Trade / BOP

Highlights Portfolio Strategy Boost restaurant stocks to neutral, as same-store sales should improve next year. A further upgrade requires evidence of top-line traction. The exodus from health care stocks represents an overreaction rather than a downshift in fundamental forces. Stay long. Recent Changes S&P Restaurants Index - Upgrade to neutral for a profit of 9%. Table 1 Profits: Is Less Bad Good Enough? Profits: Is Less Bad Good Enough? Feature Equity market buoyancy remains a liquidity rather than an earnings story. Fed commentary and the trend in global bond yields, a reflection of the global central bank narrative, continue to exert an outsize influence on short-term price action and momentum. In the background, earnings are a wildcard. Companies may be surpassing beaten down third quarter estimates, but the path of profits over the next several quarters is by no means assured and will determine the durability of any stock market advance. Even excluding the persistent drag from narrowing profit margins, courtesy of falling productivity and increasing unit labor costs, it is dangerous to look at the corporate profit outlook through rose colored glasses. The low level of economic growth, both at home and abroad, represents a major hurdle to the corporate sector. Total business sales have climbed back up to zero, but it is premature to forecast meaningful growth ahead based on moribund global export growth (Chart 1), and/or leading economic indicators. After all, sales growth has been virtually non-existent for years, reinforcing that earnings per share have been driven by cost cutting and buybacks. While measured consumer price inflation has crept higher, corporate sector pricing power remains virtually non-existent. The producer price index is still deflating, despite the rally in oil prices. U.S. import prices are very weak (Chart 1). The negative global credit impulse warns that there is still no impetus to reinvigorate final demand, and by extension, global profits (Chart 1). It is hard to envision an economic reacceleration as long as the corporate sector is more inclined to retrench than expand, as heralded by stressed balance sheets and weak durable goods orders (Chart 2). Chart 3 shows BCA's two U.S. profit models. The first one is based on reflationary variables, such as the dollar, bond yields and oil prices. It is designed to predict the trend in forward earnings momentum. This model has troughed, but is not signaling any upside ahead in already exuberant analyst earnings estimates (Chart 3, second panel). Chart 1Without Sales Growth... bca.uses_wr_2016_10_24_c1 bca.uses_wr_2016_10_24_c1 Chart 2... And Rising Costs... bca.uses_wr_2016_10_24_c2 bca.uses_wr_2016_10_24_c2 Chart 3... How Much Can Profits Improve? ... How Much Can Profits Improve? ... How Much Can Profits Improve? The second model looks at macro data such as new orders, labor costs and productivity growth to forecast the trend in actual operating earnings. This model is slightly more optimistic (Chart 3, bottom panel), and signals a decisive end to the profit contraction, albeit not a growth rate sufficient to satisfy double-digit analysts forecasts or rich valuations. The U.S. dollar is a major wildcard, as any sustained strength would compromise earnings. Typically, major profit expansions only occur after the currency begins to depreciate and labor cost inflation ebbs (Chart 2). The late-1990s was an exception, as profits climbed alongside the currency and amidst rising wage inflation (Chart 2). However, that was during an economic and credit boom, two key factors that are conspicuously absent at the moment. Nevertheless, as discussed in past Weekly Reports, the flood of central bank liquidity could sustain the overshoot in equity prices for a while longer. Investors have demonstrated a willingness to look through soggy profits as long as the liquidity taps remain open. Despite the possibility of a stubbornly resilient broad market, we do not recommend interpreting it as a sign of economic vitality, and consider it high risk. Our portfolio strategy is based on expected sectoral earnings trends, as liquidity is subject to the whims of central bankers. We recommend a largely defensive sector portfolio, with some exceptions, as discussed in last week's Special Report. Our cyclical exposure remains confined to consumption-oriented plays; this week we are lifting our view on restaurants. Restaurants: Buying Into Weakness Investors have gravitated toward washed out deep cyclical sectors rather than consumption-oriented plays in recent months. However, we doubt this trend has staying power, as outlined in our Special Report last week. Consequently, it is time to revisit the outlook for shunned consumer sectors, such as restaurants. This year's exodus from casual dining stocks has been justified on the basis of overvaluation and deteriorating industry performance. The National Association of Restaurants (NAR) survey of current performance has dipped into negative territory (Chart 4), as restaurant operators have reported a decrease in traffic. One of the major drags on restaurant same-store sales has been the gap in restaurant inflation compared with the cost of food inflation for eating at home. Relative inflation has soared (Chart 5). That has caused relative spending growth at restaurants vs. at home dining to drop sharply, in real (volumes) terms. However, next year could be different. If the inflation gap falls, as predicted by the decline in relative spending (Chart 5), then restaurant traffic should stabilize. Importantly, the odds of budgets for dining out being pruned even further are low. As long as wages and salaries growth is decent and consumer income expectations are firm, consumers should still allocate a rising share to restaurants relative to eating at home (Chart 5). There is plenty of scope for relative restaurant spending to rise on a secular basis (Chart 5, bottom panel). Clearly, if relative spending were to reaccelerate too quickly, then the inflation gap would stay wide, and same-store sales growth would stay punk. That is a risk to an optimistic view of future restaurant traffic. But the good news is that cost structures are being realigned to a more subdued sales run rate. The NAR survey shows that staffing plans are on the wane. That leads restaurant labor cost inflation (Chart 4). As the largest source of expenses, any decline in headcount would be welcome given that minimum wages in a number of states are set to climb next year. In any case, the most potent profit elixir would be a recovery in top-line growth, sourced both domestically and from abroad. Restaurant sales growth has been unimpressive for the past several years. Subdued pricing power gains, and until recently, lackluster income growth among lower income consumers have weighed on revenue growth. The good news is that consumer confidence among low income earners is on the upswing (Chart 6), which bodes well for casual dining out in the coming quarters. If our bearish view on refiners and gasoline prices continues to pan out, then a windfall from lower fuel prices may further bolster the outlook. Chart 4Expenses Set To Ease bca.uses_wr_2016_10_24_c4 bca.uses_wr_2016_10_24_c4 Chart 5Inflation Gap Should Narrow bca.uses_wr_2016_10_24_c5 bca.uses_wr_2016_10_24_c5 Chart 6Sales Set To Stabilize... bca.uses_wr_2016_10_24_c6 bca.uses_wr_2016_10_24_c6 In addition, restaurant retail sales often follow the trend in the wealth effect (Chart 7). The latter has pulled back this year, owing to the equity market consolidation and house price correction. However, financial wealth gains are rebounding, and provided the stock market does not suffer a sustained swoon, consumers' feeling of affluence may soon be bolstered. Even marginal improvements in store traffic should be impactful to same-store sales. Restaurant chains have been in retrenchment mode since the Great Recession. Construction activity is historically low, which implies limited capacity expansion (Chart 7). Contribution from abroad may become less of a drag. The industry garners roughly 67% of sales from overseas. The strong U.S. dollar, particularly against emerging market currencies, has deprived the industry of sales strength. Moreover, even in domestic currency terms, emerging markets consumption has been through a difficult period, as the Asian Hotel and Restaurant Activity Proxy spent most of the last year in negative territory (Chart 8). But EM currencies have stabilized and Asian restaurant activity has climbed back into positive territory in recent months. The upshot is that foreign revenue could make up any lingering domestic sales slack. All of this suggests that leaning into share price weakness in anticipation of improved prospects next year makes sense. Nevertheless, the S&P restaurants index does not warrant a full shift from underweight to overweight. There could still be earnings/headline risk given lackluster readings in coincident activity indicators, despite McDonald's earnings beat last week. Valuations are not cheap. On a normalized basis, the relative forward P/E ratio has dropped below its average, but still trades at a premium to the broad market. A return to above average levels is possible if operating margins expand on the back of sales improvement (Chart 9), thereby sparking higher return on equity, but it may be too soon to position for such an outcome. Chart 7... Or Even Improve In 2017 bca.uses_wr_2016_10_24_c7 bca.uses_wr_2016_10_24_c7 Chart 8End Of Foreign Drag bca.uses_wr_2016_10_24_c8 bca.uses_wr_2016_10_24_c8 Chart 9Still Not Dirt Cheap bca.uses_wr_2016_10_24_c9 bca.uses_wr_2016_10_24_c9 Bottom Line: Lift the S&P restaurant index (BLBG: S5REST - MCD, SBUX, YUM, CMG, DRI) to neutral from underweight, locking in a profit of 9% since our underweight recommendation last November. Health Care Crunch: Buying Opportunity Or Trend Change? The speed at which the health care sector has sunk toward the bottom end of this year's trading range has unnerved many investors. In fact, the sector has dropped back down to the levels where we added it to our high conviction overweight list. The question now is whether our positive views still hold, and whether would we add here if we weren't long already, or if something more sinister is at work? The hit to health care stocks reflects a rise in risk premiums related to concerns that the U.S. government will exert more control over price setting if the Democrats win the election rather than any immediate downshift in relative forward earnings drivers. While it is impossible to forecast with any precision to what extent pricing models may or may not change, the political appetite may be low for another overhaul of the sector so soon after the Affordable Care Act was implemented. Regardless, several observations suggest that the sector may already be undershooting, i.e. a Democratic victory is already discounted. Relative performance has experienced a clear uptrend over the last forty years, with cyclical swings oscillating around its upward sloping trend-line (Chart 10). It would be extremely rare for a bull phase to peak prior to hitting at least one standard deviation above trend. Instead, the price ratio hit trend and is now not far above one standard deviation below trend, a level one would normally equate with an economic boom when capital flowed to high-beta sectors. Cyclical technical measures also point to an undershoot. Our Technical Indicator has hit an oversold extreme (Chart 11), signaling that the sell-off is in the late stages. Our relative advance/decline line has also stayed firm, suggesting that the decline in the overall sector has not been broad-based (Chart 11). Chart 10Time To Buy, Not Sell bca.uses_wr_2016_10_24_c10 bca.uses_wr_2016_10_24_c10 Chart 11Buying Opportunity Buying Opportunity Buying Opportunity Whether a wholesale flight from the sector, and all defensives in general, looms is largely contingent on the path of inflation expectations, which have been in a multiyear decline. This trend reflects anemic global final demand and the repercussions from over-indebtedness. Lately, inflation expectations have firmed, but that may largely reflect the rebound in oil prices courtesy of hopes for an OPEC production cut, given the lack of confirming indicators of growth acceleration and renewed strength in the U.S. dollar. The latter is testing the top end of its recent range (Chart 11, shown inverted, bottom panel), and it would be highly unusual for inflation expectations to rise concurrent with the U.S. dollar. In a world of zero interest rates and limited aggregate demand strength, a strong currency is deflationary, especially for corporate profits. Those conditions keep bond yields low, and push capital into long duration sectors. Once the election is over, attention will refocus on the relative forward earnings outlook. Our Indicators suggest that earnings momentum will stay positive. Our health care sector pricing power proxy has rebounded after cooling from red-hot levels, and is still much stronger than overall corporate sector pricing (Chart 12, second panel). That is confirmed by the pharmaceuticals producer price index, and employment cost index for health insurance, i.e. pricing strength is broad-based. There is still scant evidence of a downshift in consumer spending patterns in reaction to rising health care sector inflation. Real (volumes) personal spending on health care goods and services continues to grow at a mid-single digit rate, well in excess of the rate of overall consumption (Chart 12). That is consistent with ongoing earnings outperformance. As noted in past research, the time to forecast negative relative earnings momentum is when consumers balk at higher prices. So far, a few high profile cases of exorbitant drug price increases have grabbed the spotlight, but in aggregate, consumers are not voting with their wallets. The biggest tangible negative for the health care sector may be that shares outstanding are no longer falling (Chart 13). That mirrors overall buyback activity, which has cooled markedly on the back of balance sheet deterioration and waning free cash flow. We doubt the supply of health care stocks is going to rise much, however, because the sector is in good financial shape, earning healthy returns and is not dependent on external financing. Chart 12Demand Driven Pricing Power Gains Demand Driven Pricing Power Gains Demand Driven Pricing Power Gains Chart 13Buybacks Are Dwindling bca.uses_wr_2016_10_24_c13 bca.uses_wr_2016_10_24_c13 Bottom Line: Health care sector risk premiums have climbed in response to polling results, but an apolitical check on relative earnings drivers and valuations points to a buying opportunity. Current Recommendations Current Trades Size And Style Views Favor small over large caps and growth over value.

