switzerland by 1 point each. Meanwhile, it increased allocation to Dutch, French and Swedish stocks by 4 points, 3 points and 1 point, respectively. In the fixed-income space, the allocation to U.K. and New Zealand paper was increased by 6 points and 5 points respectively, while allocation to Australia, Spain and the U.S. was cut by 3 points, 2 points and 1 point, respectively. Chart 2Portfolio Total Returns bca.gis_taami_2016_10_28_c2 bca.gis_taami_2016_10_28_c2 Table 1Model Weights (As Of October 27, 2016) Tactical Asset Allocation And Market Indicators Tactical Asset Allocation And Market Indicators Currency Allocation Local currency-based indicators drive the construction of our model. As such, the performance of the model's portfolio should be compared with the local-currency global equity benchmark. The decision to hedge currency exposure should be made at the client's discretion, though from time to time, we do provide our recommendations. The dollar appreciated in October and investors should position for additional dollar strength. Our Dollar Capitulation Index seems to be breaking out to the upside following a pattern of lower highs. Since 2008, such breakouts have been followed by a significant rally in the broad trade-weighted dollar (Chart 3). Chart 3U.S. Trade-Weighted Dollar* And Capitulation bca.gis_taami_2016_10_28_c3 bca.gis_taami_2016_10_28_c3 Capital Market Indicators Our model continues to exclude commodities from the portfolio. The risk index for this asset class remains at the highest level in over two years (Chart 4). For the first time since June 2014, the risk index for global equities is above the neutral line (Chart 5). The higher overall risk reflects deteriorating liquidity and momentum readings. Our model cut its weighting in equities for the third month in a row. Chart 4Commodity Index And Risk Commodity Index And Risk Commodity Index And Risk Chart 5Global Stock Market And Risk bca.gis_taami_2016_10_28_c5 bca.gis_taami_2016_10_28_c5 The value component of the risk index for U.S. stocks improved in October, but this was overshadowed by worsening liquidity and momentum readings. The model slightly trimmed its allocation to U.S. equities (Chart 6). Even after the latest small uptick in the risk index for Dutch equities, it remains one of the lowest among the model's universe. The allocation to this bourse was increased. (Chart 7). Chart 6U.S. Stock Market And Risk bca.gis_taami_2016_10_28_c6 bca.gis_taami_2016_10_28_c6 Chart 7Netherlands Stock Market And Risk bca.gis_taami_2016_10_28_c7 bca.gis_taami_2016_10_28_c7 The risk index for U.K. stocks declined slightly in October, but remains firmly in high-risk territory both compared to its own history and its global peers. This asset class remains excluded from the portfolio (Chart 8). The model slightly upgraded Swedish equities, despite a worsening risk index. The continued favorable liquidity backdrop remains a boon for Swedish stocks (Chart 9). Chart 8U.K. Stock Market And Risk U.K. Stock Market And Risk U.K. Stock Market And Risk Chart 9Swedish Stock Market And Risk bca.gis_taami_2016_10_28_c9 bca.gis_taami_2016_10_28_c9 After declining for four consecutive months, the overall risk index for bonds is not at extreme high-risk levels anymore. The increase in yields has helped completely unwind overbought conditions, as per our momentum indicator. The model used the latest selloff to increase its allocation to bonds (Chart 10). The risk index for U.S. Treasurys declined markedly in October, but a few other markets also feature improved risk readings. As a result, the model downgraded U.S. Treasurys (Chart 11). Chart 10Global Bond Yields And Risk bca.gis_taami_2016_10_28_c10 bca.gis_taami_2016_10_28_c10 Chart 11U.S. Bond Yields And Risk bca.gis_taami_2016_10_28_c11 bca.gis_taami_2016_10_28_c11 The selloff in New Zealand bonds has pushed the momentum indicator into oversold territory, boosting the allocation to this asset class (Chart 12). The risk index for euro area bonds remains firmly in the high-risk zone even after a notable decline. However, there are select bond markets in the common-currency area that have relatively more favorable risk readings (Chart 13). Chart 12New Zealand Bond Yields And Risk bca.gis_taami_2016_10_28_c12 bca.gis_taami_2016_10_28_c12 Chart 13Euro Area Bond Yields And Risk bca.gis_taami_2016_10_28_c13 bca.gis_taami_2016_10_28_c13 Within the euro area, Italian bonds feature a risk reading that has fallen below the neutral line. While the cyclical indicator continues to move into more bond-negative territory, it is currently being offset by the oversold reading on the momentum indicator (Chart 14). U.K. gilt yields moved up as the post-Brexit inflation backdrop became gilt-unfriendly and growth surprised on the upside. Now, with momentum moving from overbought to oversold over just a couple of months, any negative economic surprises could potentially weigh on gilt yields. The model has added this asset class to the portfolio (Chart 15). Chart 14Italian Bond Yields and Risk bca.gis_taami_2016_10_28_c14 bca.gis_taami_2016_10_28_c14 Chart 15U.K. Bond Yields And Risk bca.gis_taami_2016_10_28_c15 bca.gis_taami_2016_10_28_c15 A more hawkish Fed could push the dollar higher. The 13-week momentum measure for the USD remains above, but close to the neutral line. The recovery of the 40-week rate of change from mildly negative levels which have represented a floor since 2012 would suggest that a new leg in the dollar bull market is in the offing (Chart 16). Both the 13-week and 40-week momentum measures for the euro are below the neutral line (Chart 17). Growing monetary divergences could continue weighing on EUR/USD before the technical indicators are pushed into more oversold territory. Fears of hard Brexit knocked down the pound. The 13-week rate of change is now close to its post-Brexit lows, while the 40-week rate of change measure is at the most oversold level since 2000 (excluding the great recession). At these technical levels the pound seems overdue to find a temporary bottom (Chart 18). Chart 16U.S. Trade-Weighted Dollar* bca.gis_taami_2016_10_28_c16 bca.gis_taami_2016_10_28_c16 Chart 17Euro Euro Euro Chart 18Sterling Sterling Sterling Miroslav Aradski, Senior Analyst miroslava@bcaresearch.com

Highlights The perceived shape of Brexit is the single most important driver of the pound and most U.K. assets. The U.K. Courts are due to deliver landmark legal rulings, which have huge implications for the perceived shape of Brexit. Expect an eventual soft Brexit if the Courts decide against the U.K. government and deem that triggering Article 50 requires parliamentary approval. Expect a much harder Brexit if the Courts decide in favour of the U.K. government. Tactical investors should consider owning some very short-term call options on pound/dollar or a combination of call and put options. Feature Within the next two weeks, the U.K. High Court will deliver a landmark legal ruling which will have huge implications for the future of the U.K. and Europe. Chart of the WeekDifferent Levels Of Brexit Mean Different Levels Of The Pound bca.eis_wr_2016_10_27_s1_c1 bca.eis_wr_2016_10_27_s1_c1 The U.K. High Court will rule whether Prime Minister Theresa May can start the legal process to exit the EU using the so-called 'royal prerogative' - the power granted to governments to make decisions without a vote from parliament. If May cannot use the royal prerogative, she will require an Act of Parliament to trigger Article 50 of the Lisbon Treaty. The High Court judgement hinges on a fundamental issue. Triggering Article 50 necessarily means that the current government will overturn previous parliamentary decisions - the European Communities Act (1972) and European Union Act (2011). Does the constitution permit a government to overturn parliamentary decisions, take away treaties, and remove the population's legal rights without obtaining parliamentary approval? Although we are not legal experts, the court could regard that as overstretching government authority. If the High Court's judgement does go against the U.K. government, expect pound/dollar to rally immediately by about 4-5 cents. Conversely, a judgement in favour of the government could see the pound sell off by about 1-2 cents. Given the possibility of this gapping, tactical investors should consider owning some very short-term call options on pound/dollar, or a combination of call and put options. Nevertheless, the story will not end with the High Court. Whichever side loses will appeal the decision and take the case to the Supreme Court, which is expected to respond by the end of the year. This ultimate pronouncement of law will have a landmark bearing on the shape of Brexit and, thereby, the future of the U.K. and the other EU 27. Where Is The Pound Headed Longer-Term? For investors, the spectrum of Brexit possibilities - no Brexit, 'soft' Brexit, 'hard' Brexit, or 'very hard' Brexit - will be the single-most important driver of the pound, and by extension, other U.K. assets. Of course, U.K. asset prices ultimately depend on economic and financial fundamentals. But Chart I-2, Chart I-3, Chart I-4, Chart I-5, Chart I-6, Chart I-7 illustrate that by far the most important fundamental for all U.K. assets right now is the perceived hardness of Brexit, as captured in the pound's value. Chart I-2Harder Brexit Means The Eurostoxx600 ##br##Underperforms The FTSE100... bca.eis_wr_2016_10_27_s1_c2 bca.eis_wr_2016_10_27_s1_c2 Chart I-3...And The FTSE250 ##br##Underperforms The FTSE100 ...And The FTSE250 Underperforms The FTSE100 ...And The FTSE250 Underperforms The FTSE100 Chart I-4Harder Brexit Means U.K. ##br##Goods Exporters Outperform... bca.eis_wr_2016_10_27_s1_c4 bca.eis_wr_2016_10_27_s1_c4 Chart I-5Harder Brexit Means ##br##Retailers Underperform... bca.eis_wr_2016_10_27_s1_c5 bca.eis_wr_2016_10_27_s1_c5 Chart I-6...Travel And Leisure Underperforms... bca.eis_wr_2016_10_27_s1_c6 bca.eis_wr_2016_10_27_s1_c6 Chart I-7...And Real Estate Underperforms bca.eis_wr_2016_10_27_s1_c7 bca.eis_wr_2016_10_27_s1_c7 Pound/dollar has (so far) traded at three distinct levels, based on three distinct levels of perceived Brexit severity: near 1.50 before the Brexit vote; near 1.30 after the Brexit vote but perceiving a soft Brexit; and near 1.20 after Theresa May announced that she would trigger Article 50 by next March and was contemplating a hard Brexit (Chart of the Week). Hence the (post-appeal) outcome of the legal case against the government carries great significance. If the government loses, and requires a parliamentary vote to trigger Article 50, several consequences follow. Theresa May's end-March deadline for firing the Brexit starting gun would become very difficult to meet, severely delaying the whole process. Would the government even win a parliamentary majority? If in doubt, would the government call a snap General Election to try and beef up its majority? The current batch of parliamentarians has a strong bias for staying in the EU, but it would be difficult to fly in the face of the referendum result. On the other hand, the checks and balances of parliament are there precisely to stop the country walking over the cliff-edge that a very hard Brexit would be. All the while, with investment slowing and higher inflation from the weaker pound squeezing household real incomes, the economic headwinds from the U.K.s limbo status would be becoming more apparent. Given the high stakes and likely irreversibility of the formal legal process, parliamentarians would rightfully want to examine and approve the U.K.'s negotiating hand. It seems that Parliament would almost certainly water down or delay Brexit before voting it through. Hence, if the government loses its legal case after appeal, Brexit will likely end up in a soft form. And pound/dollar will ultimately elevate to 1.35. Conversely, if the government wins its legal case after appeal, Theresa May will be on course to trigger Article 50 early next year, as promised. At which point, the EU 27's optimal game-theoretical first play is to be very aggressive - effectively opening with a very hard Brexit offer as described in the next section. Whereupon, pound/dollar