Sectors

In the past few weeks, we have tweaked our cyclical portfolio exposure by downgrading early-cyclical consumer discretionary stocks to a benchmark allocation and lifting the late cyclical industrials complex to overweight. We recommend a new long S&P industrials/short S&P consumer discretionary sector pair trade to exploit the growing performance gap between the two. Four key drivers underpin our warming up to this late over early cyclical pair trade: interest rates, relative sentiment, relative demand and relative export backdrop. Higher interest rates represent a sizable hindrance to consumer spending (top panel) as rates on consumer credit rise in lockstep with fed hikes. While C&I loan pricing also suffers a setback, capital goods producers can bypass banks and raise debt in the bond markets. Relative sentiment readings also suggest that industrials manufacturers have the upper hand as the overall ISM manufacturing survey (second panel) is easily outpacing consumer confidence readings. These readings are echoed in relative demand in the form of a sustained capital expenditure upcycle, at a time when PCE growth is anemic at best (third and fourth panels). Finally, with foreign revenue exposure at 38% of revenues for industrials versus 24% for the consumer discretionary sector, the year-to-date breakdown in the greenback gives the edge to industrials. Adding up, all four key macro variables signal that the time is ripe for a new industrials versus discretionary pair trade; initiate a long S&P industrials/short S&P consumer discretionary sector pair trade, and please see yesterday’s Weekly Report for additional details.

Highlights Portfolio Strategy Go long industrials/short discretionary. Leading indicators of interest rates, relative sentiment, relative demand and relative exports all signal that industrials stocks will outperform their consumer discretionary peers. A price war is gripping airlines anew, and it will suck the air out of the industry. Recent Changes Long S&P Industrials/Short S&P Consumer Discretionary - Initiate this pair trade today. Table 1 Feature Tax relief euphoria propelled the S&P 500 to fresh all-time highs last week. While such exuberance has rekindled the "Trump trade" with small caps outshining mega caps and banks soaring (as a reminder we have a small cap size bias and are overweight financials/banks1), it will likely prove fleeting unless the tax bill becomes law. BCA's Geopolitical Strategy service believes that a tax bill passage is likely in Q1/2018.2 Were that to materialize, it would serve as a catalyst to further fuel the blow off phase in equities. Why? Empirical evidence suggests that easy fiscal policy outweighs the drag from Fed interest rate tightening. Filtering the post WWII era for periods of easing fiscal and tightening monetary policies during expansions is revealing. We define easy fiscal policy as increasing fiscal thrust (year-over-year change in cyclically-adjusted fiscal balance as a percentage of potential GDP, shown inverted, bottom panel, Chart 1) and tight monetary policy as a rising fed funds rate. Chart 1Easy Fiscal + Tight Money = Buy SPX While this is a rare occurrence, it has clearly happened seven times since the mid-1950s (shaded areas, Chart 1). As a clarification, we omitted the brief periods in the early-1960s, early-1970s and twice in the early-1980s as they were very close to the end of those recessions and positively skewed the results. All iterations resulted in positive stock returns with the SPX rising on average by over 16%. Table 2 details all seven periods that have an average duration of 16 months. There are high odds that a tax bill enactment coupled with a potential infrastructure spending bill will more than cushion the blow from the Fed's interest rate hikes in 2018, and sustain the overshoot phase in equities. As we recently showed in our equity market indicator White Paper, the business cycle stays intact during Fed tightening cycles, and historically a peak in the fed funds rate presages a recession.3 Importantly, the highly cyclical part of the U.S. economy is humming. The latest ISM manufacturing survey showed that new orders are running 20% higher than inventories, with the headline number soaring to a 13 year high (third panel, Chart 2). Prices paid also spiked to above 70, signaling that commodity inflation is looming. And, were the capex revival to gain steam as most of the leading indicators we track suggest (see Chart 8 from the October 2nd Weekly Report), then late cyclicals will continue to benefit from end-demand resurgence. Table 2SPX Returns During Periods Of Loose##br## Fiscal And Tight Monetary Policy Chart 2It's Deep##br## Cyclicals' Time As a result, we reiterate last week's upgrade of the S&P industrials sector to overweight, and this week we add more deep cyclical exposure to our portfolio by initiating a market-neutral pair trade to benefit from this enticing macro backdrop. Industrials Will Outmuscle Consumer Discretionary In the past few weeks, we have tweaked our cyclical portfolio exposure by downgrading early-cyclical consumer discretionary stocks to a benchmark allocation and lifting the late cyclical industrials complex to overweight. In fact, a once-in-a-generation opportunity to buy industrials at the expense of discretionary stocks has surfaced, and we recommend a new long S&P industrials/short S&P consumer discretionary sector pair trade to exploit this tradable opportunity. Chart 3 shows that relative share prices recently bounced near the early-1970s all-time lows and a mini V-shaped recovery is taking root. The industrials/discretionary price ratio has been in a downtrend for the better part of the past decade and the most recent peak-to-trough collapse has been a 4 standard deviation move (Chart 3). Even a modest relative performance renormalization near the historical mean would translate into impressive returns. Chart 3Compelling Entry Point Four key drivers underpin our warming up to this late over early cyclical pair trade: interest rates, relative sentiment, relative demand and relative export backdrop. The Fed embarked on a fresh tightening interest rate cycle almost two years ago and is on track to lift the fed funds rate another 100bps by the end of 2018 according to the FOMC's median dot forecast. Interest rate-sensitive stocks suffer when the Fed tightens monetary policy, whereas deep cyclicals disproportionately benefit from accelerating economic growth. Chart 4 confirms that over the past four decades a rising fed funds rate has been synonymous with an increase in the relative share price ratio and vice versa. Chart 4Tight Money Is Good For Industrials But Weighs On Discretionary The framework we use on the interest rate front is that higher interest rates represent a sizable hindrance to consumer spending (top and second panel Chart 5). Not only does the price of housing-related credit rise in lockstep with fed hikes, but also auto and credit card interest rates, two major consumer loan categories, increase on the back of the Fed's tighter monetary backdrop. True, C&I loan pricing also suffers a setback, but capital goods producers can bypass banks and raise debt in the bond markets. In fact, this cycle, the global hunt for yield and unconventional monetary policies have suppressed interest rates to the benefit of corporate borrowers. One final relative advantage industrials outfits have this cycle is rising pricing power in the form of firming commodity prices (third panel, Chart 5), while wage growth/median income (a proxy for consumer pricing power) has been subpar. Taken together, higher interest rates and rising commodity prices should continue to underpin relative share price momentum (Chart 5). Relative sentiment readings also suggest that industrials manufacturers have the upper hand versus consumer discretionary companies (Chart 6). The overall ISM manufacturing survey is easily outpacing consumer confidence readings. Importantly, the ISM survey and most of the subcomponents are making multi-year highs, while both the University of Michigan's consumer sentiment survey and The Conference Board's consumer confidence reading peaked in early 2017. Chart 5Commodity Inflation Is A Boon For##br## Industrials But Bane For Discretionary Chart 6Manufacturing Flexing ##br##Its Muscles With regard to the relative demand landscape, a sustained capital expenditure upcycle is promising for capital goods producers (second panel, Chart 7), at a time when personal consumption expenditures (PCE) are anemic at best. Notably, real capital outlays have been rising at a faster clip than real PCE, signaling that the upward trajectory in relative forward EPS estimates is sustainable (middle panel, Chart 7). Our relative pricing power gauge has recently come out of its funk reflecting this improving relative demand backdrop. The implication is that a rerating phase is likely in the coming months (bottom panel, Chart 7). Finally, the relative export backdrop suggests that industrials come out on top of discretionary stocks (top panel, Chart 8). According to FactSet the S&P consumer discretionary sector's foreign revenue exposure stands at 24% of total sales, and it is roughly 60% higher for the S&P industrials sector at 38% of revenues.4 While the year-to-date breakdown in the greenback is stimulative for industrials exporters, it is, at the margin, restrictive for the more domestically oriented consumer discretionary companies (trade-weighted dollar shown inverted, bottom panel, Chart 8). Our relative EPS growth models best capture all of these moving parts and suggest that the path of least resistance for relative profit growth is higher in the coming quarters (Chart 9). Chart 7Capex##br## Upcycle... Chart 8... And Export Markets Benefit Industrials##br## At The Expense Of Discretionary Chart 9Relative Profit Growth Models Also Say##br## Buy The Relative Share Price Ratio Adding up, all four key macro variables (interest rates, relative sentiment, relative demand and relative export exposure) signal that the time is ripe for a new industrials versus discretionary pair trade. Bottom Line: Initiate a long S&P industrials/short S&P consumer discretionary sector pair trade. Airlines Update: Mayday While we have turned positive on the broad industrials complex and remain constructive on most transports, we continue to recommend investors avoid the S&P airlines index. This decade has seen a huge recovery in consumer confidence, rising from the depths of the Great Recession. The consumer's revival has been matched by equally steep growth in airline passenger traffic (Chart 10). However, the resurgence in passenger demand has not had the expected uplift in pricing. Rather, the opposite has happened; consumers have not seen a sustainable price increase in years and airline pricing power has collapsed, even in the face of soaring jet fuel costs that eat into profits (Chart 11). The costly price war between the low cost carriers and the largely-restructured legacy airlines the industry is currently embroiled in explains deflating airfares (Chart 12). Chart 10More Passengers... Chart 11... But Higher Fuel Costs... Chart 12... And Price Concessions Crash Profits The industry has been here before, and recently too. 2015 was a tumultuous year that saw pricing collapse as the ultra-low cost carriers entered the traditional hubs, triggering a scramble for market share. Brave airline investors have been whipsawed as the industry recovered and then stumbled again earlier this year. From a profit perspective, airlines have been able to hide poor pricing with efficiency gains (Chart 13). Industry load factors have been steadily moving upward, though those gains appear to have plateaued at peak levels. The implication is that this current price war will hit profit margins and thus the bottom line worse than in the past (Chart 13). Expanding international air travel could provide some relief to the besieged legacy carriers as international airfares look to have pulled out of deflation (Chart 14). However, the sustainability of positive pricing is questionable as international no-frills carriers are gaining greater penetration and often have significantly lower cost structures. Once unheard of trans-Atlantic travel for below $200 is now widely available. Chart 13Masking Poor Pricing Backdrop Chart 14Analysts Ignore Positives At the same time as cash generation appears most threatened, the industry is in the midst of an expensive fleet renewal as airlines seek to replace declining prices and aging fleets with higher volume and more efficient aircraft. In fact, capex as a percentage of sales has nearly tripled since 2012. The result is predictable; the hard deleveraging work the industry put in over the course of this decade is being unwound (Chart 13). An increasingly geared balance sheet, combined with weakening margins should translate directly into a higher risk premium and lower valuation multiples. However, while multiples have fallen from the sky-high levels earlier this decade, they remain well above the lows of 2015-16 (Chart 14). This implies further downside risk should risk premiums expand as we expect. With sell-side analysts jumping on board the bear story, as evidenced by net forward earnings revisions falling off a cliff (Chart 14), this should probably happen sooner rather than later. Bottom Line: With no end in sight to the price war and outsized capacity additions likely to throw fuel on the fire, we think investors should stay away from the S&P airlines index. Accordingly, we reiterate our underweight recommendation. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, AAL, UAL, ALK. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report,"Girding For A Breakout?" dated May 1, 2017, available at uses.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report,"Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 3 Please see Chart 55 of BCA U.S. Equity Strategy Special Report, "White Paper: U.S. Equity Market Indicators (Part I)", dated August 7, 2017, available at uses.bcaresearch.com. 4 https://www.factset.com/earningsinsight Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

The S&P air freight & logistics group was buffeted this week on reports that Amazon was testing its own delivery service from third-party sellers. The company's interest in operating their own logistics is hardly new news; early last year, Amazon signed agreements to operate an air cargo network that could conceivably handle up to a third of its volume. The declines this week seem like overreactions for 3 reasons. First, Amazon represents approximately 3% of FDX' North American volume and 7% of UPS, according to Moody's, implying relatively small top line impacts from an Amazon shift. Second, those volumes come at extremely low margins and the companies may be able to replace them more profitably. Last, it is highly unlikely that Amazon could replace FDX and UPS completely, with their unmatched 'last mile' infrastructure, nor does this move signal that this is the intention. We think the very positive backdrop driven by surging global trade (second panel), combined with still-cheap valuations (bottom panel), makes any slide in the index an excellent buying opportunity. Anecdotally, staying overweight home improvement retailers when they were under siege from the retail giant has proven to be the right call.1 Net, we reiterate our high-conviction overweight recommendation for the S&P air freight & logistics group. The ticker symbols for the stocks in this index are: BLBG: S5AIRF - UPS, FDX, CHRW, EXPD. 1 Please see BCA U.S. Equity Strategy Insight Report, "The Amazon Curse", dated July 27, 2017, available at uses.bcaresearch.com.

