Valuations

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

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

Highlights Portfolio Strategy Industrials stocks are on the verge of a breakout on the back of firming earnings fundamentals. Lift to an above benchmark allocation. Reviving global end-demand is a boon to U.S. machinery equities. Act on the upgrade alert and boost the construction machinery & heavy truck sub-index to overweight. Recent Changes S&P Industrials - Upgrade to overweight. S&P Construction Machinery & Heavy Truck - Lift to overweight. Table 1Sector Performance Returns (%) Feature Equities gained ground last week, cheering the Trump administration's apparent headway in getting a tax bill passed. Chart 1 depicts this euphoria with small- and mid-caps breaking out to all-time highs and the broad based value line arithmetic index also vaulting into uncharted territory. Financials also jumped taking their cue from the bond market selloff as Janet Yellen reiterated that higher interest rates are in store, despite ("probably temporary") low inflation. Beneath the surface, synchronized global growth remains the dominant macro theme and on the eve of earnings season, profits will take center stage. Chart 2 plots the evolution of Q1, Q2 and Q3 2017 EPS growth forecasts using Thomson Reuters/IBES data, with the final datapoint representing actual EPS growth. Notably, forecasts have been coming down substantially only to surprise to the upside once the final numbers are in. Chart 1New Highs Abound Chart 2SPX OEPS Forecasts Vs Actuals Granted, this is the typical profile. EPS numbers tend to be "massaged" ahead of earnings season, but we are surprised by the 9 percentage point drop in Q3 EPS forecasts to a low y/y profit growth hurdle of 6%. A particularly destructive hurricane season likely played a role in this dramatic slide in growth forecasts. By comparison, in Q1 and Q2 the EPS growth forecast declines were 6 and 5 percentage points, respectively. And, on average the positive surprise EPS factor was 470bps (yellow highlight, Chart 2). If recent history is any guide, Q3 EPS will likely surprise to the upside once again. With regard to sector contribution to earnings growth in Q3, Chart 3 shows an extreme concentration in two sectors: energy and tech. These sectors comprise 70% of the growth in EPS for the current quarter. In fact, if one adds health care, industrials and financials, then the percent contribution jumps to 98%. Such high concentration is a risk. But, the recent hurricane-related increase in refining crack spreads and multi-month highs in crude oil signal that, at least, energy EPS will be robust. As a reminder we upgraded the S&P energy sector to overweight in early July.1 The sector revenue growth contribution picture is more diverse. Chart 4 shows the year-over-year sales growth sector contribution for Q3/2017. While energy and tech still dominate the revenue growth landscape, they add up to 44% of the total. Adding consumer staples, industrials and health care elevates this number to 86%, still high, but much less concentrated than the profit contribution figure. Bloomberg's soft versus hard economic data surprise index has historically been an excellent leading indicator of quarterly SPX EPS, and the current message is to expect a fresh all-time high (Chart 5). Chart 3Sector Contribution To Profit Growth Chart 4Sector Contribution To Revenue Growth Chart 5Soft Data Green Light Summing it all up, our sense is that the earnings-led advance in the equity market has staying power. Under such a backdrop, this week we continue to add deep cyclical exposure to our portfolio. Mighty Industrials Industrials stocks have been trading in a well-defined and narrow range since the end of the Great Recession (top panel, Chart 6). But now, conditions are ripe for a breakout in relative share prices. We recommend augmenting S&P industrials exposure to overweight. Valuations have corrected back to the neutral zone and our Technical Indicator (TI) has unwound previously overbought conditions. In fact our TI is steadily sinking, on track to hit one standard deviation below its historical mean, a level that has previously consistently coincided with playable rallies (third & fourth panels, Chart 6). On the earnings fundamental front, our newly introduced S&P industrials operating EPS model is humming (second panel, Chart 6). Rebounding commodity prices, with the aid of a softer U.S. dollar, a pickup in capital goods end-demand, and still generationally low interest rates are key profit model drivers. The industrials sector Cyclical Macro Indicator (CMI) echoes the EPS model's message. The CMI has surged recently, signaling that sell-side analysts are pessimistic on the sector's relative profit outlook (second panel, Chart 7). Chart 6EPS Model Says Buy Industrials Chart 7Domestic Demand... Forward looking indicators of industrials final demand suggest that this high operating leverage deep cyclical sector is on the cusp of flexing its muscle. Domestic capex intentions from a number of regional Fed surveys are the most upbeat in decades (second panel, Chart 8). Pent-up capex demand will likely continue to get unleashed in the coming quarters. While the Trump Administration's health care bill was unsuccessful, the odds are better that a tax bill and/or an infrastructure bill will receive warmer welcomes in Washington. Tack on bankers' willingness to extend credit, and 2018 may morph into a significant domestic capex revival year (Chart 8). The implication is that the nascent industrials profit margin expansion phase has more legs. In fact, the ISM manufacturing survey has been an excellent leading indicator of industrials margins and the current message is to expect a widening in the latter (Chart 8). On the domestic front there are even more signs that industry end-demand is on a solid footing. Non-tech industrial production and core durable goods orders are expanding at a healthy clip. Firming industrials pricing power reflects this vibrant demand backdrop. The upshot is that the path of least resistance for industrials relative profitability is higher (Chart 7). Nevertheless, this tightening demand narrative is not restricted to U.S. shores. Global capital goods demand also continues to firm. The global manufacturing PMI is at a six-year high on the back of synchronized global growth. Chinese wholesale price inflation has also recently reaccelerated likely reflecting increased end-demand (Chart 9). Emerging markets (EM) equities best capture all of this global manufacturing euphoria. Historically, EM equity performance and the relative share price ratio have been positively correlated, and the recent breakout in the former is a harbinger of fresh all-time highs in U.S. industrials relative performance (Chart 9). The greenback's sizable year-to-date depreciation will also boost U.S. industrials exporters' global market share and profits in the back half of 2017, irrespective of where the U.S. dollar drifts in the coming months. Moreover, a softening U.S. currency is commodity/industry pricing power positive, and thus a boon to revenue growth (Chart 10). Finally, over the past two decades, a falling trade-weighted U.S. dollar has been synonymous with a multiple expansion phase and vice versa. Currently, an unsustainably wide gap has opened that will likely narrow via a rerating phase (bottom panel, Chart 10). Chart 8... Capex Upcycle... Chart 9... Global Demand... Chart 10... And Greenback Point Point To A Rerating Phase Bottom Line: Boost the S&P industrials sector to an above benchmark allocation. We are executing this upgrade by lifting the construction machinery & heavy truck sub-index to overweight. Rise Of The Machines Machinery stocks have been in a V-shaped recovery for the past 18 months retracing all of their relative losses since the 2014 highs. Our machinery EPS model is firing on all cylinders, underscoring that the earnings-led recovery has more running room (Chart 11). This buoyant EPS growth backdrop gives us comfort to act on our upgrade alert and lift the S&P construction machinery & heavy truck sub-index to overweight.2 As a reminder, we have already been overweight the S&P industrial machinery index since early April3 and have participated in the machinery index advance. A fresh capex upcycle will likely fuel the next machinery stock outperformance upleg. Not only are expectations for overall capital outlays as good as they get (second panel, Chart 12), but there are also tentative signs that even the previously moribund mining and oil & gas complexes will be capex upcycle participants. While we are not calling for a return to the previous cycle's peak, even a modest renormalization of capital spending plans (i.e. maintenance capex alone would suffice) in these two key machinery client segments would rekindle industry sales growth (top panel, Chart 12). Chart 11EPS Recovery Is In The Early Innings Chart 12Levered To Capex A quick channel check also waves the green flag. Both machinery shipments and new orders are outpacing inventory accumulation (third & fourth panels, Chart 12). Moreover, backlogs are rebuilding at the quickest pace of the past five years (not shown). This suggests that client demand visibility is returning. This machinery end-demand improvement is a global phenomenon. In fact, the bottom panel of Chart 12 shows that global machinery new orders are climbing faster than domestic new order growth. Tack on the reaccelerating global credit impulse courtesy of the latest Bank for International Settlements Quarterly Review and the ingredients are in place for a global machinery export boom (third & fourth panels, Chart 13). Already anecdotally, bellwether Caterpillar's global sales-to-dealers figures suggest that the industry's relative EPS upward trajectory is sustainable (bottom panel, Chart 13). Similar to the global growth synchronization thesis, Caterpillar's regional sales breakdown confirms that all regions are expanding simultaneously led by Asia Pacific - even in the extremely volatile Latin American and laggard EMEA end-markets (Chart 14). Chart 13Global Growth Beneficiary Chart 14CAT Confirms Synchronized Global Growth Importantly, Chinese machinery demand is growing briskly. A cheapened U.S. dollar makes China imports of U.S. machinery more enticing. Beyond the currency dynamics, the dual force of Chinese fiscal spending thrust and credit impulse are also stimulating machinery final demand (Chart 15 on page 12). While Chinese excavator sales growth has likely petered out, it is still near a triple digit growth rate (Chart 15 on page 12). Komatsu's Chinese excavator sales data corroborate the official Chinese data.4 All of this impressive demand backdrop is not yet reflected in relative valuations. The relative forward P/E multiple has deflated of late and investors can initiate fresh positions at a market multiple, which is also the historical mean (Chart 16 on page 12). Chart 15Stable China Is Encouraging Chart 16Room For Valuation Expansion Bottom Line: We are acting on our upgrade alert and lifting the S&P construction machinery & heavy truck index to overweight. The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, PCAR, CMI. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "SPX 3,000?" dated July 10, 2017, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Daily Insight, "Building Up Steam", dated August 18, 2017, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Revenue Revival", dated April 10, 2017, available at uses.bcaresearch.com. 4 http://www.komatsu.com/CompanyInfo/ir/demand_orders/ Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights The sharp rally in Chinese developer stocks this year reflects a combination of the unwinding of "doomsday" bets and notable improvement in fundamentals rather than a bubble formation. The positive re-rating has further to run. Tighter policy imposed by local governments will probably keep developers in dormancy, but a major downturn is highly unlikely simply because there is not much excess to begin with. Urbanization still provides a powerful tailwind for residential construction from a long-term perspective. Chinese housing market will continue to experience cyclical swings, but the powerful structural tailwind will make the cyclical downturn shallow and fleeting. Feature Chart 1A Sharp Re-Rating Of Developer Stocks Chinese real estate developer stocks have more than doubled so far this year, making them the best performing sector in the investable universe - easily outpacing even the world-beating Chinese technology sector (Chart 1). The recent moves in developer stock prices have become parabolic, which combined with recent measures by some major cities to further tighten housing transactions raises the odds of profit-taking and a technical correction in the near term. However, the sharp rally since the beginning of the year has largely been a mean-reverting positive re-rating process rather than an overshoot. Moreover, the latest housing tightening measures are unlikely to have a long-lasting impact on housing demand. Therefore developer stocks should continue to advance after a period of consolidation. Beyond the cyclical horizon, residential development will remain a long-term growth driver for Chinese business activity. Positive Re-Rating Has Further To Run Chart 2Improvement In Developers' Fundamentals It is tempting to dismiss this year's sharp rally in developer stocks as a speculative frenzy, as the dramatic boom in stock price has been accompanied by cooling property sales and moderating home prices amid regulatory tightening in various cities. In our view, the sharp rally in property stocks has been a powerful positive re-rating in multiples after being deeply depressed for several consecutive years. The bottom panel of Chart 1 shows strong multiples expansion of developer stocks since the beginning of 2017. The message here is that China's cyclical improvement in the past two years has led to an aggressive repricing of Chinese equities, particularly in some of the hardest hit sectors. Investors' overwhelming bearishness towards China's macro situation in previous years took a heavy toll on Chinese investable stocks. The market had essentially priced in a chaotic hard-landing scenario, which is now being reversed due to growth improvement. In recent years we have consistently argued that the risk premium embedded in Chinese equities was exceptionally high and ultimately unsustainable, and one of our major investment themes has been a "positive re-rating in Chinese equities" - a view that has been quickly validated. Moreover, developers' stock prices have also reflected some notable improvements in earnings and balance sheet fundamentals, which can also be observed among their domestically listed peers (Chart 2): Deleveraging: The median liabilities-to-assets ratio of developers has dropped notably from the peak of 2015. Destocking: Developers have been focusing on selling inventories, and have been cautious on new projects. The median inventory-to-assets ratio has dropped from a peak of 63% in late 2015 to below 50% currently. Stronger cash positions: Aggressive de-stocking and conservative expansion have also significantly improved developers' cash flows. Cash position as a share of total assets has improved significantly, returning to the all-time highs reached in 2010. Total profits have also recovered strongly with strengthening margins.1 In short, the rally in developer stocks reflects a combination of the unwinding of "doomsday" bets and notable improvement in fundamentals rather than a bubble formation. There is little froth in the marketplace just yet. In fact, property stocks still remain quite cheap based on some conventional valuation indicators - even after this year's sharp rally. Property stocks are trading at 13 times trailing earnings and nine times forward earnings, and are still trading at hefty discounts to bottom-up net-asset-value (NAV) estimates. This means the bull market should have more legs in the coming months. Will Policy Constraints Lead To Another Major Downturn? Recent policy tightening on the residential market clearly creates some headwinds for the sector, and policy risk has been a key factor driving developer stock prices in previous tightening cycles. Historically, the government's tightening campaigns have typically restricted land supplies and bank credit to developers, and have been combined with tighter lending standards and higher interest rates for mortgage borrowers - and even outright bans on household investment demand for residential properties in major cities. In the current tightening cycle that began early last year, regulations on developers have remained largely unchanged, while the rein on households has been much tighter. Mortgage interest rates have also begun to inch higher (Chart 3). In the latest round of tightening measures announced late last week, eight major cities tightened controls on home sales, with a ban on reselling of homes within two to five years of purchase. The government's tightening measures have already led to a moderation in both home sales and prices, as shown in Chart 3, and the impact needs to be closely monitored. For now, our view is that policy constraints will not lead to major negative surprises both for developer stock prices and overall construction activity. On the demand side, household residential demand has been exceptionally strong of late. The central bank's most recent survey showed that a record high percentage of households intend to buy a home in the near future, a dramatic turnaround since the beginning of 2016 (Chart 4). The reason for the surge in home-buying intentions is not clear - we suspect it is the combination of pent-up demand accumulated in previous years and the herd-following mentality that typically follows a period of rapid increase in home prices. On the supply side, developers' inventory de-stocking and stronger cash positions have improved their ability to deal with sales slowdowns. In fact, home sales have significantly outpaced housing completions since 2015, leading to a sharp decline in inventories. Even including floor space under construction, the sellable inventories-to-sales ratio has dropped to its lowest level since 2010 (Chart 5). In our view, the sharp decline in inventories has been a key reason for the rampant increase in home prices since early last year. Chart 3Housing Market Has Been Moderating Chart 4Booming Demand For Home Purchases Taken together, with no inventory overhang and strong demand, we expect the impact of the current episode of housing tightening to be limited. In fact, real estate investment has been pretty subdued in recent years, despite surging home sales and improvement in business confidence among developers (Chart 6). Previous housing tightening measures were often implemented after a prolonged period of construction boom, leading to a sudden halt in investment and construction activity. This time around, tighter policy will probably keep developers in dormancy, but a major downturn is highly unlikely simply because there is not much excess to begin with. Chart 5Housing Destocking Becomes Advanced Chart 6Real Estate Investment Will Unlikely Slump Anew It's The Supply Side, Stupid! It appears that Chinese policymakers as well as global investors have perpetual fears of a "housing bubble" in China. The authorities are deeply worried about potential housing excesses and the negative impact on macro stability. Investors share similar concerns, and chronically worry about the global repercussions of a Chinese housing bust. Some have taken aggressive bets against Chinese developers and other asset classes that are leveraged on Chinese construction activity. While there are some idiosyncrasies in the motives of every tightening cycle in recent years, there is one common theme: the authorities' repeated attempts to cool off the housing sector are deeply rooted in the belief that both residential supplies and home prices were excessive, and therefore tighter controls on both supply and demand were warranted. Remarkably, concerns about housing excesses began to emerge almost immediately after the residential sector was privatized and a housing "market" began to develop in the early 2000s. In a special report dated April 29th 2004 titled, "What Housing Bubble?",2 I disputed for the first time the then-prevailing view on Chinese housing excesses. Fast forwarded 13 years and China's urban landscape has changed profoundly - yet the arguments for a "housing bubble" have remained essentially unchanged: speculative demand, excess supply, parabolic price increases and extreme unaffordability. To some China watchers, the housing sector's remarkable resilience despite repeated policy attacks from the early 2000s was simply an accumulation of a bigger accident waiting to eventually happen. In our analysis in recent years, we have repeatedly emphasized that the supply side shortages have been a key reason for the massive increase in Chinese home prices. While the government's various tightening measures to restrict speculators and cool off demand are well warranted, harsh supply side restrictions during various tightening campaigns have proven counterproductive, as they have amplified supply shortages, creating even more upward pressure on prices. Indeed, the supply-side restrictions are fairly easy to observe. China's leadership is fundamentally concerned about self-sufficiency of agricultural products, and therefore is reluctant to sacrifice farmland for urban development. Moreover, land supplies zoned for residential construction have accounted for an increasingly smaller share of total land supply, due to competition from infrastructure, industrial and commercial projects (Chart 7). Similarly, land purchased by developers plateaued in the early 2000s, and has dropped substantially in recent years. As a highly levered business by nature, developers have also been constantly challenged by limited access to bank loans due to regulatory restrictions. Loans to developers account for about 7% of banks' total loan book, largely unchanged in the past decade despite the massive construction boom. Tight credit controls have forced developers to other "shadow" financing options, which are both costlier and less reliable than formal bank loans, further limiting their ability to bring new housing projects to market. The prevailing heightened concerns on residential excesses and tougher regulations have pushed real estate companies to increasingly shift to commercial and industrial property development. Residential accounted for almost 80% of total real estate development in the early 2000s; the share has dropped to below 70% in recent years (Chart 8). Finally, the government's ill-informed judgement on the degree of excessive supply and speculative demand in the residential sector also prevented them from formulating a multi-tier residential market. Rental residential properties owned by professional institutional investors are rare, and "renters" often suffer discrimination for some public services, making homeownership essentially the only way for new families to establish themselves in urban areas. Chart 7Residential Land Supply Has Been Shrinking Chart 8Residential Construction's Dwindling Importance From a big-picture point of view, China is still in the midst of a spectacular urbanization process. Residential development is not only part of the growth process, but also an essential component to accommodating the massive increase in the urban population. Mainstream media often hype about "ghost towns" but ignore the fact that millions of young migrant workers still reside in dorm rooms provided by employers in sub-standard living conditions. Adjusting for the increase in the urban population, China's new residential construction in recent years has been a lot smaller than in other countries such as Japan and Korea at the prime stage of their respective urbanization process, according to our calculations (Chart 9) - likely the critical reason why Chinese home prices have remained stubbornly high, despite numerous rounds of government crackdowns. Chart 9China's Construction Boom In Perspective Since last year it appears the Chinese authorities have been paying more attention to increasing residential housing supply by providing more funding for social housing projects and shanty town reconstruction, as well as increasing land supply for residential projects. Meanwhile, there are recent proposals to develop rental markets in some major cities, allowing developers to build solely for rental, rather than for sales. In our view, policies boosting residential supplies will be a lot more effective in improving housing affordability for urban citizens. All in all, after the massive boom in recent years, home prices in certain major cities certainly feel a lot more "bubbly" than any time before, and it is easy to make a bearish structural case, as many have been doing over the past decade. However, urbanization still provides a powerful tailwind for residential construction from a long-term perspective. The Chinese housing market will continue to experience cyclical swings, but powerful structural tailwinds will make the cyclical downturn shallow and fleeting, as repeatedly demonstrated in previous policy tightening cycles. Looking forward, construction will remain an important growth driver for China for decades to come. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "China: Earnings Scorecard And Market Tea Leaves", dated September 7, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Special Report, "What Housing Bubble?" dated April 29, 2004, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Portfolio Strategy A more balanced cable & satellite and movies & entertainment industry profit backdrop is signaling that only a neutral stance is warranted in both these media sub-indexes. Trim to neutral. These moves also push our S&P consumer discretionary sector weight to a benchmark allocation. Recent Changes S&P Consumer Discretionary - Downgrade to neutral. S&P Cable & Satellite - Trim to equal weight. S&P Movies & Entertainment - Downgrade to a benchmark allocation. Table 1 Feature Equities sustained recent gains last week, largely ignoring the mildly hawkish Fed. The S&P 500 is undeterred by the prospect of another interest rate hike later this year with investors focused squarely on synchronized reaccelerating global growth. Highly-sensitive growth indicators are surging: South Korean exports are on fire, the Baltic Dry Index, lumber prices and a long forgotten global growth barometer, Brent oil prices, are breaking out (Chart 1). This suggests that S&P 500 profits are well positioned to continue expanding at a healthy clip, underpinning prices. Firming economic growth will eventually show up in inflation. In the U.S., empirical evidence signals that expanding real output growth usually does lead to a pickup in core CPI, albeit with an 18 month lag (top panel, Chart 2). A tightening labor market also corroborates this data. As the year-over-year change in the unemployment rate recedes, inflation typically rises, again with a 6 quarter lag (unemployment rate shown inverted, second panel, Chart 2). Finally, the bottom two panels of Chart 2 show the Cleveland Fed's Inflation Nowcasting1 series as a 3-month annualized rate of change in core CPI and core PCE. Both point to a continued rise in inflation. This inflation backdrop is significant as it will likely sustain the corporate sector's pricing power gains. Chart 3 updates our corporate sector pricing power proxy and the related diffusion index. We also update the business sector's overall wage inflation and associated diffusion index from the latest BLS employment report. Selling prices are recovering at a time when wages remain stable. Taken together, out margin proxy indicator suggests that the ongoing profit margin expansion phase has more legs (bottom panel, Chart 3). Chart 1Vibrant Global Growth Chart 2Inflation Comeback? Chart 3Margins Should Expand Table 2 shows our updated industry group pricing power gauges, which are calculated from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. The table also highlights shorter term pricing power trends and each industry's spread to overall inflation in order to identify potential profit winners and losers. Table 2Industry Group Pricing Power This analysis shows that 75% of the industries we cover are able to raise selling prices, and 45% are doing so at a faster clip than overall inflation. Importantly, inflation rates have increased since our late-June update. The outright deflating sectors dropped by one to 15 since our last update, but are still up from the 14 figure registered in April. Encouragingly, only 12 industries are experiencing a downtrend in selling price inflation, a decrease of 7 since our late-June and April reports. Chart 4Cyclicals Have The Pricing Power Advantage Moreover, 9 out of the top 12 industries with the highest selling price inflation are deep cyclicals/commodity-related (Chart 4), highlighting that the fall in the U.S. dollar is aiding the commodity complex to increase prices. The bottom of the table is equally split between 5 deflating tech industries and 5 consumer discretionary sectors. In sum, corporate sector pricing power is recovering painting a positive sales growth backdrop for the coming months. This will also prop up operating leverage, as we have been suggesting,2 as will still modest wage inflation. All in all, we envision a sound profit margin and EPS growth outlook for the back half of the year. This week we are executing a further early cyclical downshift to our portfolio. Consumer Discretionary Juggernaut Is Over Since the fed funds rate hit the zero line in December 2008, the S&P consumer discretionary index is not only the best performing GICS1 sector, but it is also the best performing asset class globally. In fact, it has risen by over 384% since December 1, 2008, nearly double the S&P 500's return. Even if one recalculates the GICS1 sector returns since the March 2009 broad market trough, U.S. consumer discretionary stocks still come out on top. Interestingly, relative performance bottomed in July 2008 (Chart 5), roughly two months before Lehman's collapse and in advance of that autumn's trough in deep cyclicals/China & EM levered equity plays. Simply put, U.S. discretionary equities sniffed out a massive reflationary impulse. This sector is extremely sensitive to interest rate changes and the quick slashing of the fed funds rate to zero and undertaking of unconventional monetary policies worked in their favor. Fast forward to today and our sense is that there are high odds that the consumer discretionary juggernaut is over and thus we are downgrading exposure to neutral. The Fed last week announced the commencement of the renormalization of its balance sheet. If consumer discretionary stocks are the ultimate beneficiaries of zero interest rate policy and the quantitative easing experiment, the unwinding of these emergency policies should also work in reverse (Chart 5). In other words, a winding down of the Fed's balance sheet and a rising fed funds rate should eat into consumer discretionary relative returns (top panel, Chart 6). Chart 5Mind The Fed's Balance Sheet Chart 6Rates, Money Growth... Money growth has also taken a backseat. M1 money supply is decelerating and so is M2 growth. Historically, money creation and relative performance have been joined at the hip and the current message is to lighten up on discretionary stocks (bottom panel, Chart 6). Beyond tighter, at the margin, monetary policy capping this early cyclical sectors future returns, energy inflation is also working against the S&P consumer discretionary index. The recent knee-jerk jump in retail gasoline prices will dent consumer disposable incomes as higher prices at the pump act as a tax on consumers. Our consumer drag indicator, capturing both rising interest rates and gasoline prices, is weighing on relative performance momentum (bottom panel, Chart 7). Nevertheless, there are some sizable positive offsets preventing us from downgrading exposure all the way to underweight. Recovering household net worth has historically been a boon for discretionary consumer outlays (second panel, Chart 8). Consumers feeling more flush, coupled with the jump in confidence, typically underpin real PCE growth. Tack on the fresh all-time highs in real median incomes, with the latest two year period registering the highest income gains since the history of the data, and the ingredients are in place for sustained gains in consumer spending (third & bottom panels, Chart 8). Finally, relative valuations and technicals have unwound previously expensive and overbought conditions, respectively. The S&P consumer discretionary forward P/E currently trades at a mild discount to the broad market and below the historical mean, and our Technical Indicator still hovers near washed out levels (Chart 9). Chart 7...And Energy Prices Weigh##br## On Consumer Discretionary Chart 8Positive ##br##Offsets... Chart 9...With Washed##br## Out Technicals Bottom Line: Adding it up, the Fed's historic exit from unconventional monetary policies, coupled with higher interest rates and gasoline prices, which are all income sapping, signal that only a benchmark allocation is warranted in the S&P consumer discretionary sector. We are executing this downgrade to neutral by trimming the media heavyweight sub-index (comprising cable & satellite and movies & entertainment) to a benchmark exposure. Intermittent Cable Signal Similar to the broad consumer discretionary index, cable & satellite stocks have been on a tear since troughing at the onset of the Great Recession. The more defensive in nature cable-related spending served as a catalyst to push up relative performance to all-time highs (Chart 10). This defensive industry backdrop is also evident in the positive correlation between the U.S. dollar and relative share prices. Empirical evidence shows that over the past three decades cable stocks outperform during dollar bull markets and suffer during periods of U.S. dollar weakness (Chart 10). Synchronized global growth is allowing other G10 central banks to play catch up to the Fed, which raised rates for the first time this cycle in December 2015. As a result, this looming coordinated G10 tightening monetary policy backdrop has forced investors out of the greenback. Given that the cable & satellite index sources nearly 100% of its revenues domestically, in a relative sense, the year-to-date U.S. softness is negative for sales/profits (Chart 10). On the industry operating front, there are some demand cracks forming. Cable outlays are trailing overall PCE and are anchoring relative share price momentum (middle panel, Chart 11). This message is corroborated by the softness in the ISM services survey that has been negatively diverging from ISM manufacturing. Waning services demand has historically been a bad omen for relative profit growth. At a minimum, a leveling off in the V-shaped recovery in sell-side analysts relative EPS expectations is in order (bottom panel, Chart 11). Chart 10Dollar Blues Chart 11Demand Softening Worrisomely, recent comments from Comcast that subscriber losses in the current quarter will likely erase all of last year's gains are disconcerting. This anecdote also confirms that demand for cable services is failing. The second panel of Chart 12 shows that real cable spending peaked in early 2014 and since then has been continually losing traction. If it were not for the successful offset from price hikes, cable companies would be in dire straits. The cable operators' ability to lift selling prices is undeniable and unmatched with a multi-decade track record, and remains solid despite the plethora of industry woes of late (Chart 13).Recent chatter that Charter Communications is about to be gobbled up is another factor underpinning cable pricing power. Additional industry M&A activity will take supply out of the market; recall that Charter bought out Time Warner Cable last year with positive industry pricing power results. The implication is that industry sales will remain resilient. Chart 12Margin Squeeze Alert Chart 13But Pricing Power And Valuations Are Tailwinds Tack on compelling relative valuations with the relative price-to-cash flow ratio probing 5-year lows and the industry's threats are likely well reflected following the recent derating phase (bottom panel, Chart 13). Netting it all out, a more balanced cable industry profit backdrop is signaling that only a neutral stance is warranted in this media sub-index. Bottom Line: Downgrade the S&P cable & satellite index to neutral and lock in gains of 5% since inception. The ticker symbols for the stocks in this index are: BLBG: S5CBST - CMCSA, CHTR, DISH. Movies & Entertainment: Intermission Similar to the S&P cable & satellite downgrade to neutral, the S&P movies & entertainment media sub-index no longer deserves an overweight and we recommend trimming exposure to neutral. Cord cutting is not a new phenomenon and content providers have been regrouping in order to fend off cutthroat competition from Netflix and similar outfits. This is a secular industry force that traditional media outlets must embrace and adapt to rather than be ground down by inertia. M&A activity has been a key defense mechanism for this sector and share count retirement explains a sizable part of the torrid relative performance since the Great Recession (Chart 14). This source of industry support is in late stages on the eve of the mega deal involving Time Warner. Demand for movies and entertainment has also come under pressure lately as depicted by the deceleration in recreation PCE. The softness in the ISM services survey is a yellow flag (Chart 15). The hurricane catastrophe is disquieting in the near-term, especially given the unintended consequence of the spike in gasoline prices. Historically, rising prices at the pump eat into demand for recreation activities (third panel, Chart 15). Chart 14End Of Share Retirement? Chart 15Decreasing Demand... In a broader context, when overall media-related consumer outlays suffer a setback, as is currently the case, relative forward profit estimates tend to follow suit and vice versa. The implication is that the earnings-led decline in relative share prices likely has more room to fall (bottom panel, Chart 15). All of this is transpiring in softening industry pricing power. While selling prices are still expanding, the growth rate has been cut in half since peaking early last year. Input cost inflation is not offering any positive offsets. Chart 3 showed that our broad based wage inflation diffusion index is plunging, but movies & entertainment executives have been fighting for talent, boosting industry wage growth. Taken together, they are sending a negative signal for sky high margins that appear vulnerable to a squeeze (Chart 16). Nevertheless, there is some light at the end of the tunnel for this media sub-group. Disney recently announced that it would pull content out of Netflix and start its own streaming service, disintermediating its core movie and sports (ESPN) content. Content providers in general are also working on introducing/beefing up their own streaming services options in order to better compete with online-only rivals. Live television (news and sports in particular) are still a near-monopoly that traditional media content providers are working hard to preserve. Moreover, diversified business models also assist in cushioning the cord cutting secular decline in the content business segments. Importantly, consumer confidence is pushing decade highs and will likely make all-time highs prior to the end of the business cycle. Historically, relative performance and consumer sentiment have been positively correlated for the better part of the past 22 years. Currently, a wide gap has opened and there are good odds of a catch up phase in the former (top panel, Chart 17). Chart 16...Showing Up In Loss Of Pricing Power Chart 17Cheap With Low EPS Growth Hurdle Finally, we refrain from turning very negative on this index as we deem that most of the bearish news is already reflected in historically inexpensive valuations on below par relative sales and EPS 12-month forward expectations (middle & bottom panels, Chart 17). Bottom Line: Downgrade the S&P movies & entertainment index to a benchmark allocation. The ticker symbols for the stocks in this index are: BLBG: S5MOVI - DIS, TWX, FOXA, FOX, VIAB. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 https://www.clevelandfed.org/our-research/indicators-and-data/inflation-nowcasting.aspx 2 Please see BCA U.S. Equity Strategy Weekly Report, "Operating Leverage To The Rescue?" dated April 17, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights The Fed still wants to hike in December and thrice next year, but euro area inflation could roll-over versus the U.S. This could cause some weakness in EUR/USD. Long USD/JPY remains a cleaner way to capitalize on the Fed and on higher U.S. bond yields. U.K. trend growth is falling, this will limit how high the BoE will push interest rates up. While the pound can rebound further until year-end, it is not as cheap as it may currently look. AUD/NZD could move back toward parity, but be patient before shorting this cross. Feature The Fed Is On, The Dollar Will Strengthen The dollar bear market is likely over for now, but in our view, U.S. inflation still needs to bottom meaningfully for the DXY to be able to move above 95, and for EUR/USD to trade below 1.15. We expect inflation to bottom late in the fourth quarter, and noticeably re-accelerate in 2018. For now, markets will have to fully price a December rate hike from the Federal Reserve and handle the fallout of a potential slowdown in euro area inflation in the coming months. Moreover, the European Central Bank's tapering announcement next month has been well telegraphed, and is likely to be fully priced in a euro already trading well above levels implied by interest rate differentials. Fed Chair Janet Yellen and the Fed's economic projections have been unequivocal: Governor Lael Brainard has not convinced the rest of the FOMC that U.S. inflation expectations are becoming unmoored to the downside. As a result, the Fed still plans to hike in December and still expects to lift U.S. interest rates thrice next year. The committee also continues to foresee inflation returning to 2% in 2019. The market got the message: on Wednesday, the dollar experienced its strongest rally in eight months, and bond yields moved higher. New evidence is also accumulating that U.S. core CPI will soon trough. This week, U.S. non-oil import prices, a key input to non-oil goods prices continued to increase and the Philly Fed survey's prices-paid and price-received components both showed improvement - corroborating the message from the ISM price paid, which has shot up to 62. This should give Wednesday's message from the Fed more credence among investors. Meanwhile, euro area growth remains very strong, but there are early signs that core inflation may be peaking. BCA's euro area core CPI diffusion index has rolled over and fallen below 50%, normally a precursor sign to a top in core CPI (Chart I-1). Moreover, the strength in EUR/USD is redistributing previous U.S. deflationary pressures into the euro area. As Chart I-2 illustrates, the tightening in euro area financial conditions relative to the U.S. points to a rollover in relative inflation trends. Chart I-1Euro Area CPI Peaking? Chart I-2Euro Area Core CPI Peaking Against The U.S. The market is still pricing far too little in the way of rate hikes in the U.S. over the next two years, while it is pricing the ECB appropriately, anticipating a 2019 lift-off of euro area policy rates (Chart I-3). This leaves the EUR/USD quite vulnerable if the market reassesses the Fed's capacity to lift rates, as this pair continues to trade at a level of premium to interest rate parity models last recorded in 2009 (Chart I-4) - premia that have historically been followed by declines over the following six months, averaging 6%. Chart I-3The Potential For A Repricing Of The ##br##Fed Relative To The ECB... Chart I-4..Will Hurt ##br##EUR/USD The yen too remains at risk. The yen might be cheaper than the euro, trading in line with its interest rate-implied fair value, but it is also burdened by a central bank inclined to leave policy as easy as possible for as long as possible. In fact, new Bank of Japan board member Goshi Kataoka dissented this week because, in his view, Japan needs more easing, both fiscal and monetary. Thus, in an environment where the Fed is trying to lift interest rates and where U.S. Treasury yields trade well below fair value (Chart I-5), the yen could suffer greatly as interest rate differentials move in favor of the USD, since the BoJ will still cap JGB yields for an extended period. Moreover, on the political front, an October election is becoming increasingly possible. Japanese Prime Minister Shinzo Abe's popularity has rebounded, and the opposition is in disarray, pointing to a very likely win for the LDP. Abe is seeking a new mandate as he wants to set a referendum to amend the Japanese constitution, removing its pacifist bias in order to increase military spending, which has greatly lagged that of rival China (Chart I-6). The North Korean crisis is obviously beneficial to this goal, and Abe wants to capitalize on it. Chart I-5Biggest Problem For The Yen Chart I-6Abe Wants To Rectify This Gap In order to increase the likelihood of a successful referendum, we anticipate Abe to push for more stimulus to goose the economy. Additionally, when Japanese wages are adjusted for the change in the breakdown between full-time and part-time positions, wage growth has already picked up significantly - well above 3% compared to a paltry 0.4% annual rate for the headline measure. This combination of potential fiscal stimulus, improving underlying wage growth and a staunchly dovish central bank could ultimately put upward pressure on inflation expectations, and thus downward pressure on Japanese real yields. This could further augment the negative impact of rising U.S. bond yields on the yen. Bottom Line: The dollar is set to appreciate against the euro and the yen in the coming weeks. The Fed has not deviated from its message and it still intends to follow the path set in the "dot plot." Meanwhile, euro area inflation could roll over, limiting how close to today markets can bring forward the first hike from the ECB. The euro is too expensive to withstand this eventuality. The BoJ in unwilling to abandon its current extremely dovish policy, setting the stage for additional yen weakness in the face of higher U.S. bond yields. GBP: As Cheap As It Seems? GBP/USD is currently trading at a large 20% discount to its purchasing parity equilibrium rate, and the trade-weighted pound is 10% below our long-term fair value estimate (Chart I-7). Since valuations have been strong predictors of currency returns on a two- to five-year horizon, this begs the following question: Is the pound a buy? Tactically, yes, the GBP still offers upside for the next three months or so, especially vis-à-vis the euro. The Brexit negations are likely to lead to long transition periods for FTAs after the U.K. leaves the EU. Moreover, interest rate markets currently assign a 65% probability of a hike by the Bank of England in November. However, recent communications from BoE Governor Mark Carney and his colleagues suggest the British central bank will hike that month. House prices have regained some composure and wage growth has rebounded to 2.2% after hitting a low of 1.7% six months ago, explaining some of the recent strength in retail sales. Inflation remains sticky at 2.9% per annum, and even the non-tradeable sector, where the pound's movements should bear little influence, continues to experience elevated inflation readings. This would support Carney's recent assertion that the U.K.'s output gap is closing faster than the BoE originally anticipated. It also raises question marks as to whether long-term inflation expectations in the private sector are beginning to become unanchored - something that would justify removing monetary accommodation from the system. Beyond this time horizon, the picture becomes more complex. The problem for the pound arises from the fact that the earlier-than-expected closure of the output gap is first and foremost a reflection of falling trend growth, a phenomenon that will continue well into the future. It is one of the inevitable consequences of last year's Brexit vote. Brexit principally impacts trend growth by depressing the U.K.'s labor force growth. As Chart I-8 illustrates, pre-Brexit, the U.K. experienced much more robust labor force growth than its EU peers thanks to a steady inflow of immigrants. However, at its core, the Brexit vote was a referendum on immigration. The U.K. government's hard stance on rejecting free movement of people going forward demonstrates that the Conservatives understand this, and it will remain a key pillar of their strategy going forward. Chart I-7Is The Pound Really That Cheap? Chart I-8U.K. Trend Growth Will Fall Problematically, leaving the EU will not improve the British trade balance, despite the fall in the pound. It may even hurt it. The fall in the pound can marginally help the U.K.'s goods balance with the EU, which currently stands at a deficit of 5% of GDP. However, this deficit is structural and reflects the U.K.'s lack of competitive advantage in manufacturing vis-à-vis the rest of the EU. Thus, a fall in the pound will do little to fully redress this gap. Meanwhile, the U.K. runs a surplus of 1.3% of GDP in the services balance (Chart I-9). However, by leaving the EU, the U.K.'s service sector is likely to lose much access to the continent as trade in services is heavily regulated, and creating new trade deals on services between the U.K. and the EU will prove a difficult process. Moreover, this services balance seems insensitive to the gyrations in EUR/GBP. Thus, while leaving the EU might marginally help the goods balance thanks to a lower pound, this exchange rate benefit will be nullified by a loss of access to EU markets by U.K. service sector firms. Why does a lower trend growth matter for the pound in the long run? The U.K. has been running a large current account deficit for 20 years. Even at 3.9% of GDP, this deficit does not have to be a problem if it can be financed. Thankfully, the U.K. has benefited from a higher level of neutral interest rates, itself a function of Britain's higher trend GDP growth. This higher neutral rate means the U.K. has been able to enjoy higher interest rates in general than the EU or the U.S. (Chart I-10). These higher returns have attracted the necessary capital to finance the current account. Chart I-9A Lower Pound Will Not Undo##br## The Pain Of Leaving The EU Chart I-10Lower Trend Growth Equals##br## Lower Terminal Rate Going forward, lower trend growth will lower the neutral interest rate, which will limit both the terminal rate hit by the BoE this cycle as well as the average level of rates in the U.K. In this context, the U.K. will need a permanently cheaper pound to finance its current account deficit. As a result, the apparent cheapness of the pound on long-term valuation metrics may prove to be nothing more than an illusion. Chart I-11Will Higher GBP Volatility Hurt London? The other problem that could negatively affect the pound is that the U.K. remains a global financial center. Historically, having low exchange rate volatility has helped financial centers achieve the pre-requisite level of stability needed to attract foreign capital (Chart I-11). However, the pound's volatility has increased in the aftermath of Brexit. If realized volatility was computed from 2000 to 2015, the standard deviation of the pound's returns rank below that of the Swiss franc and the Norwegian krone; if the sample is expanded to today, its volatility ranks above