would find its fourth, even lower, new level: near 1.10. Two Myths About Brexit It is important to debunk a couple of common myths about Brexit. First, that the U.K.'s current position as the EU 28's second largest economy will force the remaining EU 27 to give the U.K. a special status - allowing access to the three freedoms of goods, services, and capital but with controls on the fourth freedom of movement: people. This belief is misplaced. The biggest worry for the EU 27 is that a special status for Britain could catalyse other countries, under populist pressure, to ask for equivalent deals. The EU 27 does not want to give Marine Le Pen the opportunity to say "let's follow the Brits, they've negotiated a great deal." Hence, the U.K. will not get special treatment. Quite the contrary, it must be seen to be paying a substantial price for Brexit. Even for Anglophile Angela Merkel, protecting the indivisibility of the four freedoms and the integrity of the EU is the overriding priority. If the U.K. restricts free movement of people, it almost certainly means a hard Brexit: substantially restricted access to the single market. The U.K. would then have to negotiate a free trade agreement (FTA) with the EU. Given the current difficulty that Canada is experiencing in negotiating a FTA, this might not be a straightforward process for the U.K either. Furthermore, as a FTA does not usually cover services, it would handicap the services-heavy U.K. economy, while perfectly suiting the goods-heavy German economy. A second common belief is that the pound will act as an automatic economic stabilizer. That irrespective of a very tough deal from the EU 27, a weaker sterling will soothe the pain of a very hard Brexit by making British exports more competitive. Granted, the weaker pound will boost the demand for the U.K.'s goods exports. But total U.K exports are much less sensitive to devaluations compared to when the pound tumbled out of the Exchange Rate Mechanism in 1992. Then, just a quarter of the U.K's exports were services; today that proportion is approaching a half (Chart I-8) With the exception of tourism, these services tend to be high value-added financial and business services. Cutting their price will not significantly boost the demand for them. Chart I-8Almost Half Of U.K. Exports Are Services Almost Half Of U.K. Exports Are Services Almost Half Of U.K. Exports Are Services Meanwhile, U.K. consumers will feel distinctly poorer as the sterling prices of food and energy rise (Chart I-9), squeezing real household incomes and spending. In turn, this will leave the Bank of England with a major headache. How best to support real spending: defend the plunging pound to keep a lid on food and energy prices, or cut interest rates? Chart I-9Higher Sterling Prices For Food And Energy Will Squeeze Real Incomes Higher Sterling Prices For Food And Energy Will Squeeze Real Incomes Higher Sterling Prices For Food And Energy Will Squeeze Real Incomes Investment Reductionism For U.K. Assets The charts throughout this report show that the strategy for many U.K. investments reduces to an overriding question. Will the U.K largely retain access to the single market, defining a soft Brexit? Or will the U.K. largely lose access to the single market, defining a hard Brexit? In a soft Brexit: Sterling would rally 10%, taking pound/dollar to 1.35. The Eurostoxx600 and S&P500 would outperform the FTSE100. Within U.K. equities, sterling earners would outperform dollar earners, favouring small and mid-cap over large cap. The FTSE250 would outperform the FTSE100. The heavily domestic-focused retailers, travel and leisure, and real estate sectors would outperform the market. Goods exporters, such as the apparel sector would become less competitive and underperform the market. In a hard Brexit, expect the exact opposite of the above. Pound/dollar would slump 10% to 1.10, and so on. To determine which strategy to follow, await the post-appeal Supreme Court judgement on how Article 50 must be triggered, due at the end of the year. If Article 50 requires parliamentary approval, expect a soft Brexit. If it doesn't require parliamentary approval, expect the Brexit game theory to become hard and aggressive. Right now this is a coin toss, but forced to choose, we expect events may eventually prevent a damaging hard Brexit. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com Fractal Trading Model* This week's trade is another commodity pair trade: long copper / short tin. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart 10 Long Copper / Short Tin Long Copper / Short Tin * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields bca.eis_wr_2016_10_27_s2_c1 bca.eis_wr_2016_10_27_s2_c1 Chart II-2Indicators To Watch - Bond Yields bca.eis_wr_2016_10_27_s2_c2 bca.eis_wr_2016_10_27_s2_c2 Chart II-3Indicators To Watch - Bond Yields bca.eis_wr_2016_10_27_s2_c3 bca.eis_wr_2016_10_27_s2_c3 Chart II-4Indicators To Watch - Bond Yields bca.eis_wr_2016_10_27_s2_c4 bca.eis_wr_2016_10_27_s2_c4 Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_10_27_s2_c5 bca.eis_wr_2016_10_27_s2_c5 Chart II-6Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_10_27_s2_c6 bca.eis_wr_2016_10_27_s2_c6 Chart II-7Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_10_27_s2_c7 bca.eis_wr_2016_10_27_s2_c7 Chart II-8Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_10_27_s2_c8 bca.eis_wr_2016_10_27_s2_c8

Highlights Dear Client, The growth of the electric-vehicle market, particularly re its implications for hydrocarbons as the primary transportation fuel in the world, will remain a key issue for energy markets, particularly oil. The IEA estimates transportation accounted for 64.5% of oil demand in 2014, the latest data available, compared to natural gas's 7% share and electricity's 1.5% share.1 Last week, Fitch Ratings published a report concluding, "Widespread adoption of battery-powered vehicles is a serious threat to the oil industry." For example, the agency contends that "in an extreme scenario, where electric cars gained a 50 per cent market share over 10 years about a quarter of European gasoline demand could disappear." This is not a widespread view in the energy markets. IHS Energy published a report in 2014 finding, "Past energy transitions took decades to unfold and were driven by a combination of market factors: cost, scarcity of supply, utility and flexibility, technology development, geopolitical developments, consumer trends, and policy.2" While our view is more aligned with IHS's, it is undeniable electric vehicles are a growing market. For this reason, we are publishing an analysis by BCA Research's EM Equity Sector Strategy written by our colleague Oleg Babanov, which explores the lithium-battery supply chain and how investors can gain exposure to this critical element of the fast-growing global electric-vehicle market. Separately, we are downgrading our strategic zinc view from neutral to bearish, and recommending a Dec/17 short if it rallies. Robert P. Ryan Senior Vice President, Commodity & Energy Strategy Lithium is a rare metal with a costly production process and a high concentration in a small number of countries. Difficulty in production is comparable to deep-sea oil drilling. Lithium is the key element in lithium-ion batteries. Demand is rapidly increasing as more countries adopt environment-protection policies and electric-car production is on the rise. We recommend an overweight on the lithium battery supply chain (Table 1), on a long-term perspective (one year plus). We estimate demand for the raw material to rise by approximately 30% over the coming years, driven by the main electric vehicle production clusters in Asia and the U.S. Table 1Single Stock Statistics For Companies##br## In The Lithium Battery Supply Chain (Oct 2016)* The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market What Is Powering Your Battery? Being a relatively rare and difficult to produce metal, lithium demand is rapidly increasing due to the metal's unique physical characteristics, which are utilized in long-life or rechargeable batteries. Rapidly rising demand from portable electronics manufacturers, and the push of the auto industry to develop new fuel-efficient technology, backed by the widespread support of many governments to reduce transportation costs and improve CO2 emissions, are driving prices for the metal higher. We believe that companies in the electric vehicle (EV) supply chain, from miners to battery producers and down to EV manufacturers, will benefit from the change in environmental policies and the growing need for more portable devices with larger energy storage. As the focus of the wider investment community remains tilted towards the U.S. (and Tesla in particular), many companies in the lithium battery supply chain, as well as EV producers, remain overlooked and undervalued. EV Production Expected To Surge We expect a continuation of the push towards energy-saving vehicles among car manufacturers, driven by government incentives and new tougher regulations (EU regulations for CO2 emissions in 2020 will be the strictest so far). Over one million EV vehicles of different types were sold in 2015. In countries such as Norway, the penetration of PEVs is reaching up to 23% (Chart 1). Based on the current growth rates (Chart 2), the compound annual growth rate of EV production is estimated at 30% to 35% over the next 10 years. Japan will remain in top spot in EV penetration (the current HEV rate is around 20% of the overall market). Japan's market (controlled by Toyota and Honda) is dominated by the HEV type of vehicles, and we expect it to remain this way. Chart 1PEV Penetration By Country The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market Chart 2EV Sales By Country The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market We expect the largest boost in market share gains to happen on the European market, based on very stringent CO2 emissions regulation (Chart 3) and ambitious EV targets set by the larger countries. EV market share is set to reach 20% (from the current 5%) in the coming seven to 10 years. The EU is closely followed by South Korea. The Ministry of Trade, Industry and Energy (MOTIE) has developed an ambitious plan of growth, by which EV market share should reach 20% by 2020 and 30% by 2025. New EVs will receive special license plates, fuel incentives, and new charging stations. MOTIE wants the auto industry to be able to produce 920,000 NEVs per year, of which 70% should be exported. Among other large markets, the U.S. and China will remain the two countries with lowest EV penetration rates, although growth rates will be impressive. This will be due to low incentives from the government and cheap traditional fuel supply (in the U.S.), or a low base, some subsidy cuts, and infrastructure constraints (in China). Especially in China's case, the numbers remain striking (Chart 4). According to statistics published by the China Association of Automobile Manufacturers (CAAM), EV sales in 2015 grew 450% YOY. The market is estimated to grow at an average rate of 25% over the next 10 years. Chart 3EU CO2 Emission Targets bca.ces_wr_2016_10_27_c3 bca.ces_wr_2016_10_27_c3 Chart 4Monthly NEV Sales China Monthly NEV Sales China Monthly NEV Sales China In this report we will highlight companies from the raw material production stage: Albermarle (ALB US), Gangfeng Lithium (002460 CH), Tianqi Lithium Industries (002466 CH), and Orocobre (ORE AU); to added-value battery producers: BYD (1211 HK), LG Chem (051910 KS), and Samsung SDI (006400 KS); down to some electric vehicle companies: Geely Automobile Holdings (175 HK) and Zhengzhou Yutong Bus Company (600066 CH). The Supply Side Driven by demand from China and the U.S., the raw material base for lithium has shifted in the past 20 years from subsurface brines to more production-intensive hard-rock ores. Brine operations are mostly found in the so-called LatAm "triangle" - Argentina, Chile and Bolivia - while China and Australia produce lithium from spodumene (a mineral consisting of lithium aluminium inosilicate) and other minerals. The U.S. Geological Survey estimates world reserves at 14 million