Automotive components companies (as well as auto manufacturers) just finished their best month of the year in September (top panel), lifted by expectations of a spike in sales to replace the estimated 700,000 light vehicles destroyed by hurricanes Harvey and Irma. Yesterday's best monthly auto sales report since the end of the recession (second panel) validated this expectation. It is too soon to break out the party hats for three reasons. First, vehicle replacement does not translate one-for-one into new vehicle sales as the used vehicle market will likely take up the bulk of the demand. Second, August lost a week of normal sales in the southern states which were pushed into September, skewing the month. Lastly, and most importantly, manufacturer incentives reached their highest level ever (according to J.D. Power) in an effort to clear out the end-of-model-year inventory; neither this nor weak pricing (third panel) support the idea of a strong auto consumer and constrained supply. Bottom Line: Exceptionally strong September (and probably October as well) vehicle sales are masking still-weak core auto demand. Stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5AUTC - DLPH, BWA, GT.

Special Report

Highlights China's growth momentum is unlikely to continue to accelerate, but the downside risk is low. Some more recent developments suggest economic momentum remains fairly robust. The heated debate on a "soft or hard landing" in recent years has disproportionally diverted investors' attention to China's cyclical growth fluctuations, while some larger picture changes have gone unnoticed. The Chinese economy will undoubtedly continue to experience cyclical swings; it is equally important to keep in mind some mega trends that hold the potential to reshape the world in profound ways. Feature The Chinese economy has likely ended the third quarter on a slightly higher note, according to "nowcast" types of models using high-frequency data (Chart 1). The latest PMI surveys, focusing on both the manufacturing and service sectors, accelerated in September from the prior month, and remain comfortably in expansionary territory, heralding positive surprises in the macro numbers to be released in the coming weeks. China's mini-cycle acceleration since early last year has been fairly modest by historical standards, but it has been a key component driving synchronized improvement in global growth. Moreover, the resilience of the Chinese economy has led to a quick repricing of risk assets that were deeply depressed in previous years due to China "hard landing" concerns. Stock prices of both Chinese investable equities and the emerging market benchmark have rallied massively since the 2016 bottom. Total returns of Chinese equities and EM stocks, price appreciation and dividend payments combined, have both broken out to all-time highs (Chart 2). Chart 1Chinese Q3 GDP Should Have Remained Strong Chart 2Breakout In China And EM Equities Looking forward, Chinese growth momentum is unlikely to continue to accelerate, but the downside risk remains low in the near term, as we have argued in recent months. In fact, some more recent developments suggest economic momentum remains fairly robust. More importantly, the heated debates among investors and analysts in recent years on China's macro stability have disguised some dramatic changes in the Chinese economy, which will have a profound and long-lasting impact on the global economy and financial markets from a big-picture standpoint. Given China's rising economic significance, getting China right will become all the more important for investors going forward. Near-Term Growth Outlook Remains Solid The Chinese economy will likely continue to surprise to the upside in the coming months. First, there is little risk of aggressive policy tightening that would prematurely choke off the economy, as economic growth is within the government's target, consumer price inflation is exceedingly low and financial excesses have been reined in.1 The latest decision of the People's Bank of China (PBoC) to lower reserve requirement ratios (RRR) for banks offering loans to small-sized enterprises should not be confused as a broad attempt to boost credit and growth. The move certainly reflects the authorities' preference for offering credit to smaller private borrowers, but it also reflects the PBoC's continued fine-tuning of its liquidity management.2 The PBoC has significantly ramped up direct lending to banks since 2015 to offset the liquidity drainage from capital outflows from the country's financial sector - the pace of PBoC direct lending has slowed since early this year (Chart 3, top panel). This means that the central bank will need to resort to other tools to manage interbank liquidity should stress increase - releasing required reserves being one of them. Taken together, the PBoC's liquidity injection has almost precisely matched the liquidity withdrawal due to capital outflows, as can be seen in the bottom panel of Chart 3. The key point here is that the PBoC's latest decision is not to encourage a lending spree, but it certainly does not indicate intentions of aggressive tightening. Second, some view China's lukewarm industrial activity as a sign of weak growth momentum, and argue for a pending relapse. In fact, some sectors have been under strict government scrutiny to cut capacity and production in recent years - a key reason behind the exceptional weakness in these industries despite massive improvement in their sales, pricing power and profits. In other words, these sectors have not been responding to market signals due to government restrictions of "supply side reforms" to cut excess capacity and reduce pollution. For example, some sectors that are subject to "supply side" constraints such as coal, base metals and cement producers have chronically underperformed in recent years, and have also hurt the overall performance of the industrial sector (Chart 4). Similarly, capital spending in the mining sector, historically highly sensitive to moves in global metals prices, have continued to contract, despite the sharp increase in metals prices since 2016. Without these regulations, the performance of the industrial sector should have been a lot stronger. In addition, without aggressive expansion in the "good times," the odds of another major relapse in these highly cyclical industries when the "bad times" do come are also lower. Chart 3The PBoC Liquidity Operation Chart 4Policy Constraints Weigh Heavy On Some Sectors Third, the Chinese authorities' tightening measures on the real estate sector pose a growth risk, and should continue to be monitored; the impact is unlikely to be significant, as discussed in detail in last week's report.3 Developers have also been subject to "supply side" constraints and have not increased construction in this cycle, despite rising home prices, increasing transactions and booming profits (Chart 5). Tighter policies imposed by local governments will probably keep developers in dormancy, but a major downturn is highly unlikely, simply because there is not much excess to begin with. Finally, while China has been a key component of the synchronized global growth improvement, the country has also benefited from a pickup in global demand.4 Korean exports, a harbinger of global trade, jumped by a whopping 35% in dollar terms in September versus a year ago. It is certainly unrealistic to expect such strong momentum to last, but the benign global demand situation is unlikely to immediately falter without some sort of extreme external shock. Similarly, our model expects Chinese export growth to moderate, but there are no signs of a sharp contraction anytime soon (Chart 6). Chart 5Real Estate Investment May Surprise To The Upside Chart 6Exports: Moderating, Not Relapsing Bottom Line: China's near-term growth outlook will remain resilient, providing a supportive macro backdrop for global risk assets. The China Debate: Seven Years On Ever since the Chinese economy recovered from the aftermath of the global financial crisis, with the help of a massive government stimulus package, investors' opinions on China's macro situation have been deeply divided.5 To be sure, sensational predictions of an imminent China collapse have