Oil

Highlights The resilience of EM industrial commodity demand, which is helping to lift inflation and inflation expectations in the U.S., will be tested over the next few months, as markets gear up for a possible oil-production deal between OPEC and Russia, and the first of perhaps three Fed rate hikes in December and next year. Any indication Janet Yellen has persuaded her colleagues to run a "high-pressure economy" will provoke us to get long gold, given its sensitivity to the Fed's preferred inflation gauge. We remain wary, however, given the higher-rates stance favored by some Fed officials, which, our modeling suggests, would reverse the pick-up in inflation and inflation expectations in the U.S. by depressing EM growth. Energy: Overweight. We continue to favor U.S. shale-oil producers at this stage in the cycle, and continue to look for opportunities to take commodity price exposure. Base Metals: Neutral. We downgraded copper to neutral from bullish last week, expecting prices to trade sideways over the next three months. Precious Metals: Neutral. We continue to be buyers of gold at $1,210/oz. If we continue to see the Fed's preferred inflation gauge increase, we will raise that target. Ags/Softs: Underweight. We are recommending a tactical long position in Mar/17 wheat versus a short in Mar/17 soybeans. Feature In her Boston Fed speech last week, Fed Chair Janet Yellen dangled catnip in front of commodity markets by discussing the possibility of "temporarily running a 'high-pressure economy,' with robust aggregate demand and a tight labor market" as a means of countering the prolonged hysteresis in the U.S. economy.1 Any indication Dr. Yellen has succeed in convincing her colleagues to pursue such a strategy would compel us to get long gold, given the sensitivity of the yellow metal to core PCE, the Fed's preferred inflation gauge (Chart of the Week).2 Indeed, we find there is a long-term equilibrium between spot gold prices and the core PCEPIand U.S. financial variables, which is extremely robust over time.3 Core PCEPI has been ticking up this year, most recently in March and appears to be leading 5-year/5-year inflation expectations tracked by the St. Louis Fed, which bottomed in June and have been trending higher since (Chart 2).4 In our modeling, we find a 1% increase in core PCE translates into a 4% increase in gold prices, suggesting gold would provide an excellent hedge against rising inflation. Chart of the WeekGet Long Gold If Pressure ##br##Builds in U.S. Economy bca.ces_wr_2016_10_20_c1 bca.ces_wr_2016_10_20_c1 Chart 2Core PCE ##br##Ticking Up bca.ces_wr_2016_10_20_c2 bca.ces_wr_2016_10_20_c2 Core PCE And EM Commodity Demand There is an enduring long-term relationship between inflation generally and EM commodity demand, which we have highlighted in previous research.5 This week we are exploring long-term equilibrium relationships between EM industrial commodity demand and core PCE, given the obvious interest among commodity investors. The big driver of core PCE is EM industrial commodity demand, as can be seen in Chart 3, which shows the output of two regressions we ran using non-OECD oil demand - our proxy for EM oil demand - and world base metals demand, which is dominated by China's roughly 50% share of global base metals demand. Core PCE is cointegrated with these measures of industrial-commodity demand, which makes perfect sense considering most - sometimes, all - of the demand growth for industrial commodities (oil and base metals, in this instance) is coming from EM economies.6 For example, of the total growth in oil demand since 2013, non-OECD demand accounted for 1.1mm b/d of an average 1.2mm b/d global demand growth. Within other markets, China accounts for more than 50% of global iron ore, copper ore, metallurgical and thermal coal demand.7 At the margin, prices in the real economy are being set by EM demand, not by DM demand. This, in turn, feeds into core and headline PCE and other inflation gauges. Feedback Between Fed Policy And EM Commodity Demand Leading economic indicators for EM growth are turning up, which is supportive for commodity demand near term (Chart 4). This has been aided by accommodative monetary policy in the U.S., which has kept the USD relatively tame after peaking in January 2016.8 Chart 3EM Industrial Commodity Demand,##br## Core PCE Share Common Trend bca.ces_wr_2016_10_20_c3 bca.ces_wr_2016_10_20_c3 Chart 4EM Leading Indicators ##br##Point to Growth Upturn bca.ces_wr_2016_10_20_c4 bca.ces_wr_2016_10_20_c4 The single biggest risk to commodity demand and commodity prices remains U.S. monetary policy. The longer-term cointegrating relationships highlighted in this week's research are consistent with earlier results we reported on the impact of U.S. financial variables on commodity demand.9 When we model EM oil demand as a function of U.S. financial variables, we find a 1% increase (decrease) in the USD broad trade-weighted index (TWI) is consistent with a 22bp decrease (increase) in consumption using these longer-dated models. For global base metals, a 1% increase (decrease) in the USD TWI corresponds with a 27bp drop (increase) in demand. As a general rule, each 1% increase (decrease) in the USD TWI is accompanied by a 25bp drop (increase) in EM demand for oil and global base metals (Charts 5 and 6). Chart 5EM Oil Demand Will Fall If ##br##The Fed Gets Too Aggressive... bca.ces_wr_2016_10_20_c5 bca.ces_wr_2016_10_20_c5 Chart 6...As Will##br## Base Metals