Poland

Highlights Trade 1: An unwinding of the Trump reflation trade... has worked exactly as expected. Take profits and switch into Trade 5. Trade 2: Short pound/euro at €1.18 and simultaneously buy call options at €1.30... is up 4%. Take profits and add to long euro/dollar. Trade 3: Underweight French OATS... has worked well both in a European bond portfolio and in a global bond portfolio. Stick with this trade. Trade 4: Long euro/yuan... is up 6%. Stick with this trade. Trade 5 (New): Underweight emerging market equities. European equity investors should underweight Poland. Feature At the mid-point of the year, we are devoting this report to appraise our top investment ideas for 2017 - as recommended in our December 22 report Five Pressing Questions (And Four Trades) For 2017. Half-time is a good moment to review the thoughts we had at the start of 2017, establish how the ideas have performed in the first half, and assess whether to stick with them or make some changes in the second half. Chart of the WeekFor EM Equities, Excessive Groupthink Is Hitting Its Natural Limit Trade 1: An Unwinding Of The Trump Reflation Trade Chart I-2The Trump Reflation Trade Has Unwound Our thoughts at the start of 2017: "Can a modern day King Canute1 single-handedly turn the tide of global deflation - the combined structural forces of over-indebtedness, demographics, technology, and globalization? This publication believes that the tide has not turned... Rationality and analysis will conclude that Trumponomics is not the structural game changer that the market seems to believe right now." How has the trade performed in the first half? Exactly as scripted, the Trump reflation trade - in its various guises - has unwound. Since our original report, the trade-weighted dollar is down 5%; the global bond yield is down 15bps (the 10-year T-bond yield is down 40bps); and banks have underperformed the market by 5% (Chart I-2). Our thoughts for the second half of 2017: Never forget that the financial markets are a complex ecosystem in which long-term investors jostle with short-term traders. The equilibrium of this ecosystem relies on rationality and analysis ultimately checking emotion and impulse. In February, our prescient warning in The Contrarian Case For Bonds was that as emotional and impulsive short-term traders had been left unchecked to drive markets, excessive groupthink was hitting its natural technical limit. The 6-month sell-off in bonds had reached a point of instability. And sure enough, the trend broke (Chart I-3). Chart I-3For Bonds, Excessive Groupthink Hit Its Natural Limit In February At such tipping points of excessive groupthink, a good benchmark is that the preceding trend will reverse by one third. On this basis, a large part of the gains in the Trump trade unwind have now been made. Take profits and switch into new trade 5. Trade 2: Short Pound/Euro At €1.18 And Simultaneously Buy Call Options At €1.30 Our thoughts at the start of 2017: "2017 will be an especially unpredictable year for U.K. politics and economics because Brexit creates a larger number of moving parts, complex interactions and feedback loops, both negative and positive... The pound is unlikely to stay near today's €1.18. Expect a sharp move one way or the other." How has the trade performed in the first half? For U.K. politics, "especially unpredictable" could be the understatement of the year! An unpredicted general election generated an even more unpredicted result. With pound/euro now below €1.13, the directional position is up 5% in gross terms, and up around 4% in net terms allowing for the cost of the call options (Chart I-4). Chart I-4Pound / Euro Has Underperformed In 2017 Our thoughts for the second half of 2017: In a hung parliament, the minority Conservative government does not have the parliamentary maths to legislate for a hard Brexit in either the House of Commons or the House of Lords. Significantly, the so-called 'Salisbury Convention' - in which the House of Lords does not oppose the second or third reading of any government legislation promised in its election manifesto - does not necessarily apply in a hung parliament. This is because, by definition, the minority Conservative government's manifesto did not secure a majority in the House of Commons. With the hard Brexit tail-risk diminished, our current preference for currencies is euro first, pound second, dollar third, based on the evolution of interest rate expectations explained below. Hence, take profits in short pound/euro and add to long euro/dollar. Trade 3: Underweight French OATS Our thoughts at the start of 2017: "2016 was the year when QE peaked... The credibility of the ECB to suppress long-term bond yields would then be severely damaged. And the greatest danger would be to those euro area bond yields closest to zero." How has the trade performed in the first half? French OATS have substantially underperformed both U.K. gilts (Chart I-5) and U.S. T-bonds (Chart I-6). So it has been correct to underweight French government bonds both in a European bond portfolio and in a global bond portfolio. Chart I-5French OATs Have Underperformed In##br## A European Bond Portfolio... Chart I-6...And A Global ##br##Bond Portfolio Our thoughts for the second half of 2017: Central banks' professed commitment to data-dependency means that their words - and ultimately