always existed, ever since the country's economic reform, but they were mostly rooted in ideological bashing and were largely ignored by global investors. In recent years, however, predictions of a Chinese "hard landing" have been taken much more seriously by the mainstream media, as well as investors and policymakers. Amid mounting doubts about its long term sustainability, the Chinese economy has experienced some remarkable achievements and dramatic changes in the past several years. The Chinese economy continues to gain global significance, accounting for 16% of global economic output currently versus 9% in 2010. More importantly, its contribution to global economic growth is far larger, given its faster growth rate (Chart 7). China's nominal GDP currently stands at about US$11.5 trillion, a distant second to the mighty US$19.2 trillion U.S. economy. However, 7% of nominal growth in China feasibly amounts to an increase of US$800 billion in gross output, compared with US$770 billion for the U.S., assuming the latter is to grow by 4% in nominal terms. Although China's growth rate has downshifted since the global financial crisis, the increase in the country's total output in value terms has become even greater, given the economy's much larger size. China remains the dominant factor in driving global commodities demand, especially base metals. China's base metals consumption accounts for over 50% of the global total, higher than the rest of the world combined (Chart 8). More importantly, China's base metal consumption has continued to climb in recent years, while demand from the rest of the world has stagnated. In recent years, "sluggish" Chinese metals consumption has been blamed for commodities woes by some analysts; in reality, the country has been the only source of demand increase for base metals. China's role in driving the supply/demand balance of raw materials has increased significantly since the global financial crisis. Chart 7China's Growing Significance In World Economy Chart 8China And Base Metals The country's heavy investment on infrastructure has massively changed its urban landscape, leading to a significant improvement in the country's transportation system, with massive expansion in high-speed railway, urban metro and light-rail system, and further extensions of the highway network (Chart 9). This has significantly narrowed the country's infrastructure gap with more advanced countries, facilitating both international trade and domestic demand (Chart 10). Chinese car sales have jumped from about 10 million per year in 2010 to 25 million currently, by far the largest car market in the world. Without improvement in logistical infrastructure, there is little doubt the country's growth trajectory would have faced severe bottlenecks. Chart 9Massive Expansion Of ##br##Transportation Infrastructure... Chart 10...Has Narrowed The Gap ##br##With Developed Economies Finally, the impact of Chinese consumers has become all the more visible on the global stage. Even though China still ranks as a middle-income country with a per-capita GDP of about US$8000, a fraction of the US$57,000 in the U.S., the sheer size of the Chinese population, the rapid increase in household income and the country's very high savings rate have fundamentally shifted the wealth distribution of the global population. Currently, only about 20% of the world population has a per-capita GDP higher than China, a rapid change within a short period of time (Chart 11). This dramatic shift has profoundly redefined the global economic landscape, affecting the spectrum of essentially all businesses, from manufacturers' cost structures to luxury goods markets to tourism and education to financial services. Chart 11China's Rising Income In Perspective The list can easily be extended, but the point here is that the heated debate on a "soft or hard landing" in recent years has disproportionally diverted investors' attention to China's cyclical growth fluctuations, while some larger picture changes have gone unnoticed. Of course, financial markets are an emotional discounting mechanism, and stock prices always exaggerate any subtle changes in growth fundamentals, which can in turn impact economic reality through a complex web of reflexivity relationships. Chinese equities lagged significantly behind developed markets, particularly the U.S. bourses, between 2011 and 2015, which apparently validated the bears' views. In reality, however, multiples of Chinese equities, and emerging market in general, were deeply compressed compared with their developed market peers (Chart 12). In other words, it is largely multiples compression associated with heightened risk aversion and greater risk premium that was behind the woes of Chinese and EM markets before 2015. Since 2016, China's mini-cycle upturn has progressively raised investors' risk appetite towards China and EM, lifting their multiples and prices - essentially a positive re-rating of these markets. Chart 12Positive Rerating Of China ##br##And EM Has Further To Run The debate on China's growth sustainability will likely remain firmly in place in the coming years, which will continue to create cross-currents and outsized volatility. As an investor, it is futile to argue with "Mr. Market." Even with strong convictions on the fundamental case, investors should be nimble and avoid standing in front of an oncoming train - however ill-informed the market consensus could be. For now, Chinese and EM equities are still much more attractively valued compared with the developed world, and the train of the positive re-rating of these bourses will likely have further to run. It is too soon to bet on a trend reversal. Whither China: The Big Picture Fundamentally the China debate boils down to the country's growth model, which invests a much greater share of its output than most other major economies. The "bears" conclude this amounts to capital misallocation and propose a "rebalancing" towards consumption. Some even claim China's massive savings, essential for financing domestic capital spending, are byproducts of banks' "out of thin air" money printing - to me, if "thin air" money was indeed such a magical silver bullet, the world would have solved its poverty problems a long time ago. Over the years I have argued firmly against these assertions. In economics, it is well known that a country's income level is fundamentally determined by its productivity, which is in turn determined by the level and sophistication of its capital stock. Chart 13 shows a clear positive correlation between a country's per capita output, a measure of productivity, and its per capita capital stock. In general, industrialized countries enjoy much higher levels of per capita capital stock than developing economies, leading to much higher productivity, income as well as living standards. Therefore, the industrialization process, by definition, is the process of accumulation of capital stock through investment, which has been proven by many economies that have successfully industrialized. China's growth path in the past several decades is simply repeating these success stories. As shown in Chart 14, despite some remarkable achievements, the productivity level of the average Chinese worker is still just a fraction of the level in more advanced countries. If China remains on the path of accumulation of capital stock through savings and investment, the country will continue to progress on the productivity and income ladder. If, however, it abandons its current growth model and "rebalances" towards a consumption-driven one, odds are much higher that the country will stagnate and fail to advance beyond the "middle income trap." Chart 13Productivity Is Positively ##br##Correlated With Capital Stock Chart 14China's Catchup Process ##br##Has A Lot Further To Run In my 15 years of covering China for BCA, the country has dramatically shifted beyond recognition - the pace of changes are still accelerating. Looking forward, the Chinese economy will undoubtedly continue to experience cyclical swings; it is equally important to keep in mind some mega trends that hold the potential to reshape the world in profound ways. The following are a few worth highlighting. Chart 15China's Tech Boom The first mega