tonnes in 2015, with Bolivia and Chile on top of the table (Chart 5). The main lithium producing countries, according to the U.S. Geological Survey, are Australia, Chile, and Argentina (Chart 6). Chart 5Lithium Reserves Concentrated In LatAm The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market Chart 6Lithium Production Dynamics By Country The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The lithium mining process starts with pumping lithium-containing brine to subsurface reservoirs and leaving the water to evaporate (from 12 to 24 months) until the brine reaches a 6% lithium content. From here there are three ways to process the concentrate, or the hard-rock in mineral form: Treatment with sulfuric acid (acidic method) Sintering with CaO or CaCO3 (alkali method) Treatment with K2SO4 (salt method) Further, lithium carbonate (Li2CO3), a poorly soluble solution, is isolated from the received concentrate and transferred into lithium chloride, which is purified in a vacuum distillation process. Storage is also difficult: as lithium is highly corrosive and can damage the mucous membrane, it is most commonly stored in a mineral oil lubricant. Due to the rare nature of the metal, lithium comes mainly as a by-product of other metals and comprises only a small part of the production portfolio. This is the reason why the underlying metal price and the share prices of the largest producers of lithium have low correlation (Chart 7). Albermarle, SQM, and FMC Corp currently control as much as three-quarters of global lithium production, but price performance is not keeping up with the price of the underlying metal. For best exposure to the metal, we concentrate on companies with a large degree of dedication to mining lithium and close ties to the end-users. We recommend one established market leader (by volume) - Albermarle (ALB US); one company that just started operations - Orocobre (ORE AU), whose assets are concentrated in Argentina; and two lithium miners from China - Jiangxi Ganfeng Lithium (002460 CH) and Tianqi Lithium (002466 CH). These companies display much higher correlation to the metal price (Chart 8). Chart 7FMC Corp., SQM And ##br##Albermarle Vs. Lithium Price bca.ces_wr_2016_10_27_c7 bca.ces_wr_2016_10_27_c7 Chart 8Orocorbe, Jiangxi Ganfeng And##br## Tianqi Lithium Vs. Lithium Price bca.ces_wr_2016_10_27_c8 bca.ces_wr_2016_10_27_c8 Albermarle (ALB US): U.S. company with EM exposure (Chart 9). After the acquisition of Rockwood Holdings in 2015, Albermarle became one of the largest producers of lithium and lithium derivatives. Lithium accounts for more than 35% of the company's revenue stream (+20% YOY), which compares favourably to the 20% of the Chilean producer SQM and the 8% of another large US producer FMC Corp. Chile comprises 31% of global production. Albermarle's 2Q16 results on 3 August came broadly in line with market expectations. Some deviation from expectations occurred because of discontinued operations in the Surface Treatment segment. Group sales contracted by 7%, due to divestures started in previous quarters (Chemetal). Positively, lithium sales grew 10% YOY due to both better pricing and higher volumes, and EBITDA in the segment improved by 20%. Group EBITDA (adjusted) grew by 5% YOY and the bottom-line (adjusted) expanded by 11% YOY. Management appears confident about FY16 operations, guiding 1% improvement in EBITDA, as well as 3% in FY EPS and aims to maintain EBITDA margins in the lithium segment at over 40%. We see high growth potential due to Albermarle's portfolio composition. The market is currently expecting an EPS CAGR of 9% over the next four years. Albermarle is trading at a forward P/E of 23.1x. Orocobre (ORE AU): An Australian company mining in Argentina (Chart 10). Orocobre is an Australian resource company, based in Brisbane. As in the case with Albermarle, the majority of operations are located in EM, so we see it as appropriate to include the company into our portfolio. Chart 9Performance Since October 2015: ##br##Albermarle vs MXEF Index bca.ces_wr_2016_10_27_c9 bca.ces_wr_2016_10_27_c9 Chart 10Performance Since October 2015: ##br##Orocobre vs MXEF Index bca.ces_wr_2016_10_27_c10 bca.ces_wr_2016_10_27_c10 Orocobre is at an initial stage in the lithium production process. The only division working at full capacity is Borax Argentina (acquired from Rio Tinto in 2012), an open-pit borate mining operation (producing 40 kilotonnes per annum (ktpa)). The flagship project (65% share), launched in a JV with Toyota Tsusho Corp, is the Olaroz lithium facility, a salt lake with an estimated 6.5 million tonnes of lithium carbonate (LCE) reserves. The planned capacity is at 17.5 ktpa. Due to the geological structure, it comes with one of the lowest operational costs ($3500 per tonne). The production ramp-up to 2,971 tonnes of lithium, reported on 19 July together with the 4Q16 results, came a notch below market expectations. The management lowered the production guidance, delaying full operational capacity by two months until November (realistically it might take even longer). Positive points in guidance included an LCE price exceeding $10,000/tonne in the upcoming quarter and confirmation that the company turned cash flow positive in the first half of this year.3 Orocobre is already planning capacity expansion at the Olaroz facility to 25 ktpa, with diversification into lithium hydroxide. Further exploration drilling is underway in the Cauchari facility, just south of Olaroz. The market forecasts the company to produce a positive bottom-line in FY17 and grow EPS by a CAGR of 25% for the next four years. Orocobre is currently trading at a forward P/E of 36.1x. Jiangxi Ganfeng Lithium (002460 CH): one of the largest lithium producers in China (Chart 11). Gangfeng is a unique company in the lithium space in the sense that it is a raw material producer with added processing capabilities. The main trigger for our OW recommendation was the acquisition of a 43% stake in the Mt Marion project in Australia. From 3Q16 onwards the bottleneck in raw material supply will be removed and the company can count on approximately 20 thousand tonnes (kt) of lithium spodumene. On the back of this news, the company announced a production expansion into lithium hydroxide (20 kt) from which 15 kt will be battery grade and 5 kt industry grade. This has the potential to lift Ganfeng to one of the top five producers in the world. Ganfeng reported stellar 2Q16 results on 22 August. The top-line grew two times YOY, while operating profit increased by 7.8x. Operating margin jumped from 9.8% to 35.9%, and the bottom-line expanded five-fold YOY. The profit margin also improved from 8.55% to 25.3%. We expect less strong, but still robust, YOY growth for the upcoming quarters. Market projects EPS CAGR of over 50% during the next four years, as the production run-up will continue. The company is currently trading at a forward P/E of 36.8x. Tianqi Lithium Industries (002466 CH): Making the move (Chart 12). Tianqi is the third largest producer in the world (18% of global capacity). Recently the company got into the news on rumors of its attempted expansion by taking a controlling stake in the world's largest lithium producer, Chile's SQM. Chart 11Performance Since October 2015:##br## Jiangxi Ganfeng Lithium vs MXEF Index bca.ces_wr_2016_10_27_c11 bca.ces_wr_2016_10_27_c11 Chart 12Performance Since October 2015: ##br##Tianqi Lithium vs MXEF Index bca.ces_wr_2016_10_27_c12 bca.ces_wr_2016_10_27_c12 SQM has an intricate shareholding structure, with the involvement of the Chilean government and a rule that no shareholder is currently allowed to own more than a 32% stake in the company (this rule can be changed only through an extraordinary shareholder meeting). At the moment the largest shareholder is Mr. Ponce Lerou (son-in-law of former President Augusto Pinochet), who owns just under 30% and has a strategic agreement with a Japanese company, Kowa, which makes the combined holding 32%. During the last week of September Tianqi acquired a 2% stake (for USD209 m) from US-based fund SailtingStone Capital Partners, which held a 9% stake, with the option to buy the remaining 7%. In a further step, Tianqi is trying to negotiate a deal with one of Mr. Ponce Lerou's companies which holds a 23% stake. It is said that Mr. Ponce Lerou has got into a political stalemate with the Chilean government on a production increase at one of its deposits and is looking to exit the company. Tianqi reported strong Q2 results on 22 August. Revenues grew by 2.4x YOY, and operating profit improved by 3.9x YOY. Operating margin grew from 42.99% in 2015 to 69.35% in 2Q16, and bottom-line increased twofold QOQ as production ramp-up continued. At the same time profit margin reached 48.9%, up from 2.8% a year ago. The company is currently trading at a forward P/E of 23.4x, and the market is forecasting an EPS CAGR of 13% over the next three years. The Demand Side4 Lithium is used in a wide range of products, from electronics to aluminium production and special alloys, down to ceramics and glass. But battery production takes the largest share of utilization (Charts 13A & 13B). Chart 13ALithium Usage The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market Chart 13BLithium Batteries Most Widely Used The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market As confirmed by import statistics (from the U.S. Geological Survey), demand in many Asian countries, as well as the U.S., has been constantly rising. Among the main importers, South Korea is in fourth place with the largest number of new lithium-related projects started. In top position is the U.S., where we expect a strong demand increase, once the Tesla battery mega-factory in Nevada is completed, followed by Japan, which has the highest penetration of electric vehicles (EV), and China (Chart 14). Chart 14Composition Of Lithium Imports By Country The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market Because of its low atomic mass, lithium has a high charge and power-to-mass ratio (a lithium battery generates up to 3V per cell, compared to 2.1V for lead-acid or 1.5V for zinc-carbon), which makes it the metal-of-choice for battery electrolytes and electrodes, and makes it difficult to replace with other metals, due to its unique physical features. Lithium is used in both disposable batteries (as an anode) and re-chargeable ones (Li-ion or LIB batteries, where lithium is used as an intercalated compound). Li-ion batteries are used in: Portable electronics, such as mobile phones (lithium cobalt oxide based); Power tools / household appliances (lithium iron phosphate or lithium manganese oxide); EVs (lithium nickel manganese cobalt oxide or NMC). The most produced battery is the cylindrical 18650 battery. Tesla's Model S uses over 7000 of these type of batteries for its 85 kWh battery pack (the largest on the market until mid-August, when Tesla announced a 100 kWh battery pack). The amount of lithium used in a battery pack depends on the kW output. Rockwood Lithium (now Albermarle), estimated in one of its annual presentations that: A hybrid electric vehicle (HEV) uses approximately 1.6kg of lithium A plug-in hybrid (PHEV) uses 12kg An electric vehicle (EV) uses more than 20kg (but all depends on make, model, and technology). An average car battery (PHEV/EV) would use over 10kg of lithium, assuming 450g per kWh (please note that real-life calculations suggest a usage of up to 800g per kWh of lithium. We have used the lower end of the range for our estimates), with Tesla's battery consuming around 70kg of lithium. Simple math suggests that with the completion of the mega-factory (estimated production of 35 GWh or 500k batteries p.a.), Tesla alone will be consuming at least half of world lithium production by 2020, and create a large overhang in demand. Among car battery producers, we like global players with dominant market positions and strong ties to end-users, such as LG Chem, Samsung SDI in Korea, and BYD in China. Those three companies together control more than half of global battery production (Chart 15) and will most likely maintain market share in the foreseeable future, as barriers to entry are