Highlights The U.S. is not yet a "high-pressure" economy, but slack is dissipating. U.S. growth, while not torrid, will remain high enough to push interest rates higher. The euro area continues to exhibit tepid domestic demand growth, and slack there remains higher than in the U.S. Monetary divergences will grow, weighing on EUR/USD. The Canadian economy displays underlying weaknesses which will prevent the BoC from hiking for an extended period of time. Stay long USD/CAD, but favor the CAD to the AUD and the NZD on a USD rally. Feature Following Janet Yellen's Boston speech last week, a new phrase has entered the lexicon of investors: "high-pressure economy". The speech was originally interpreted as a clarion call to let the economy overheat in order to absorb the slack created by the shock of 2008. However, Yellen still sees some slack in the economy. In her eyes, an easy monetary stance, at this point, will not cause an overheating, it will only bring back to the marketplace workers that had left the labor force. Chart I-1Drying Global Liquidity bca.fes_wr_2016_10_21_s1_c1 bca.fes_wr_2016_10_21_s1_c1 We have sympathy toward this view, especially when put in an international context where global capacity utilization remains depressed. Also, countries like China, Saudi Arabia, and Mexico have been intervening in the FX markets to preempt or limit downside to their currencies, tightening global liquidity conditions (Chart I-1). Nonetheless, the Fed Chair also highlighted that the FOMC did not want the U.S. economy to overheat as the domestic slack gets absorbed. Doing so would raise the risk that the Fed will have to then overcompensate by tightening rates very aggressively. This would prompt another recession. U.S.: Not High Pressure Yet, But... No indicator suggests that there is a burning need to quickly ratchet U.S. rates higher. However, domestic economic conditions are falling into place to justify a slow move toward higher rates. Our aggregate U.S. capacity utilization gauge is showing a dissipation of U.S. economic slack (Chart I-2, top panel). This is a side-effect of the tepid growth in the capital stock of U.S. businesses this cycle, which limits the expansion of the supply-side of the economy (Chart I-2, bottom panel). Meanwhile, household consumption should remain robust. Not only did 2015 register the strongest growth in the median household's real income since 1967, consumption is unlikely to slow much. In fact, vehicle-miles traveled and the Federal income tax receipts are both pointing toward healthy consumption (Chart I-3). Despite punky construction starts, housing activity shows signs of improvement. Housing inventories are near record lows and construction has underperformed household formation. Moreover, building permits are hooking upward, while housing affordability remains generous (Chart I-4). Additionally, the NAHB survey also points toward a rising share of residential activity in the economy (Chart I-4, bottom panel). Finally, capex intentions are slowly recovering. Moreover, the BCA House view is that the U.S. profit contraction is past its nadir. Going forward, capex and inventories are unlikely to subtract as much from growth as they did in 2015 and 2016. They may even become accretive to GDP growth. Chart I-2Vanishing U.S. Slack Vanishing U.S. Slack Vanishing U.S. Slack Chart I-3Positive Signs For The U.S. Consumer bca.fes_wr_2016_10_21_s1_c3 bca.fes_wr_2016_10_21_s1_c3 Chart I-4Residential Investment Will Improve bca.fes_wr_2016_10_21_s1_c4 bca.fes_wr_2016_10_21_s1_c4 Limited slack and a continued economic expansion imply a high likelihood of a Fed hike this year, and maybe two more next year if no shocks to financial conditions emerge. With markets currently pricing in 65 basis points of rate hikes by the end of 2019, this should lift rates across the curve. Higher interest rates on U.S. assets should drive private inflows into the country, pushing the U.S. dollar higher (Chart I-5). From a technical perspective, the U.S. capitulation index is breaking out to the upside following a pattern of lower highs. Since 2008, such breakouts have been followed by a significant rally in the broad trade-weighted dollar (Chart I-6). Thus, we continue to position ourselves for additional dollar strength this cycle. Chart I-5Flows Into The U.S. ##br##Are Set To Grow bca.fes_wr_2016_10_21_s1_c5 bca.fes_wr_2016_10_21_s1_c5 Chart I-6Favorable Technical ##br##Backdrop For The Greenback bca.fes_wr_2016_10_21_s1_c6 bca.fes_wr_2016_10_21_s1_c6 Bottom Line: The household sector remains healthy, and U.S. economic slack is dissipating. Hence, the Fed will try, rightfully or wrongly, to push rates higher this year and next, lifting the dollar in the process. Euro Area: Less Pressure A dollar rally could be painful for the euro. Yet, the euro is cheap and supported by a current account surplus of 3.3% of GDP (Chart I-7). What to do with this conflicting picture? For a currency to embark on a durable bull market, productivity growth needs to be stronger than that of its trading partners. A strong currency makes the tradeable-goods sector less competitive, hampering growth. A positive terms-of-trade shock, like that undergone by commodity producers during the previous decade can also do the trick. Neither of these statements currently describe the euro area. Another avenue for a country to withstand a strong currency is for growth to be domestically driven. If household consumption is the main locomotive, exporters' loss of market share do not hurt activity as much. This is true until the domestic economy enters a recession, an event usually driven by higher policy rates. This is why when the share of salaries in the U.S. economy expands, the dollar undergoes cyclical bull markets (Chart I-8). More salaries in the national income means more consumption. Chart I-7Euro ##br##Supports Euro Supports Euro Supports Chart I-8Domestically-Driven Growth##br## Is Good For A Currency Domestically-Driven Growth Is Good For A Currency Domestically-Driven Growth Is Good For A Currency In the euro area, GDP growth is above trend, but, in recent quarters, final private domestic demand has been weak (Chart I-9). In fact, last quarter, net exports were the main contributor to growth. This could explain why, since 2015, stronger European business surveys vis-à-vis the U.S. were unable to boost EUR/USD (Chart I-10). Chart I-9European Consumption##br## Isn't Strong Relative Pressures And Monetary Divergences Relative Pressures And Monetary Divergences Chart I-10If EUR/USD Could Not ##br##Rally Then, When Will It? bca.fes_wr_2016_10_21_s1_c10 bca.fes_wr_2016_10_21_s1_c10 We do expect eurozone final domestic demand to remain tepid. Yes, the credit impulse has improved, but this amelioration will prove temporary. The previous rebound in credit flows reflected the movement from a large contraction to a small expansion. Today, the dismal performance of euro area bank stocks - which have been a good leading indicator of European loan growth - points to slowing credit growth (Chart I-11). Fiscal policy is also moving from a small positive to a small negative. Work by the ECB staff shows that the cyclically adjusted budget balance in Europe fell by 0.3%, from -1.7% to -2.0% of GDP in 2016. Aggregate cyclically-adjusted budget balances are forecasted to improve to -1.8% and -1.6% of GDP in 2017 and 2018, respectively, representing a 0.2% fiscal drag each year. While a small number, we have to keep in mind that euro area trend growth is between 0.5% and 1%. This suggests that the European economy remains ill-equipped to handle a stronger euro. Moreover, the European economy exhibits much more slack than the U.S. economy. While total hours worked in the U.S. are 14% above Q1 2010 levels, in Europe, they are only 1.5% above such levels (Chart I-12), a gap much greater than demographics alone would have suggested. This means that monetary divergence will continue between Europe and the U.S. Chart I-11Euro Area Credit Impulse Will Weaken bca.fes_wr_2016_10_21_s1_c11 bca.fes_wr_2016_10_21_s1_c11 Chart I-12Less Capacity Pressures In Europe Less Capacity Pressures In Europe Less Capacity Pressures In Europe In fact, this week, the ECB did little to dispel this notion. Beyond trying to squash ideas of a sudden end to the QE program or any imminent tapering, president Draghi communicated that December will be the month when the real action occurs. Based on current trends, we expect the ECB to extend its QE program beyond March, but to hint at a tapering of purchases later in 2017. The ECB will also make it very clear that rates will remain as low as they currently are for an extremely long time. Thus, while the ECB might be slowly moving away from its hyper-stimulative stance, it will not do so as fast as the Fed. Therefore, policy divergences should continue to weigh on EUR/USD. Technicals are also pointing toward a lower euro. Not only has EUR/USD broken down its 1-year old series of higher lows, the euro's capitulation index, the intermediate-term momentum indicator, and the euro's A/D line are forming negative divergences with EUR/USD (Chart I-13). An interesting way to play the euro's weakness is to go short EUR/CZK, a position championed by our Emerging Market Strategy service.1 A floor at 27 has been set under EUR/CZK since November 2013. Yet, this floor looks increasingly untenable. Speculators are beginning to pile in. This week, 2-year Czech yields temporarily dipped below those of Swiss 2-year bonds, the current holder of the world's lowest yield. To fight appreciation pressures, the Czech National Bank (CNB) is accumulating a lot of reserves by buying euros, which is fueling a surge in the money supply (Chart I-14, top panel). Chart I-13Worrying Euro ##br##Technicals Worrying Euro Technicals Worrying Euro Technicals Chart I-14CZK: Reserves Expansion##br## Leading To Inflation bca.fes_wr_2016_10_21_s1_c14 bca.fes_wr_2016_10_21_s1_c14 This accumulation of reserves, in turn, is fanning inflationary forces in the Czech economy. The output gap is closing and core inflation already is increasing at a rate of 1.8% p.a. Easy financial conditions and expanding credit growth are likely to boost already-accelerating unit labor costs and wages (Chart I-14, bottom panel). This means that the 2% inflation target is likely to be hit as early as Q2 2017 according to the CNB. We expect this goal to be handily surpassed if the floor stays in place. Thus, we expect the CNB to abandon the floor within the next twelve months and we are shorting EUR/CZK. Finally, while we are bearish EUR/USD, we do believe that the euro will outperform the pound and commodity currencies. Moreover, despite poorer fundamentals, the euro could also temporarily outperform the SEK and the NOK if the dollar strengthens. The latter two are more sensitive to the USD than the euro is. Bottom Line: EUR/USD is at risk from the broad dollar rally. It is also likely to suffer from the tepid state of the euro area's final domestic demand, fueling monetary-policy divergences with the U.S. A speculative opportunity to short EUR/CZK is emerging, as the CNB's peg is outliving its usefulness. Canada: Falling Pressure USD/CAD has become more correlated with movements in rate differentials than with the vagaries of oil prices (Chart I-15). This puts the actions of the Bank of Canada in sharper focus. As expected, this week, the BoC left policy rates unchanged at 0.5%. More interesting was the quarterly monetary report. The economy has rebounded from the slump induced by the Q2 Alberta wildfires, and many key gauges of the Canadian economy have improved (Chart I-16). Yet, the BoC is looking the other way. Chart I-15CAD: Now More Rates Than Oil bca.fes_wr_2016_10_21_s1_c15 bca.fes_wr_2016_10_21_s1_c15 Chart I-16The BoC Is Looking The Other Way... bca.fes_wr_2016_10_21_s1_c16 bca.fes_wr_2016_10_21_s1_c16 The BoC is now forecasting the Canadian output gap to close in mid-2018; in July, this was expected to happen in the second half of 2017. This is because the BoC cut the expected Canadian growth rate by a cumulative 0.5% over the next two years. There have been some worrying developments warranting a more cautious forecast. While the Trudeau government's new childcare benefits are currently being rolled out and new infrastructure spending is to be implemented in 2017, the Canadian private sector's finances are increasingly shaky. The aggregate debt-servicing costs of the non-financial private sector is at record highs, with generous contributions from both households and the corporate sector (Chart I-17). The aggregate credit impulse has responded to this handicap, contracting by 7% of potential GDP, a move driven by the corporate sector (Chart I-18). While not as dramatic, the pace of debt accumulation by the household sector has also weakened. Recent administrative measures to cool the housing market - put in place by various provincial entities as well as the federal government - could accentuate this trend. Chart I-17...Rightfully So bca.fes_wr_2016_10_21_s1_c17 bca.fes_wr_2016_10_21_s1_c17 Chart I-18Collapsing Canadian Credit Impulse Collapsing Canadian Credit Impulse Collapsing Canadian Credit Impulse Another problem for Canada has been its loss of competitiveness. Non-oil Canadian exports have not responded as expected to the fall in the CAD. This is because many Canadian manufacturers have set up factories in Mexico and other EMs, or are competing with firms operating out of these nations. With these countries' currencies witnessing devaluations as deep as, or deeper than the loonie's, it is no wonder that Canada has lost market shares in the U.S. (Chart I-19). This means that Canadian rates will remain low for longer, making Canada another contributor to global monetary divergences vis-a-vis the U.S. The BoC is right to be worried that the Canadian economy will take longer than anticipated to close its output gap. With the pass-through to inflation of a lower CAD dissipating, the BoC expects Canadian core inflation to remain well contained for the next two years. We see little cause to disagree. This means that despite trading at a premium to PPP, USD/CAD has upside. Moreover, the Canadian dollar's A/D line is rolling over, another factor pointing to upside for USD/CAD (Chart I-20). At this point, the biggest risk to our view is oil. If WTI can breakout above $52 - perhaps in response to an as-yet negotiated OPEC/Russia oil-production cut or freeze - this could mitigate the downside for the CAD. Thus, while we like USD/CAD, we think the CAD has upside against the AUD and the NZD, especially as the loonie is less sensitive to the USD and EM spreads than the two antipodean currencies. Chart I-19Canada Is Losing Competitiveness Relative Pressures And Monetary Divergences Relative Pressures And Monetary Divergences Chart I-20Falling CAD A/D Line Falling CAD A/D Line Falling CAD A/D Line Bottom Line: The Canadian economy is showing surprising signs of underlying weakness. With the CAD having recently been more correlated to rate differentials than to oil, USD/CAD could rally on monetary divergences. That being said, on the back of a strong USD, CAD is likely to outperform the AUD and NZD. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report, "Central European Strategy: Two Currency Trades", dated September 28, 2016, available at ems.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 bca.fes_wr_2016_10_21_s2_c1 bca.fes_wr_2016_10_21_s2_c1 Chart II-2USD Technicals 2 bca.fes_wr_2016_10_21_s2_c2 bca.fes_wr_2016_10_21_s2_c2 Policy Commentary: "The risks have changed in terms of overshooting what I think is full employment with implications for potential imbalances...Those imbalances might result in a reaction by the Fed that we end up having to tighten more quickly than I would like" - FOMC Voting Member Eric Rosengren (October 17, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 The Euro Chart II-3EUR Technicals 1 bca.fes_wr_2016_10_21_s2_c3 bca.fes_wr_2016_10_21_s2_c3 Chart II-4EUR Technicals 2 bca.fes_wr_2016_10_21_s2_c4 bca.fes_wr_2016_10_21_s2_c4 Policy Commentary: "An abrupt ending to bond purchases, I think, is unlikely...We remain committed to preserving a very substantial degree of monetary accommodation" - ECB President Mario Draghi (October 20, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 The Yen Chart II-5JPY Technicals 1 bca.fes_wr_2016_10_21_s2_c5 bca.fes_wr_2016_10_21_s2_c5 Chart II-6JPY Technicals 2 bca.fes_wr_2016_10_21_s2_c6 bca.fes_wr_2016_10_21_s2_c6 Policy Commentary: "Since the employment situation has continued to improve, no further easing of monetary policy may be necessary... at any rate, I would like to discuss this thoroughly with other board members at our monetary policy meeting" - BoJ Board Member Yutaka Harada (October 12, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 British Pound Chart II-7GBP Technicals 1 bca.fes_wr_2016_10_21_s2_c7 bca.fes_wr_2016_10_21_s2_c7 Chart II-8GBP Technicals 2 bca.fes_wr_2016_10_21_s2_c8 bca.fes_wr_2016_10_21_s2_c8 Policy Commentary: "Our judgment in the summer was that we could have seen another 400,000-500,000 people unemployed over the course of the next few years...So we're willing to tolerate a bit of overshoot in inflation over the course of the next few years in order to avoid that situation, to cushion the blow" - BOE Governor Mark Carney (October 14, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9AUD Technicals 1 bca.fes_wr_2016_10_21_s2_c9 bca.fes_wr_2016_10_21_s2_c9 Chart II-10AUD Technicals 2 bca.fes_wr_2016_10_21_s2_c10 bca.fes_wr_2016_10_21_s2_c10 Policy Commentary: "We have never thought of our job as keeping the year-ended rate of inflation between 2 and 3 percent at all times...Given the uncertainties in the world, something more prescriptive and mechanical is neither possible nor desirable" - RBA Governor Philip Lowe (October 17, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 bca.fes_wr_2016_10_21_s2_c11 bca.fes_wr_2016_10_21_s2_c11 Chart II-12NZD Technicals 2 bca.fes_wr_2016_10_21_s2_c12 bca.fes_wr_2016_10_21_s2_c12 Policy Commentary: "There are several reasons for low inflation - both here and abroad. In New Zealand, tradable inflation, which accounts for almost half of the CPI regimen, has been negative for the past four years. Much of the weakness in inflation can be attributed to global developments that have been reflected in the high New Zealand dollar and low inflation in our import prices" - RBNZ Assistant Governor John McDermott (October 11, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 bca.fes_wr_2016_10_21_s2_c13 bca.fes_wr_2016_10_21_s2_c13 Chart II-14CAD Technicals 2 bca.fes_wr_2016_10_21_s2_c14 bca.fes_wr_2016_10_21_s2_c14 Policy Commentary: "Given the downgrade to our outlook, Governing Council actively discussed the possibility of adding more monetary stimulus at this time, in order to speed up the return of the economy to full capacity" - BoC Governor Stephen Poloz (October 19, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swiss Franc Chart II-15CHF Technicals 1 bca.fes_wr_2016_10_21_s2_c15 bca.fes_wr_2016_10_21_s2_c15 Chart II-16CHF Technicals 2 bca.fes_wr_2016_10_21_s2_c16 bca.fes_wr_2016_10_21_s2_c16 Policy Commentary: "[On the effects of low interest rates on the housing market]...If you look at the recent past, the dynamics have been a bit more reassuring...[still]let's not forget, this disequilibrium that we have achieved remains very high" - SNB Vice-President Fritz Zurbruegg (October 12, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 bca.fes_wr_2016_10_21_s2_c17 bca.fes_wr_2016_10_21_s2_c17 Chart II-18NOK Technicals 2 bca.fes_wr_2016_10_21_s2_c18 bca.fes_wr_2016_10_21_s2_c18 Policy Commentary: "A period of low interest rates can engender financial imbalances. The risk that growth in property prices and debt will become unsustainably high over time is increasing. With high debt ratios, households are more vulnerable to cyclical downturns" - Norges Bank Governor Oystein Olsen (October 11, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 bca.fes_wr_2016_10_21_s2_c19 bca.fes_wr_2016_10_21_s2_c19 Chart II-20SEK Technicals 2 bca.fes_wr_2016_10_21_s2_c20 bca.fes_wr_2016_10_21_s2_c20 Policy Commentary: "[On Sweden's financial stability]...it remains an issue because we are mismanaging out housing market. Our housing market isn't under control in my view" - Riksbank Governor Stefan Ingves (October 27, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Dazed And Confused - July 1, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Dear Client, I am on the road visiting clients in Toronto, Chicago, and Wisconsin this week, and as such there will be no regular Weekly Report. Instead, we are sending you a Special Report written by my colleague Marko Papic, Chief Strategist of BCA's Geopolitical Strategy service. In this report, Marko argues that Hillary Clinton has not yet sealed the election, despite her high odds of winning. I hope you will find this report both interesting and informative. Best regards, Peter Berezin, Senior Vice President Global Investment Strategy Highlights Clinton has a 65.5% chance of winning the presidency. A Trump win requires a surprise - such as in voter turnout. Still, we doubt Trump can punch more than 3% above his polling. Regardless of the outcome, multinational corporate profits will suffer. Go long the USD. Feature With the conclusion of the final presidential debate on October 19, the U.S. election is now in its final inning. Donald Trump's chances of mounting a comeback are slipping away (Chart 1). Could there be a Brexit-like surprise for the markets on November 8? And what are the investment implications of this year's unprecedented election? Chart 1 How Trump Can Still Win... Paddy Power, one of the world's biggest bookies, has begun to pay out bets to people who had wagered on Secretary Hillary Clinton winning the election. Meanwhile, according to Nate Silver, America's statistical Geek-in-Chief, Donald Trump has a meager 13.7% chance of winning the election.1 While our own model gives Clinton a 65.5% chance of winning, we have not forgotten Yogi Berra's wisdom: "It ain't over till it's over." There are three reasons why we would have held onto the pay-outs if we ran Paddy Power: Turnout assumptions could be wrong: Silver's quant model - and ours - is based on the assumption that the publically available opinion polls are high-quality data points. To iron-out the noise of an occasional bad poll, political analysts aggregate the polls to create a "poll-of-polls." The problem is that this method is mathematically the same as combining bad mortgages into securities. The idea is that each individual object (mortgage or poll) may be flawed, but if you get enough of them together, the problems will all average out and you have a very low risk of something bad happening.2 If there is a bias that is common to a large part of the data, then you are in real trouble. And why would there be a bias in election polls? For one, polling is not a science. It is an art. To extrapolate the results of an opinion survey of ~1,000 individuals to the general election of ~130 million people, polling professionals have to make turnout assumptions that are based partly on previous elections and partly on guesswork. This year, these assumptions are notoriously difficult to make as both candidates are extremely unpopular (Chart 2). This is bound to throw off pollsters' assumptions and may partially explain the regular gyrations that can be gleaned in Chart 1. For Secretary Hillary Clinton, the problem is compounded by the fact that she requires a high turnout to win. She needs the "Obama Coalition" of minorities and Millennial voters to show up as they did for President Barack Obama in 2008 and 2012. But we know that she struggled with the latter, with Senator Bernie Sanders picking up 70% of the youth vote in the Democratic primaries (Chart 3). If the 2016 turnout resembles the turnout from mid-term elections - which Republicans have generally won this century - then Trump could still have a chance. Chart 2 Chart 3 People may be lying: Another concern for Clinton is that she may be the 21st century Tom Bradley. Bradley was an African-American Mayor of Los Angeles who lost the 1982 California governor's race despite being ahead in the polls right up until election day. The "Bradley effect" theory goes that white voters lied when answering the polls in 1982 for fear of appearing racially prejudiced. Today, voters may be telling pollsters what they think is "politically correct," thus favoring Clinton in the polls. In the same vein - but ideologically opposite - the former Imperial Wizard of the Knights of the Ku Klux Klan, David Duke, outperformed expectations in both the 1996 U.S. Senate election and the 1999 special election for Louisiana's First Congressional District. He lost both elections, but he managed to garner double-digit support both times. More recently, the June 23 Brexit vote surprised markets. In our view, investors and betting markets underestimated Brexit largely in spite of polls, which had been close throughout the campaign stage (Charts 4 and 5). BCA's Geopolitical Strategy outlined the case for why the probability of Brexit was much higher than the market assumption as early as March.3 Our concerns began to manifest in the polls with the "Leave" camp comfortably ahead throughout June. And then, from June 16 (one week before the vote) to June 23, the "Stay" vote surged ahead in the polls, garnering a 4% lead the day before the election. This surge in the last week was clearly false, as the "Leave" camp won by a 3.8% margin, a 7.8% swing on the day of the election. So, what happened? The vertical line in Chart 5 shows the day that Member of Parliament Jo Cox was murdered by a British ultra-nationalist. Our guess is that the stunning political assassination - an extremely rare event in the U.K. - created a "Cox effect" in the Brexit polling. Those who were polled may have mourned for Cox, or resisted being associated with the extreme views of a self-professed neo-Nazi, yet they silently stuck to their legitimate concerns regarding EU membership on the day of the referendum. Chart 4Online Betting Got Brexit Wrong... bca.gps_sr_2016_10_21_c4 bca.gps_sr_2016_10_21_c4 Chart 5...So Did Prominent Opinion Polls bca.gps_sr_2016_10_21_c5 bca.gps_sr_2016_10_21_c5 The Brexit example illustrates that lying to pollsters is not something that only happens in the past. It has happened as recently as June. Given Donald Trump's controversial statements - and particularly his misogynist rants going back to 2005 - American voters may be lying to pollsters when it comes to their choice for president. Chart 6Media Narratives Are Cyclical bca.gps_sr_2016_10_21_c6 bca.gps_sr_2016_10_21_c6 Media narratives: As our geopolitical team has stressed throughout this election, the news media work through narratives (Chart 6). These narratives appear to have influenced polls, leading to regular gyrations in support levels for the two candidates. Will the media have another "comeback kid" narrative for Trump in store ahead of the election? It cannot be discounted. And if the polls tighten to the 0-3% range again, the turnout concerns and the "Bradley/Cox effect" from above could be enough to swing the election for Trump. Bottom Line: Clinton remains the favorite to win the election, but her probability of winning is closer to 65.5% than the 85% that appears to be "priced in the market." ...And Why He Will Not Win While we are not comfortable calling the election a "done deal," we do believe that Clinton is a favorite. The BCA Geopolitical Strategy quantitative model predicts that she has about a 65.5% probability of winning.4 And the team's qualitative analysis of Trump's electoral strategy suggests that the hurdles to his victory are considerable, particularly in swing states Virginia and Colorado. Before we introduce the quantitative and qualitative models that underpin our election forecast, let us address the above concerns about turnout and the "Bradley/Cox effect" head on. In our view, the polls are telling the truth. We concede that Trump's support level may be underestimated by approximately 3%, which would not be out of line with the last five presidential elections (Chart 7). However, a Clinton lead greater than ~3% the day of the election will be insurmountable for four reasons: Chart 7 GOP primary: It was not the polling that got Trump wrong during the Republican primary race, but the pundits. The polls were generally accurate, particularly those in the swing states where polls tend to be frequent and sophisticated (Chart 8). Polls only underestimated Trump by more than 3% in Illinois, Massachusetts, New York and Pennsylvania. Some of Trump's most controversial statements were made in late 2015 and early 2016 and