trend is the explosive growth of the Chinese technology sector, which will increasingly challenge players in more advanced economies. The tech boom is reflected in the dramatic expansion of e-commerce and mobile payments, spectacular price gains in the BAT giants (Baidu, Alibaba and Tencent) and surging patent applications among the corporate sector (Chart 15). With a massive and homogenous domestic market and increasingly affluent consumers, China has rapidly become the testing ground of all new high-tech sectors - from big data and artificial intelligence to industrial robotics and additive manufacturing, to genetic analysis and quantum computing - with numerous startups and venture capitalists as well as government support on basic research and development. This is bound to create exciting investment opportunities with winners and losers far beyond Chinese borders. The second major development is the "Belt & Road Initiative" (BRI), also known as "One Belt One Road," or OBOR, that links China with some less developed nations. The project, initially proposed by President Xi Jinping in 2013 but met with heavy doubts, has been quietly gaining momentum. Some commentators have viewed the BRI as an attempt by the Chinese authorities to export excess domestic industrial capacity and have tried to quantify the impact, which is shortsighted and likely useless. China's vision of the BRI is an ambitious open-ended geo-strategic, economic and social undertaking to promote globalization with distinct "Chinese characteristics." There is no doubt that BRI will face tremendous challenges, and its ultimate destiny is simply an "unknowable unknown" at the moment. However, some solid progress has been made, and foreign authorities are increasingly taking the BRI seriously. Even with limited success, the BRI holds the promise of redefining the balance of geopolitics, global trade and international finance. The role of the RMB in international finance will inevitably grow at the expense of other majors, particularly the dollar. Investors will be well served to closely follow this mega development. Finally, how China's governance and political system will evolve remains a major question mark for investors, especially from a long-term perspective. Democracy has increasingly become the norm of world politics since the early 1990s, with over half of the global population currently living in democratic regimes, while China's political system is decisively foreign (Chart 16). Investors are ideologically skeptical on the long-term sustainability of China's essentially meritocratic authoritarian regime. Investors mostly see democracy as China's ultimate future, and expect the country to progressively move in this direction, along with rising economic prosperity. In reality, however, the ruling Communist Party has tightened its grip over the country in recent years, apparently reverting the trend of political liberalization that was underway in previous years. Chart 16Is Democracy China's Future? In essence, China, with over 20% of the world population, is conducting a mega-political experiment by searching for an alternative to open democracy, the prospect of which remains unknown. The majority of the Chinese population have been content with the existing system, and have been adapting to drastic social and economic changes with ease in the past several decades. Numerous previous predictions of an imminent collapse of the Chinese regime have repeatedly proven wrong, but the underlying anxiety will remain, especially when China's economic growth further downshifts. Political and social stability is crucial for the country's continued economic development. A major social upheaval, on the other hand, would have devastating consequences, not only for China but also for the entire world. Stay tuned. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report "Chinese Financial Tightening: Passing The Phase Of Maximum Strength," dated June 22, 2017, available at cis.bcaresearch.com 2 Please see China Investment Strategy Special Report "More On The Chinese Debt Debate," dated April 20, 2017, available at cis.bcaresearch.com 3 Please see China Investment Strategy Weekly Report "Chinese Real Estate: Which Way Will The Wind Blow?" dated April 20, 2017, available at cis.bcaresearch.com 4 Please see China Investment Strategy Weekly Report "China Outlook: A Mid-Year Revisit," dated July 13, 2017, available at cis.bcaresearch.com 5 Please see China Investment Strategy Weekly Report "The China Debate," dated April 14, 2010, and China Investment Strategy Weekly Report "The China Debate: Four Years On," dated April 30, 2014, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights Expect Spain's strong growth to fade somewhat as its credit impulse appears to have peaked. The Catalan independence debate is an inconvenience but not a long term tail-risk. Expect Italy's growth to pick up as the Italian banking system is repaired. Brave investors could go long Italian bonds versus Spanish bonds now. More cautious investors might wait until after the Italian election in the first half of next year. France's CAC40 is our preferred mainstream euro area equity market right now. Feature Recent history teaches us that to leave the European Union is inconvenient, but to leave the euro is disastrous. To leave the EU means redefining laws, institutions and trading relationships, but to leave the euro means redenominating the entire banking system's assets and liabilities into different currencies - leading to bank runs and chaotic insolvencies. For this reason, even tiny Greece chose to suffer an extended depression rather than to leave the euro. Chart of the WeekSpain Fixed Its Banks In 2013, Italy Is Fixing Its Banks Now Leaving The EU Is Inconvenient, Leaving The Euro Is Disastrous To leave the EU, there is a broadly defined process but the process is inconvenient and protracted, as the United Kingdom is now discovering. The U.K. will technically leave the EU on March 31 2019, but Prime Minister May has proposed a further transition period of "around two years." Therefore the U.K. will remain in the European single market and customs union - and fully subject to EU laws and regulations - until at least 2021, five years after the U.K. voted to leave the EU. This protraction of the exit process creates a tasty irony. Not long after the U.K. fully leaves in 2021, the Leave vote's 1.25 million majority will have disappeared - counting those who voted in 2016 who are still alive. This is because out of the 0.625 million deaths in the U.K. in each of the coming years, there is a very heavy skew to Leave's much older voters1 (Chart I-2). As the U.K is not in the euro there is no secondary issue of whether to leave the single currency. But this does raise an interesting hypothetical question. If a euro area country - or region like Catalonia - inconveniently left or was ejected from the EU, does it follow that it must also crash out of the euro? No. Several non-EU countries already use the euro. There are the European microstates of Andorra, Monaco, San Marino and Vatican City. More significantly, Montenegro and Kosovo have adopted the euro as their de facto currency. To be clear, we do not expect Catalonia to secede. Polls consistently show a significant majority in Catalonia do not want full independence (Chart I-3). The unionists mostly boycotted the independence referendum because Madrid deemed it illegal. Given the low turnout, the 89% vote for independence equalled just 37% of eligible voters. Chart I-2The Vote For Brexit Was ##br##Driven By Older Voters Chart I-3A Significant Minority In Catalonia##br## Do Not Want Full Independence But even if Catalonia did become independent, this hypothetical eventuality would not involve a catastrophic exit from the euro. Catalonia, in its economic interest, would want to keep the euro, and the EU would let it. The Spain/Italy Conundrum The much bigger threat would be if a major euro area country felt that the single currency was not in its economic interest, and decided to jettison the euro. In this regard, the problem - at first sight - appears to be Italy. Through the 19 years of the euro, Italy's real GDP per head has grown by just 6%, substantially less than any other major