high due the amount of investment required into technology and production facilities, and the end-product is difficult to differentiate on the market. BYD Corp (1211 HK): Build Your Dreams, it's in the name (Chart 16). Founded in 1995 and based in Shenzhen, BYD covers the whole value chain, from R&D and production of batteries (phone and car batteries) to automobile production and energy storage solutions. It is currently the largest battery and PHEV producer in China. The total revenues stream consists of 55% from auto and auto components sales, 33% portable electronics battery, and 12% car battery sales. Chart 15Largest Lithium ##br##Battery Producers The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market Chart 16Performance Since October 2015: ##br##BYD Corp vs MXEF Index bca.ces_wr_2016_10_27_c16 bca.ces_wr_2016_10_27_c16 We believe the company is best positioned to reap multi-year rewards from the recent drive of the Chinese government to promote new electronic vehicle (NEV) growth through subsidies, support of charging infrastructure, and changes in legislation. The introduction of carbon trading in August (carbon credit will be measured on the number of gasoline-powered vehicles in the producer's fleet) will give BYD a benefit over other car manufacturers. BYD's model pipeline and battery manufacturing capacity (expected to reach 20 GWh by FY17), as well as favourable pricing ($200 kWh compared to over $400 kWh for Tesla) put the company into a leadership position. BYD reported 2Q16 results on 28 August, which came out very strong. Revenues grew by 52.5% YOY and 384% on a semi-annual perspective, driven by all three business segments and especially strong in EV sales (+29% YOY). This came with a significant beat of consensus estimates and later we saw a 68% upwards adjustment. As a result operating margin and profit margin improved from 3.8% and 2.2% in 2Q15 to 8.5% and 5.8% in 2Q16. Bottom-line was up 4x YOY. The market is currently pricing in an EPS CAGR of 12% over the next three years. BYD is trading at a forward P/E of 23.9x. LG Chem (051910 KS): Catering for the US market (Chart 17). LG Chem is the largest chemical company in South Korea, operating in three different divisions: petrochemicals (from basic distillates to polymers), which account for 71% of total revenues, information technology and electronics (displays, toners etc.), which represent 13% of total revenues, and energy solutions, 16% of total revenues. LG Chem is the third largest battery producer in the world, manufacturing a pallet from small watch and mobile phone batteries down to auto-packs. LG's North American operations in Holland, Michigan produce battery packs for the whole range of GM (Chevrolet, Cadillac) EVs (including the most popular Volt range), as well as for the Ford Focus. In Europe, customers include Renault; in Asia, LG is working with Hyundai, SAIC, and Chery. The company reported better-than-expected 2Q16 results on 21 July. Revenues grew by 3% YOY and operating profit by 8.5% YOY, driven solely by the petrochem division (up 10% YOY). Bottom-line expanded by a healthy 8% YOY. LG Chem trades at deeply discounted levels (forward P/E of 11.6x) due to the remaining negative profitability in the battery segment (partly due to licensing issues in China, which represents 32% of total revenues), but we estimate that the trend will turn in the following quarters, as Chevrolet is ramping up demand with new product lines and management is guiding for a resolution in China. Furthermore, plans released by the Korean government in June/July (renewable energy plan and EV expansion plan) will increase demand for batteries by more than 30% CAGR in the next five years. The market is forecasting an EPS CAGR of 9% over the upcoming four years. Samsung SDI (006400 KS): Investing into the future (Chart 18). In contrast to LG Chem, Samsung SDI is fully focused on Li-ion battery production, with 66.5% of total revenues coming from this division (BMW and Fiat among clients). The company also produces semiconductors and LCD displays, which account for 35.5% of total revenue. Chart 17Performance Since October 2015: ##br##LG Chem vs MXEF Index bca.ces_wr_2016_10_27_c17 bca.ces_wr_2016_10_27_c17 Chart 18Performance Since October 2015: ##br##Samsung SDI vs MXEF Index bca.ces_wr_2016_10_27_c18 bca.ces_wr_2016_10_27_c18 Samsung SDI is currently in a reorganization phase, as the company is spinning off "Samsung SDI Chemicals" and has announced it will invest $2.5 bn into further development of its car battery business. The proceeds from the sale of Samsung SDI Chemicals (taken over by Lotte Chemicals in April for around $2.6 bn) will also be directed towards the car battery segment. Samsung SDI reported weak 2Q16 results on 28 July, as expected. Revenues continued to contract on a YOY basis, although the rate of decline slowed compared to Q1 and even registered 2% QOQ growth. The bottom-line was positive due to a one-off gain (the sale of the chemical business). The main headwinds came from delays in licensing Chinese factory production and a strong Japanese yen. On the positive side, Li-ion batteries in portable devices performed well, due to better than expected Galaxy S7 sales, as well as OLED sales, due to increased demand and capacity constraints in the mobile phone and large panel spaces. Due to the high concentration of EV battery-related revenues in its portfolio, we believe that Samsung SDI will be the largest beneficiary of government's renewable energy and EV expansion plans. The company is also ideally positioned to take advantage of the fast-growing Chinese market (35% of revenues coming from China), once the issue with licensing is resolved (which management guided will happen in Q3). The recent problems with overheating or exploding batteries, reported by users of the new Samsung phones, have sent the share price lower. We believe that this offers an excellent entry point, as ultimately the company will replace/improve the technology, and, at the same time, there are no alternatives which could threaten Samsung SDI's leadership in the portable battery space. The temporary issue in China has weighted on valuations, as Samsung SDI is trading at a forward P/E of 27.7x, while the market expects EPS to increase fivefold in the coming four years. Accessing The Chinese EV Market Best access to the fast growing Chinese market is through local car manufacturers, such as Geely (Chart 19). The subsidy schemes, put in place by the National Development and Reform Commission (NDRC), currently cover only domestic-made models (except the BMW i3). Furthermore, import duties are making foreign-made vehicles uncompetitive in terms of price. We recommend to overweight Geely (0175 HK) and electric bus producer Yutong Bus (600066 CH) on the 30% NEV rule for public transport procurement. Chart 19Accessing The Chinese EV Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market Geely ("Lucky" in Mandarin) Automobile Holdings (175 HK): A company with large ambitions (Chart 20). Probably best known for its two foreign car holdings, Volvo and the London Taxi Company, Geely grew from a small appliances manufacturer to the second largest EV producer in China, with an ambitious goal to manufacture 2 mn units by 2020. We see the main positive driver in Geely's big push into the EV market. The goal set by management is to have 90% of its fleet powered by electricity by 2020. The so called "Blue Geely" initiative is based on a revamp of Geely's current fleet into HEVs/PHEVs (65% as per plan) and EVs (35%). In May the company raised $400 mn in "green bonds" in a first for a Chinese car company, to support its R&D and manufacturing project, Ansty, to produce the first zero-emission TX5 black cabs in the U.K. The company reported strong 1H16 results on 18 August. Revenues were up 30% YOY, driven by higher production volume (up 10% YOY) and a sales price hike of around 15% YOY. The co-operation with Volvo seems to be working well (Volvo's design, Geely's production capabilities). The average waiting time for new models in China is approximately two months. The bottom-line expanded by 37.5% YOY despite a high density of new model launches, and we expect to see some margin improvement in the coming quarters. The market forecasts an EPS growth CAGR of 25% over the coming four years. Geely is currently trading at a forward P/E of 15.6x. Zhengzhou Yutong Bus Company (600066 CH): An unusual bus manufacturer (Chart 21). Yutong Bus Company is the world's largest, and technologically most advanced, producer of medium and large-sized buses (over 75k units produced in FY15, 10% global market share), with its own R&D and servicing capabilities. Even more important, Yutong is one of the largest producers of electric-powered buses in China and globally. Chart 20Performance Since October 2015: ##br##Geely Automobile Holdings vs MXEF Index bca.ces_wr_2016_10_27_c20 bca.ces_wr_2016_10_27_c20 Chart 21Performance Since October 2015:##br## Yutong Bus Company vs MXEF Index bca.ces_wr_2016_10_27_c21 bca.ces_wr_2016_10_27_c21 Due to the 30% EV procurement rule for local governments, the number of electric buses produced in 2015 soared 15 times to 90,000, a quarter of which were produced by Yutong. We expect this number to grow further with the introduction of the new carbon emission trading scheme. We see Yutong as best positioned in the bus manufacturers' space to take advantage of the new trading rules. Yutong reported 2Q16 results on 23 August, which came in broadly in line with market expectations. Revenue expanded by 34% YOY, driven by volume growth (7400 NEV units sold, +100% YOY). The push into EVs came with higher cost-of-sales (warranty and servicing). This did not affect gross margin (up 1% to 25%). Bottom-line grew by 50% YOY. Management maintained an upbeat outlook, guiding 25,000 units of NEV sales in FY16, with an average sales price increase due to higher sales in the large-bus segment. Management also expects to receive the national subsidy for FY15 in 3Q16 and for 2016 in 1Q17. The market currently factors in an EPS CAGR growth of 8% over the next four years. Yutong is trading at a forward P/E of 12.3x. How To Trade? The EMES team recommends gaining exposure to the sector through a basket of the listed equities, which would consist of four mining companies, three car battery pack producers, and two EV manufacturers. The main goal is active alpha generation by excluding laggards and including out-of-benchmark plays, to avoid passive index hugging via an ETF. Direct: Equity access through the tickers (Bloomberg): Albermarle (ALB US), Gangfeng Lithium (002460 CH), Orocobre (ORE AU), Tianqi Lithium Industries (002466 CH), BYD (1211 HK), LG Chem (051910 KS), Samsung SDI (006400 KS), Geely Automobile Holdings (175 HK), Zhengzhou Yutong Bus Company (600066 CH). ETFs: Global X Lithium ETF (LIT US) Funds: There are currently no funds available, which invest directly into lithium or lithium-related stocks. Please note that the trade recommendation is long-term (1Y+) and based on an OW call. We don't see a need for specific market timing for this call (for technical indicators please refer to our website link). Trades can also be implemented through our recommendation versus MXEF index either directly through equities in the recommended list or through ETFs. For convenience, the performance of both the ETFs and market cap-weighted equity baskets will be tracked (please see upcoming updates as well as the website link to follow performance). Risks To Our Investment Case Because of the broad diversification, we see our portfolio exposed to idiosyncratic risk factors, which could affect single-stock performance, as well as the following macro factors: Mining: Falling lithium prices due to lower demand or a ramp-up in production on some of the Australian projects, could hurt profitability or delay new projects (especially in case of Orocobre). We also see some political risk stemming from the region of operations (Argentina, Chile), especially taking into account the weak performance of Chile's own lithium producer SQM and its role in a Brazil-like political scandal. Battery and EV production. We identify