Demand bca.ces_wr_2016_10_20_c6 bca.ces_wr_2016_10_20_c6 As mentioned above, we continue to expect a 25bp hike by the Fed at its December meeting, followed by two additional hikes next year. Our House view continues to maintain this round of rate hikes will cause the USD to appreciate by 10% over the next 12 months. If this is fully passed through, we expect this gauge to register a ~ 2.5% decline in EM demand for industrial commodities. This would reduce the core PCE's yoy rate of change to ~ 1%, vs. the current level of 1.7% yoy growth. Walking A Tightrope Chair Yellen's speech makes it clear the Fed is well aware of how its monetary policy affects the global economy and the feedback loop this creates. This is of particular moment right now, given the Fed is the only systemically important central bank even considering tightening its monetary policy. As she notes, "Broadly speaking, monetary policy actions in one country spill over to other economies through three main channels: changes in exchange rates; changes in domestic demand, which alter the economy's imports; and changes in domestic financial conditions - such as interest rates and asset prices - that, through portfolio balance and other channels, affect financial conditions abroad." The other major threat to EM commodity demand is the oil-production deal being negotiated by OPEC, led by the Kingdom of Saudi Arabia (KSA), and non-OPEC, led by Russia. Should these negotiations result in an actual cut in oil production, it would accelerate the tightening of global oil markets - likely increasing the rate at which global inventories of crude oil and refined products are drained - and put upward pressure on prices. While we do not expect a material agreement to emerge from these negotiations - KSA and Russia already are producing at or close to maximum capacity at present. A freeze in production by these states would result in no change in production globally. The risk here is KSA actually cuts production beyond its seasonal decline by adding, say, a 500k b/d cut to the expected 500k b/d seasonal decline, and Russia agrees to something similar. This would be offset by continued production increases in Iran, and possibly in Libya and Nigeria, but would, nonetheless, surprise the market and rally prices. All else equal, higher prices would weaken EM demand growth at the margin, and feed back into lower inflation expectations. We do not believe it is in KSA's or non-OPEC producers' interest to try to tighten markets sharply, since a price spike would re-energize conservation efforts by consumers, particularly in DM economies, and incentivize alternative transportation technologies like electric cars, as happened when oil prices were above $100/bbl from 2010 to mid-2014. Nonetheless, KSA, Russia, and other parties to any production-management agreement will have to balance this risk against the likelihood U.S. shale producers step in to fill the production cutbacks before any meaningful increase in revenues accrues to these states. Bottom Line: It still is too early to discuss the implications of a production cut, given negotiations between the KSA and Russia camps ahead of OPEC's November meeting continue. However, this could become a material issue next year, just as the Fed is considering whether to hike rates two more times, as we expect. A combined oil-production cut emerging from the KSA - Russia negotiations, which is a non-trivial risk, coupled with two Fed rate hikes could set off a new round of disinflation or even deflation, just as EM commodity demand was starting to enliven inflation and inflations expectations in the U.S.10 This could force the Fed to back off further rate hikes, or even walk back previous rate hikes. If on, the other hand, Chair Yellen is successful in persuading her colleagues to run a "high-pressure economy" we would look to get long commodities generally, gold in particular, given our expectation core PCE inflation and inflation expectations will move higher. As our research has shown, the yellow metal is particularly sensitive to the Fed's preferred inflation gauge. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com SOFTS China Commodity Focus: Softs Grains: Focus On Relative-Value Trade We remain strategically bearish grains, but we are upgrading our tactical view for wheat from bearish to neutral. We believe most of the negative news already is reflected in wheat prices. Over next three to six months, we expect wheat to outperform soybeans. Wheat prices could move up on reduced U.S. acreage, rising Chinese imports, or any unfavorable winter weather in major producing countries while expanding area-sown in Brazil, Argentina, China and the U.S. will likely pressure down soybean prices. We recommend a tactical long position in March/17 wheat versus March/17 soybeans. We suggest a 5% stop-loss to limit the downside risk. Grain prices have already rebounded 10.3% since August 30, when prices collapsed to a 10-year low (Chart 7, panel 1). There were three main reasons behind the precipitous price drop from early June to late August. 1.The 25% rally grain prices in 2016H1 encouraged global planting of spring wheat, soybeans, corn and rice. 2.Favorable weather lifted yields of all grains to record highs. 