yet they prompted no shame from his supporters when answering pollsters' questions. Turnout seesaw: Trump's strategy - which we dubbed "The Great White Hype" back in March - is a serious and mathematically viable electoral strategy.5 The effort focuses on boosting the GOP share and overall turnout of the white, blue-collar voter. The problem with this strategy, as executed by Trump, is that its effect could be a seesaw. Trump's rhetoric and policy proposals may appeal to less-educated, lower-income white voters, but may also reduce his support among well-educated, upper-income voters. This is a serious problem for Trump given that the 2012 exit polls indicate that Romney won college graduates by 4 points and voters earning $100k or above by 10 points. In other words, upper-income, well-educated voters are a key constituency of the Republican Party. And just as Clinton may have trouble getting Millennials and minorities to vote for her by the same margin as they did for Obama, Trump could be struggling to get key conservative constituencies out as well. Debates: All scientific polls taken after the debates have Hillary Clinton as a clear winner (Chart 9). This may seem surprising given the reaction of many pundits that Trump outperformed the very low expectations for him in the debates. Many analysts scored the debates close, but voters did not. Why? Because independent and undecided voters are just now tuning into the election and want to see candidates discuss serious policy issues and show leadership. Chart 8 Chart 9 Political science research shows that the direct influence of party identification decreases in presidential elections over time, but issues gain importance, especially after the presidential debates.6 As such, voters tuning into the debates were not discounting Trump's fiery rhetoric and behavior, they were appalled by it. We can't say we were surprised, as we have been showing Chart 10 to clients since February. Chart 10 Senate: If voters are hiding their true support level for Donald Trump, then their genuine preference should be revealed in Senate races where less controversial Republicans are contesting close elections. Instead, Republicans are on a path to lose four of their Senate seats, with another three in play (Democrats need four to take the Senate, assuming that Clinton wins the presidency, since Vice-President Tim Kaine would then cast the tie-breaking vote in that body). Democrats are ahead in Indiana, Illinois, Wisconsin, and Colorado. Nevada is also expected to stay blue. Missouri, New Hampshire, North Carolina, and Pennsylvania are all still in contention, despite the GOP incumbent advantage in all three. Bottom Line: Despite the challenges that this election presents - two highly disliked candidates, questions about turnout, and concerns about polling quality - we doubt that Donald Trump can surprise his poll numbers by more than ~3%. With Hillary Clinton up by 6.4% in the latest RealClearPolitics poll of polls, this means that Trump has to start rallying now if he is going to have a chance on November 8. What Do Our Quantitative & Qualitative Models Say? Our geopolitical team's quantitative model predicts that Hillary Clinton will win the election with 335 electoral votes. The model, built using historical macroeconomic and election data since 1980, has been projecting a strong Clinton victory for some time.7 It currently shows that Clinton already has 279 electoral votes from states where she has more than a 70% chance of winning (Chart 11). These results mean that even under the unlikely scenario in which the GOP wins all the remaining swing states (North Carolina, Arizona, Florida, Ohio, and Iowa), Clinton will still win the election, all other things being equal. Chart 11 Meanwhile, our qualitative model relies on testing Trump's electoral strategy - boosting the share of the white vote accruing to the GOP - in the real world. We concluded in March that Trump did have a path to victory, albeit a very narrow one. Our research showed that Trump's strategy is mathematically viable, at least in 2016 when the white share of the total population remains large enough. We specifically showed that Trump would only need to increase white voters' support by 1.7% and 2.9% in Florida and Ohio, respectively, to flip those states, which seems quite reasonable. We also pointed out that getting a 5.7% swing in Iowa could be feasible. On the other hand, we showed that "flipping" Midwest states like Michigan, Pennsylvania, and Wisconsin would require a very large swing of white voters in Trump's favor: 13.9%, 7.8%, and 8.1%, respectively. With those numbers, Trump would have to win nearly 70% of Michigan's white voters, 65% of Pennsylvania's, and 58% of Wisconsin's. Of the three, Wisconsin looks the most achievable. On the other hand, the GOP only managed to pick up 52% of the state's white share in 2004, the last time a Republican candidate for president won an actual majority of the popular vote since 1988. So, getting to 58% is a high bar given Wisconsin's recent electoral history. How did our qualitative model hold up in terms of state-by-state polling? It did really well! As we predicted, Trump has led the race or nearly led the race in Iowa, Florida, and Ohio (Chart 12). In Michigan, Pennsylvania, and Wisconsin, Clinton's lead has remained higher than 5% through most of the election cycle, even when the media narrative shifted against her (Chart 13). Chart 12The 'White Hype' Model Works Here bca.gps_sr_2016_10_21_c12 bca.gps_sr_2016_10_21_c12 Chart 13White Hype' Does Not Work Here bca.gps_sr_2016_10_21_c13 bca.gps_sr_2016_10_21_c13 If Trump were to win all the states that our White Hype model predicts as competitive, he would still be short of the necessary 270 electoral votes. Map 1 shows the ideal distribution of states for Trump, one that ignores the polls and assigns swing states to Trump or Clinton based on whether the White Hype model is feasible or not. Notice that the two remaining major states are Virginia and Colorado. For Trump to win this election, we believe that he needs to win one of the two (Colorado in combination with either Nevada or New Hampshire), in addition to all of Florida, Ohio, North Carolina, and Iowa. This is a tall order! Particularly given that his polling in Virginia and Colorado is poor (Chart 14). Chart Chart 14Two Critical Swing States bca.gps_sr_2016_10_21_c14 bca.gps_sr_2016_10_21_c14 Bottom Line: BCA's Geopolitical Strategy quantitative and qualitative models both show that Hillary Clinton is a clear favorite to win the election, a view we have held since December 2015.8 Investment Implications: MNCs Vs. SMEs Our colleague Peter Berezin has already discussed the implications of a Trump victory: a stronger USD and a sell-off in stocks.9 We agree and would add that a rally in Treasurys would be likely in the event of a surprise Trump win (Chart 15). Chart 15Trump's Success Helps Safe-Haven Assets bca.gps_sr_2016_10_21_c15 bca.gps_sr_2016_10_21_c15 The rally in safe-haven assets would eventually give way, however, to a bear market in Treasurys as investors realized that Trump has no intention of controlling public spending or reining in the (already growing) budget deficit. Growth, and likely inflation, would surprise to the upside, allowing the Fed to hike rates beyond the 48 bps expected by the market through the end of 2018. We do not foresee that a Republican-held Congress would stand in Trump's way, despite the clear dislike between the Speaker of the House, Representative Paul Ryan, and Trump. Ryan would not go against a sitting president from the same party who just pulled off a revolutionary election. The entire House will face re-election in 2018 and moderate Republicans will be wary of standing up to Trump, lest he campaign against them in GOP primaries in a short two years. Investors are putting way too much faith in America's checks-and-balances to keep Trump from enacting his policies, at least in the short term. These are constitutional, legal, and technical checks, and political expediency often overrules all three. In case of a Clinton win, we would expect the House to remain controlled by the GOP. There are only about 38 truly competitive electoral districts in this race, according to The Cook Political Report.10 Given that the Republicans have a 60-seat majority in the House, a Democratic takeover would require Democratic candidates to defeat Republican Representatives in 30 out of 38 competitive districts. At best, this means that the current, market- bullish status quo of divided government will continue. With the House remaining in Republican hands, and Democrats clinging to a potential razor-thin control of the Senate (vulnerable to a post-Trump Republican comeback in 2018), the Clinton White House would be constrained on some of its most left-leaning policies.11 And what are the chances of cooperation on modest reforms? We think they are actually quite good. Unlike Obama, Clinton's victory will not be a popular sweep. She will not control Congress, she will likely receive less than 50% of the popular vote (due to the presence of two notable third-party candidates), and she will be the first candidate ever elected that has more voters saying they dislike her than like her. Therefore, the odds are slim that Clinton will come to power with the same level of confidence and agenda-setting vision as Obama did in 2008. Instead, we see two potential avenues for modest cooperation with the GOP-controlled House: Chart 16Corporate Taxes Have Bottomed Corporate Taxes Have Bottomed Corporate Taxes Have Bottomed Corporate tax reform: It is unlikely that we will see reform that lowers the already historically-low effective tax rates (Chart 16). However, broadening the tax base by closing various loopholes could be feasible. This will hurt S&P 500 multi-national corporations that have been able to lobby for special treatment over the past three decades. However, it will benefit America's SMEs, which are the backbone of employment and growth. Fiscal spending: Paul Ryan and moderate Republicans understand that there is a paradigm shift in America and that the median voter is moving to the left.12 After all, Donald Trump won the GOP primary with an unorthodox economic message that combined both left- and right-wing economic policies. As such, we would expect House Republicans to give in to a modest infrastructure spending plan from Clinton, in exchange for corporate tax reform. Even a modest plan could make a substantive difference for the economy given the high fiscal multipliers of infrastructure spending in an economy with low interest rates. This in turn would allow the Fed to surprise the markets with more than two rate hikes by the end of 2018 and thus sustain the USD bull market. If there is one trend that we are certain will end with the 2016 U.S. election, it is the dominance of American economic policy by the S&P 500, or perhaps the S&P 100. What Trump and Senator Bernie Sanders have shown is that challenging for the presidency no longer requires a cozy relationship with either Wall Street or the large multinational corporations (MNCs). We therefore do not expect a Clinton-Ryan coalition to care as much about the concerns of America's large corporations as otherwise might be the case. Policies that lead to higher effective corporate tax rates on major S&P 500 corporations, a dollar bull market, and higher wages are likely over the course of the next four years. The political pendulum is shifting in the U.S. and it should marginally favor growth, inflation, the USD, and SMEs.13 Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com 1 Please see FiveThirtyEight, "Who Will Win The Presidency?" dated October 20, 2016, available at fiverthirtyeight.com. 2 "You mean like the 2008 Global Financial Crisis?" Yes. Like that. 3 Please see BCA Geopolitical Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Final Forecast & Implications," dated October 12, 2016, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "U.S. Election: The Great White Hype," dated March 9, 2016, available at gps.bcaresearch.com. 6 Please see Andreas Graefe, "Issues and Leader Voting in U.S. Presidential Elections,"Electoral Studies 32:4 (2013), pp.644-657. 7 For the assumptions underpinning our model, we encourage clients to read BCA Geopolitical Strategy Special Report, "U.S. Election: Final Forecast & Implications," dated October 12, 2016, available at gps.bcaresearch.com. 8 Please see The Bank Credit Analyst Strategy Outlook, "Stuck In A Rut," dated December 17, 2015, available at bca.bcaresearch.com. 9 Please see BCA Global Investment Strategy Special Report, "Three (New) Controversial Calls," dated September 30, 2016, available at gis.bcaresearch.com. 10 Please see "House: Recent Updates," accessed October 20, 2016, available at cookpolitical.com 11 We believe that it will be very difficult, if not impossible, for the Democrats to retain a razor-thin majority in the Senate if they get one in November. First, Democrats will have to defend 25 Senate seats (including two allied independent seats) out of 33 in contention in 2018. Second, Democrats always see a drop-off in voter turnout and enthusiasm in mid-term elections. 12 Please see BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Monthly Report, "King Dollar: The Agent Of Righteous Retribution," dated October 12, 2016, available at gps.