actions - must acknowledge the hard data. No ifs, buts or maybes. Based on the latest PMIs which capture current economic sentiment, and on 6-month credit impulses, which lead activity, euro area hard data will continue to be among the best among the major economies. Combined with the supply shortages the ECB is now facing in buying German bunds, expect the ECB's words to continue becoming more hawkish. The recent relatively smooth winding down of three failing banks - Spain's Banco Popolare and Italy's Banca Popolare di Vicenza and Veneto Banca - will also hearten the ECB that the strategy for resolving its undercapitalised banks does not pose a systemic risk to the economy or markets. Hence, expect euro area interest rate expectations to continue converging with other developed economies. And stick with the underweight French OATS (or German Bunds) trade, especially in a global bond portfolio. Chart I-7Euro / Yuan Is Up 6% Trade 4: Long Euro/Yuan Our thoughts at the start of 2017: "The debt super cycle is over when the cost of malinvestment and misallocation of capital outweighs the benefit of good credit creation... China appears to be approaching this point. One manifestation would be continued weakness in its currency against the major developed market crosses." How has the trade performed in the first half? Euro/yuan is up 6% (Chart I-7). Our thoughts for the second half of 2017: The thoughts we expressed at the start of 2017 are still entirely valid and supported by the argument for trade 5 below. Stick with long euro/yuan. Trade 5 (New): Underweight Emerging Market Equities Just as we presciently warned of excessive negative groupthink towards bonds in February, we are now seeing similarly excessive positive groupthink towards EM equities hitting its natural technical limit. This is a strong warning that the first half 15% rally risks reversing, or fizzling, in the second half (Chart of the Week). Chart I-8If EM Underperforms DM, Poland ##br##Underperforms Europe For the detailed fundamental analysis, I refer you to the latest reports penned by my colleague, BCA's Chief Emerging Markets Strategist, Arthur Budaghyan. But in summary, Arthur says: "China's liquidity conditions have tightened, warranting a meaningful slowdown in money/credit and economic growth... the outlook for EM risk assets is extremely poor... and we continue to recommend an underweight allocation towards EM within global portfolios across stocks, credit and currencies."2 For European equity investors, this means underweighting Poland, whose relative performance tracks EM versus DM equities (Chart I-8). Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 In fact, the story of King Canute has been misinterpreted. Rather than show that he could turn the tide, he wanted to show the opposite: that he was powerless against the tide. 2 Please see the Emerging Markets Strategy Weekly Report "EM: Contradictions And A Resolution" published on June 14, 2017 and available at ems.bcaresearch.com Fractal Trading Model* As shown on page 1, this week's trade is to go short emerging markets with a corresponding long in developed markets. In this case, the trade duration is up to 6 months with a profit target and stop-loss of 3%. Amongst our other open trades, long FTSE100 / short IBEX35 is approaching 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 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. * 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 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 Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Special Report

Highlights The European Central Bank's ultra-dovish policies have depressed the value of the euro and, by extension, boosted German manufacturing. Germany has diffused its inflationary pressures by outsourcing jobs and production to central Europe. As a result of this and labor shortages, wages in central Europe are rising rapidly, and inflation is accelerating. The Polish and Czech central banks will be forced to hike rates sooner than later. Hungary's central bank will lag behind. Go long the PLN versus the IDR. Stay long the CZK versus the euro and the PLN against the HUF. Feature Inflation in central Europe is picking up and will continue to rise (Chart I-1). The main driver is surging wage growth in central Europe. Considerable acceleration in wage growth, in Poland, Hungary and the Czech Republic signifies genuine inflationary pressures that could very well spread. Based on this, our primary investment recommendation is to be long the PLN and CZK versus the euro and/or EM currencies. Labor Shortages There is a shortage of labor in the central European manufacturing economies of Poland, Hungary and the Czech Republic. This partially reflects similar trends in Germany and its increased use of outsourcing to central European countries. Escalating wage growth (Chart I-2) in central European economies denotes widening labor shortages. Chart I-1Inflation Is Rising In CE3 Chart I-2Labor Shortages = Higher Wages Indeed, our proxy for labor shortages - calculated as the number of job vacancies divided by the number of unemployed looking for a job - has surged of late across all central European countries (Chart I-3). The same measure for Germany is at a 27-year high (Chart I-3, bottom panel). Chart I-4A and Chart I-4B illustrate both components of the ratio: the number of job vacancies has skyrocketed to all-time highs and the number of unemployed people has dropped to multi-decade lows as well. Chart I-3Labor Is Scarce In CE3 And Germany Chart I-4AA Breakdown Of Labor Shortage Proxy Chart I-4BA Breakdown Of Labor Shortage Proxy Importantly, it is not the case that labor shortages are occurring because people are discouraged and giving up on their search for work. The participation rate for all these countries has risen to its highest level since data have been available. In brief, a rising share of the population in these countries is either working or actively looking for a job. (Chart I-5). Finally, their working age population is shrinking (Chart I-6), with Germany being the exception because of immigration inflows (Chart I-6, bottom panel). Chart I-5Labor Participation Rate Is ##br##High In CE3 And Germany... Chart I-6...While Working Age ##br##Population Is Declining In CE3 Robust labor demand has been occurring in central Europe because of the ongoing manufacturing boom in the region. Given central Europe's extensive supply chain linkages to German manufacturing, the artificial cheapness of the euro that the ECB engineered has boosted the German economy and by extension central Europe's manufacturing boom. Germany: A Cheap Currency And Export Boom The ECB's ultra-accommodative policy has suppressed the value of the euro, and caused German exports to mushroom (Chart I-7, top panel). Chart I-7ECB Policies Have Been ##br##A Boon For German Exports A cheap common European currency has boosted Germany's manufacturing competitiveness and has led to rising demand for German exports. An overflow of manufacturing orders in Germany in turn has led to labor shortages in central Europe via increased German outsourcing. Currency appreciation is the conventional economic adjustment in a country with a flexible exchange rate and an export boom coupled with a large current account surplus. However, this has not occurred in Germany in recent years. This is because of the ECB's ultra-easy policies. The euro has depreciated even as the German and euro area overall current account has mushroomed (Chart I-7, bottom panel). Since the currency has not been allowed to appreciate in nominal terms, the real effective exchange rate will inevitably appreciate via inflation - rising wages initially and broader inflation increases later. In our opinion, the best currency valuation measure is the real effective exchange rate based on unit labor costs. Our basis is that this measure reflects both changes in productivity and wages - i.e. it reflects genuine competitiveness. Chart I-8 demonstrates Germany's real effective exchange rate based on unit labor costs in absolute terms compared to other advanced manufacturing competitors like the U.S., Japan, Switzerland and Sweden. Based on this measure, it is clear that Germany continues to enjoy a significant comparative advantage on the manufacturing world stage among advanced manufacturing economies. It is only less competitive versus Japan. Chart I-8Germany Is Very Competitive Based On Real Effective Exchange Rates Bottom Line: The ECB's ultra-dovish policies have depressed the value of the euro and boosted German manufacturing. This has boosted central European manufacturing and demand for labor. Germany Is Passing The Inflation Baton To Central Europe Despite a historic low in the unemployment rate and ongoing labor shortages, German wages have not risen by much (Chart I-9). Our hunch is that German companies faced with some labor shortages have been increasing their use of outsourcing. Central European economy's export to Germany have boomed, especially after the euro started depreciating circa 2010 (Chart I-10). Chart I-9German Wage Inflation Is Muted Chart I-10Growing Dependence On ##br##Germany For CE3 Growth Being the lower marginal cost producer in the region, central European economies have benefited from German competitiveness and the cheap euro. Outsourcing is economically justified because German wages are still four times higher than in Poland, Hungary and the Czech Republic. (Chart I-11). Even though Germany's productivity is higher than in central Europe, manufacturing wages adjusted for productivity are still higher than in central European economies (Chart I-12). Therefore, it still makes sense for German businesses to outsource more to lower-cost producers in central Europe. Chart I-11CE3 Wage Bill Is Cheaper ##br##Than That Of Germany... Chart I-12...Even After Adjusting ##br##For Productivity Faced with strong orders as well as a lack of available labor, businesses in central European countries have been competing for labor by raising wages. Unlike in Germany, manufacturing and overall wages in Poland, Hungary and the Czech Republic have recently surged (Chart I-2 on page 3). Wages are rising more so in Hungary and the Czech Republic since they have smaller labor pools compared to Poland. Notably, wage growth has exceeded productivity growth, and unit labor costs have been rising rather rapidly (Chart I-13). Chart I-13Unit Labor Costs Are Rising Rapidly In CE3 Higher unit labor costs amid rising output denote genuine inflationary pressures. Producers faced with rising unit labor costs and shrinking profit margins will attempt to raise prices. Given that income and demand are strong, they will partially succeed - meaning genuine inflationary pressures in central Europe are likely to intensify. Since the beginning of the ECB's accommodative monetary policy, Germany has been able to avoid the fallout of higher wages because it has been able to outsource a portion of its production to other countries, namely central Europe. The problem is that the supply of labor in central Europe is now drying out, so its price will naturally rise. If Germany did not have the labor pool of CE3 available as a resource, German wage inflation would be significantly higher by now because companies would have been forced to employ Germans more rapidly, paying more in labor costs. Bottom Line: Germany has diffused its inflationary pressures by outsourcing jobs and production to central Europe. Overheating In Central Europe Various inflation measures are showing signs that inflation is escalating in CE3. With rising wages and unit labor costs, these trends will continue. Consequently, output gaps in central European economies are closing or have closed, warranting further increases in inflation (Chart I-14). Money and credit growth are booming, which is further facilitating the rise in inflation (Chart I-15). Finally, employment growth is very robust and retail sales are strong (Chart I-16). Chart I-14Inflation Will Remain On An Up Trend In CE3 Chart I-15Money & Credit Will Facilitate Path To Inflation Chart I-16Employment & Retail Sales Growth Is Robust Bottom Line: A cheap euro has supercharged German demand for central European labor at the time when the pool of available labor in CE3 is shrinking. This has generated genuine inflationary pressures in the region. Conclusions And Investment Recommendations 1. The Polish and Czech central banks will hike rates sooner than later. This will boost their currencies. The Hungarian central bank will lag and the HUF will underperform its regional peers. CE3 currencies are set to appreciate, especially the CZK and the PLN: stay long the PLN versus the HUF, and the CZK versus the euro. We recommended going long PLN/HUF and long CZK/EUR on September 28 2016 due to stronger growth and rising inflationary pressures. This week's analysis reinforces our conviction on these trades. In the face of rising inflationary pressures, the Czech National Bank (CNB) and the National Bank of Poland (NBP) will be less reluctant to tighten policy than the National Bank of Hungary (NBH) and the ECB. This will drive the PLN and CZK higher relative to the EUR and HUF. The NBH is unlikely to tighten policy while credit growth is still weak. Given strong political pressure for faster economic growth, our bias is that the NBH is more interested in ending six years of non-existent credit growth rather than containing inflation. The ECB is unlikely to tighten policy either, given the still-poor structural growth outlook among the peripheral European economies. A new currency trade: go long the PLN versus the IDR, while closing our short IDR/long HUF trade with a 9% loss. This is based on our expectations that central European currencies will appreciate versus their EM peers, and the PLN will do better than the HUF. 2. Relative growth trajectory favors Central European economies relative to other EM countries. Such economic outperformance and resulting currency appreciation will be a tailwind to CE3 equity performance versus EM in common currency terms. Continue overweighting CE3 equity markets within the EM benchmark. We recommended equity traders go long CE3 banks / short euro area banks on April 6, 2016. This position has not worked out due to a significant rally in euro area banks since Brexit. However, euro area banks remain less profitable and overleveraged compared to their central European counterparts. As such they will likely underperform in the coming months. 3. In fixed income, we have the following positions: Overweight Hungarian sovereign credit within an EM sovereign credit portfolio. Long Polish and Hungarian 5-year local currency bonds / short South African and Turkish domestic bonds. A new trade: Receive 1-year Hungarian swap rates / Pay 10-year swap rates. As structural inflationary pressures become rampant in the Hungarian economy, the market will start pricing in rate hikes further down the curve, and the yield curve will consequently steepen (Chart I-17). Polish and Czech bonds offer better value relative to bunds as investors stand to gain from currency appreciation as well as an attractive spread. (Chart I-18). Chart I-17Bet On Yield Curve ##br##Steepening In Hungary Chart I-18Polish & Czech Bond Offer Value ##br##Relative To German Bunds Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Investors stand to benefit from Czech koruna revaluation versus the euro and also from positive carry, while waiting for the central bank to remove the exchange rate floor. Go long CZK / short euro. Economic fundamentals and policy divergence between Poland and Hungary point to a stronger zloty versus the forint. Go long PLN / short HUF.

Gold seems to be leading global share prices. Gold prices have rolled over since March 10. Hence, odds are that the U.S. dollar is about to bottom, and that global and EM stocks, as well as commodities prices, are about to relapse. We recommend two new trades in central Europe: Go long central European banks / short euro area banks and buy 10-year Polish domestic bonds.