3.Extremely cheap Russian, Ukraine, Argentine and Brazilian currencies boosted exports from these major grain producing countries. In addition, grain-related policy changes in Argentine and Russia also have stimulated their grain exports (wheat benefited most and corn next). Given a 10% rebound recently, as the USDA expects global grain stocks to rise 3% to a new high next year, we remain a strategical bearish view on grain. Looking forward, we will continue to focus on relative-value trades in grain markets. Tactically, we are interested in long wheat versus soybeans. Wheat: Tactically Neutral Wheat has underperformed other grains so far in 2016 (Chart 7, panel 2). Prices fell to 361 cents per bushel on August 31, which was the lowest level since June 2006 (Chart 7, panel 3). Wheat prices have already recovered 16.7% from their August bottom. We believe, over the next three to six months, wheat prices may have limited downside due to one or a combination of the following factors. U.S. farmers are currently in the process of planting winter wheat. According to the USDA, as of October 9, 59% of winter wheat acreage has been planted. As U.S. wheat production costs are well above current market prices, U.S. farmers likely will further cut their wheat acreage over the next several weeks. This year, U.S. wheat-planted acreage has already dropped to the lowest since 1971 (Chart 8, panel 1). Global wheat yields improved 2.8% this year, with 13.4% and 20.8% increases in Russian and U.S. yields, respectively. Even though Russia will raise its wheat-sown area for next season, the country's wheat crop still faces plenty of risks during its development period. Too cold a winter or too hot a summer, which may not even result in a considerable drop in yields, still could spur a temporary rally in wheat prices. Similarly, U.S. wheat yields are also likely to retreat from the record high in 2017H1. In addition, extremely low wheat prices will encourage global farmers to plant other more profitable crops instead. As a result, both global wheat acreage and yields will likely go down next year (Chart 8, panel 2). Speculators are currently holding sizable net short positions. Market sentiment is also extremely bearish. Given this backdrop, any short-covering also would drive prices up (Chart 8, panels 3 and 4). Chart 7Wheat: Cautiously Bullish bca.ces_wr_2016_10_20_c7 bca.ces_wr_2016_10_20_c7 Chart 8Wheat: Upgrade To Tactically Neutral ##br##On Supportive Factors bca.ces_wr_2016_10_20_c8 bca.ces_wr_2016_10_20_c8 Soybeans: Tactically Bearish Soybeans have outperformed other grains significantly this year (Chart 7, panel 2). As planting soybeans general is more profitable than planting corn, wheat and rice, global farmers are likely to expand their soybean acreage for the next harvest season. According Conab, Brazil's national crop agency, Brazil's soybean production next spring will increase 6.7% to 9%. Record high U.S. soybean production is likely to weigh down the market as well. According to the USDA, 7.1% jump in the yields will bring U.S. soybean crop to a record high, an 8.7% increase from last year. As of October 9, 2016, only 44% U.S. soybean has been harvested, 12 percentage points behind last year. Chart 9China Grain Imports Will Continue Rising China Grain Imports Will Continue Rising China Grain Imports Will Continue Rising How does China contribute to our grain view? As the world's largest grain producer and also the largest consumer, China is an important player in global grain market. Last year the country accounted for 20.7% of global aggregate grain production and 23% of global consumption. In terms of grain imports, as we predicted in our January 2011 Special Report "China-related Ag Winners For The Long Term," China's grain imports have been on the uptrend, despite the depreciating RMB in the most recent two years (Chart 9). In terms of individual grain markets, China has been the most significant player in the global soybean market, accounting for 62.7% of global imports last year. China is also the world's largest rice importer, accounting for 12.5% of global rice trade. However, for corn and wheat markets, China only accounted for about 2% of global trade. In late March, the Chinese government announced an end to its price-support program for corn, but the government maintained price-support policies for wheat and rice. The government also announced its temporary reserve policy will be replaced by a new market-oriented purchase mechanism for the domestic corn market. In addition, the policy of giving direct subsidies to soybean farmers will continue in the 2016-17 market year. What Are The Implications Of China's Grain-Related Policy? Domestic corn prices fell sharply with global prices, while the gap between domestic soybean prices and the international ones remains large (Chart 10, panels 1 and 2). This will discourage domestic corn sowing and encourage soybean production, which is positive to global corn markets, but negative for global soybean markets. China's imports of wheat and rice are set to rise, given a widening price gap (Chart 10, panels 3 and 4). The country's demand for high-quality wheat and rice are rising as household incomes have greatly improved. China will likely liquidate its elevated grain inventories, which account for about 45% of global stocks. This will be bearish for all grains. However, as most of the domestic grain stocks are low-quality grains, inventory liquidation may affect animal feed market rather than the good-quality grain market. Overall, China's grain policy is positive for international corn, wheat and rice prices, but negative for global soybean prices. Investment strategy As we expect