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The near-term RMB outlook is entirely dictated by the movement of the dollar. We expect the CNY/USD to weaken alongside broad dollar strength, which could rekindle financial market volatility and cap the upside in Chinese stocks. The Chinese currency is better prepared for a stronger dollar than a year ago, and therefore the authorities should be able to maintain exchange rate stability. Joining the SDR does not automatically award the RMB international currency status. However, raising the relevance of the SDR as well as the RMB is part of China's long-term strategic plan. Feature The resumption of the dollar bull market has once again generated downward pressure on the RMB. How long the dollar bull run will last remains to be seen, but the broader global backdrop supports its continued strength against other major currencies, at least in the near term, including the yuan. Renewed downward pressure on the RMB may be perceived as a sign of domestic economic troubles, which could expedite capital outflows, creating a self-feeding vicious circle. The saving grace is that the Chinese currency is better prepared for a stronger dollar than a year ago, and therefore the authorities should be able to maintain exchange rate stability. Interestingly, the RMB's renewed weakness came in the wake of its official inclusion in the IMF's Special Drawing Right (SDR) basket early this month. While joining the SDR bears no near-term relevance from both an economic and financial market point of view, it marks an important milestone in the internationalization process of the RMB, with potential longer term implications. The RMB: From Goldilocks To Gridlock Chart 1The RMB: Stronger Or Weaker? The RMB: Stronger Or Weaker? The RMB: Stronger Or Weaker? The relapse of the CNY/USD of late is entirely driven by the strong dollar. While the RMB has weakened against the greenback, it has strengthened in trade-weighted terms (Chart 1). This is undoubtedly bad news for China, as it has very quickly pushed the RMB from a goldilocks scenario to essentially a gridlock. The goldilocks scenario that prevailed over the past several months was ushered in primarily by the weak dollar. It allowed the RMB to stay largely stable against the dollar but weaken substantially in trade-weighted terms - an ideal combination for both the market and the economy. Investors took comfort in a stable CNY/USD, while the Chinese economy benefited from the reflationary impact of a weaker trade-weighted exchange rate. In this vein, the reversal of the dollar trend will also lead to a reversal of this positive dynamic that prevailed over the past several months. Financial markets and investors will once again pay attention to the weakening CNY/USD, while the "stealth" depreciation of the trade-weighted RMB will also be halted, removing its reflationary impact. In other words, a weaker CNY/USD and a stronger trade-weighted RMB is the least desirable combination for both financial markets and the economy. To break this gridlock, the People's Bank of China (PBoC) could either "peg" the currency to the dollar, or weaken it substantially enough to achieve a weaker RMB in trade-weighted terms, neither of which is likely in our view. The path of least resistance is for the PBoC to bear it out, with managed CNY/USD depreciation together with tightened capital account controls to prevent capital flight. This is far from optimal and may still stoke financial market volatility, similar to the several episodes last year when a weakening RMB stoked fears of Chinese financial instability. However, a few factors suggest that this time the PBoC may be better prepared: Frist, the Chinese authorities have been paying much more attention to "open-mouth" operations in communicating their intention to market participants. Overall, investors are less 'spooked" by China's foreign exchange rate policy than a year ago. Second, pressure from capital outflows from the corporate sector will likely subside going forward. Paying down foreign debt has been one of the biggest sources of capital outflows in the past year, which has substantially reduced the domestic corporate sector's foreign currency liabilities (Chart 2).1 Moreover, despite dwindling foreign debt obligations, the corporate sector still holds near-record-high foreign currency deposits (Chart 3), which should further reduce its incentive to hoard the dollar. Chart 2Corporate Sector Foreign ##br##Debt Has Dropped Substantially... bca.cis_wr_2016_10_20_c2 bca.cis_wr_2016_10_20_c2 Chart 3... But Still Hoards ##br##Lots Of Dollar Deposits bca.cis_wr_2016_10_20_c3 bca.cis_wr_2016_10_20_c3 Further, Chinese growth is a tad stronger than last year, due largely to the reflationary impact of previous easing measures, including a weaker trade-weighted RMB. Even though the headline third quarter GDP growth figures reported this week remained essentially unchanged, the industrial sector has recovered notably, with improving activity, strengthening pricing power and accelerating profits. As economic variables typically respond to policy thrusts with a time lag, we expect the economy will continue to build momentum in the coming months, even if the reflationary impact of the RMB begins to diminish. More importantly, the Chinese government appears more willing to engage in fiscal pump-priming than last year, with a focus on infrastructure and private-public-partnership projects. Improving growth momentum and expansionary fiscal policy should be supportive for the exchange rate. Finally, the CNY/USD is already 12% lower than its peak in early 2014, and is no longer significantly overvalued, according to our valuation models (Chart 4). This means that additional CNY/USD weakness will further boost market share of Chinese products in the U.S., helping China to reflate while at the same time acting as an increasingly heavier drag on the U.S (Chart 5). It is therefore in the mutual interests of both the Chinese and U.S. authorities to maintain a steady RMB exchange rate. The U.S. Treasury once again cleared China from being currency manipulator in its last week's semi-annual review, and acknowledged the PBoC's efforts in preventing rapid RMB depreciation as beneficial for both the Chinese and global economies. To be sure, the U.S. and China will not explicitly coordinate monetary policy to regulate exchange rate movements. However, a weaker CNY/USD will lead to much quicker dollar appreciation in trade-weighted terms than otherwise, which in of itself will prove self-limiting. Chart 4RMB/USD Is No Longer Overvalued RMB/USD Is No Longer Overvalued RMB/USD Is No Longer Overvalued Chart 5A Weaker RMB/USD Is ##br##Boosting Chinese Exports To The U.S. A Weaker RMB/USD Is Boosting Chinese Exports To The U.S. A Weaker RMB/USD Is Boosting Chinese Exports To The U.S. The bottom line is that the near-term RMB outlook is entirely dictated by the movement of the dollar. We expect the CNY/USD to weaken alongside broad dollar strength in the near term, but unless the dollar massively overshoots the downside will not be substantial. This could rekindle financial market volatility and cap the upside in Chinese stocks. We tactically downgraded our "bullishness" rating on Chinese H shares from "overweight" to "neutral" last week,2 and this view remains unchanged. At the same time, we continue to argue against being outright bearish, because of the deeply depressed valuation matrix of this asset class, especially H shares. When Will The RMB Float? We expect Chinese regulators will tighten capital account controls significantly in the coming months in order to slow capital outflows in the wake of renewed CNY/USD depreciation. The impossible trinity of international finance dictates that a country cannot target its exchange rate with independent monetary policy and simultaneously allow free capital flows. Among these three conditions, "free capital flows" is the least-costly sacrifice. There is no way the PBoC will raise interest rates to defend the currency. Tightening capital account controls goes against the long-term objective of China's foreign exchange rate reforms, but it is not only justified but necessary in the near term. Pointing at the dilemma the PBoC faces today, some pundits are now singing the "I-told-you-so" song, claiming the country should have moved to a much greater degree of exchange-rate flexibility "back when the going was good", as they had advised. In our view, this argument is completely flawed. In previous years when "the going was good", China was facing massive foreign capital inflows, unleashed by extremely aggressive monetary easing by other central banks in the wake of the global financial crisis. If the PBoC indeed took this advice back then and did not intervene to slow down RMB appreciation by hoarding massive foreign reserves, it would simply have led to a dramatic overshoot of the RMB. By the same token, when the tide turned, capital outflows would have proven overwhelming, leading to an RMB collapse. In fact, without the massive foreign reserves accumulated in previous years during the PBoC's RMB intervention, the Chinese authorities' ability to maintain exchange rate stability would have been much more seriously challenged, particularly in the past year. Chart 6Lopsided Expectations On The RMB ##br##Drive One-Way Moves Of Capital Flows bca.cis_wr_2016_10_20_c6 bca.cis_wr_2016_10_20_c6 In other words, the key problem with China's exchange rate is that expectations on the RMB have been lopsided in recent years (Chart 6). Consequently, the RMB has long been a one-way bet, accompanied by one-way moves of capital flows. The unanimous view on a rising RMB in previous years drove capital inflows; expectations completely reversed in 2015, leading to persistent outflows. In this environment, without the PBoC's intervention, a "greater degree of exchange rate flexibility" as advised by some would simply mean extreme RMB moves, inevitably leading to much greater financial and economic volatility. Therefore, the RMB should only be allowed to float when there is a healthy divergence of views among market participants, so that there are enough "buyers" and "sellers" to collectively price the RMB exchange at a market-determined "equilibrium" level. Until then, any premature and imprudent capital account deregulation would prove catastrophic, and should be avoided at all cost. We are hopeful the Chinese authorities will remain pragmatic enough not to hasten this process. The RMB's SDR Debut: Playing The Long Game The RMB has officially joined the SDR basket since the beginning of October, the first emerging country currency to join this "elite club". The RMB's SDR debut has little economic relevance in the near term. If anything, officially joining the SDR means that the RMB, under China's prevailing capital account regulations, meets the IMF's criteria as a "freely usable" currency. Therefore, it implies that the IMF endorses China's capital control measures currently in place. Some analysts suggest that the Chinese government's determination to join the SDR is largely to show off national pride. In our view, it serves more pragmatic purposes both at the private and official level. Chart 7The RMB's Rising Importance As ##br##An International Payment Currency The RMB's Near-Term Dilemma And Long-Term Ambition The RMB's Near-Term Dilemma And Long-Term Ambition At the private level, an important function of an international currency is for trade invoicing - an area where the RMB has witnessed remarkable progress in recent years. The RMB currently ranks fifth among world payment currencies, accounting for a mere 2% of world payments, which pales in comparison with the dollar's 40% and the euro's 30%. However, an increasingly large share of China-related trade has been settled directly with the RMB. Currently, the RMB accounts for about 13% for all international payments sent and received by value with China and Hong Kong (Chart 7), up from practically zero a few years ago. Moreover, RMB settlement already accounts for over half of Chinese trade with specific regions such as the Middle East and African countries. For Example, the use of the RMB in the United Arab Emirates (UAE) and Qatar accounted for 74% and 60% of their respective payments to China/Hong Kong in 2015. As the largest trade partner with a growing number of countries, China should have no problem continuing to promote RMB settlement, especially in the emerging world. At the official level, the Chinese government is certainly intent on having the RMB act as an international reserve currency, but not in such a way as to challenge the dollar's mighty dominance. Rather, the government appears to be following dual mandates in its purse. Domestically, it is aiming to use the SDR inclusion as a catalyst to reform its financial system, much like what joining the World Trade Organization (WTO) in the early 2000s did to its manufacturing sector. Globally, it is seeking to play a more active role in reforming the international monetary system. After witnessing the dramatic liquidity crunch during the global financial crisis, the Chinese authorities see the necessity to reduce the world's heavy reliance on the dollar by creating credible alternatives. Neither of these dual mandates can be easily accomplished, but it is important to keep the big picture in mind in understanding China's policy initiatives going forward. The bottom line is that joining the SDR does not automatically award the RMB international currency status, and it is naïve to expect the RMB to challenge the U.S. dollar anytime soon, if at all. However, raising the relevance of the SDR as well as the RMB is part of China's long-term strategic plan. Its determination to internationalize the RMB should not be underestimated. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Special Report, "Mapping China's Capital Outflows: A Balance Of Payment Perspective", dated February 3, 2016, available at cis.bcaresearch.com 2 Please see China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010", dated October 13, 2016, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

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