the main risk in drastic changes to governments' environmental and subsidy policies, which would hit the whole supply chain. A slowdown in economic development can make green or power-saving initiatives too expensive and governments will have to rethink their subsidy policies or production/penetration goals. This will hurt profitability through either a negative impact on sales or through smaller subsidies, which producers and end-users are receiving from their governments. One further risk is the dramatic increase in demand for lithium after the completion of Tesla's factory in Nevada, but may also come from other large players such as BYD. We currently see this risk as muted. As with all large Tesla initiatives, you have to take them with a pinch of salt, as the exact end numbers and the time the factory will be working at full capacity are unclear. Furthermore, Tesla, unlike many Chinese competitors, has no supply of lithium of its own, so there is little chance that it can protect supply or control prices. In any case, we see the overall portfolio as balanced, as the mining companies' performance should compensate for a negative impact on the end producers. Oleg Babanov, Editor/Strategist obabanov@bcaresearch.co.uk BASE METALS China Commodity Focus: Base Metals Zinc: Downgrade To Strategically Bearish We downgrade our strategic zinc view from neutral to bearish. We believe zinc supply (both ore and refined) will rise in response to current high prices, resulting in a 10-15% decline in zinc prices over next 9-12 months. Tactically, we still remain neutral on zinc prices as we believe the market will remain in supply deficit over the near term. Chinese zinc ore production will recover in 2017, while the country's zinc demand growth will slow. China is the world's biggest zinc ore miner, refined zinc producer, and zinc consumer. We recommend selling Dec/17 zinc if it rises to $2,400/MT (current: $2,373.5/MT). If the sell order gets filled, put on a stop-loss level at $2,500/MT. Zinc has been the best-performing metal in the base-metals complex, beating copper, aluminum and nickel this year. After bottoming at $1,456.50/MT on January 12, zinc prices have rallied 64.7% to $2,399/MT on October 3 (Chart 22, panel 1). The Rally The rally was supercharged by a widening supply deficit, which was mainly due to a record shortage of zinc ores globally (Chart 22, panels 2, 3 and 4). Late last October our research showed the output loss from the closure of Australia's Century mine, the closure of Ireland's Lisheen mine and Glencore's production cuts would reduce global zinc supply by 970 - 1,020 KT in 2016, which would be equivalent to a 7.1 - 7.5% drop in global zinc ore output.5 Moreover, a 16% price decline during the November-January period spurred additional production cut worldwide. According to the WBMS data, for the first seven months of 2016, global zinc ore production declined 11.9% versus the same period of last year, a reduction never before seen in the zinc market. In comparison, there was no decline in global zinc demand (Chart 22, panel 4). As a result, the global supply deficit reached 152-thousand-metric-tons (kt) for the first seven months of 2016, versus the 230kt supply surplus during the same period last year. What Now? Tactically, We Remain Neutral. On the supply side, we do not see much new ore supply coming on stream over the next three months. On the demand side, both monetary and fiscal stimulus in China has pushed Chinese zinc demand higher. For the first seven months of 2016, the country's zinc consumption increased 209 kt, the biggest consumption gain worldwide. Because of China, global zinc demand did not fall this year. China will continue lifting global zinc demand as its auto production, highway infrastructure investment, and overseas demand for galvanized steel sheet will likely remain elevated over the near term (Chart 23, panels 1, 2 and 3). Inventories at the LME are still hovering around the lowest level since August 2009, while SHFE inventories also have been falling (Chart 23, bottom panel). Speculators seem to be running out of steam, as the open interest has dropped from the multi-year high on futures exchanges. Chart 22Zinc: Strategically Bearish, Tactically Neutral bca.ces_wr_2016_10_27_c22 bca.ces_wr_2016_10_27_c22 Chart 23Positive Factors In The Near Term bca.ces_wr_2016_10_27_c23 bca.ces_wr_2016_10_27_c23 The aforementioned factors militate against zinc prices dropping sharply in the near term. However, with prices near the 2014 and 2015 highs, and facing strong technical resistance, we do not see much upside. Strategically, We Downgrade Our Strategic Zinc View From Neutral To Bearish We believe zinc supply (both ore and refined) will rise in response to current high prices, resulting in a 10-15% decline in zinc prices over next 9-12 months. Chart 24High Prices Will Boost Supply In 2017 bca.ces_wr_2016_10_27_c24 bca.ces_wr_2016_10_27_c24 Zinc prices at both LME and China's SHFE markets are high (Chart 24, panel 1). Last year, many miners and producers cut their ore and refined production due to extremely low prices. If zinc prices stay high over next three to six months, we expect to see an increasing amount of news stories on either production cutbacks coming back or new supply being added to the market, which will clearly be negative to zinc prices (Chart 24, panels 2 and 3). So far, even though Glencore, the world's biggest ore producing company, is still sticking firmly to its output reduction plan, there have been some news reports about other producers raising their output, all of which will increase zinc ore supply in 2017. The CEO of the Peruvian Antamina mine said on October 10 the mine operator will aim to double its zinc output in 2017 to 340 - 350 kt, up from an estimated 170 kt - 180 kt this year, as the open pit operation transitions into richer zinc areas. This alone will add 170 kt - 180 kt new zinc supply to the market. Vedanta said last week that its zinc ore output from its Hindustan Zinc mine located in India will be significantly higher over next two quarters versus the last two quarters. Nyrstar announced in late September that it is reactivating its Middle Tennessee mines in the U.S., expecting ore production to resume during 2017Q1 and to reach full capacity of 50 kt per year of zinc in concentrate by November 2017. Red River Resource is also restarting its Thalanga zinc project in Australia, and expects to resume producing ore in early 2017. Glencore may not produce more than its 2016 zinc production guidance over next three months. But it will likely set its 2017 guidance higher, if zinc prices stay elevated. After all, the company has massive mothballed zinc mines, which are available to bring back to the market quickly. In comparison to the high probability of more supply coming on stream, global demand growth is likely to stay anemic in 2017, as the stimulus in China, which was implemented in 2016H1, will eventually run out of steam. How Will China Affect The Global Zinc Market? Chart 25Look To Short Dec/17 Zinc bca.ces_wr_2016_10_27_c25 bca.ces_wr_2016_10_27_c25 China is the world's largest zinc ore producing country, the world's largest refined zinc producing country, and the world's largest zinc consuming country. Last year, the country produced 35.9% of global zinc ore, 43.8% of global refined zinc, and consumed 46.7% of global zinc. Over the near term, China is a positive factor to global zinc prices. Domestic refiners are currently willing to refining zinc ores as domestic zinc prices are near their highest levels since February 2011. With inventories running low and domestic ore output falling 7.8% during the first seven months of 2016, the country may increase its zinc ore imports in the near term, further tightening global zinc ore supply. Domestic zinc demand and overseas galvanized steel demand are likely to stay strong in the near term. However, over the longer term, China will become a negative factor to global zinc prices. China's ore output the first seven months of 2016 was 221 kt lower than the same period of last year as low prices in January-March forced widespread mine closures. The country's mine output may not increase much, as the government shut 26 lead and zinc mines in August in Hunan province (the 3rd largest zinc-producing province in China) due to safety and environmental concerns. The ban will be in place until June 2017. Looking forward, elevated zinc prices and a removal of the ban will boost Chinese zinc ore output in 2017. Regarding demand, we expect much weaker Chinese zinc demand growth next year as this year's stimulus should run out of steam by then. Risks If global zinc ore supply does not increase as much as we expect, or global demand still have a robust growth next year, global zinc supply-demand balance may be more tightened, resulting in further zinc price rallies. If Chinese authorities resume their reflationary policies next year during the lead-up to the 19th National Congress of the Communist Party of China in the fall, which may increase Chinese and global zinc demand considerably, we will re-evaluate our bearish strategic zinc view. Investment Ideas As we are strategically bearish zinc, we recommend selling Dec/17 zinc if it rises to $2,400/MT (current: $2,373.5/MT) (Chart 25). If the sell order gets filled, put on a stop-loss level at $2,500/MT. Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com 1 Please see p. 32 of the 2016 edition of the International Energy Agency's "Key World Energy Statistics." The IEA reckons global oil demand in 2014 averaged just over 93mm b/d. 2 Please see the Financial Times, p. 12, "Warning on electric vehicle threat to oil industry," in the October 9, 2016, re the Fitch Ratings report, and IHS Energy's Special Report, "Deflating the 'Carbon Bubble,' Reality of oil and gas company valuation," published in September 2014. 3 Because of the early stage of the project, a conventional equity analysis is not yet applicable. 4 Please see Technology Sector Strategy Special Report "Electric Vehicle Batteries", dated September 20, 2016, available at tech.bcaresearch.com 5 Please see Commodity & Energy Strategy Weekly Report for Base Metal section, "Global Oil Market Rebalancing Faster Than Expected", dated October 22, 2015, available at ces.bcaresearch.com Investment Views and Themes Recommendations Tactical Trades Commodity Prices and Plays Reference Table Closed Trades