wheat to outperform soybeans over the next three to six months, we recommend a tactical long position in March/17 wheat versus short March/17 soybeans with a 5% stop-loss (Chart 11). Chart 10Implications Of China Grain Related Policy bca.ces_wr_2016_10_20_c10 bca.ces_wr_2016_10_20_c10 Chart 11Go Long Wheat Versus Soybeans With Stops bca.ces_wr_2016_10_20_c11 bca.ces_wr_2016_10_20_c11 Downside risks To Our Relative-Value Trade Position Currently, global wheat inventories still are at a record highs, and almost all the major wheat exporting countries continue to hold considerable inventory for sale. If farmers in Russia, Ukraine and Argentina rush to sell to take advantage of recent price rally, wheat prices will fall. Also, a strengthening USD will put a downward pressure on grain (including wheat and soybeans) prices. For this reason, it will be important to monitor U.S. dollar strength against the currencies of these countries - too-strong a USD will keep grains from being exported, which will keep domestic U.S. prices under pressure. However, our relative-value trade may weather this risk well as a strengthening dollar affects both wheat and soybeans. Moreover, if weather continues to be favorable during the winter, wheat prices may drop below the August lows. On the other side, if unfavorable weather reappears in South America next spring like this year, soybean prices may quickly go up. To limit our downside risk, we suggest putting a 5% stop-loss to our long wheat/short soybeans trade. Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com 1 Please see "Macroeconomic Research After the Crisis," Dr. Yellen's speech delivered at the October 14, 2016, Boston Fed 60th annual economic conference in Boston. She highlighted hysteresis - "the idea that persistent shortfalls in aggregate demand could adversely affect the supply side of the economy" - in her discussion on how demand affects aggregate supply. She noted, "interest in the topic has increased in light of the persistent slowdown in economic growth seen in many developed economies since the crisis. Several recent studies present cross-country evidence indicating that severe and persistent recessions have historically had these sorts of long-term effects, even for downturns that appear to have resulted largely or entirely from a shock to aggregate demand." 2 Core PCE is the Personal Consumption Expenditures (PCE) price index, which excludes food and energy prices 3 The relationship shown in the Chart Of The Week covers the period March 2000 to present. The adjusted R2 of the cointegrating regression we estimated is 0.97; the price elasticity of gold with respect to a 1% change in the core PCE is close to 4%. The model is dominated by real rates, however: a 1% increase in real rates translates to a 15% decrease in gold prices, while a 1% increase in the broad trade-weighted USD implies a decrease in gold prices of just under 2.5%. Data and modeling constraints took the last observation to August 2016, when the model suggested the "fair value" of gold was close to $1,200/oz. At the time, gold was trading at just below $1,310/oz. Prices subsequently fell into the low to mid $1,200s, and were trading at ~ $1,270/oz as we went to press). 4 For this chart, we use the St. Louis Fed's 5y5y U.S. TIPS inflation index. Please see Federal Reserve Bank of St. Louis, 5-Year, 5-Year Forward Inflation Expectation Rate [T5YIFR], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/T5YIFR , October 19, 2016. 5 Please see "Memo To Fed: EM Oil, Metals Demand Key To U.S. Inflation" and "Commodities Could Be Hit Hard By Fed Rate Hikes," in the August 4, 2016, and September 1, 2016, issues of BCA Research's Commodity & Energy Strategy. Both are available at ces.bcaresearch.com. See also "China's Evolving Demand for Commodities," by Ivan Roberts, Trent Saunders, Gareth Spence and Natasha Cassidy," presented at the Reserve Bank of Australia's Conference focused on "Structural Change in China: Implications for Australia and the World," 17 - 18 March 2016. 6 The adjusted-R2 statistics for cointegrating regressions we ran for core PCE as a function of non-OECD oil demand and world base metals demand were 0.99 and 0.98 from 2000 to present. 7 Please see discussion beginning on p. 4 of "China's Evolving Demand for Commodities," by Ivan Roberts, Trent Saunders, Gareth Spence and Natasha Cassidy," presented at the Reserve Bank of Australia's Conference focused on "Structural Change in China: Implications for Australia and the World," 17 - 18 March 2016. 8 The Fed's broad trade-weighted USD index post-Global Financial Crisis peaked in January at just under 125 and currently stands at 122.6. Please see Board of Governors of the Federal Reserve System (US), Trade Weighted U.S. Dollar Index: Broad [TWEXBMTH], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/TWEXBMTH, October 18, 2016. 9 Please see p. 3 of "Commodities Could Be Hit Hard By Fed Rate Hikes," in the September 1, 2016, issue of BCA Research's Commodity & Energy Strategy, available at ces.bcaresearch.com. 10 We define a non-trivial risk as a 1-in-6 chance of occurrence - i.e., the same odds as Russian roulette. Investment Views and Themes Recommendations Tactical Trades Commodity Prices and Plays Reference Table Closed Trades