that of the CHF and the NOK. Not only does this point to a large increase in the relative volatility of the pound in the interim two years, but this trend could continue in the future, especially if as our Geopolitical Strategy sister service argues, the leftward-shift in the U.K.'s median voter could lead to a Corbyn Premiership down the road.1 Bottom Line: The pound still has upside in the short-term as markets re-assess the path of the BoE toward a rate hike this year, removing the emergency easing implemented in the wake of the last year's referendum. However, the long-term outlook for the pound is trickier. The GBP's apparent cheapness is warranted. The U.K.'s potential growth rate is falling, which will drag down the country's neutral interest rates. As a result, the BoE will not be able to increase interest rates much over the course of the cycle. This means that financing the U.K.'s current account deficit will require the pound to remain cheap for an extended period of time. AUD/NZD: The RBNZ Can Tighten More Than The RBA The AUD/NZD is likely to experience a move toward parity over the next six months. Currently, AUD/NZD trades approximately 10% above its long-term fair value (Chart I-12, left panels), a level that has historically resulted in sharp reversals. This cross is also trading at a significant premium to our Intermediate-Term timing model (Chart I-12, right panels), further highlighting the medium-term downside risk for the aussie/kiwi. Chart I-12AAUD/NZD Is Expensive Chart I-12BAUD/NZD Is Expensive Valuations are not the only consideration raising a red flag for AUD/NZD. Relative monetary policy dynamics could also weigh on this cross going forward. As the Reserve Bank of New Zealand has been trying to talk down the kiwi, interest rate markets are pricing in 34 basis points of hikes over the next 12 months, while they expect the Reserve Bank of Australia's Cash Rate to increase by 41 basis points over the same timeframe. We think the RBNZ has more room to tighten policy than the RBA, especially as our central bank monitor is much more hawkish on New Zealand than Australia (Chart I-13). Corroborating the message of this indicator, the New Zealand output gap is now at 0.9% of potential GDP while it stands at -1.6% in Australia, suggesting more pronounced underlying inflationary pressures in the smaller economy. Moreover, New Zealand's growth is outpacing Australia's by nearly 1%, and relative LEIs suggest no end in sight for this trend. Thus, the relative output gap between the two countries will continue to move in favor of a tighter RBNZ than RBA. Additionally, Australia house prices have been in a cyclical downtrend versus New Zealand, depreciating nearly 15% in relative terms since 2011. This is resulting in a large underperformance of Australia's credit growth against New Zealand, which points to downside risk in AUD/NZD (Chart I-14). Mirroring these two factors, Aussie retail sales are lagging their neighbors by a near-record 3% annual pace. Beyond domestic conditions, terms-of-trade dynamics are also a negative for AUD/NZD. This cross tends to mimic movements in the prices of metals relative to dairy prices, reflecting the composition of the two nations' exports. Since May this year, metals have been outperforming milk, but AUD/NZD has massively overshot this driver (Chart I-15), exposing the cross to a reversal in relative commodities prices. Going forward, with Chinese monetary conditions tightening, with Chinese fiscal stimulus waning, and with EM money growth sharply decelerating, metals prices, which are much more sensitive to global industrial activity, are likely to underperform the less growth-sensitive dairy prices. Chart I-13The RBNZ Needs To be More##br## Hawkish Than The RBA Chart I-14Disconnect Between AUD/NZD##br## And Relative Credit Growth Chart I-15AUD/NZD Out Of Line ##br##With Terms Of Trade Technically, it is too early to enter this bet with any degree of certainty. Short-term momentum metrics are deeply oversold, and AUD/NZD, currently trading at 1.085, could rebound once it moves to 1.08 - the next key support level and slightly above the 50% retracement of the rally begun in June. This rebound could lift AUD/NZD close to the 1.11 neighborhood. Thus, we will wait for a better entry point to begin shorting this cross, especially as this weekend's election remains too close to call despite a recent rebound in the National Party. A Labour/NZ First coalition could cause a temporary sell-off in the NZD. Bottom Line: AUD/NZD is very expensive, and the market is underestimating the risk that the RBNZ will tighten policy more than the RBA over the next 12 months. The New Zealand economy has much less slack and is growing more strongly than Australia's, pointing to greater inflation risk. Additionally, metals prices are likely to underperform dairy prices, which will hurt Australian terms of trade relative to New Zealand. Technically, a better opportunity to short AUD/NZD is likely to emerge in the coming weeks. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The highlight of this week was the Fed's Monetary Policy meeting, where the FOMC announced the unwinding of the Fed's US$4.5 trillion balance sheet in October. It also intend to boost in interest rates in December, with the probability of a hike that month now at 63%. This is likely to move to 100%. While data continued to be mixed this week - existing home sales slowed but the Philly Fed survey was very strong, the Fed decided to ignore this as well as the potential impact of hurricanes, instead concentrating on the strong fundamentals underpinning the U.S. economy. Interest rates will therefore increase alongside inflation, providing a fillip for the greenback. On the fiscal side, tax cuts seem increasingly likely to be implemented. As investors begin to price out fiscal policy disappointments, the dollar will rally. Nevertheless, inflation is likely to pick up some time in 2018, and the dollar will fully bloom then. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Fade North Korea, And Sell The Yen - August 11, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Euro area data continues to outperform expectations: Core CPI, unchanged at 1.3%, beat expectations of 1.2%; Headline CPI also remained unchanged at 1.5%; German ZEW Economic Sentiment outperformed greatly coming out at 17.0, while the Current Situation also outperformed at 87.9; German producer prices grew at 2.6% annually, outperforming expectations of 2.5%. While the euro traded positively on the news, it lost most of this week's gains due to the Fed policy decision. We believe that sustained growth in the euro area will sustain the euro between 1.15 and 1.20. However, a pickup in U.S. inflation in 2018 could push EUR/USD toward 1.10. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Machinery orders yearly growth underperformed to the downside, contracting by 7.5%. The contraction also accentuated from July to August. Domestic corporate goods price yearly growth also underperformed, coming in at 2.9%. However both export and import growth outperformed expectations, coming in at 18.1% and 15.2% respectively. Additionally the merchandise trade balance in August also outperformed, coming in at 113.6 Billion yen. The Bank of Japan decided to leave their policy rate unchanged at -0.1% on Wednesday on an 8 to 1 vote, with dissenter Goshi Kataoka presenting an even more dovish slant. The BoJ highlighted that the economy continues to expand moderately, and that inflation should continue to slowly grind higher. Overall we are more bearish on the ability of the BoJ to spur inflation without a meaningful depreciation in the yen. Continue to long USD/JPY. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Fade North Korea, And Sell The Yen - August 11, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has surprised to the upside: Retail sales growth and retail sales ex-fuel growth outperformed expectations coming in at 2.4% and 2.8% respectively. Manufacturing production yearly growth came in at 2.9%, also outperforming expectations. Furthermore the ILO unemployment rate came in at 4.3%, outperforming expectations. The BoE left rates unchanged in their latest interest rate decision by a majority of 7 to 2. The BoE was more hawkish than expected, commenting that monetary policy could need to be "tightened by a somewhat greater extent over the forecast period than current market expectations". Overall we continue to be positive on the pound relatively to the euro. However on a longer term basis, the outlook for the pound remains tricky, as Brexit could result in a lower neutral rate in the U.K., and thus a lower pound. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 AUD fell sharply following RBA Governor Philip Lowe's speech. Lowe stated that "a rise in global interest rates has no automatic implications for us here in Australia", prompting a repricing of Aussie rates. The high level of household debt was also brought to light, with Governor Lowe highlighting that "household spending could be quite sensitive to increases in interest rates, something the Reserve Bank will be paying close attention to." He also surmised that "there are risks on the horizon, with the Chinese economy going through some difficult adjustments". This speech largely confirms are bearish view on the Australian dollar. While the AUD did rally this summer, this was mostly due to disappointing U.S. inflation. When inflation re-emerges, which we believe will be in early 2018, the AUD could give up most of its gains. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been positive: Electronic card retail sales yearly growth increased to 4.4% from 2% the month before. Gross Domestic product yearly growth came at 2.5%, in line with expectations. Meanwhile the current account outperformed to the upside, coming in at a deficit of 2.8% of GDP, compared to expectations of 3%. Finally the Business NZ PMI came in at 57.9, increasing significantly from last month's reading of 55.4. The kiwi has appreciated in the past 2 weeks, as a weak dollar coupled with positive data in New Zealand and falling political risk in that country have helped the currency. At the present, we are bearish on AUD/NZD, as the inflationary backdrop continues to be more positive in New Zealand than in Australia. Meanwhile iron ore prices seem to have peaked. These factors should weigh on this cross. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The Canadian consumer sector remains strong, with wholesale sales increasing at a 1.5% monthly pace in July, beating the expected 0.9% contraction. Higher rates are also increasing portfolio inflows, as foreign portfolio investment in Canadian securities jumped to CAD 23.95 bn in July, from the previous outflow of CAD 0.86 bn, also larger than the expected CAD 4.46 bn. While the CAD depreciated against the USD following the Fed's monetary policy meeting, it remained largely flat against other G10 currencies. The CAD will continue to fight headwinds against the USD but to rally on its crosses. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: Producer price inflation came in at 0.6%, beating expectations. The trade balance came in at 2.713 billion CHF for the month of August, underperforming expectations. A week ago the SNB left rates unchanged as expected. Most importantly, there was a slight upward revision in the inflation forecast, with the SNB anticipating an inflation rate of 0.4% in 2018 and 1.1% in 2019 compared to the previous forecast of 0.3% and 1%. These forecast assume a 3-month LIBOR of -0.75% through the forecast period. Moreover, the central bank also expects the modest recovery in Switzerland to continue. However, it seems that the floor under EUR/CHF will stay for the time being, as the SNB said that the Swiss Franc continues to be "highly valued" and that that continued intervention in the FX market will continue to be necessary. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Despite a rebound in Norway's economic surprise index, Norway continues to experience a marked lack of inflation: Headline inflation came in at 1.3%, decreasing from last month's reading of 1.5% and underperforming expectations. Core inflation also underperformed expectations, falling from 1.2% last month to 0.9% in the latest data point. Yesterday the Norges Bank decided to keep rates unchanged at 0.5%. The bank released a statement highlighting that capacity utilization is "on the rise, and higher than previously assumed", however they also highlighted that "wage growth will remain moderate". More importantly they signaled that they would likely increase rates somewhat earlier than previously expected. Overall we continue to be bullish on USD/NOK, as interest rate expectations should help the dollar against the krone. That being said, higher oil prices should help the krone outperform its commodity peers and the euro. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 USD/SEK has remained flat for a month, as markets are assessing the situation between the two hawkish central banks. Data in Sweden has disappointed recently: Manufacturing PMI went down to 54.7 from 60.4; The current account decreased by SEK 39.5 bn; Industrial production also grew by 5.3% annually, lower than the previous 8.9% figure; New orders are also growing by less than before at 2.1%; Inflation also underperformed the expected 2.2%, coming in at 2.1%; However, the unemployment rate dropped significantly from 6.6% to 6%. While inflation disappointed, it still remains in the target range and the upward trend is still intact. The Swedish economy is performing very well, and the Riksbank is likely to join the Fed and the BoC in hiking rates next year. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Trades & Forecasts Forecast Summary Core Portfolio Closed Trades