Highlights When interest rates are ultra-low, central banks have no margin for policy error. A small loosening or tightening has the potential to produce either a stall or catastrophic turbulence. The analogy is flying a plane at high altitude. Bond investors should have a strong preference for U.S. T-bonds over German bunds (currency hedged). Currency investors should prefer the euro over the dollar. For equity investors, valuations do not appear structurally attractive anywhere, once a sufficient equity risk premium is factored in. But a setback in the region of 5-10% could create a tactical entry point. Feature As the ECB Governing Council convenes for its October monetary policy meeting, an experience familiar to pilots1 provides a perfect analogy for central banks' very limited margin for error. Pilots call the experience "flying in coffin corner." Chart of the WeekUnusually High Turbulence For The German 30-Year Bund Unusually High Turbulence For The German 30-Year Bund Unusually High Turbulence For The German 30-Year Bund Next time you're in a plane climbing to 35,000 feet, here's something to think about; or perhaps, not to think about. As the plane gains altitude, its stall speed increases while its upper speed limit simultaneously decreases. For the pilot, this means less and less margin for error (Figure I-1). The plane's stall speed is the minimum speed to generate sufficient lift. At higher altitude, as the air gets thinner, the stall speed increases. Meanwhile, the plane's upper speed limit is set by the speed of sound. Airliners cannot fly too close to the speed of sound because the sonic shockwave produces violent and catastrophic turbulence. At higher altitude, as the air temperature drops, so does the speed of sound. Which means the plane's upper speed limit decreases. By the time the plane has reached the rarefied atmosphere of 35,000 feet, these lower and upper speed limits are barely 25 knots (30mph) apart,2 leaving almost no room for flight data misinterpretation or pilot error.3 Hence, at high altitude pilots morbidly say they are "flying in coffin corner." Analogously, in the rarefied atmosphere of zero or near-zero interest rates, central bank policy is also in coffin corner. When short-term and long-term interest rates approach the zero bound, there is no room for economic data misinterpretation or policy error. A small loosening or tightening of monetary policy has the potential to produce either a stall or catastrophic turbulence (Figure I-2 and Chart of the Week). Figure I-1Flying At High Altitude ##br## Has No Margin For Error Flying At The Edge Flying At The Edge Figure I-2Monetary Policy At Ultra-Low Rates ##br##Has No Margin For Error Flying At The Edge Flying At The Edge Avoiding A Stall At today's zero or near-zero interest rates in the euro area, a small loosening of monetary policy risks stalling the banking system, and thereby stalling the economy. A bank's core business is simple. Take in deposits, and lend them out at a higher interest rate than the deposit-rate - with the difference in the two defining the bank's net interest margin. A part of the net interest margin is a compensation for the risk of non-performing loans. This should be profit-neutral if correctly priced. The other large part of the net interest margin comes from the interest rate term-structure, as loans tend to be long-term while deposits are short-term. Hence, all else being equal, the bank's profitability suffers as the term-structure flattens. For a while, the bank can protect its profitability by cutting the interest rate paid on short-term deposits to well below the policy rate. However, once the policy rate hits zero, this profit-protection strategy hits a wall - because a negative deposit rate would risk an exodus of deposits into cash or cash-substitutes. Alternatively, the bank could charge a higher rate to borrowers, but this would tighten credit conditions. The third possibility is for the bank to suffer a hit to its already-thin net lending margin, but this would also tighten credit conditions. The pressure on the bank's profitability and share price would increase the cost of equity, making it harder to raise capital (Chart I-2). Given that an insufficient capital buffer is a major constraint to euro area bank lending, this would be a de facto tightening of credit conditions. The paradox is that at the zero bound, the smallest additional monetary loosening - via interest rate cuts or QE - risks stalling euro area bank credit creation (Chart I-3). Thereby it risks stalling economic growth. Chart I-2The ECB's QE Has Hurt Bank Valuations The ECB's QE Has Hurt Bank Valuations The ECB's QE Has Hurt Bank Valuations Chart I-3The Interplay Between Bank Profits And Bank Credit Creation Flying At The Edge Flying At The Edge Avoiding Violent Turbulence An extended period of ultra-low interest rates, and a commitment to keep them structurally low, has compressed the yields on government bonds pushing up their prices. As competing asset classes, the prices of corporate bonds and equities have also increased. This phenomenon is called the Portfolio Balance Effect. The big problem is that the prices of riskier assets have increased by more than is justified by the portfolio balance effect alone. This distortion is the result of a behavioural finance phenomenon called Mental Accounting Bias. Mental Accounting Bias describes the irrational distinction between the return from an investment's yield and that from its capital growth. The distinction is irrational because the money that comes from yield and the money that comes from capital growth is perfectly fungible.4 Rationally, what should matter is an investment's total return. But psychologically, the distinction between yield and capital is very stark. Fears about self-control cause people to compartmentalise yield as spending money and capital as saving money. Hence, people who want their investments to generate spending money - say, retirees - have an irrational focus on yield. Traditionally, the safe income from cash and government bonds satiates the people who irrationally focus on yield. However, in recent years, central banks' extended experiments with ZIRP, NIRP and QE have forced these yield-focussed investors out of cash and government bonds into risky investments. And just like every distortion, this phenomenon has generated memes to justify the act: 'reach for yield', 'search for yield', and 'there is no alternative' (TINA). But the irrational focus on yield instead of total return has artificially bid up the prices of risky investments. To the point that they no longer offer a sufficient risk premium5 for the very real possibility of substantial losses over a 5-10 year horizon (Chart I-4 and Chart I-5). The unfortunate thing is that as central bankers have little expertise in psychology or behavioural finance, they have been blind to the very dangerous behavioural distortion that their monetary policy experiments have unwittingly unleashed. Chart I-4A Positive Yield On Equities##br## Can Produce A Negative 5-Year Return... bca.eis_wr_2016_10_20_s1_c4 bca.eis_wr_2016_10_20_s1_c4 Chart I-5...And Even A Negative ##br##10-Year Return bca.eis_wr_2016_10_20_s1_c5 bca.eis_wr_2016_10_20_s1_c5 The risk is that the smallest monetary tightening could trigger an aggressive unwinding of this behavioural distortion. Recall the violent turbulence in global financial markets at the start of the year after just one 25bps rate hike from the Federal Reserve. Now consider what might happen if the Fed hiked again and the ECB simultaneously announced a rapid tapering of its QE program. How Must The Pilots Fly? In a rarefied atmosphere, pilots have very little margin to alter speed without inducing a stall or violent turbulence. The same applies to central banks today. The ECB has the hardest piloting task. It is becoming difficult to justify the current aggressive pace of QE given the danger of stalling the euro area banking system; and given that the euro area's nominal GDP and nominal wage bill are both growing at a very respectable 3% (Chart I-6). But an abrupt end to the ECB's QE could create violent turbulence in QE-distorted financial markets. Chart I-6What Deflation Threat? Euro Area Nominal GDP And The Wage Bill Growing At 3% bca.eis_wr_2016_10_20_s1_c6 bca.eis_wr_2016_10_20_s1_c6 Hence, the ECB's best course of action is to hint at a very gradual deceleration of QE to start at some point in the second half of 2017. Turning to developed economy central banks in general, we remind readers of a very powerful observation. Since 2008, no major central bank has been able to hike interest rates by more than 1.75%. And every central bank that has hiked rates has had to start unwinding those hikes within a year, ultimately taking the policy rate to a new all-time low (Chart I-7 and Chart I-8). Chart I-7Since 2008, All Rate Hikes ##br##Have Been Quickly Reversed bca.eis_wr_2016_10_20_s1_c7 bca.eis_wr_2016_10_20_s1_c7 Chart I-8Will The U.S. Be ##br##Any Different? No bca.eis_wr_2016_10_20_s1_c8 bca.eis_wr_2016_10_20_s1_c8 Given the turbulence that rate hikes will generate in the financial markets and/or the economy, we fully expect the Federal Reserve to go through exactly the same experience. The important upshot is that global central bank policy through 2017-18 will be considerably less divergent than is discounted. Bond yields could creep higher in the short term. But on a 1-year horizon, bond investors should have a strong preference for U.S. T-bonds over euro area bonds, and especially over German bunds (currency hedged). Over the same horizon, currency investors should prefer the euro over the dollar. For equity investors, valuations do not appear structurally attractive anywhere once a sufficient equity risk premium is factored in. Moreover, the potential for ECB QE-tapering combined with expectations for a Fed rate hike could generate some near-term turbulence. That said, a setback in the region of 5-10% could create an excellent entry point for a 3-month trade. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com Fractal Trading Model* There are no new trades this week. Last week's long silver/short lead pair trade has bounced sharply. And the short U.K. A-rated corporate bonds trade has achieved its 4% profit target. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 Long Silver / Short Lead Long Silver / Short Lead * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. 1 Your author is a former pilot in the Royal Air Force reserve. 2 For an Airbus A330. 3 Tragically, a combination of flight data misinterpretation and pilot error at 35,000 feet was disastrous for Air France flight AF447 flying from Rio de Janeiro to Paris in June 2009. Going through a storm, the airspeed indicator started giving a false reading and the pilot took the wrong corrective action, resulting in a catastrophic stall. 4 Assuming no difference in tax treatment of income and capital gains. 5 Please see the European Investment Strategy Weekly Report "The Great Distortion... And How It will End" dated September 15, 2016 available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields bca.eis_wr_2016_10_20_s2_c2 bca.eis_wr_2016_10_20_s2_c2 Chart II-3Indicators To Watch - Bond Yields bca.eis_wr_2016_10_20_s2_c3 bca.eis_wr_2016_10_20_s2_c3 Chart II-4Indicators To Watch - Bond Yields bca.eis_wr_2016_10_20_s2_c4 bca.eis_wr_2016_10_20_s2_c4 Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations bca.eis_wr_2016_10_20_s2_c5 bca.eis_wr_2016_10_20_s2_c5 Chart II-6Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_10_20_s2_c6 bca.eis_wr_2016_10_20_s2_c6 Chart II-7Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_10_20_s2_c7 bca.eis_wr_2016_10_20_s2_c7 Chart II-8Indicators To Watch ##br##- Interest Rate Expectations bca.eis_wr_2016_10_20_s2_c8 bca.eis_wr_2016_10_20_s2_c8

Highlights Our protector portfolio is a combination of assets that have a low or negative correlation with equities that give investors some downside protection. Replacing cash and/or Treasuries with our protector portfolio in 60-30-10 or 60-40 benchmark portfolios would have produced superior returns since 2011. We continue to advocate allocating investments to our protector portfolio in the near term as it represents an effective hedge against immediate risks such as a negative market reaction to the upcoming elections and/or disappointing third quarter profits. Feature Both equities and bonds are under pressure, as a higher likelihood of a December interest rate hike is beginning to be priced in at the same time as nervousness about Q3 earnings results has intensified. This confluence of factors - less liquidity and earnings disappointment - has been the central argument of our defensive portfolio stance for some time: any handoff from liquidity to growth would be shaky, and potentially premature. Indeed, as we wrote in the September 26 Weekly Report, liquidity conditions will largely remain favorable for risk assets for some time because even with a December rate hike, interest rates are well below equilibrium, i.e. are not restrictive. However, equity investors will suffer through bouts of earnings disappointments, similar to the chronic disappointment in GDP growth. As we show in Chart 1, throughout the economic recovery, expectations for economic growth have been revised lower and are only now finally in line with what we expect is close to reality. As highlighted in last week's report, investors' expectations about earnings are most likely to undergo the same fate because profit margins will remain a lasting headwind: investors have not yet adjusted to this new reality (Chart 2). That will hold equity gains to low single digits, at best. Chart 1Years Of One-Way (Down) Revisions bca.usis_wr_2016_10_17_c1 bca.usis_wr_2016_10_17_c1 Chart 2Earnings Set To Disappoint? bca.usis_wr_2016_10_17_c2 bca.usis_wr_2016_10_17_c2 Overall, our view is that the economic