Highlights EM tech stocks are overbought while banks are fundamentally vulnerable due to bad-loan overhang. EM stocks have never decoupled from the U.S. dollar and commodities prices. There has been no recovery in EM corporate profitability and EPS. We reiterate two equity trades: short EM banks / long U.S. banks, and short Chinese property developers / long U.S. homebuilders. Upgrade Thai stocks to overweight within the EM equity benchmark and go long THB versus KRW. Feature Our Reflation Confirming Indicator - an equal-weighted aggregate of platinum prices (a proxy for global reflation), industrial metals prices (a proxy for China growth) and U.S. lumber prices (a proxy for U.S. reflation) - has decisively rolled over, and is spelling trouble for emerging market (EM) equities (Chart I-1). In particular, platinum prices have relapsed after hitting a major resistance at their 800-day moving average (Chart I-2). Such a technical pattern often leads to new lows. If so, it could presage a major selloff in EM markets in the months ahead. Chart I-1A Red Flag From ##br##Reflation Confirming Indicator A Red Flag From Reflation Confirming Indicator A Red Flag From Reflation Confirming Indicator Chart I-2Platinum: A Canary##br## In A Coal Mine? bca.ems_wr_2016_10_19_s1_c2 bca.ems_wr_2016_10_19_s1_c2 The rationale behind using platinum rather than gold or silver prices is because platinum is a precious metal that also has industrial uses. Besides, we have found that platinum prices correlate with EM stocks better than gold or silver. The latter two sometimes rally due to global demand for safety, even as EM markets tank. Finally, platinum seems to be the most high-beta precious metal in the sense that it "catches a cold" sooner and, thus, might be leading other reflationary plays. In short, EM share prices have been flat since August 15, and odds are that they are topping out and the next large move will be to the downside. Can EM De-Couple From The U.S. Dollar? Many investors are asking whether EM risk assets can rally if the greenback continues to rebound. Chart I-3 illustrates that since the early 1980s, there have been no periods when EM share prices rallied amid strength in the real broad trade-weighted U.S. dollar (the dollar is shown inverted on this and the proceeding charts). The same holds true if one uses the nominal narrow trade-weighted U.S. dollar1 (Chart I-4). Chart I-3Real Trade-Weighted ##br##U.S. Dollar And EM Stocks Real Trade-Weighted U.S. Dollar And EM Stocks Real Trade-Weighted U.S. Dollar And EM Stocks Chart I-4Nominal Trade-Weighted ##br##U.S. Dollar And EM Stocks Nominal Trade-Weighted U.S. Dollar And EM Stocks Nominal Trade-Weighted U.S. Dollar And EM Stocks One could disregard these charts and argue that this time around is different. We don't quite see it that way. Chart I-5Nominal Trade-Weighted ##br##U.S. Dollar And Commodities Nominal Trade-Weighted U.S. Dollar And Commodities Nominal Trade-Weighted U.S. Dollar And Commodities Notably, the narrative behind the EM rally since February's lows has been based on the Federal Reserve backing off from rate hikes and the U.S. dollar weakening - with the latter propelling a rally in commodities prices. These arguments appear to be reversing: the U.S. dollar is already firming up and commodities prices are at best mixed. The broad index for commodities prices always drops when the U.S. dollar rallies (Chart I-5). In recent months, the advance in commodities prices has been uneven and narrow based. While oil prices have spiked substantially, industrial metals prices have advanced very little. The current oil price rally is proving a bit more durable and lasting than we thought a few months ago. Nevertheless, China's apparent consumption of petroleum products is beginning to contract (Chart I-6). Consequently, resurfacing worries about EM/China's demand for commodities will lead to a meaningful pullback in crude prices in the months ahead, especially since the likelihood that oil producers act to restrain supply at the current prices is very low. As for commodities trading in China such as steel, iron ore, rubber, plate glass and others, they have been on a roller-coaster ride in recent months (Chart I-7). Chart I-6China's Demand For Oil Products Is Very Weak China's Demand For Oil Products Is Very Weak China's Demand For Oil Products Is Very Weak Chart I-7Commodities Prices In China Commodities Prices In China Commodities Prices In China Bottom Line: There are reasonably high odds that as the U.S. dollar strengthens and commodities prices roll over, EM risk assets (stocks, currencies and credit markets) will start to relapse. EM Beyond Commodities: Still Shrinking Profits Table I-1EM Sectors Weights: In 2011 And Now The EM Rally: Running Out Of Steam? The EM Rally: Running Out Of Steam? Another question that many investors have been asking is as follows: Is there not a positive story in EM beyond commodities? Given that the weight of the EM equity market benchmark in commodities stocks - energy and materials - has drastically declined in recent years, from 29.2% in 2011 to 13.7% now (Table I-1), and the weight in technology stocks has risen substantially (from 12.9% in 2011 to 23.9% now), couldn't non-commodities stocks drive the index higher? In this regard, we have the following observations: Information technology stocks are overbought. The EM information technology equity index has surged to its previous highs (Chart I-8, top panel). This sector is dominated by five companies that have a very large weight also in the overall EM benchmark: Samsung (3.6% weight in the EM equity benchmark), TMSC (3.5%), Alibaba (2.9%), Hon Hai Precision (1%) and