Highlights Portfolio Strategy The S&P hotels, resorts and cruise lines index will suffer from a profit margin squeeze, which should weigh on valuations. Cut exposure to underweight. A cyclical capex recovery is a boon for software outlays and coupled with reviving animal spirits, signal that it no longer pays to underweight the S&P software index. Augment positions to a benchmark allocation. Recent Changes Downgrade the defensive/cyclical portfolio bias to neutral. Downgrade the S&P hotels, resorts and cruise lines index to underweight today. Lift the S&P software index to neutral. Table 1 Feature Chart 1Weak Dollar Positive Contributor##br## To EPS Growth Equities broke out in a bullish fashion last week, as geopolitical fears subsided and the backlash from hurricane Irma was less severe than initially feared. Beneath the surface, non-inflationary synchronized global growth remains the dominant macro theme. While the latest U.S. CPI print was better than anticipated the Fed would have to see a couple more perky inflation reports before an uptrend is established, cementing the December hike. Until then, the path of least resistance is higher for equities. In our last Weekly Report, we noted that our four-factor S&P 500 operating EPS model has recently accelerated.1 This week, Chart 1 isolates the U.S. dollar as the sole regression variable on SPX earnings and the fitted value suggests that profits will likely surprise to the upside in the back half of the year despite difficult comparisons. Importantly, as we posited earlier this summer, irrespective of where the trade-weighted U.S. dollar ends the year, delayed FX translation effects will act as a tonic for S&P 500 profits. Since late-December's peak, the broad trade-weighted dollar has deflated by 9%. Regression analysis shows that a 1% fall in the U.S. dollar boosts operating EPS by 0.98%, with our dataset going back to the early 1970s. If, however, we narrow the interval of estimation starting in 1994 when NAFTA come into effect then the greenback's sensitivity on SPX EPS increases to 1.6%. While every cycle is different, a fresh all-time high in quarterly EPS - driven by a weak dollar - would not surprise us in Q3 and Q4. At some point, the deflating currency should show up in selling price inflation, again as a lagged effect (middle panel, Chart 2). This is encouraging for our firming operating leverage thesis, as a modest inflationary backdrop would reinforce top line growth (bottom panel, Chart 2). The implication of a sustainable revenue growth outlook is a profit margin-led flow through to EPS, especially for high fixed cost businesses. Already, sell side analysts' overall S&P 500 net earnings revisions are benefitting from the U.S. dollar's decline, and so is sector EPS breadth (trade-weighted dollar shown inverted, Chart 3). Chart 2Will The Dollar's Fall Show Up In Inflation? Chart 3EPS Breadth Improvement Moreover, U.S. dollar-based liquidity (defined as the sum of the Fed's balance sheet and foreign central bank U.S. Treasury holdings) has finally arrested its fall and has recently ticked higher above the zero line. This even mild increase in U.S. dollar-based liquidity represents a de facto easing in global monetary conditions, and historically has been synonymous with S&P 500 EPS acceleration (Chart 4). The upshot is that profits are on a solid upward trajectory. Chart 4Dollar Based Liquidity Also On The Rise The equity market's sensitivity to the greenback has been increasing as the percentage of foreign sourced earnings has been rising over the decades. Globally-exposed goods-producers are in the driver's seat. This raises the question: what to do with our long held preference for defensives versus cyclicals? We are taking our cue from the U.S. dollar-induced shifting macro backdrop, and locking in gains of 11% since the mid-2014 inception in our defensive over cyclical sector tilt, and moving to the sidelines. As a reminder, since the beginning of the spring we have been tweaking our portfolio adding cyclical exposure and, at the margin, removing defensive protection.2 Thus, a defensive over cyclical sector preference is no longer in place. Synchronized global growth, reviving emerging markets, a stable China, and a deflating U.S. dollar are all giving us confidence that it no longer pays to play defense (Chart 5). Finally, following a sling shot recovery, relative valuations are on a more even keel, as is our relative Technical Indicator which is hovering in the neutral zone (Chart 6). Chart 5Book Gains And Move##br## To Neutral Chart 6Valuations And Technicals##br## In The Neutral Zone This week we are making an early cyclical downshift and deep cyclical upshift to our portfolio. Hotels Update: Check Out Time This year has been a good one to be overweight the S&P hotels, resorts and cruise lines index which has outperformed the S&P 500 by a wide margin. However, earnings expectations have moved broadly in line with the market in 2017, meaning that the index's outperformance has been entirely valuation multiple driven. Normalizing earnings to smooth out profit volatility reveals a more severe picture with valuation multiples at decade highs, above the historical mean and at a 40% premium to the broad market (Chart 7). The index's strength has been most pronounced since the beginning of the summer and, unsurprisingly given the cyclical rotation into highly discretionary stocks, has been exclusive to the cruise line operator segment of the index. The two relevant stocks (RCL and CCL) now represent nearly half of the S&P hotels, resorts and cruise lines index's market capitalization. Cruise line operators' margins have climbed to 10-year highs (top panel, Chart 8), justifying soaring stock prices. Profit gains have come on the back of healthy unit revenue as unit costs have remained mostly unchanged (third panel, Chart 8). Chart 7Very Expensive Beneath The Surface Chart 8Cruise Lines Leading The Pack Cruise line occupancy rates corroborate this firm demand backdrop. They have risen in line with margin gains (second panel, Chart 8), a result of improving passenger growth and constrained capacity (bottom panel, Chart 8). This has been the industry's largest margin lever, i.e.: incremental passengers per room come with much higher incremental margin. As cruise lines cannot increase their occupancy ad infinitum (occupancy rates above 100% already imply more than two occupants of a double-occupancy berth), further margin gains of this magnitude seem doubtful. In fact, if cruise operators are to continue growing profits, a capacity growth cycle will eventually have to begin anew, meaning margin contraction rather than expansion. Thus, extrapolating profit growth far into the future is fraught with danger, warning that sky-high valuation multiples are vulnerable to even a modest de-rating. The outlook is even less bright for hotels, an industry that has been losing its share of the consumer's wallet for some time (Chart 9, second panel). Specifically, the low/non-corporate end of the market seems increasingly exposed to competition from Airbnb and other room share competitors; cutthroat competition is pricing power negative with industry selling prices sinking into outright deflation (Chart 9, third panel). Hoteliers are trying to compensate for low prices with huge capacity additions, adding a sense of permanence to recent pricing power declines. However, just as pricing has fallen, the accommodation related employment cost index has gone vertical (bottom panel, Chart 9). The implication of soft pricing power and a rising wage bill is a profit letdown. Our newly introduced S&P hotels, resorts and cruise lines EPS model (comprising the U.S. dollar, employment, PCE and confidence measures) does an excellent job encompassing all these moving parts and confirms our bearish industry profit stance. In fact, it is pointing to significant relative declines vis-à-vis the S&P 500 (Chart 10). Chart 9Mind The Deflationary Impulse Chart 10EPS Model Says Rush For The Exits Putting it together, shrinking margins and increased capital deployment mean lower return on capital and hence lower valuation multiples. This implies that the index's relative gains are in the past. Bottom Line: Take some chips off the table and reduce exposure to underweight in the S&P hotels, resorts and cruise lines index. The ticker symbols for the stocks in this index are: BLBG: S5HOTL - MAR, CCL, RCL, HLT, WYN. Software: A Capex Upcycle Winner? Software stock relative performance has returned to its long-term uptrend, but remains far from the two standard deviations above-the-mean peak reached during the tech bubble (top panel, Chart 11). The structural pull from the proliferation of cloud computing and software-as-a-service has served as a catalyst to raise the profile of this more defensive and mature tech sub-sector. Traditional hardware tech sectors, like communications equipment, are also suffering from the "virtualization" threat as software is making inroads into hardware and blurring the lines between the two. Beyond this constructive backdrop, cyclical forces are also painting a brighter picture for software equities. Importantly, there is tentative evidence that a fresh capex upcycle has commenced (see Chart 3 from last Monday's Weekly Report 3), and if software commands a larger slice of the overall spending pie, industry profits should enjoy a healthy rebound (second panel, Chart 11). Small business sector plans to expand have returned to a level last seen prior to the Great Recession, underscoring that software related outlays will likely follow them higher. Recovering bank loan growth is also corroborating this upbeat spending message: capital outlays on software are poised to accelerate based on rebounding bank loans. The latter signals that businesses are beginning to loosen their purse strings anew (third & fourth panels, Chart 11). Reviving animal spirits also suggest that demand for software upgrades will stay elevated. CEO confidence is pushing decade highs. Such ebullience is positive for a pickup in software investments (second panel, Chart 12). It has also rekindled software M&A activity, with the number of industry deals jumping in recent months (bottom panel, Chart 13). Chart 11Back To Trend Chart 12Capex Upcycle... Chart 13... And Reviving Animal Spirits Are Key Drivers Supply reduction presents a bullish backdrop for software selling prices that have exited deflation at a time when overall corporate sector inflation is decelerating. The upshot is that revenue growth will likely reaccelerate (middle panel, Chart 14). But before getting too carried away, there is some cause for concern. The S&P software index is priced to perfection fully reflecting most, if not all, of the positive drivers (bottom panel, Chart 14), warning that any sales/profit mishaps will likely knock relative performance over. Moreover, productivity dynamics are waving a yellow flag. Business sector productivity growth troughed in early 2017. Historically, this output per hour worked metric has been inversely correlated with software outlays (productivity shown inverted, third panel Chart 15). Importantly, even shown as a deviation from the long-term trend, productivity gains have troughed, suggesting that relative profit growth will likely remain muted (productivity shown inverted, bottom panel Chart 15). Keep in mind that, historically, software spending has been countercyclical (second panel, Chart 15) and given that we are not at the end of the line yet, relative outlays on software may not rebound to the same extent as our other aforementioned indicators suggest. Chart 14Impressive Pricing Power, ##br##But Fully Priced Chart 15Productivity Dynamics##br## Are A Sizable Offset Adding it up, enticing structural software forces aside, a cyclical capex recovery is a boon for software outlays and, coupled with reviving animal spirits, signal that it no longer pays to underweight this tech sub-sector. Bottom Line: The S&P software index does not deserve an underweight. Lift exposure to a benchmark allocation. The ticker symbols for the stocks in this index are: BLBG: S5SOFT - MSFT, ORCL, ADBE, CRM, ATVI, EA, INTU, ADSK, SYMC, RHT, SNPS, CTXS, ANSS, CA. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see Chart 5 of the U.S. Equity Strategy Report titled "Still Goldilocks", on September 11, 2017, available at uses.bcaresearch.com. 2 Please see the August 14, 2017 U.S. Equity Strategy Report titled "Three Risks" for a quick recap of most of our portfolio moves, available at uses.bcaresearch.com. 3 Please see the September 11, 2017 U.S. Equity Strategy Report titled "Still Goldilocks", available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Special Report