backdrop is stable as there are low odds of a recession-inducing monetary tightening occurring, and we do not see any other negative shocks that are concerning enough to trigger a recession. Still, above and beyond our worry about profit disappointments, many client queries are currently focused on U.S. election risks. On September 26, we warned of market volatility leading up to the election, since investors may continue to assign too low odds of a Trump Presidential win. However, we would expect markets to quickly recover - at least until Trump reveals his true policy colors. We took a page from the market reaction to Brexit as a possible guideline to the outcome of Trump winning the election, i.e. the election is ultimately won by a non-status quo candidate. Investors will recall that the post-vote U.K. equity market reaction to Brexit was short-lived but savage. However, the uncertainty around the upheaval of institutions and structures in the euro area and the U.K. are far greater than the election of a non-conformist U.S. President within an institutionally sound system with checks and balances. All of that said, we recognize that we could be wrong and that the U.S. election has taken over the pole position on investors' list of concerns. More specifically, investors are worried about negative financial market fallout from a Trump win.1 So, how should investors hedge the downside risk of these election results? And for that matter, what about other near-term risks? Protector Portfolio Explained This publication has been advocating for some time that investors hold some portion of their capital in a protector portfolio (currently a combination of TIPS, gold and the U.S. dollar). The goal is to find assets with a low or negative correlation to U.S. equities and offer a measure of protection against a steep selloff in stocks. As Chart 3 shows, a portfolio of 60/30/10, where 10% is placed in the protector portfolio, would have outperformed a traditional 60/30/10 allocation in which the 10% is held in straight cash since 2011 (in a ZIRP world). A 60/40 allocation where 40% is placed in the protector portfolio also beats a 60/40 stock/Treasury allocation since 2011. Chart 3Protector Portfolio Enhances Performance ##br## Since 2011 Protector Portfolio Enhances Performance Since 2011 Protector Portfolio Enhances Performance Since 2011 Chart 4Protector Components Are ##br## Negatively Correlated With S&P 500 bca.usis_wr_2016_10_17_c4 bca.usis_wr_2016_10_17_c4 The three assets included in our protector portfolio were chosen with specific risks in mind: USD: As the main global reserve currency, the U.S. dollar benefits when global risk aversion is on the rise. Admittedly, when fears have emanated from U.S. soil, the dollar has performed less well compared to other safe-haven assets, such as the Swiss franc and/or Swiss bonds. Nonetheless, for U.S. investors, investing in one's home currency can provide a natural hedge/advantage. In Chart 4, we show the one-year correlation between USD and S&P 500 equity returns. Since 2009, the correlation has been negative and the implication is that by holding USD, investors are already implicitly defensive. Gold: Gold traditionally does well in times of extreme geopolitical uncertainty and also as a hedge against inflation. More recently, gold has done less well as a hedge because the negative correlation between equity prices and gold broke down from 2011 until earlier this year (Chart 4). Gold has once again become negatively correlated with equity prices and we believe it will be an effective safe-haven asset should inflation become a concern. TIPS: Both 10-year TIPS and nominal Treasuries are negatively correlated with U.S. equity returns and both provide some measure of insurance in risk-off periods/phases of economic disappointment. Nonetheless, we prefer TIPS at the moment since they offer a measure of protection against a back-up in inflation expectations (also Chart 4). In sum, our protector portfolio is a combination of assets that are uncorrelated enough with equities to give investors some protection against a range of downside risks. Protector Portfolio: But Beware Buy And Hold Chart 5Protector Buy And Hold Will Not Work bca.usis_wr_2016_10_17_c5 bca.usis_wr_2016_10_17_c5 As Chart 2 has shown, our protector portfolio has outperformed both a 60-30-10 and 60-40 portfolio in recent years. However, longer -term performance has been less outstanding (Chart 5). Indeed, adding a constant proportion of safe-haven assets to a balanced portfolio over an extended period underperforms the balanced portfolio benchmark for long stretches of time: there are non-negligible costs associated with holding safe-haven assets over prolonged periods. The bottom line is that timing plays a critical part in investing in safe-haven assets. Owning a fixed share of protector portfolio assets over long horizons will not beat a traditional buy and hold strategy, although superior returns over cash offer a compelling case in a NIRP world. We continue to recommend that investors hedge against downside risk in the form of the protector portfolio - or simply by choosing the safe haven that most closely corresponds as a hedge to the specific risk at hand. However, it is important to know that safe-haven assets fall in and out of favor through time and the protector portfolio will at some point no longer be justified, and/or its components will need to be adjusted. For example, only after 2000 did Treasuries start providing a good hedge against equity corrections. The contrary is true for gold - it acted as one of the most secure investments during corrections until that time, but then became correlated with S&P 500 total returns from 2012-early 2016. That said, gold's coefficient has turned negative again, and it should be viewed as an all-weather safe haven, especially if deflation risks begin to dissipate. The Most Relevant Safe Haven In Case Of A Policy Mistake Chart 6Fed Policy Mistake? Buy Protector Portfolio bca.usis_wr_2016_10_17_c6 bca.usis_wr_2016_10_17_c6 As we wrote above, our base investment case is that the prospect of less liquidity and the risk of an earnings disappointment mean that investors should keep a defensive portfolio stance and be prepared for pullbacks in equities in the single digits. However, the Minutes of the latest FOMC meeting highlight that a fairly low threshold has been set for a December interest rate rise. If financial market participants interpret incoming economic information more bearishly than the Fed, then a December rate hike risks being perceived by investors as a policy mistake. Under this scenario, risk assets could be set for a much greater fall, buoying the case for further portfolio insurance. Which safe havens will outperform? We take our cue from the market reaction to the December, 2015 rate hike. In that episode, equity prices fell 12%. The protector portfolio in its current configuration2 increased 10%. The bulk of the appreciation was due to a strong run in gold prices (surely helped in part by massive woes in China) and TIPS (Chart 6). We believe that this basket of assets would once again offer an important buffer against equity losses associated with a policy mistake. The Most Relevant Safe Haven For A Trump Win If a Trump win triggers a correction in risk assets, we would expect the U.S. dollar to rally due to Trump policy uncertainty and heightened geopolitical risk. We noted above that USD does not always rally when a stress event occurs on U.S. soil. However, in the past several weeks, the performance of the dollar as well as Treasury yields has been linked to Trump's probability of winning the election. Whenever the odds of a Trump presidency rise, these risk-off assets have appreciated. And The Most Relevant Lessons From The Election Cycle This month's Geopolitical Strategy Special Report 3 provides a final forecast and implications for the elections. As we note above, we agree that a Trump win is a red herring in terms of the key issues investors face. But we also agree with our geopolitical strategists that there are several important lessons from the election cycle that may have long term ramifications for investors. Below, we highlight the most relevant for financial market participants: The median voter has moved to the left on economic policy. Trump's victory over an army of seasoned, relatively orthodox GOP contenders in the primary exposed the fact that the party's grassroots voters no longer care deeply about fiscal austerity and no longer wish to tolerate the corporate incentive for importing cheap labor. Similarly, demographic trends favoring millennials and minorities (who tend to vote left on economic policies), portends a shift by which the GOP attempts to capture left-leaning voters. Fiscal conservatism (and social conservatism, for that matter) will have less to show by way of official party machinery. The 2016 election campaign has amplified the notion that the news media works in narratives. These narratives work as a filter that preempts and distorts the presentation and, to some extent, reception of facts. This phenomenon was influential in Trump's rise - the first "Twitter" candidacy - as well as his recent decline. Investors cannot be too wary of what the mainstream press or financial "smart money" says about any particular political trend or event. It is essential to separate the wheat from the chaff by using empirics and looking at macro and structural factors to identify the constraints rather than the preferences of candidates or politicians. U.S. Economy: Neither Hot Nor Cold The NFIB survey of small business survey ranks as one of our preferred indicators of U.S. business confidence. The employment related indicators serve as a key input into our payroll model; questions about the pricing environment often provide a good leading/coincident gauge about inflation trends, and; as Chart 7 shows, the labor cost versus pricing series provides an excellent leading indicator for the profit margin outlook. The latter remains in a downtrend, reinforcing our message that profit margins will remain a headwind to earnings growth for still some time. Overall, small business optimism has been generally flat this year, after peaking in late 2014. It is somewhat discouraging that "demand" as a most important problem is no longer falling. Consumption has been one of the more robust areas of growth in the past several years and we expect consumption to continue to outshine other areas of the economy. However, even here, the data should be monitored closely. Chart 7Small Business Concerns (Part 1) bca.usis_wr_2016_10_17_c7 bca.usis_wr_2016_10_17_c7 Chart 8Small Business Concerns (Part 2) bca.usis_wr_2016_10_17_c8 bca.usis_wr_2016_10_17_c8 Retail sales (excluding gasoline and autos) growth has been slowing throughout 2016 and September data did not buck this trend (Chart 8). Results among retailers varied substantially, with growth strongest at building supply stores, sporting goods stores, vehicle dealers and furniture stores. Laggards include electronics and appliance stores - segments that are still under siege from falling prices. The bottom line is that in aggregate, consumption is holding up reasonably well and should continue to do so, as long as employment gains and modest wage growth remain intact. Stay tuned. Lenka Martinek Vice President, U.S. Investment Strategy lenka@bcaresearch.com 1 Our Geopolitical Strategy service concurs that a Trump win is a red herring, i.e. is unlikely to occur and is a distraction from more relevant issues. For more insight, please see Geopolitical Strategy Monthly Report "King Dollar: The Agent Of Righteous Retribution", dated October, 2016, available at gps.bcaresearch.com 2 At the time, the protector portfolio performed slightly less well, as 30-year government bonds were used instead of TIPS. 3 Please see Geopolitical Strategy Special Report "U.S. Election: Final Forecast & Implications", dated October 12, 2016, available at gps.bcaresearch.com Market Calls