Tencent (3.8%). Their share price performance has been spectacular, and some of them have gone ballistic (Chart I-9). TMSC and to a lesser extent Samsung have benefited from the rising prices of semiconductors (Chart I-9, second panel from top). However, it is not assured that semiconductor prices will continue soaring from these levels as global aggregate demand remains very weak. In short, the outlook for semi stocks is by and large a semiconductor industry call, not a macro one. As for Alibaba and Tencent, they are bottom-up stories - not macro bets at all. At the macro level, we reassert that EM/China demand for technology goods and services as well as for health care will stay robust. Hence, from a revenue perspective, technology and health care companies will outperform other EM sectors. This still warrants an overweight allocation to technology and health care stocks, a recommendation that we have had in place since June 2010 (Chart I-8, bottom panel). Odds are that tech outperformance will persist, but we are not sure about absolute performance, given overbought conditions and not-so-cheap valuations. Excluding information technology, the EM benchmark is somewhat weaker (Chart I-10). Chart I-8EM Technology Stocks: Sky Is Limit? bca.ems_wr_2016_10_19_s1_c8 bca.ems_wr_2016_10_19_s1_c8 Chart I-9Individual Tech Names Are Overbought Individual Tech Names Are Overbought Individual Tech Names Are Overbought Chart I-10EM Equities: Overall And Excluding Tech EM Equities: Overall And Excluding Tech EM Equities: Overall And Excluding Tech There is no improvement in EM corporate profitability The return on equity (RoE) for EM non-financial listed companies has stabilized at very low levels, but it has not improved at all (Chart I-11, top panel). The reason we use non-financials' RoE rather than overall RoE is because in EM the latter is artificially inflated at the moment, as banks are originating a lot of new loans but are not sufficiently provisioning for bad loans. Among the three components of non-financials RoE, net profit margins have stabilized but asset turnover is falling and leverage continues to mushroom (Chart I-11, bottom two panels). Remarkably, the relative performance between EM and U.S. stocks has historically been driven by relative RoE. When non-financial RoE in EM is above that of the U.S., EM stocks outperform U.S. ones, and vice-versa (Chart I-12). This relationships argues for EM stocks underperformance versus the S&P 500. Chart I-11EM Non-Financials: ##br##RoE And Its Components EM Non-Financials: RoE And Its Components EM Non-Financials: RoE And Its Components Chart I-12EM Versus U.S.: ##br##Relative RoE And Share Prices EM Versus U.S.: Relative RoE And Share Prices EM Versus U.S.: Relative RoE And Share Prices Overall EM EPS is still contracting in both local currency and U.S. dollar terms (Chart I-13). Even though the rate of contraction is easing for EPS in U.S. dollar terms, it is due to EM exchange rate appreciation versus the greenback this year. Furthermore, EPS in U.S. dollars is contracting in a majority of non-commodities sectors (Chart I-13A, Chart I-13B). The exceptions are utilities and industrials, which both exhibit strong EPS growth despite poor share price performance. The latter could be a sign that strong industrials and utilities EPS have been due to temporary factors and are not sustainable. Chart I-13AEM EPS Growth: Overall And By Sector EM EPS Growth: Overall And By Sector EM EPS Growth: Overall And By Sector Chart I-13BEM EPS Growth: Overall And By Sector EM EPS Growth: Overall And By Sector EM EPS Growth: Overall And By Sector Banks hold the key. Apart from commodities/the U.S. dollar and tech stocks, EM banks' share prices are probably the most important precursor to the direction of the overall EM benchmark. Financials are the second-largest sector in the EM equity benchmark (26.4% weight), so if bank share prices break down, the broader EM index will likely relapse. Our analysis of bank health in various EM countries leads us to believe that banks are under-provisioned for non-performing loans (NPL) (Chart I-14A, Chart I-14B). As EM growth disappointments resurface, investors will question the quality of banks' balance sheets and push down bank equity valuation. Hence, odds are bank share prices will drop sooner than later. Chart I-14AEM NPLs Are Unrecognized ##br##And Under-Provisioned EM NPLs Are Unrecognized And Under-Provisioned EM NPLs Are Unrecognized And Under-Provisioned Chart I-14BEM NPLs Are Unrecognized ##br##And Under-Provisioned EM NPLs Are Unrecognized And Under-Provisioned EM NPLs Are Unrecognized And Under-Provisioned In turn, concerns about EM banks will heighten doubts about overall EM growth and the EM equity benchmark will sell off. Bottom Line: EM tech stocks are overbought, while banks are fundamentally vulnerable due to the bad-loan overhang. As commodities prices relapse anew and worries about the EM credit cycle resurface, the EM benchmark will drop considerably. An Update On Two Relative Equity Trades We reiterate two relative equity trades: short EM banks / long U.S. banks, and short Chinese property developers / long U.S. homebuilders. For investors who do not have these positions, now is a good time to initiate them. Short EM banks / long U.S. banks (Chart I-15). The credit cycle in EM/China will undergo a further downturn: credit growth is set to decelerate as banks recognize NPLs and seek to raise capital. Even if a crisis is