Feature Valuations, whether for currencies, equities, or bonds, are always at the top of the list of the determinants of any asset's long-term performance. This means that after large FX moves like those experienced this year, it is always useful to pause and reflect on where currency valuations stand. In this context, this week we update our set of long-term valuation models for currencies that we introduced in February 2016 in a Special Report titled, "Assessing Fair Value In FX Markets". Included in these models are variables such as productivity differentials, terms-of-trade shocks, net international investment positions, real rate differentials and proxies for global risk aversion.1 The models cover 22 currencies, incorporating both G10 and EM FX markets. Twice a year, we provide clients with a comprehensive update on all of these long-term models in one stop. These models are not designed to generate short- or intermediate-term forecasts. Instead, they reflect the economic drivers of a currency's equilibrium. Their purpose is therefore threefold. First, they provide guideposts to judge whether we are at the end, beginning, or middle of a long-term currency cycle. Second, by providing strong directional signals, the models help us judge whether any given move is more likely be a countertrend development or not, offering insight on potential longevity. Finally, they assist us and our clients in cutting through the fog and understanding the key drivers of cyclical variations in a currency's value. The U.S. Dollar Chart 1The Dollar's Overvaluation Is Gone After its large 7.5% fall in trade-weighted terms since the end of 2016, the real effective dollar is now trading at a 2% discount vis-à-vis its fair value based on its principal long-term drivers - real yield differentials and relative productivity between the U.S. and its trading partners (Chart 1). The U.S. dollar's equilibrium - despite having been re-estimated higher earlier this year due to upward revisions by the Conference Board to its U.S. productivity series - has flattened as of late, as real rate differentials between the U.S. and the rest of the world have declined. While 2017 has been an execrable year for dollar bulls, glimmers of hope remain. First, the handicap created by expensive valuations has been purged. Second, the excessive bullishness toward the greenback that prevailed earlier this year has morphed into deep pessimism. Third, U.S. real interest rates have fallen as investor doubts that the Federal Reserve will be able to increase interest rates as much as it wants to in the face of paltry inflation have surged. However, the U.S. economy is strong and at full capacity, suggesting that inflation will hook back up at the end of 2017 and in the first half of 2018. This should once again lift the U.S. interest rate curve, the dollar's fair value, and the dollar itself. That being said, this story is unlikely to become fully relevant over the next three months. The Euro Chart 2The Euro's Fair Value Is Now Rising On a multi-year time horizon, the euro is driven by the relative productivity trend of the euro area with its trading partners, its net international investment position, terms-of-trade shocks and rate differentials. Thanks to its powerful rally this year, the euro's discount to its fair value has narrowed from 7% in February to 6% today (Chart 2). This narrowing is not as great as the rally in the trade-weighted euro itself as its fair value has also improved, mainly thanks to continued improvement in the euro area's net international position - a development driven by the euro zone's current account of 3% of GDP. Nonetheless, the EUR's current discount to fair value is still not in line with previous bottoms, such as those experienced in both early 1985 or in 2002. We do expect a new wave of weakness in the EUR to materialize toward the end of the year and in early 2018 as markets once again move to discount much more aggressive tightening by the Fed than what will be executed by the European Central Bank: U.S. inflation is set to move back towards the Fed's target, but European inflation will remain hampered by the large amount of labor market slack still prevalent in the European periphery. What's more, euro area inflation is about to suffer from the lagged effects of the tightening in financial conditions that have been created by a higher euro. However, the fact that the euro's fair value has increased implies it is now very unlikely for the EUR/USD to hit parity this cycle. The Yen Chart 3The Yen Is Very Cheap, But It May Not Count For Much The yen's long-term equilibrium is a function of Japan's net international investment position, global risk aversion, and commodity prices. The JPY discount to this fair value has deepened this year, despite the fall in USD/JPY from 118 to 108 (Chart 3). This is mainly because the euro and EM as well as commodity currencies have all appreciated against the Japanese currency. Low domestic inflation has been an additional factor that has depressed the Japanese real effective exchange rate. While valuations point to a higher yen in the coming year, this will be difficult to achieve. The Bank of Japan remains committed to boosting Japanese inflation expectations. To generate such a shock to expectations, the BoJ will have to keep policy at massively accommodative levels for an extended period. As global growth remains robust, global bond yields should experience some upside over the next 12 months. With JGB yields capped by the Japanese central bank, this will create downside for the yen. However, because the yen is so cheap, it is likely to occasionally rally furiously each time a risk-off event, such as any additional North Korean provocations, puts temporary downward pressure on global yields. The British Pound Chart 4The Pound Is Attractive On A Long-Term Basis The pound has fallen 6% against the euro this year, the currency of its largest trading partner. This has dragged down the GBP's real effective exchange rate to a large 11% discount to its fair value, the largest since the direct aftermath of the Brexit vote (Chart 4). Because Great Britain has entered a paradigm shift - the exit from the European Union will change the nature of the U.K. relationship on 43% of its trade - assessing where the pound's fair value lies is a more nebulous exercise than normal. However, signs are present that the pound is indeed cheap. British inflation remains perky, the current account has narrowed to 4% of GDP, and despite large regulatory uncertainty, net FDI into the U.K. has hit near record highs of 7% of GDP. Movements in cable are likely to remain a function of the gyrations in the U.S. dollar. However, at this level of valuation, the pound is attractive against the euro on a long-term basis. We had a target on EUR/GBP at 0.93, which was hit two weeks ago. This cross is likely to experience downside for the next 12 months. The biggest risk for the pound remains British politics - and not Brexit itself but its aftershock. The EU has made clear the transition process will be long, leaving time for the British economy to adjust. However, the conservative party has been greatly weakened, and Jeremy Corbyn's popularity is increasing. This raises the specter that, in the not-so-distant future, a Labour government could be formed. Under Corbyn's leadership, this would be the most left-of-center administration in any G10 country since François Mitterrand became French president in 1981. The early years of the Mitterrand presidency were marked by a sharp decline in the franc as he nationalized broad swaths of the French private sector, increased taxes and implemented inflationary policies. Keep this in mind. The Canadian Dollar Chart 5The CAD Has Lost Its Valuation Advantage The loonie's fair value is driven by commodity prices, relative productivity trends, and the Canadian net international position. In February, the CAD was trading in line with its fair value. However, after its blistering rally since May, when the Bank of Canada began to hint that policy could be tightened this year, the Canadian dollar is now expensive vis-à-vis its long-term fundamental drivers (Chart 5). In a Special Report two months ago, we argued that the BoC was one of the major global central banks best placed to increase interest rates.2 With the Canadian economy firing on all cylinders, and with the output gap closing faster than the BoC anticipated in its July Monetary Policy Statement, the two interest rate hikes recorded this year so far make sense, and another one is likely to materialize in December. However, while the CAD could continue to rise until then, traders have moved from being massively short the CAD to now holding very sizeable net long positions. Additionally, interest rate markets are now discounting more than two hikes in Canada over the next 12 months, while expecting less than one full hike in the U.S. over the same time frame. If this scenario were to pan out, the tightening in monetary conditions emanating from a massive CAD rally would likely choke the Canadian recovery. Instead, we expect U.S. rates to increase more than what is currently embedded in interest rate markets, thus limiting the downside in USD/CAD. We prefer to continue betting on a rising loonie over the next 12 months by buying it against the euro and the Australian dollar. The Australian Dollar Chart 6The AUD Is Very Expensive The fair value of the Aussie is driven by Australia's net international position and commodity prices. Even with the tailwind of stronger metal prices, the AUD's rallies have been beyond what fundamentals justify, leaving it at massively overvalued levels (Chart 6). This suggests the AUD is at great risk of poor performance over the next 24 months. Timing the beginning of this decline is trickier, and valuations offer limited insight. One of the key factors that has supported the AUD has been the large increase in fiscal and public infrastructure spending in China this year - a move by Beijing most likely designed to support the economy in preparation for the 19th National Congress of the Communist Party of China, where the new members of the Politburo are designated. As this event will soon move into the rearview mirror, China may abandon its aggressive support of the industrial and construction sectors - two key consumers of Australia's exports. The other tailwind behind the AUD has been the very supportive global liquidity backdrop. Global reserves growth has increased, dollar-based liquidity has expanded and generalized risk-taking in global financial markets has generated large inflows into EM and commodity plays.3 While U.S. inflation remains low and investors continue to price in a shy Fed, these conditions are likely to stay in place. However, a pick-up in U.S. inflation at the end of the year is likely to force a violent re-pricing of U.S. interest rates and drain much of the global excess liquidity, especially as the Fed will also be shrinking its balance sheet. This is likely to be when the AUD's stretched valuations become a binding constraint. The New Zealand Dollar Chart 7No More Premium In The NZD Natural resources prices, real rate differentials and the VIX are the key determinants of the kiwi's fair value, highlighting the NZD's nature as both a commodity currency and a carry currency. Both the fall in the VIX and the rebound in commodities prices are currently causing gradual appreciation in the New Zealand's dollar equilibrium exchange rate. However, despite these improving fundamentals, the real trade-weighted NZD has fallen this year, and now trades in line with its fair value (Chart 7). Explaining this performance, the NZD began 2017 at very expensive levels, even when compared to the already-pricey AUD. Also, despite a very strong New Zealand economy, the Reserve Bank Of New Zealand has disappointed investors by refraining from increasing interest rates, as the expensive currency has tightened monetary conditions on its behalf. Going forward, the recent weakness in the real effective NZD represents a considerable easing of policy, which could warrant higher rates in New Zealand. As a result, while a tightening of global liquidity conditions could hurt the NZD in addition to the AUD, the kiwi is likely to fare better than the much more expensive Aussie, pointing to an attractive shorting opportunity in AUD/NZD over the next 12 months. The Swiss Franc Chart 8The CHF Is Cheap, The SNB Is Happy Switzerland's enormous and growing net international investment position