Highlights It is premature to position for an equity market handoff from liquidity to growth. Cyclical sectors have overshot the mark in recent months. There is scant evidence from macro variables that cyclical sector earnings validation will materialize, especially if the U.S. dollar continues its stealth appreciation. Defensive sectors are primed to resume their market leadership role. Feature Rotational Correction Beneath the surface, equity markets have behaved as if a handoff to growth from liquidity is underway. Since July, defensives have not benefited from the broad market consolidation and increased volatility (Chart 1). Instead, cyclical sectors have celebrated the easing in financial conditions in recent months. The bounce in oil prices, commensurate narrowing in corporate bond spreads and firming inflation expectations have provided enough fuel for cyclical vs. defensive outperformance. Other financial markets appear to corroborate such a view. The equity-to-bond ratio has firmed. Inflation expectations have risen, partly reflecting commodity price appreciation. Gold prices are down. The Fed is itching to lift interest rates. Long-term global government bond yields have climbed. Even the U.S. dollar is testing the top end of its recent range (Chart 1). All of these factors would suggest that the growth outlook is steadily improving. If so, then a rethink of our defensive portfolio positioning would be imperative. Sectoral trends have reached a critical point. Defensive sectors have unwound overbought conditions, and are close to hitting oversold levels (Chart 2). The interest rate-sensitive consumer discretionary, financials and utilities sectors have already hit deeply oversold levels on the latest blip up in Treasury yields (Chart 2). Cyclical sectors are just starting to roll over from overbought levels. Chart 1The U.S. Dollar Is A Critical Influence The U.S. Dollar Is A Critical Influence The U.S. Dollar Is A Critical Influence Chart 2End Of Rotational Correction? bca.uses_sr_2016_10_17_c2 bca.uses_sr_2016_10_17_c2 These dynamics reflect a rotational equity market correction. Indeed, there have been many episodes in the past few years when countertrend sector swings occurred, but each was fleeting and the economy's need for liquidity stayed as strong as ever, ultimately propelling defensive shares back to a leadership position. Is this time different? Below, we revisit a range of indicators that we use to help forecast and time durable shifts in the cyclical vs. defensive trade off. Cyclical Vs. Defensive Checklist Update In our March, 2016 Special Report on cyclical vs. defensive sector strategy, we outlined a checklist of factors that would trigger the need for more aggressive positioning rather than simply riding out the anticipated countertrend move: Broad-based U.S. dollar weakness, particularly against emerging market currencies in countries with large current account deficits. An end to Chinese manufacturing sector deflation. A decisive upturn in global manufacturing purchasing manager's indexes. A return to growth in global export volumes and prices. A resynchronization in global profitability such that U.S. profits were not the only locomotive. A rebound in global inflation expectations. China credibly addressing banking sector weakness to the point where economic growth can reaccelerate rather than move laterally. Of this checklist, items 1, 2, 4, 5 and 7 remain unfulfilled, while items 3 and 6 have moved from a deep negative to a more neutral setting. Financial Variables Offer Modest Cyclical Sector Hope... Financial variables that typically lead the cyclical vs. defensive share price ratio have improved, on the margin, as noted in our March 29th Special Report. Commodity prices bounced on the back of the pause in the U.S. dollar rally, aided more recently by hopes for oil market supply restraint, while developed world equities have lagged behind their emerging market counterparts. The latter is notable, because goods producing cyclical sectors have a tight link with manufacturing-intensive emerging market economies (Chart 3). However, we do not recommend extrapolating these financial market messages, especially since the greenback and commodity prices are starting to reverse. It is also worth noting the bounce in emerging market currencies has been modest, and pales in comparison with the scale of the previous slide (Chart 3). In other words, we are not convinced that EM currency moves are signaling that countries are gaining better access to global funding. Moreover, the back up in global bond yields has not yet produced any meaningful steepening in the U.S. yield curve, which would be a reliable confirming indication that U.S. growth expectations were improving. At the moment, the yield curve is signaling that defensive sectors are now undershooting (Chart 4). Chart 3Some Financial Variables Have Firmed... bca.uses_sr_2016_10_17_c3 bca.uses_sr_2016_10_17_c3 Chart 4... But Not All bca.uses_sr_2016_10_17_c4 bca.uses_sr_2016_10_17_c4 ... But There Is Still A Dearth Of Fundamental Support Financial variables are only useful when confirmed by economic variables. Global manufacturing surveys have stabilized, but are oscillating around the boom/bust line rather than recording incremental gains. Inventory destocking may have finally run its course, based on the trough in the U.S. business sales-to-inventory ratio (Chart 5, top panel), but it is premature to forecast improvement in final demand. Keep in mind that ex consumption, the U.S. economy is in recession. Heavy truck sales have been an excellent business cycle indicator for decades. Truck orders tend to be an early indicator for activity. Heavy truck orders peaked in 2015, and the shipments-to-inventory ratio is heading rapidly toward recession levels (Chart 5). The risk is that employment cools. Corporate employment decisions are profit-motivated. Wages are currently rising much faster than nominal GDP. That is never a good environment for the labor market (Chart 6). True, wages are up, but productivity is down. While broad-based labor market weakness has yet to materialize, the risks are skewed to the downside. Sinking profits and rising wages warn that the unemployment rate is headed higher (shown inverted, Chart 6). Goods producing employment is rolling over relative to service sector employment, which is often a leading indicator of cyclical vs. defensive relative performance momentum (Chart 7, middle panel). Chart 5Cyclicals Have Overshot Fundamentals bca.uses_sr_2016_10_17_c5 bca.uses_sr_2016_10_17_c5 Chart 6Buy Cyclicals When The Economy Overheats bca.uses_sr_2016_10_17_c6 bca.uses_sr_2016_10_17_c6 Chart 7Mixed Signals bca.uses_sr_2016_10_17_c7 bca.uses_sr_2016_10_17_c7 The time to tilt portfolios in favor of cyclical sectors is when profits and profit margins are expanding at a rate such that the labor market is steadily tightening, creating a self-reinforcing consumption/economic feedback loop that feeds into rising inflation pressures, i.e. when the corporate sector is in a position of financial strength. Defensives often outperform when the unemployment rate is rising. Consumers are still much stronger than the corporate sector, and should remain so even if job growth recedes. Consumer balance sheets have been repaired and savings rates are up. Conversely, the BCA Corporate Health Monitor is deep in deteriorating health territory (Chart 5), as profits are contracting and free cash flow is eroding. That divergence is reflected in economic data. For instance, the producer price index is still deep in deflation relative to the consumer price index, albeit the rate of decay has lessened. The upshot is that a meaningful pricing power advantage exists for businesses that sell to consumers rather than to other businesses. Defensives are much more consumer-oriented than deep cyclical sectors, and move in line with relative pricing power (Chart 7). Little Help From Abroad It does not appear as if external forces will take up any slack from lackluster U.S. growth. The all important emerging market PMI has edged back to the boom/bust line, reflecting the tailwind from monetary easing. However, emerging market inventories have spiked in the last two months (shown inverted, Chart 8), warning against getting too excited about growth. It is notable that emerging markets, and China, have failed to begin deleveraging (Chart 9). Chart 8Global: From Negative To Neutral bca.uses_sr_2016_10_17_c8 bca.uses_sr_2016_10_17_c8 Chart 9A Bearish Credit Impulse A Bearish Credit Impulse A Bearish Credit Impulse The global credit impulse is negative, especially in commodity-dependent developing economies (Chart 9). It is no wonder that global export prices continue to deflate, and export volumes have slipped back into negative territory (Chart 10). The message is that developed country domestic demand is not yet sufficiently robust to boost global final demand. Instead, growth will continue to be redistributed through foreign exchange resets. While China has opened the fiscal taps, the economic outlook is still only for stabilization rather than growth acceleration. Money growth has surged and the Chinese Keqiang index has climbed off its lows (Chart 11), but we are reluctant to extrapolate these signals. Chart 10Still Deflating Still Deflating Still Deflating Chart 11Not Ready To Bet On China Acceleration Not Ready To Bet On China Acceleration Not Ready To Bet On China Acceleration Credit growth continues to sink and loan demand remains anemic (Chart 11). The speed of the debt build up since the financial crisis has been breathtaking, and undoubtedly included capital misallocation. While the unknown scale of the non-performing loan implications for the banking system is cause for concern, it is notable that the growth in fixed asset investment projects started has rolled over (Chart 11), and the authorities recently introduced measures to curb house price inflation. The Chinse manufacturing sector price deflator is still below zero (Chart 11). Now that the U.S. dollar is perking back up, the pressure on the authorities to reduce prices and/or further devalue the yuan will increase, representing another headwind for global cyclical companies, especially given the recent relapse in exports. Another bout of deflationary stress would cause risk premiums to rise for global cyclical equities, which garner a significant portion of revenue from abroad. Interest coverage is already razor thin, and free cash flow growth is deeply negative (Chart 12). U.S.-sourced profits are still outpacing earnings from the rest of the world, despite the pause in the U.S. dollar bull market over the past year. Now that the U.S. dollar is quietly grinding higher, the outlook is for ongoing U.S. profit outperformance. That is conducive to defensive sector outperformance (Chart 13). In all, it appears as if a technical adjustment has occurred in equity markets, rather than a fundamentally-driven trend change. In fact, the cyclical vs. defensive share price ratio appears to now be overshooting after having undershot. Worrisomely, most of this overshoot reflects a surge in tech stocks, and to a lesser extent, energy, as both industrials and materials have rolled over in relative performance terms (Chart 14). We expect leadership to revert back to non-cyclical sectors once the current rotational correction has run its course, given the lack of confirmation from the bulk of the macro variables on our checklist. Chart 12Risk Premiums Will Stay High Risk Premiums Will Stay High Risk Premiums Will Stay High Chart 13No Turn Yet No Turn Yet No Turn Yet Chart 14Deep Cyclicals: A One Trick Pony Deep Cyclicals: A One Trick Pony Deep Cyclicals: A One Trick Pony Bottom Line: Now is not the time to chase momentum in recent outperformers, as defensives are about to reclaim the leadership role from cyclical sectors, based on a broad range of macro, valuation and financial market indicators.

The U.S. dollar's corrective/consolidation phase is over, and it is about to rally. The risk-reward for EM stocks and currencies is extremely unattractive. We are reiterating our recommendation to short a basket of ZAR, BRL, TRY, MYR, IDR and CLP versus the U.S. dollar. There is a value opportunity in the Mexican peso. Go long MXN versus ZAR. Also, double down on the long MXN / short BRL trade.