Highlights Global liquidity conditions are set to tighten in the months ahead. This could add some fire to a dollar rally, especially against EM and commodity currencies. The GBP has become the new anti-dollar, reflected by its strong sensitivity to the greenback. Financing the U.K.'s large current-account deficit is a difficult task when global liquidity tightens, the layer of political uncertainty now makes it a herculean labor. While the pound is now attractive as a long-term play, it still possesses plenty downside risk. A quick look at EUR/SEK, NOK/SEK, GBP/CAD, and AUD/JPY. Feature Global liquidity conditions have begun to tighten. This development is likely to send the dollar higher and inflict serious damage on EM and commodity currencies. The pound's weakness fits nicely into this larger story. Not only is the current political climate in the British Isles prompting investors to think twice about buying British assets, but a tightening in global liquidity makes financing the U.K. current account deficit even more onerous. This adjustment demands a cheaper GBP. Global Yields: A Step Forward, Half A Step Backward The main reason why global liquidity conditions are tightening is the recent back up in global bond yields. In normal circumstances, a 39 basis-point (bp), a 24bp, and a 16bp back-up in 10-year Treasury yields, JGB yields, and bund yields, respectively, would not represent much of a problem. But today is anything but normal. The shift in global monetary policy has been behind the back-up in yields. In aggregate, global central banks are about to begin decreasing their purchases of securities. This will not only lift interest rates on government paper, but it will also raise rates for private-sector borrowing, especially as global risk premia have been depressed by an effect known as TINA - or "There Is No Alternative" (Chart I-1). The Fed too is in the process of lifting global bond yields. For one thing, U.S. labor market slack is dissipating and we are starting to witness rising wage pressures (Chart I-2). As such, we expect the Fed to raise its policy rate in December, and to further push rates higher in 2017 and 2018. Given that only 62 basis points of hike are priced in until the end of 2019, there is scope for U.S. bond yields to rise. Chart I-1Central Banks Are Contributing##br## To Tightening Liquidity Central Banks Are Contributing To Tightening Liquidity Central Banks Are Contributing To Tightening Liquidity Chart I-2U.S. Labor Market Is ##br##Showing Signs Of Tightening U.S. Labor Market Is Showing Signs Of Tightening U.S. Labor Market Is Showing Signs Of Tightening In terms of investor sentiment, despite the recent back-up in long bond yields, investors remain surprisingly upbeat on the outlook for T-bonds (Chart I-3). This, combined with their still-poor valuations, is another reason to be worried about the outlook for U.S. and global bonds for the remainder of the year. Finally, we expect U.S. real rates to have more upside than non-U.S. rates. Why? The U.S. output gap is arguably narrower than that of Europe or Japan. Moreover, the U.S. economy has deleveraged more than the rest of the G10. With U.S households enjoying strong real income growth, strong balance sheet positions, and with banks easing their lending standards to households, U.S. private-sector debt levels can expand vis-à-vis those of other developed economies. This will lift U.S. relative real rates (Chart I-4). Chart I-3Upside For ##br##Yields Upside For Yields Upside For Yields Chart I-4Real Rate Differentials Should ##br##Move In The Dollar's Favor Real Rate Differentials Should Move In The Dollar's Favor Real Rate Differentials Should Move In The Dollar's Favor What does this all mean for currency markets? As we highlighted last week, we expect the U.S. dollar to display more upside, potentially rising by around 10% over the next 18 months. We also expect more tumultuous times to re-emerge in the EM space. Rising real rates have been a bane for EM assets in this cycle. This is because EM growth has been dependent on EM financial conditions, which themselves, have been a function of global liquidity conditions (Chart I-5). Exacerbating our fear, the recent narrowing in EM spreads has not been reflective of EM corporate health. This suggests that EM borrowing costs and financial conditions are at risk of a shakeout (Chart I-6). Chart I-5Global Liquidity Conditions Will Hurt EM Global Liquidity Conditions Will Hurt EM Global Liquidity Conditions Will Hurt EM Chart I-6EM Spreads Are Priced For Perfection EM Spreads Are Priced for Perfection EM Spreads Are Priced for Perfection This obviously leads us to worry about commodity currencies as well. For one, they remain tightly linked with EM equities, displaying a 0.82 correlation with that asset class since 2000. Moreover, as Chart I-7 and Table I-1 illustrate, commodity currencies are tightly linked with the dollar and EM spreads. Thus, a combo of a higher dollar and deteriorating EM financial conditions could do great harm to the AUD, the NZD, and the NOK. Interestingly, SEK and GBP are also two potential big casualties of any such development. Chart I-7The GBP Has Become The Anti-Dollar The Pound Falls To The Conquering Dollar The Pound Falls To The Conquering Dollar Table I-1Currency Sensitivities To Key Factors, Since 2014 The Pound Falls To The Conquering Dollar The Pound Falls To The Conquering Dollar That being said, these dynamics contain the seeds of their own demise. As they are deflationary shocks, EM and commodity sell-offs are likely to elicit a dovish response from global policymakers. This will limit the upside for yields, implying that any tightening in global liquidity conditions is likely to prompt another reflationary push early in 2017. Bottom Line: Global rates still have more upside from here. U.S. real rates could rise the most as the Fed is now confronted with an increasingly tight labor market. Moreover, the U.S. economy possesses the strongest structural fundamentals in the G10. Together, this set of circumstances is likely to boost the dollar, especially at the expense of EM, commodity currencies, and the pound. GBP: Another Arrow In The Eye Nine hundred and fifty years ago to this day, King Harold, the last Anglo-Saxon King of England, died on the battlefield at Hastings from an arrow to the eye.1 The kingship of Norman William the Conqueror ushered a long and complex relationship between the British Isles and the rest of the continent. Over the past two weeks, the fall in the pound has been a dramatic story. The collapse of the nominal effective exchange rate to a nearly 200-year low, is a clear indication that the battle between the U.K. and the rest of the EU is inflicting long-term damage on the kingdom (Chart I-8). The key shock to the pound remains political. PM May made it clear that Brexit means Brexit. Additionally, elements of her discourse, such as wanting firms to list their foreign-born employees, are raising fears among the business community that the Conservatives are taking a very populist, anti-business slant that could weigh on the long-term prospects for British growth. True, these policies may never see the light of day. But across the Channel, the EU partners are taking a hardline approach to Brexit negations. Investors cheered the announcement on Wednesday that PM Theresa May will allow deeper scrutiny from parliament before triggering Brexit. Altogether, this mostly means that the cacophony over the future of the U.K. will only grow louder. Thus, we expect political headline risks to remain a strong source of uncertainty. These political games are poisonous for the pound. The U.K. is highly dependent on FDI inflows to finance it large current account deficit of nearly 6% of GDP (Chart I-9). Not knowing the status of the U.K. vis-à-vis the common market heightens any risk premium on investments in the U.K. Also, any shift of rhetoric toward a more populist discourse increases the risk that regulations could be implemented that either hurt the future profitability of British firms or increase their cost of capital. At the margin, this makes the U.K. less attractive to foreign investors. Chart I-8Something Evil This Way Comes bca.fes_wr_2016_10_14_s1_c8 bca.fes_wr_2016_10_14_s1_c8 Chart I-9The U.K. Needs Capital The U.K. Needs Capital The U.K. Needs Capital This has multiple implications. The pound remains highly sensitive to global liquidity trends, a fact highlighted by its extremely elevated sensitivity to EM spreads. The pound will also remain correlated with EM equity prices. This suggests that if a rising dollar acts as a lever to tighten global liquidity conditions, the pound will continue to be the currency with the largest beta to USD. In other words, investors will continue to express bullish-dollar views through the pound. Domestic dynamics are also problematic. The recent fall in the pound is lifting British inflationary pressures, a reality picked up by our Inflation Pressure Gauge (Chart I-10). In normal times, this could have lifted the pound as investors would have expected a response by the BoE. Today, however, the British credit impulse is very weak, in part reflecting the lack of confidence toward the future of the U.K. (Chart I-10, bottom panel). Hence, the BoE is not responding to these inflationary pressures. This combo is very bearish for the pound. It means that British real rates are falling, especially vis-à-vis the U.S. (Chart I-11). The U.K. is now in a vicious circle where the more the pound falls, the higher British inflation expectations go, which depresses British real rates and puts additional selling pressure on the pound. In other words, the U.K. is in the opposite spot of where Japan was in the spring of 2016. Chart I-10Stagflation Light! Stagflation Light! Stagflation Light! Chart I-11A Vicious Circle For GBP A Vicious Circle For GBP A Vicious Circle For GBP What is the downside for the pound? On a 52-week rate of change basis, the pound is not as oversold as it was at long-term bottoms like in 1985, 1993, or 2009. More concerning, long-term bottoms are also characterized by the 2-year rate of change staying oversold for a prolonged period, which again, has yet to be the case (Chart I-12). On the valuation front, GBP/USD is cheap, trading at a 25% discount to its PPP. However, in 1985, the pound was trading at a 36% discount to PPP (Chart I-13). The uncertainty around the future of the British economy is much higher today than in 1985. A move away from the pro-business Thatcherite policies of the 1980s, could result in a GBP discount similar to that of 1985. The sensitivity of the pound to the dollar amplifies the probability that such a scenario materializes. This could imply a GBP/USD toward 1.1-1.05 at its bottom. Chart I-12GBP/USD: Not Oversold Enough GBP/USD: Not Oversold Enough GBP/USD: Not Oversold Enough Chart I-13GBP/USD Valuation GBP/USD Valuation GBP/USD Valuation When is that bottom likely to emerge? With the strong downward momentum currently weighing on the pound, and the progressive un-anchoring of market based inflation expectations in the U.K., the bottom in the pound is a moving target. Moreover, Dhaval Joshi, who runs our European Investment Strategy service, has written about the fractal dimension as a tool to identify turning points in a trend. When the fractal dimension hits 1.25, a reversal in the trend is likely. Essentially, this metric measures group-think. When both short-term and long-term investors end up uniformly expressing the same views, liquidity dries up as there are fewer and fewer sellers for each buyer (or vice-versa).2 Currently GBP/USD's fractal dimension has not yet hit that stage. While the 3-6 months risk-reward ratio for the pound remains poor, the pound is now attractive as a long-term buy. The recent collapse in real rates and sterling has massively eased monetary conditions in the U.K. (Chart I-14). Also, even if valuations are a poor guide of near term returns, the 25% discount currently experienced by the pound suggests that on a one- to two-year basis, holding the GBP will be a rewarding bet. What about EUR/GBP? EUR/GBP has moved out of line with its historical link to real-rate differentials (Chart I-15). However, the pound's beta to the dollar is twice as high as that of the euro. Moreover, the pound is many times more sensitive to EM spreads than the euro. This suggests that our view of a strong dollar and tightening EM liquidity conditions are likely to weigh on GBP more than on the EUR for the next few months. Thus we believe it is still too early to short EUR/GBP. In fact EUR/GBP could flirt with 0.95. Chart I-14A Glimmer of Hope For The Long-Term A Glimmer of Hope For The Long-Term A Glimmer of Hope For The Long-Term Chart I-15EUR/GBP Has Overshot Fundamentals EUR/GBP Has Overshot Fundamentals EUR/GBP Has Overshot Fundamentals Bottom Line: While the pound is cheap, it can cheapen further. Not only is the pound being hampered by the political quagmire surrounding Brexit, but the strong sensitivity of the pound to the dollar and EM spreads are two additional potent headwinds for the British currency. Altogether, while the pound is most likely a long-term buy at current levels, it could still experience significant downside in the near term. We remain long gold in GBP terms. Four Chart Reviews Four long-term price charts caught our eye this week. First is EUR/SEK. As Chart I-16 shows, despite the valuation, economic momentum, and balance of payments advantages for the SEK, EUR/SEK broke out. We think this reflects the SEK's strong sensitivity to the dollar and brewing EM risks. A move to slightly above 10 on this cross is likely. Second, while we remain positive on NOK/SEK, the next few weeks may prove challenging. As Chart I-17 illustrates, NOK/SEK is about to test a potent downward sloping trend line, exactly as it is becoming overbought. With NOK being slightly more sensitive to the dollar than SEK, punching above this trend line will require much firmer oil prices. While our energy strategists see oil in the mid- to upper-$50s for next year, they worry that the recent rally to $52/bbl may have been too violent and is already eliciting a supply response from U.S. shale producers. Chart I-16EUR/SEK Can Rise Higher EUR/SEK Can Rise Higher EUR/SEK Can Rise Higher Chart I-17Big Ceiling Above Big Ceiling Above Big Ceiling Above Third, since the early 1980s, GBP/CAD has formed long-term bottom in the 1.5 region, a zone we expect to be tested again (Chart I-18). While CAD is more sensitive to commodity prices than the GBP, it is much less sensitive to the USD and EM spreads than the British currency. Also, the loonie does not suffer from a massive political handicap. That being said, each time the 1.5 zone has been hit, GBP/CAD slingshots higher. We recommend buying GBP/CAD at that level. Finally, since 1991, AUD/JPY has been strongly mean-reverting in a trading band between 60 and 110 (Chart I-19). Any blow-up in EM in the next few months is likely to prompt this cross to hit the low end of this band once again. Chart I-18GBP/CAD: Target 1.5 GBP/CAD: Target 1.5 GBP/CAD: Target 1.5 Chart I-19AUD/JPY: A Model Of Mean Reversion AUD/JPY: A Model Of Mean Reversion AUD/JPY: A Model Of Mean Reversion Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 This story of his death is now considered more a legend than an historical event, but we like this story. 2 Please see European Investment Strategy Special Report, "Fractals, Liquidity & A Trading Model", dated December 11, 2014, available at eis.