economy. If the single currency is to blame for the significant underperformance of its third largest economy with 60 million people, then the euro's long-term viability has to be in question. But it is hard to blame the euro per se for Italy's painful underperformance. For the first half of the euro's life, 1999-2007, Italian real GDP per head performed more or less in line with the United States, Canada and France (Chart I-4) - even without a substantial tailwind from a credit-fuelled boom which the other economies had. Then, in the post-2007 years, there was little to distinguish the economic performances of Italy and Spain until 2013 (Chart I-5). At which point, Spain took off, with real GDP per head subsequently expanding by 15%. Whereas Italy struggled to grow. The conundrum is: what explains this stark recent difference between Spain and Italy? Chart I-4Through 1999-2007, Italy Grew In Line ##br##With Other Major Economies Chart I-5Post-Crisis, There Was Little To Distinguish##br## Italy and Spain Until 2013 The start of Italy's underperformance in 2008 and the start of Spain's strong recovery in 2013 provide the solution to the conundrum. Following the global financial crisis in 2008, Italy has still to repair its banking system. Whereas Spain fixed its banks in 2013. Significantly, Spain ring-fenced bad assets within a bad bank while recapitalising good banks. In effect, it finally did what other economies - most notably the U.S., U.K. and Ireland - had done several years earlier in response to their own housing-related banking crises. Therefore in 2013, Spanish banks' aggressive deleveraging ended. The result was that Spain's credit impulse - which measures the change in bank credit flows - rebounded very sharply and has remained positive for four years. This explains Spain's remarkably strong recovery (Chart I-6). In contrast, Italy's still dysfunctional banking system means that its own credit impulse has been much more muted and barely positive over the past four years (Chart I-7). Begging the question: why has Italy been so slow to fix its dysfunctional banking system? One reason is that Italy's banking malaise has built up stealthily, generating frequent financial tremors but without an outright crisis. In contrast, the credit booms in the U.S., U.K., Ireland and Spain did eventually cause housing busts and full-blown banking crises, requiring urgent policymaker response. A second reason is that the Italian government is more highly indebted than other governments, making it more difficult to raise public funds to fix the banking system. The good news is that the Italian government, the EU and the ECB are now on the same page and finally progressing to repair the banking system. Italian banks' equity capital is rising (Chart I-8), their solvency is improving, and the share of non-performing loans has fallen sharply this year (Chart of the Week). Chart I-6Spain's Credit Impulse Rebounded Sharply Chart I-7Italy's Credit Impulse Has Been More Muted Chart I-8Italian Banks Are Raising Equity Capital Moreover, the recent smooth winding down of the failing Banca Popolare di Vicenza and Veneto Bank showed that the EU's new rules for resolving failing banks is working. Admittedly, the rules mean that institutional investors could still suffer losses. But a pragmatic solution will permit public funds to protect 'widows and orphans' retail investors. Some Investment Thoughts As the Italian banking system is repaired, there will be a pickup in Italy's growth just as there was in Spain. However, the strong tailwind to Spain's growth that started in 2013 is now fading given that Spain's credit impulse has peaked. This suggests that the yield spread between Italian BTPs and Spanish Bonos - which measures the extra risk premium in Italy - is at a cyclical peak from which it is likely to compress (Chart I-9). Brave investors could go long Italian bonds versus Spanish bonds now. More cautious investors might wait until after the Italian election in the first half of next year. On the face of it, a fading risk of euro breakup should also boost euro area equity relative performance. The trouble is that the relative performance of the broad Eurostoxx50 index is entirely at the mercy of its major sector skews - specifically, a huge underweighting to Technology and an overweighting to Banks (Chart I-10). The way around this dilemma - to like euro area equities but to dislike the overall sector skew - is to steer towards mainstream indexes which have less of a distorting skew. On this basis, the mainstream euro area equity market we would pick right now is France's CAC40 (Chart I-11). Chart I-9The Yield Spread Between Italian And ##br##Spanish Bonds Is At A Cyclical Peak Chart I-10Eurostoxx50 Relative Performance Is ##br##At The Mercy Of Its Sector Skews Chart I-11Prefer the CAC40 To##br## The Eurostoxx50 Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 In the U.K. around 625,000 people die every year and the vast majority of these are aged over 65. But in this older age cohort, 64% voted Leave (source: YouGov). So we can infer that of the 625,000 deaths, about 400,000 voted Leave and 225,000 voted Remain, eroding the Leave majority who are still alive by 175,000 every year. Fractal Trading Model This week, we note that the Canadian 10-year government bond is oversold and due a trend reversal. We prefer to express this as a new relative trade: long Canadian 10-year bond / short 10-year German bund with a profit target / stop-loss of 1% and double position size. In other trades, long USD/CAD hit its 2.5% profit target - the second success in this specific trade in the last three months. We now have three open positions. 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-12 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

Weak spots in the U.S. economy have become increasingly hard to find. That said, two standouts are non-residential construction and light vehicle production, both of which remain in contraction despite the overall economic expansion (second panel). Importantly, growth in both of these sectors relies heavily on expanding credit; in the most recent Fed senior loan officer survey, these categories both saw tightening lending standards, implying a negative credit impulse (third panel). All of this is bad news for domestic steel producers, for whom non-residential construction and light vehicle production are the key end markets. Even worse news is that steel imports are gaining share of an increasingly diminished market (fourth panel), despite the Trump administration's pledge to protect domestic steel production through tariffs. Iron ore prices in China, which have struggled to climb off lows (bottom panel), imply that tariffs will need to be substantial to stem foreign inflows. Bottom Line: Weak demand, policy uncertainty and increasing offshore competition should sustain downward pressure on steel stocks. Stay underweight. The ticker symbols for the stocks in the S&P 1500 steel index are: BLBG: S15STEL - NUE, STLD, RS, X, ATI, CRS, CMC, WOR, AKS, TMST, SXC, HAYN, ZEUS.

Overweight Machinery stocks have been in a V-shaped recovery for the past 18 months retracing all of their relative losses since the 2014 highs. Our machinery EPS model is firing on all cylinders (second panel), underscoring that the earnings-led recovery has more running room, giving us comfort to act on our upgrade alert and lift the S&P construction machinery & heavy truck subindex to overweight. We think a fresh capex upcycle will fuel the next machinery stock outperformance upleg. Not only are expectations for overall capital outlays as good as they get (third panel), but there are also tentative signs that even the previously moribund mining and oil & gas complexes will be capex upcycle participants. A quick channel check also waves the green flag as industrial production remains expansionary and new orders are outpacing inventory accumulation (bottom panel). Bottom Line: We are acting on our upgrade alert and lifting the S&P construction machinery & heavy truck index to overweight. As a result of this change, we have boosted the S&P industrials sector to an above benchmark allocation. Please see yesterday's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, PCAR, CMI.