avoided, the need to raise substantial amounts of equity will considerably erode the value of EM bank shares. Meanwhile, risks to U.S. banks such as a flat yield curve and a possible spillover effect from European banking tremors are considerably less severe than the problems faced by EM banks. Importantly, unlike EM banks, U.S. banks' balance sheets are very healthy. Short Chinese property developers / long U.S. homebuilders (Chart I-16). Chart I-15Stay Short EM Banks##br## Versus U.S. Banks Stay Short EM Banks Versus U.S. Banks Stay Short EM Banks Versus U.S. Banks Chart I-16Stay Short Chinese Property ##br##Developers Versus U.S. Homebuilders Stay Short Chinese Property Developers Versus U.S. Homebuilders Stay Short Chinese Property Developers Versus U.S. Homebuilders Chinese property developers are on the verge of another downturn, as the authorities have tightened policy surrounding housing. Residential and non-residential property sales have boomed in the past 12 months, but starts have been less robust (Chart I-17). The upshot could still be high shadow inventories. Going forward, as speculative demand for housing cools off, property developers' chronic malaise - high leverage and lack of cash flow - will come back to play. Remarkably, property stocks trading in Hong Kong have failed to break out amid the buoyant residential market frenzy in the past 12 months, and are likely to break down as demand growth falters in the coming months (Chart I-18). Chart I-17China's Real Estate: ##br##Sales And Starts Will Contract China's Real Estate: Sales And Starts Will Contract China's Real Estate: Sales And Starts Will Contract Chart I-18Chinese Property Developers: ##br##On A Verge Of Breakdown? Chinese Property Developers: On A Verge Of Breakdown? Chinese Property Developers: On A Verge Of Breakdown? Arthur Budaghyan, Senior Vice President Emerging Markets Strategy & Frontier Markets Strategy arthurb@bcaresearch.com Thailand: Upgrade Stocks To Overweight And Go Long THB Versus KRW The death of King Bhumibol Adulyadej marks the end of an era not only because he symbolized national unity but also because his entire generation is passing. This generational shift has far-reaching consequences for Thailand's political establishment: in the long run it could hurt the Thai military's - and its allies' - attempt to cement their dominance over parliament. However, as Box II-1 (on page 17) explains, there is a low probability of serious domestic instability over the next 12 months2 - although beyond that risks will be heating up. For now, the military junta faces no major political or economic constraints: The junta has already consolidated control over all major organs of government and has purged or intimidated political enemies. The military will have to turn power back to parliament, or make a major policy mistake, for the opposition movement to rise again. The government's fiscal deficit has been stable (around 3% of GDP) over the past few years, public debt is at 33% of GDP, government bond yields are low and debt servicing costs are at 5% of total expenditures (Chart II-1). Hence, the military government can ramp up expenditures further to appease the disaffected. Indeed, the military junta has already accelerated public capital expenditures (Chart II-2) and investments have poured into the Northeast, a populous base of opposition to the junta. Chart II-1Thailand: More Room ##br##For Fiscal Stimulus Thailand: More Room For Fiscal Stimulus Thailand: More Room For Fiscal Stimulus Chart II-2Thailand: Government ##br##Capex Has Been Booming bca.ems_wr_2016_10_19_s2_c2 bca.ems_wr_2016_10_19_s2_c2 Likewise, fiscal expenditure has also accelerated in areas such as general public services, defense, and social protection (Chart II-3). Additionally, the Bank of Thailand (BoT) has scope to cut interest rates as the policy rate is still above a very low inflation rate (Chart II-4). This will limit the downside for credit growth and contribute to economic and political stability. Chart II-3Rising Public Spending bca.ems_wr_2016_10_19_s2_c3 bca.ems_wr_2016_10_19_s2_c3 Chart II-4Thailand: No Inflation; Room To Cut Rates bca.ems_wr_2016_10_19_s2_c4 bca.ems_wr_2016_10_19_s2_c4 The large current account surplus - standing at 11% of GDP - provides the authorities with plenty of fiscal and monetary maneuverability without having to worry about a major depreciation in the Thai baht (Chart II-5). Amid this sensitive political transition, the central bank will likely defend the currency if downward pressure on the baht emerges due to U.S. dollar strength. Therefore, we recommend traders to go long the Thai baht versus the Korean won (Chart II-6). Despite Korea's enormous current account, the won is at risk from depreciation in the RMB and the Japanese yen. Chart II-5Enormous Current Account ##br##Surplus Will Support The Baht Enormous Current Account Surplus Will Support The Baht Enormous Current Account Surplus Will Support The Baht Chart II-6Go Long THB Against KRW bca.ems_wr_2016_10_19_s2_c6 bca.ems_wr_2016_10_19_s2_c6 On the whole, although the Thai economy has been stagnant (Chart II-7), fiscal spending and low interest rates will limit the downside in growth. Bottom Line: We expect relative calm on the political surface in Thailand over the next 12 months and a stable macro backdrop. Therefore, we are using the latest weakness to upgrade this bourse from neutral to overweight within an EM equity portfolio (Chart II-8). Chart II-7Thai