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Policy Commentary: "We're at a point where the economic expansion has plenty of room to run. Inflation's a little bit below our target, rather than above our target... so, I think we can be quite gentle as we go in terms of gradually removing monetary policy accommodation" - Federal Reserve Bank of New York President William Dudley (October 12, 2016) Report Links: The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Policy Commentary: "Due to the role of global inflation, more stimulus is needed than in the past to deliver their domestic mandates; and where, due to the falling equilibrium interest rates, their ability to deliver that stimulus is more constrained" - ECB Executive Board Member Yves Mersch (October 12, 2016) Report Links: The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Clashing Forces - July 29, 2016) The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Policy Commentary: "Since the employment situation has continued to improve, no further easing of monetary policy may be necessary... at any rate, I would like to discuss this thoroughly with other board members at our monetary policy meeting" - BoJ Board Member Yutaka Harada (October 12, 2016) Report Links: The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 How Do You Say "Whatever It Takes" In Japanese? - September 23, 2016 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Policy Commentary: "If the MPC and other monetary authorities hadn't eased policy - if they had failed to accommodate the forces pushing down on the neutral real rate - the performance of the economy and equity markets, and the long-term prospects for pension funds, would probably have been worse" - BoE Deputy Governor Ben Broadbent (October 5, 2016) Report Links: The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Messages From Bali - August 5, 2016 Australian Dollar Chart II-9AUD Technicals 1 bca.fes_wr_2016_10_14_s2_c9 bca.fes_wr_2016_10_14_s2_c9 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Policy Commentary: "Inflation remains quite low. Given very subdued growth in labor costs and very low cost pressures elsewhere in the world, this is expected to remain the case for some time" - RBA Monetary Policy Statement (October 3, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Messages From Bali - August 5, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Policy Commentary: "Interest rates are at multi-decade lows, and our current projections and assumptions indicate that further policy easing will be required to ensure that future inflation settles near the middle of the target range" - Reserve Bank Assistant Governor John McDermott (October 11, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Policy Commentary: "Policy is having its effects. And obviously we have room to maneuver but its not a great deal of room to maneuver and fortunately we have a different mix of policy today and the fiscal effects we talked about should be showing up in the data any time now" - BoC Governor Stephen Poloz (October 8, 2016) Report Links: The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Policy Commentary: "We feel [negative interest rates and currency market interventions] is actually how we can ensure our mandate, namely by making the Swiss franc less attractive" - SNB Vice President Fritz Zurbruegg (October 12, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Policy Commentary: "Review [of the monetary policy framework] is in order... I would, however, emphasise that our experience of the current framework is positive. This suggests a need for adjustments rather than a regime change" - Norgest Bank Governor Oeystein Olsen (October 11, 2016) Report Links: The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Policy Commentary: "We have all the tools but there are limits since the repo rate and additional bond purchases can produce undesired side-effects... We don't really know for how long future interest rate cuts will work in an effective way." - Riksbank Deputy Governor Cecila Skingsley (October 7, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Dazed And Confused - July 1, 2016 Grungy Times - A Replay Of The Early 1990s? - June 10, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Recent U.S. economic data have surprised to the upside, raising the odds of a December rate hike. U.S. GDP growth is likely to accelerate further in 2017 on the back of stronger business capex, a turn in the inventory cycle, and a pickup in government spending. Faster wage growth should also support consumption. The real broad trade-weighted dollar will appreciate by 10% over the next 12 months, as the market prices in more Fed tightening. The stronger dollar will pose a headache for U.S. multinationals, as well as emerging markets and commodity producers. However, it will be a boon for Europe and Japan. Global equities are vulnerable to a near-term correction, but the longer-term outlook for developed market stocks outside the U.S. looks reasonably good. Investors should overweight euro area and Japanese equities in currency-hedged terms. Feature Why The Fed Hit The Pause Button When the FOMC decided to hike rates last December, it signaled to investors via its "dot plot" that rates would likely rise four times this year. Ten months later, the fed funds rate remains unchanged. What caused the Fed to stand down? External factors certainly played a role: Fears of a hard landing in China permeated the markets at the start of the year. And just as these worries were beginning to recede, the Brexit vote sent investors into a hurried panic. However, the more important reason for the Fed's decision to hit the pause button is that U.S. domestic activity slowed sharply, with real GDP growing by just 0.9% in Q4 of 2015 and by an average of 1.1% in the first half of 2016. Rays Of Light Fortunately, recent data suggest that the growth drought may be ending (Chart 1): Chart 1Some Bright Spots In the U.S. Data Some Bright Spots In the U.S. Data Some Bright Spots In the U.S. Data The ISM non-manufacturing index jumped 5.7 points in September, the largest monthly increase on record. The ISM manufacturing index also surprised to the upside, with the new orders index jumping six points to 55.1. Factory orders increased by 0.2% in August, against consensus expectations for a modest decline. Initial unemployment claims continue to decline, with the four-week average falling to a 42-year low this week. The Conference's Board's consumer confidence index hit a nine-year high in September. The University of Michigan's index also rose. The key question for investors is whether the recent spate of good data is just noise or the start of a more lasting improvement in underlying demand growth. We think it's the latter. As we expand upon below, the adverse lagged effects on growth from the dollar's appreciation between mid-2014 and early this year should dissipate, pushing aggregate demand higher. Energy sector capex appears to be stabilizing after plunging nearly 70% since its peak in 2014. Stronger wage growth should also keep consumption demand elevated, even as employment growth continues to decelerate. In addition, fiscal policy is likely to loosen somewhat regardless of who wins the presidential election. Lastly, the inventory cycle appears to be turning, following five straight quarters in which falling inventory investment subtracted from growth. To what extent will better U.S. growth translate into a stronger dollar? To answer this question, we proceed in three steps: First, we estimate the magnitude by which U.S. growth will exceed its trend rate if the Fed takes no action to tighten financial conditions. Our answer is "by around one percentage point in 2017," which we think is considerably above market expectations. Second, we assess the degree to which the Fed will need to tighten financial conditions - via higher interest rates and a stronger dollar - in order to keep inflation from significantly overshooting its target. Third, we consider how developments abroad will affect the dollar. Our conclusion is that the real trade-weighted dollar will likely rise by around 10% over the next 12 months. How Quickly Will Aggregate Demand Grow If The Fed Does Not Raise Rates? As detailed below, a bottom-up analysis of the various components of GDP suggests that real GDP growth could reach 2.5% in the second half of 2016 and accelerate to 2.8% in 2017 if financial conditions remain unchanged from current levels. This would represent a significant step up in growth from the average pace of 1.6% experienced between Q1 of 2015 and Q2 of 2016. While growth of 2.8% next year might sound implausibly high, keep in mind that real final sales to private domestic purchasers - the cleanest measure of underlying private-sector demand - has grown by an average of 3% since Q3 of 2014 and increased by 3.2% in Q2 of this year, the last quarter for which data is available. Consumption Assuming that interest rates and the dollar remain unchanged, we project that real personal consumption will grow by an average of 2.7% in Q4 of this year and over the course of 2017. This is equivalent to the average growth rate of real PCE between Q1 of 2015 and Q2 of 2016, but below the 3% pace recorded in the first half of this year. Granted, employment growth is likely to slow over the coming quarters, as labor market slack is absorbed. Nevertheless, real income growth should remain reasonably robust, as real wages accelerate in response to a tighter labor market. A rough rule of thumb is that a 1% increase in real wage growth boosts real household income by the equivalent of 120,000 extra jobs per month over one full year. Thus, it would not take much of a pickup in wage growth to ensure that consumption keeps rising at a fairly solid pace. In fact, one could see a virtuous circle emerging, where accelerating wage growth pushes up consumption, leading to a tighter labor market, and even faster wage growth. At some point the Fed would raise rates by enough to cool the economy, but not before the dollar had moved sharply higher. This may explain why there is such a strikingly strong correlation between the dollar and labor's share of national income (Chart 2). Households may also end up spending a bit more of their incomes. Faster wage growth, rising consumer confidence, continued home price appreciation, and negative real deposit rates have all given households even more incentive to spend freely. While we do not expect the savings rate to fall anywhere close to the rock-bottom levels seen before the financial crisis, even a 0.5 percentage point decline from the current level of 5.7%, spread out over six quarters, would add 0.4% to GDP growth. Residential Investment Real residential investment dropped 7.7% in Q2 after growing by an average of nearly 12% over the preceding six quarters. The Q2 dip was mainly due to the warm winter, which pulled forward home-improvement spending. Housing activity has recovered since then, with new home sales, single-family housing starts, and the NAHB homebuilders index all at or near post-crisis highs (Chart 3). Chart 2The Dollar Is Redistributing Income bca.gis_wr_2016_10_14_c2 bca.gis_wr_2016_10_14_c2 Chart 3U.S. Housing Remains Robust U.S. Housing Remains Robust U.S. Housing Remains Robust The underpinnings for housing continue to look good. The ratio of household debt-to-GDP has declined nearly 20 points from its 2008 high - the lowest figure since 2003 - while the debt- service ratio is back to where it was in the early 1980s (Chart 4). Excess inventories have also been absorbed. The homeowner vacancy rate has fallen to 1.7%, completely reversing the spike experienced during the Great Recession (Chart 5). With household formation picking up and housing starts still 20%-to-25% below most estimates of how much construction is necessary to keep up with population growth, it is likely that housing activity can increase at a reasonably brisk pace over the next two years. We assume that real residential investment will expand by 4% in both Q4 and 2017. Chart 4Household Debt Burdens Have Declined bca.gis_wr_2016_10_14_c4 bca.gis_wr_2016_10_14_c4 Chart 5The Excess Supply In Housing Has Cleared bca.gis_wr_2016_10_14_c5 bca.gis_wr_2016_10_14_c5 Business Capex Growth in business capital spending has been falling since mid-2014 and turned negative on a year-over-year basis in the first quarter of this year. Initially, the deceleration in capital spending was largely confined to the energy sector. Since late last year, however, non-energy capex has also weakened sharply (Chart 6). Chart 6Easing In Energy Sector Retrenchment Better U.S. Economic Data Will Cause The Dollar To Strengthen Better U.S. Economic Data Will Cause The Dollar To Strengthen The recent slowdown in business capex reflects three factors. First, the disaggregated data on corporate investment spending indicate that lower energy prices generated a second-round effect on businesses that are not officially classified as being part of the energy space, but that are nonetheless major suppliers to the sector. Second, the stronger dollar hurt the manufacturing sector more broadly, leading to a lagged decline in capital spending. Third, the backup in corporate borrowing spreads that began in May 2014 and the associated tightening in bank lending standards put further downward pressure on business capex. All three of these headwinds have waned over the past few months (Chart 7). The oil rig count has started to recover, suggesting that energy capex should stabilize and perhaps even improve. The dollar and corporate credit spreads have also come down, while loan growth remains robust (Chart 8). Reflecting these developments, core capital goods orders have risen for the past three months. Corporate capex intentions have also perked up (Chart 9). We project that real business capex will increase by 2.5% in Q4 and 3.5% in 2017 if the dollar and interest rates remain unchanged. Chart 7Borrowing Costs Have Fallen bca.gis_wr_2016_10_14_c7 bca.gis_wr_2016_10_14_c7 Chart 8Solid Loan Growth bca.gis_wr_2016_10_14_c8 bca.gis_wr_2016_10_14_c8 Chart 9Recent Signs Of Improving Corporate Capex Spending Intentions bca.gis_wr_2016_10_14_c9 bca.gis_wr_2016_10_14_c9 Inventories Lower inventory investment shaved 1.2 percentage points off Q2 growth. This marked the fifth consecutive quarter that inventories have been a drag on growth - the first time this has happened since 1956. Real inventory levels fell by $9.5 billion at a seasonally-adjusted