Highlights Chart 1Tax Reform Is A Bear-Steepener The federal government provided some details about its tax reform proposal last week. Markets reacted immediately, once again starting to price-in the possibility of lower tax rates. A basket of high tax-rate stocks outperformed the S&P 500, although the relative price remains well below the highs reached in the immediate aftermath of the election (Chart 1). Bond markets have also been influenced by the "will they, won't they" tax reform drama. Since tax cuts at this relatively late stage of the economic cycle are widely expected to be inflationary, the slope of the yield curve steepens and long-dated TIPS breakevens widen whenever the passage of a tax bill seems more likely. Our political strategists expect that a tax bill will be passed by the end of Q1 2008, or by early Q2 at the latest.1 All else equal, this will bias TIPS breakevens wider and cause the Treasury curve to steepen. Even in the absence of significant tax legislation we think that TIPS breakevens will widen and the yield curve will steepen as inflation starts to pick up during the next few months. But any fiscal stimulus related to tax reform would certainly expedite the process. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 87 basis points in September, bringing year-to-date excess returns up to 234 bps. The average index option-adjusted spread tightened 9 bps on the month to reach 101 bps. Valuation looks increasingly stretched across much of the corporate bond universe. The 12-month breakeven spread for A-rated corporate bonds has dipped well below its mid-2014 trough and is approaching the minimum value witnessed in the early stages of prior Fed tightening cycles. The same measure for Baa-rated credits fell to 17 bps last month, almost exactly equal to its mid-2014 low. While spreads are somewhat expensive, recent data on profit and debt growth have been positive. We noted in last week's report2 that net leverage declined in the second quarter, breaking a streak of two consecutive increases (Chart 2). In addition, other credit cycle indicators such as the slope of the yield curve and C&I bank lending standards do not yet signal wider spreads. Further declines in leverage will depend on whether profit growth can sustain its recent strength (bottom panel). While some moderation is likely, as of now, our leading profit indicators - particularly the weak dollar and surging manufacturing PMI - suggest that growth will stay firm for the remainder of the year (Table 3). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 143 basis points in September, bringing year-to-date excess returns up to 526 bps. The index option-adjusted spread tightened 31 bps to end the month at 347 bps, 24 bps above the mid-2014 cycle low. After adjusting for expected default losses, we calculate that the junk index currently offers an excess spread of 213 bps. We would expect a default-adjusted spread at this level to translate into low, but positive, excess returns during the next year. A simple linear regression suggests those excess returns will be on the order of 100 to 200 bps (Chart 3), but with a fairly wide margin for error. The default-adjusted spread incorporates our estimate of default losses for the next 12 months. This estimate currently sits at 1.3%. The estimate is derived from the Moody's baseline forecast of a 2.7% default rate and our own estimate of a 51% recovery rate (bottom panel). The relatively benign default outlook is reinforced by the persistent environment of steady growth and low inflation. Last week's third estimate showed that second quarter GDP growth was 3.1%, well above most estimates of trend. Meanwhile, the St. Louis Fed Price Pressures Measure predicts only a 2% chance that inflation will rise above 2.5% during the next year (panel 3). This combo of steady growth and low inflation will ensure that Fed policy remains sufficiently accommodative to support high-yield bond returns. MBS: Upgrade To Neutral Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 35 basis points in September, bringing year-to-date excess returns up to 26 bps. The conventional 30-year MBS yield rose 10 bps in September, driven by a 19 bps increase in the rate component. This was partially offset by an 8 bps tightening of the option-adjusted spread (OAS), while the compensation for prepayment risk (option cost) narrowed 1 bp. OAS have widened considerably during the past few months. In all likelihood this has been in anticipation of the Fed starting to unwind its MBS portfolio. The result is that MBS no longer look expensive compared to Aaa-rated credit (Chart 4). With more attractive valuations and the Fed's schedule for balance sheet runoff now well known, we think the time is right to edge MBS exposure higher. After having sold the rumor of Fed balance sheet runoff, it is time to buy the news. Arbitrage between MBS and credit should limit how much MBS OAS can widen during the next 6-12 months, even in the face of higher MBS supply. Further, recent spread widening has been helped along by falling mortgage rates and rising refinancings. With Treasury yields and mortgage rates now poised to put in a bottom, refis will also roll over and lend support to the MBS trade (bottom panel). Government-Related: Underweight Chart 4MBS Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 26 basis points in September, bringing year-to-date excess returns up to 181 bps. Sovereign bonds outperformed the Treasury benchmark by 93 bps on the month. Foreign Agencies and Local Authority bonds outperformed by 25 bps and 46 bps, respectively. Domestic Agency bonds outperformed by 1 bp and Supranationals outperformed by 3 bps. Year-to-date Sovereign bond outperformance has been spurred by dollar weakness, even though spread differentials are tilted firmly in favor of domestic U.S. credit (Chart 5). But with U.S. economic data just now starting to surprise to the upside, we think the tailwind from a weakening dollar is about to fade. Mexico is the single largest issuer in the Sovereign index, and appreciation in the peso versus the U.S. dollar has been a particularly important driver of Sovereign outperformance this year. However, our Emerging Markets Strategy team now believes that peso appreciation is overdone.3 Mexican growth has been supported by strong exports and a weak currency while domestic demand has been soft. Without a solid foundation from domestic demand, this year's currency appreciation will soon cause inflation to roll over and Mexican interest rates to fall. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 62 basis points in September (before adjusting for the tax advantage). Munis have outperformed the Treasury benchmark by 207 bps, year-to-date. The average Municipal / Treasury (M/T) yield ratio edged up from 84% to 86% in September, but it remains extremely tight relative to its post-crisis trading range (Chart 6). State & local government budgets dodged a bullet when the Graham-Cassidy healthcare reform bill was defeated last month. The bill included a block-grant provision for Medicaid that would have reduced federal government transfer payments, a significant source of state & local government revenue. Last week we also learned more specifics about the federal government's proposed tax reform legislation. While the lower tax rates in the proposal are obviously negative for M/T yield ratios, the impact should be somewhat offset by the elimination of tax deductions, the state & local income tax deduction in particular. Eliminating deductions makes the tax advantage in municipal bonds appear more attractive, irrespective of the tax rate. Most importantly, the municipal bond tax exemption itself appears safe. Of course, it will still be some time before we know the final details of tax reform, which our political strategists expect will be passed by the end of Q1 2018. With the plan still not finalized, M/T yield ratios near post-crisis lows look too complacent. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve shifted higher in September and steepened out to the 5-year maturity point. The 2/10 Treasury slope steepened 7 bps and the 5/30 slope flattened 9 bps. The market brought a December rate hike back into focus last month following a somewhat stronger CPI inflation report and Fed Chair Janet Yellen's insistence that low inflation will prove transitory. Our 12-month fed funds discounter, which shows the market's expected change in the fed funds rate during the next 12 months, moved up to 40 bps from 19 bps. As discussed in last week's report,4 we tend to agree with Chair Yellen that inflation will soon follow growth indicators higher. The market implication of this thesis is that wider TIPS breakevens will lead to one last bout of curve steepening this cycle. We continue to position for curve steepening via a trade long the 5-year bullet and short a duration-matched 2/10 barbell. This trade has returned 16 bps since inception last December. At present, our fair value model shows that the 5-year bullet is slightly expensive on the curve (Chart 7). Or put differently, that the 2/5/10 butterfly spread is fairly priced for 2 bps of 2/10 curve steepening during the next 6 months.5 We think curve steepening will easily surpass this threshold and maintain our long 5-year, short 2/10 position. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 39 basis points in September, bringing year-to-date excess returns up to -131 bps. The 10-year TIPS breakeven inflation rate rose 8 bps on the month but, at 1.84%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. CPI beat expectations in August for the first time in several months and, as was discussed in a recent report,6 the bond market was quick to react to even a tentative sign that inflation might have troughed. The market's sensitivity should not be surprising. Leading pipeline indicators of inflation, such as the prices paid and supplier deliveries components of the ISM manufacturing index, suggest that inflation and TIPS breakevens are biased higher (Chart 8). Counter-acting some of the optimism on inflation was the slightly weaker-than-expected August PCE report. While trimmed mean PCE inflation did perk up on a month-over-month basis, the 6-month and 12-month rates of change continue to fall (bottom panel). The 2% inflation target is of utmost importance to the Fed. In our base case scenario there is sufficient inflationary pressure for this target to be achieved with a pace of rate hikes similar to the Fed's median projection. But if that turns out not to be the case, then the Fed will respond with a slower pace of hikes. Either way, long-maturity TIPS breakevens must move higher before the end of the cycle or the Fed will have failed. ABS: Cut To Neutral Chart 9ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 3 basis points in September, dragging year-to-date excess returns down to 68 bps. Credit card and auto loan ABS both underperformed the duration-equivalent Treasury benchmark by 2 bps in September, pulling year-to-date excess returns down to 67 bps and 69 bps, respectively. The index option-adjusted spread for Aaa-rated ABS widened 3 bps on the month to reach 39 bps. It remains well below its average pre-crisis level (Chart 9). At 39 bps, the Aaa-rated ABS spread is still 11 bps wider than the average option-adjusted spread for conventional 30-year agency MBS. However, as we observed in last week's report,7 delinquency rates for consumer credit (credit cards, auto loans and student loans) are rising, while mortgage delinquency rates continue to fall. This squares with the message from the Fed's Senior Loan Officer Survey which shows that lending standards are tightening for both credit cards and auto loans (bottom panel). While delinquencies appear to have bottomed, the charge-off rate in credit card ABS collateral pools remains near all-time lows. Meanwhile, net losses in auto loan ABS collateral pools are in a clear uptrend. We continue to prefer Aaa-rated credit card ABS over Aaa-rated auto loan ABS, but are wary that credit card charge-offs will also start to increase in the near future, albeit from very low levels. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 6 basis points in September, dragging year-to-date excess returns down to 110 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 1 bp on the month, but it remains well below its average pre-crisis level. Fundamentally, the commercial real estate space continues to be characterized by tightening lending standards and falling demand (Chart 10) and, outside of the multi-family sector, CMBS delinquencies are trending higher (panel 5). Against this back-drop, spreads are not wide enough to entice us. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 18 basis points in September, dragging year-to-date excess returns down to 62 bps. The average index option-adjusted spread for the Agency CMBS index widened 3 bps on the month to reach 51 bps. This compares favorably to the 39 bps offered by Aaa-rated consumer ABS and the 28 bps offered by conventional 30-year Agency MBS. Especially since multi-family delinquency rates remain very low. Treasury Valuation Chart 11Treasury Fair Value Models The current reading from our 2-factor Treasury model (which is based on Global PMI and dollar sentiment) places fair value for the 10-year Treasury yield at 2.65% (Chart 11). Our 3-factor version of the model (not shown), which also includes the Global Economic Policy Uncertainty Index, places fair value at 2.62%. The Global Manufacturing PMI held flat at 53.2 in September, while bullish sentiment toward the dollar crept higher. This caused our model's fair value to edge lower to 2.65% from 2.67%. The U.S., Eurozone and Japan all saw stronger PMIs in September. While China's PMI dipped slightly (from 51.6 to 51), it remains firmly above the 50 boom/bust line. For further details on our Treasury models please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 11, 2016, available at usbs.bcaresearch.com At the time of publication the 10-year Treasury yield was 2.33%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?", dated September 20, 2017, available at gps.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Won't Back Down", dated September 26, 2017, avail-able at usbs.bcaresearch.com 3 Please see Emerging Markets Strategy Weekly Report, "Questions From The Road", dated September 20, 2017, available at ems.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Won't Back Down", dated September 26, 2017, available at usbs.bcaresearch.com 5 For further details on our fair value model please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "The Great Unwind", dated September 19, 2017, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "Won't Back Down", dated September 26, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of September 29th, 2017. The model sharply reduced its allocation to the U.K. to a bare minimum in response to the tightening in liquidity condition as the Bank of England warned of a rate hike in "coming months." The funds are reallocated to the Spain and Germany. Other smaller changes are the reductions in Italy and Australia in favor of Sweden and Switzerland, as shown in Table 1. As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed its benchmark by 44 bps in September. Both level 1 and level 2 models performed well, with level 2 outperforming its benchmark by 63 bps and level 1 outperforming its benchmark by 9 bps, as the underweight in Australia, U.S. and Japan versus the overweight in Italy, Germany and Netherland worked very well. Since going live in January 2016, the overall model has outperformed the benchmark by 341 bps, largely from the allocation among the 11 non-U.S. countries, which has outperformed its benchmark by 743 bps. Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level1) Chart 3GAA Non U.S. Model (Level 2) Table 1Model Allocation Vs. Benchmark Weights Table 2Performance (Total Returns In USD) Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see the January 29th, 2016 Special Report, "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model." http://gaa.bcaresearch.com/articles/view_report/18850. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of September 30, 2017. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live The model continues to be optimistic on global growth as seen by an increasing allocation to cyclical sectors. Additionally, the model has also reduced its underweight on consumer discretionary stocks, which is currently the only cyclical sector to have a below-benchmark allocation. Finally, the biggest shift was a downgrade in utilities from overweight to underweight. This was primarily driven by momentum. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com