Growth Has Been Stagnant bca.ems_wr_2016_10_19_s2_c7 bca.ems_wr_2016_10_19_s2_c7 Chart II-8Upgrade Thai Stocks ##br##From Neutral To Overweight Upgrade Thai Stocks From Neutral To Overweight Upgrade Thai Stocks From Neutral To Overweight In addition, currency traders should go long THB versus KRW. Ayman Kawtharani, Research Analyst aymank@bcaresearch.com Matt Gertken, Associate Editor mattg@bcaresearch.com BOX 1 The Military Coup In 2014 Pre-empted The King's Death... The May 2014 military coup was timed to pre-empt this event. The king's health had been declining for years and it was only a matter of time until he died. This raised the prospect of an intense political struggle that could have escalated into a full-blown succession crisis. Thus the military moved preemptively so that it would be in control of the country ahead of the king's death and could reshape the constitutional system in the military's favor before his death, as it has done. ... And This Means Stability For Now If the populist, anti-royalist faction had been in control of government at the time of the king's death, it could have attempted to manipulate the less popular new king and take advantage of the vacuum of royal authority in order to reduce the role of the military and their allies. That in turn could have sparked a wave of mass protests from royalists, pressuring the government to collapse, or a military coup that would not have carried the king's implicit approval like the 2014 coup. That would have fed the narrative that a final showdown between the factions was finally emerging, and would have been highly alarming to foreign investors. But Risks Still Linger Make no mistake: a new long-term cycle of political instability is now emerging. Potential military mistakes and the return to parliamentary rule are potential dangers. The country's deep divisions - between (1) the Bangkok-centered royalist bureaucratic and military establishment and (2) the provincial opposition -have not been healed but aggravated since the 2014 coup and the new pro-military constitution: The junta's constitutional and electoral reforms will weaken the representation of the largest opposition party, the Pheu Thai Party, and will marginalize a large share of the 65% of the country's population that lives in the opposition-sympathetic provinces. It is also conceivable that the new king could trigger conflict by lending support to the populist opposition. For instance, he could pardon the exiled leader of the rural opposition movement, or he could transform the powerful Privy Council. However, we do not expect discontent to flare up significantly until late 2017 or 2018 when the military steps back and a new election cycle begins.3 We will reassess and alert investors if we foresee a rapid deterioration in the palace-military network, or in the military's ability to prevent seething resistance in the provinces. 1 The narrow U.S. dollar is a trade-weighted exchange rate versus the euro, Canadian dollar, Japanese yen, British pound, Swiss franc, Australian dollar, and Swedish krona. Source: The Federal Reserve. 2 The exception is that isolated acts of terrorism remain likely and could well strike key areas in Bangkok, signaling the reality that the underground opposition to military dictatorship remains alive and well. 3 The junta will use the one-year national period of mourning to its advantage and opposition forces will not want to be targeted for causing any trouble during a time of mourning. The junta could very easily delay the transition to nominal civilian rule, including the elections slated for November 2017. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

The volte-face being attempted by OPEC and non-OPEC producers in an attempt to keep oil prices above a pure-competition market-clearing level arises from the dire financial circumstances key states in both camps find themselves. Now begins the arduous process of determining just how much the Gulf Arab states within OPEC, led by the Kingdom of Saudi Arabia (KSA); and non-OPEC states, chiefly Russia, can cut oil production without giving shale-oil producers in the U.S. a huge windfall.

At last year's BCA New York Investment Conference, I made five controversial predictions. This week's <i>Special Report</i> looks at how they have panned out.

We put the odds of an oil-production freeze agreement between OPEC and Russian officials next week in Algiers at slightly better than a coin toss.

Fed policy - and, importantly, policy expectations' effect on the broad trade-weighted USD (TWI) - will dominate price evolution over the short term, as markets puzzle out if and when a rate hike is coming this year.

Forget about the production-cooperation pact agreed between Russia and KSA over the weekend at the G20 meeting in China. With or without it, rebalancing of the oil market will force global inventories to draw beginning in 2016Q4 and continue into next year, setting the stage for a gradual rise in prices - slightly above our central tendency for WTI of $50/bbl - to encourage more rigs to return to the U.S. shales.

Chair Janet Yellen's comments at Jackson Hole reinforce our view that a Fed rate hike is highly unlikely until December. The risk is that overbought equity and junk bond markets correct as an oversold dollar prices in a December move.

The lack of inflation makes a Fed rate hike before December unlikely. In the interim, the continued flow of liquidity could sustain the high-risk rally.