annualized pace in the second quarter and are likely to be flat-to-slightly down again in Q3. However, since it is the change in inventory investment that affects growth, this should translate into a modestly positive contribution to Q3 GDP growth. Looking further out, firms are likely to start slowly rebuilding inventories as we head into 2017. The economy wide inventory-to-sales ratio is now back near its trend level (Chart 10). Durable goods inventories excluding the volatile aircraft component rose in the third quarter, as did the inventory component of the ISM manufacturing index (Chart 11). We expect inventory restocking to boost growth by 0.1 percentage points in Q4 and 2017, a big improvement over the drag of -0.6 percentage points between Q2 of 2015 and Q2 of 2016. Chart 10Room To Stock Up Better U.S. Economic Data Will Cause The Dollar To Strengthen Better U.S. Economic Data Will Cause The Dollar To Strengthen Chart 11Inventory Rebuilding Has Commenced Inventory Rebuilding Has Commenced Inventory Rebuilding Has Commenced Government Spending Real government consumption and investment declined by 1.7% in Q2 on the back of lower state and local spending and continued weakness in defense expenditures. The drop at the state and local levels should be reversed, given that tax revenues are trending higher. Federal government spending should also pick up regardless of who wins the presidency. There is now bipartisan support for removing the sequester and increasing infrastructure spending. We are penciling in growth in real government expenditures of 1.5% in Q4 and 2.5% in 2017. Net Exports Net exports shaved 0.8 percentage points off growth in the five quarters spanning Q4 of 2014 to Q4 of 2015. Net exports made a slight positive contribution to growth in the first half of this year. Unfortunately, this was mainly a consequence of sluggish import growth against a backdrop of decelerating domestic demand. Looking out, assuming no change in the dollar index, a rebound in import demand will lead to a modest widening in the trade deficit, which will translate into a 0.2 percentage-point drag from net exports over the remainder of this year and 2017. Putting It All Together The analysis above suggests that the U.S. economy will grow by around 2.5% in Q4 - close to the pace that Q3 growth is currently tracking at - with growth accelerating to 2.8% in 2017. This is a point above the Fed's estimate of long-term real potential GDP growth based on the latest Summary of Economic Projections. How Will The Fed React To Faster Growth? We tend to agree with most FOMC officials who think that the economy is now close to full employment. We also concur that the relationship between inflation and spare capacity is not linear. When spare capacity is high, even large declines in unemployment have little effect on inflation. In contrast, when the labor market becomes quite tight, modest declines in the unemployment rate can cause inflation to rise appreciably. As Chart 12 illustrates, the existence of such a "kinked" Phillips Curve is consistent with the data. Where this publication's view differs with the Fed's is over the question of how much of an inflation overshoot should be tolerated. Considering that the Fed has undershot its inflation target by a cumulative 4% since 2009, a strong case can be made that it should aim for a sizable overshoot in order to bring the price level back to its pre-crisis trend. Most FOMC members do not see it that way, however. This point was reinforced by Chair Yellen at her September press conference when she said that "We don't want the economy to overheat and significantly overshoot our 2 percent inflation objective."1 Chart 13 shows that many measures of core inflation are already above 2%. This suggests that the Fed is unlikely to stand pat if aggregate demand growth looks set to accelerate to nearly 3% next year, as our analysis suggests it will. Chart 12The Phillips Curve Appears To Be Non-Linear Better U.S. Economic Data Will Cause The Dollar To Strengthen Better U.S. Economic Data Will Cause The Dollar To Strengthen Chart 13Some Measures Of U.S. Core Inflation Are Already Above 2% Some Measures Of U.S. Core Inflation Are Already Above 2% Some Measures Of U.S. Core Inflation Are Already Above 2% How high will rates go? This is a tricky question to answer because it requires us to know the value of the so-called neutral rate - the short-term interest rate consistent with full employment. Complicating the matter is the fact that changes in interest rate expectations will affect the value of the dollar, and that changes in the value of the greenback, in turn, will affect the level of the neutral rate. This is because a stronger dollar means a larger trade deficit, which necessitates a lower interest rate to keep the economy at full employment. It is a "joint estimation" problem, as economists call it. One key point to keep in mind is that currencies tend to be more sensitive to changes in interest rate differentials when those differentials are expected to persist for a long time. Chart 14 makes this point using a visual example.2 The implication is that most of the tightening in financial conditions that the Fed will need to engineer is likely to occur through a stronger dollar rather than through higher interest rate expectations. Chart 14The Longer The Interest Rate Gap Persists, The Bigger The Exchange Rate Overshoot Better U.S. Economic Data Will Cause The Dollar To Strengthen Better U.S. Economic Data Will Cause The Dollar To Strengthen A back-of-the-envelope calculation suggests that the level of aggregate demand would exceed the economy's supply-side potential by 2% of GDP by end-2019 in the absence of any effort by the Fed to tighten financial conditions.3 We estimate that in order to keep the output gap at zero, the real trade-weighted dollar would need to appreciate by 10% and the fed funds rate would need to rise to 2% in nominal terms, or 0% in real terms. Despite this month's rally, the real broad trade-weighted dollar is still down more than 2% from its January high. Thus, a 10% appreciation would leave the dollar index less than 8% above where it was earlier this year, and well below past peaks (Chart 15). Chart 15Still Far From Past Peaks Still Far From Past Peaks Still Far From Past Peaks In terms of timing, a reasonable baseline is that the Fed will raise rates in December and twice more in 2017. This would represent a more rapid pace of rate hikes than what is currently discounted by markets, but would only be roughly half as fast as in past tightening cycles. How quickly the dollar strengthens will depend on how fast market expectations about the future path of short-term rates adjust. In past episodes such as the "taper tantrum," they have moved quite rapidly. This suggests that the dollar could also rise at a fairly fast clip. The Impact From Abroad Chart 16A Stronger Dollar Could Push Up EM Spreads A Stronger Dollar Could Push Up EM Spreads A Stronger Dollar Could Push Up EM Spreads Exchange rates are nothing more than relative prices. This means that developments abroad have just as much of an effect on currencies as developments at home. Given the size of the U.S. economy, better U.S. growth would likely benefit the rest of the world. Could this impart a tightening bias on other central banks that cancels out some of the upward pressure on the dollar? For the most part, the answer is no. Both the euro area and Japan have more of a problem with deflation than the U.S. The neutral rate is also lower in both economies. This implies that neither the ECB nor the BoJ are likely to raise rates anytime soon. Thus, to the extent that stronger U.S. growth buoys these economies, this will translate into somewhat higher inflation expectations and thus, lower real rates in the euro area and Japan. This is bearish for their currencies. The possibility that the ECB will start tapering asset purchases next March, as many have speculated, would not alter our bullish view on the dollar to any great degree. Granted, if the ECB did take such a step without introducing any offsetting measures to ease monetary policy, this would cause European bond yields to rise, putting upward pressure on the euro. However, anything that strengthens the euro would weaken the dollar, giving the U.S. a competitive boost. This, in turn, would prompt the Fed to raise rates even more than it otherwise would. The final outcome would be that the dollar would still appreciate, although not quite as much as if the ECB kept its asset purchases unchanged. As far as emerging markets are concerned, a hawkish Fed is generally bad news. Tighter U.S. monetary policy will reduce the pool of global liquidity that has pushed down EM borrowing costs (Chart 16). And given that 80% of EM foreign-currency debt is denominated in dollars, a stronger greenback could cause distress among some over-leveraged borrowers. To make matters worse, a stronger dollar has typically hurt commodities - the lifeblood for many emerging economies. All of this is likely to translate into weaker EM currencies, and hence, a stronger dollar. Investment Conclusions Today's market climate is similar to the one around this time last year. Back then, the Fed was also gearing up to hike rates. Initially, stocks held their ground even as bond yields edged higher. But then, shortly after the Fed raised rates, the floodgates opened and the S&P 500 fell 13% within the course of six weeks (Chart 17). We are nearing such a precipice again. And, in contrast to earlier this year when the 10-year Treasury yield fell by 70 basis points, there is less scope for the bond market to generate an easing in financial conditions in response to plunging equity prices. The 10-year Treasury yield stood at 2.30% on December 29, just before the stock market began to sell off. Today it stands at 1.74%. Investors should position for an equity correction that sends the S&P 500 down 10% from current levels. Looking out, if U.S. growth does begin to accelerate, that should provide some support to stocks. Nevertheless, a stronger dollar and faster wage growth will weigh on corporate earnings, while stretched valuation levels will limit any further expansion in P/E multiples (Chart 18). Investors should underweight U.S. stocks relative to their global peers, at least in local-currency terms. Chart 17Beware Of A Replay Of The Last Correction Beware Of A Replay Of The Last Correction Beware Of A Replay Of The Last Correction Chart 18U.S. P/E Ratios: High, Very High U.S. P/E Ratios: High, Very High U.S. P/E Ratios: High, Very High Turning to bonds, while an equity market correction would not cause Treasurys to rally as much as they did in January, the 10-year yield could still touch 1.5% if risk sentiment were to deteriorate. Once the dust settles, however, bond yields will resume their upward grind. Lastly, a stronger dollar will pose a significant headwind for commodities. That said, as we discussed in last week's Fourth Quarter Strategy Outlook, recent cuts to capital spending are likely to generate supply shortages in some corners of the commodity complex.4 BCA's commodity strategists prefer energy over metals and are particularly bullish on U.S. natural gas heading into 2017. Peter Berezin, Senior Vice President peterb@bcaresearch.com 1 Please see "Transcript of Chair Yellen's Press Conference September 21, 2016," Federal Reserve, September 21, 2016. 2 To understand this concept in words, consider two countries: Country A and Country B. Suppose rates in both countries are initially the same, but that Country A's central bank then proceeds to raise rates by one percentage point and pledges to keep them at this higher level for five years. Why would anyone buy Country B's short-term debt given that Country A's debt yields one percent more? The answer is that people would be indifferent between investing in Country A and Country B if they thought Country A's currency would depreciate by 1% per year over the next five years. To generate the expectation of a depreciation, however, Country A's currency would first have to appreciate by 5%. Now modify the example with the only difference being that Country A's central bank pledges to keep rates higher for ten years, rather than five. For interest rate parity to hold, Country A's currency would now have to overshoot its fair value by 10%. The implication is that the longer interest rates in Country A are expected to exceed those in Country B, the more "expensive" Country A's currency must first become. 3 For the purposes of this calculation, we assume that the output gap this year will be -0.5% of GDP and that aggregate demand growth will exceed potential GDP growth by 1% in both 2017 and 2018, with the gap between demand and supply growth falling to 0.5% in 2019 and stabilizing at zero thereafter. The New York Fed's trade model suggests that a 10% appreciation in the dollar would reduce the level of real GDP by a cumulative 1.2 percentage points over a two-year period. A slightly modified Taylor Rule equation implies that an 80 basis-point increase in interest rates on average across the yield curve would reduce the level of real GDP by 0.8 percentage points after several years. We assume that Fed tightening would lead to a flatter yield curve so that short-term rates rise more than long-term yields. 4 Please see Global Investment Strategy Strategy Outlook, "Fourth Quarter 2016: Supply Constraints Resurface," dated October 7, 2016, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Hillary Clinton has a 65% chance of winning the election; she receives 334 electoral college votes according to our model. Trump still requires an exogenous shock to win. Meanwhile, the USD is poised to rally - and leftward-moving policymakers will applaud its redistributive effects while MNCs suffer the consequences.

Global bond yields continue to grind higher, led by signs of improving growth, moderately higher inflation and central banks having difficulty staying credibly dovish. Maintain a below-benchmark duration stance.

The sharp spike in HIBOR will be short lived. The RMB "carry trade" has been largely unwound. The RMB will not experience the intense selling as seen in the past year. H shares are still trading at substantial discounts to A shares, which will inevitably continue to draw domestic investors. Strategically, H shares remain a better bet than their domestic counterparts.