continues to be the most important factor lifting the fair value of the Swiss franc. The recent sharp rally in EUR/CHF has now pushed the Swissie into decisively cheap territory (Chart 8). The decline in political risk in the euro area along with the lagging economic and inflation performance of the Swiss economy fully justify the discount currently experienced by the Swiss franc: money has flown out of Switzerland, and the Swiss National Bank is doing its utmost to keep monetary policy as easy as it can. For a small open economy like Switzerland, this means keeping the exchange rate at very stimulative levels. The continued growth in the SNB's balance sheet is a testament to the strength of its will. For the time being, there is very little reason to bet against SNB policy; the CHF will remain cheap because the economy needs it. However, this peg contains the seeds of its own demise. The cheaper the CHF gets, the larger the economic distortions in the Swiss economy become. Already, Switzerland sports the most negative interest rates in the world. This directly reflects the large injections of liquidity required from the SNB to keep the CHF down. These low real rates are fueling bubble-like conditions in Switzerland real estate and are threatening the achievability of return targets for Swiss pension plans and insurance companies, forcing dangerous risk-taking. But until core inflation and wage growth can move and stabilize above 1%, these conditions will stay in place. The Swedish Krona Chart 9The Swedish Krona Has More Upside Even after its recent rebound, the Swedish krona continues to trade cheaply, even if its long-term fair value remains on a secular downward trajectory (Chart 9). Yet the undemanding valuations of the SEK hide a complex picture. It is approximately fairly valued against the GBP and expensive against the NOK, two of its largest trading partners. However, the SEK is cheap against the USD and the euro. We expect the SEK to continue appreciating. While Swedish PMIs have recently softened, the Swedish economy is running well above capacity, and the Riksbank resources utilization indicator suggests the recent surge in inflation has further to run. Moreover, Sweden is in the thralls of a dangerous real-estate bubble that has pushed nonfinancial private-sector debt above 228% of GDP. With many amortization periods on new mortgages now running above 100 years, the Swedish central bank is concerned that further inflating this bubble could result in a milder replay of the debt crisis experienced in the early 1990s. The shift in leadership at the Riksbank's helm at the beginning of 2018 is likely to be the key factor that prompts the beginning of the removal of policy accommodation in that country. We like buying the krona against the euro. The USD/SEK tends to be a high-beta play on the greenback, and thus is very much a call on the USD. However, EUR/SEK displays a much lower correlation, and thus tends to be a more effective medium to isolate the upcoming tightening in monetary policy we expect from the Riksbank. The Norwegian Krone Chart 10The NOK is The Cheapest Commodity Currency The Norwegian krone remains the cheapest commodity currency in the world, along with the Colombian peso (Chart 10). The slowdown in Norwegian inflation and a very negative output gap of 2% of GDP implies that the Norges Bank will remain one of the most accommodative central banks in the G10. Thus, the NOK should remain cheap. However, we continue to like buying the krone against the euro. EUR/NOK has only traded above current levels when Brent prices have been below US$40/bbl. Not only is Brent currently trading above US$50/bbl, but the outlook for oil remains bright: production is in control as the agreement between Russian and OPEC is still in place. Additionally, the recent carnage and refinery shutdowns caused by hurricane Harvey should result in large drawdowns to finished-products inventories in the coming months. This will contribute to an anticipated normalization in global excess petroleum inventories, which have been the most important headwind to oil prices. Finally, the fact that the Brent curve is now backwardated also represents a support for oil prices, as this creates a "positive carry" for oil investors. The Yuan Chart 11The Yuan Can Rise On A Trade-Weighed Basis Despite the recent strength in both the trade-weighted RMB and the yuan versus the U.S. dollar, the renminbi still trades at a discount to its long-term fair value (Chart 11). Confirming this insight, China continues to sport a sizeable current account surplus, and its share of global exports is still on an expanding path. With the RMB being cheap, now that China is once again accumulating reserves instead of spending them to create a floor under its currency, the downside risk to the CNY has decreased significantly. Thus, since the People's Bank of China targets a basket of currencies when setting the yuan's value, to legitimize any bullish view on USD/CNY one needs to have a bullish view on the USD. While we do anticipate the dollar to rally toward the end of the year, our expectation that it will remain flat until then implies that we do not see much upside for now to USD/CNY. However, our bullish medium-term USD view, along with the cheapness of the CNY, suggests that the RMB could continue to appreciate on a trade-weighted basis going forward. While Chinese policymakers have highlighted their desire to make their currency a more countercyclical tool, the recent stability in Chinese inflation implies there is no need to let the CNY depreciate to reflate China. In fact, at this point, elevated PPI readings would argue that the Chinese authorities do have a built-in incentive to let the CNY appreciate on a trade-weighted basis for the coming six to 12 months. The Brazilian Real Chart 12The BRL is Vulnerable To A Pullback In Global Liquidity Hampered by poor productivity trends, which weigh on the Brazilian current account balance, the fair value of the real remains quite depressed, even as commodity prices have sharply rebounded since early 2016. In fact, the violent rally in the BRL over the same timeframe has made it one of the most expensive currencies tracked by our models (Chart 12). This level of overvaluation points to poor returns for the BRL on a one-to-two-year basis, however, it gives no clue to timing. The strong sensitivity of the Brazilian real to EM asset prices implies that the BRL is unlikely to weaken significantly so long as EM bonds remain well-bid. Moreover, because the BRL still offers an elevated carry, until U.S. interest rate expectations turn the corner, U.S. market dynamics will continue to put a floor under the real. However, this combination suggests the BRL could become one of the prime casualties of any rebound in U.S. inflation. Such a development would cause global liquidity to fall, hurting EM bonds in the process and making the BRL's high-risk carry much less attractive. Confirming this danger, the fact that the USD/BRL has not been able to breakdown for more than a year despite the weakness in the USD suggests momentum under the BRL is rather weak. The Mexican Peso Chart 13Mexican Peso: From Bargain To Luxury In the direct aftermath of Trump's electoral victory, the Mexican peso quickly became one of the cheapest currencies in the world. However, the peso's 25% rally versus the U.S. dollar since January has eradicated this valuation advantage to the point where it is now one of the most expensive major currencies in the world (Chart 13). As the peso was collapsing through 2016, the Mexican central bank fought back, increasing interest rates. The massive surge in the prime lending rate points to a protracted period of weakness in the growth of nonfinancial private credit, which should weigh on consumption and investment. Actually, the growth in retail sales volumes has already begun to weaken. This could force the Banxico to cut rates, especially as inflation will slow in the face of peso's rebound this year. Lower Mexican rates, in the face of stretched long positioning in MXN by speculators, could be the key to generating a weakening in the peso over the next 12 months. To see real fireworks in the peso, one would need to see a resumption in the U.S. dollar bull market. Mexico has external debt equivalent to 66% of GDP, the highest among large EM nations. This makes the Mexican economy especially vulnerable to a strong dollar, as such a move would imply a massive increase in debt servicing costs. Thus, while the MXN may not be as vulnerable as the BRL, it could still suffer greatly if global liquidity becomes less generous next year. The Chilean Peso Chart 14CLP Needs HIgh Copper Prices The Chilean peso real effective exchange rate is driven by the country's productivity trend relative to its trading partners and the real price of copper - which proxies Chilean terms-of-trade. Thanks to the CLP's rally since the winter of 2015, the real peso is at a four-year high and is now in expensive territory (Chart 14). We expect copper to see downside from now until the end of the year, pulling down the CLP with it. Current dynamics in the Chinese real estate market and the Chinese credit cycle, which tend to be leading indicators of industrial metals prices, point to an upcoming selloff. Moreover, Chinese monetary conditions have begun to tighten, and are set to continue doing so. This will weigh on Chinese credit growth and capex, creating headwinds for copper and the peso. That being said, the CLP will likely outperform the BRL and the ZAR. M1 money growth is back in positive territory after contracting last year, while industrial activity seems to have hit a bottom and is now picking up. Moreover, since Chile's economy does not have the credit excesses of its other EM peers, we expect the CLP to show more resilience than other currencies linked to industrial metals. The Colombian Peso Chart 15COP: A Rare Bargain Among EM The real COP's fair value is driven by Colombia's relative productivity trends and the price of oil, the country's main export. The fall in oil prices since the beginning of the year have caused a small decline in the fair value of the COP. Nevertheless, the peso is still one standard deviation below fair value (Chart 15). This partly reflects the premium demanded by investors to compensate for Colombia's large current account deficit of 6.3% of GDP. Overall the COP looks attractive, particularly against other commodity currencies. Historically a discount of 20% or more, like what the peso has today, marks a bottom in the real effective exchange rate. Furthermore, our Commodity and Energy Strategy Service expects Brent prices to climb to US$60/bbl towards the end of year, as OPEC's and Russia's production controls translate into oil inventory drawdowns. This should further increase the value of the COP against the ZAR and the BRL. Domestic dynamics also point to outperformance of the peso against other EM currencies. As opposed to countries like Brazil, where private debt stands at nearly 85% of GDP, Colombia has a more modest 60% leverage ratio - the byproduct of an orthodox banking system. Thus, the peso should be able to withstand a liquidity drawdown in EM better than its peers. The South African Rand Chart 16Lack Of Productivity And Politics Are The Greatest Risk To The Rand South Africa's dismal productivity trend continues to be the greatest factor pulling the rand's long-term fair value lower. Due to this adverse trend, while the ZAR has been broadly stable this year, it is now slightly more expensive than it was in February (Chart 16). Not captured by the model, the political risks in South Africa remain elevated, creating a further handicap for the rand. The story behind the ZAR is very similar to the one underpinning the gyrations in the BRL. Both currencies, thanks to their elevated carries and deep liquidity - at least by EM currency standards - will continue to be buoyed by very generous global liquidity conditions. However, global real rates seem dangerously low and could move sharply higher, especially when U.S. inflation picks up at the end of the year and in early 2018. Such a move would cause the currently very supportive reflationary conditions to dissipate. This would put the expensive ZAR in a very precarious position. An additional danger for the ZAR is the price of gold. Gold and precious metals have also benefited from these generous global liquidity conditions. This has helped the South African terms of trade. However, gold is likely to be a key victim if U.S. interest rates rise because it is negatively correlated with both real interest rates and the U.S. dollar. Thus, while we do not see much upside for the expensive ZAR for the time being, it is likely to suffer greatly once U.S. inflation turns around, suggesting the ZAR possesses a very poor risk/reward ratio. The Russian Ruble Chart 17The Ruble Is Expensive But Russia Has The Best EM Fundamentals The RUB is currently trading at a very large premium to fair value (Chart 17). The risk created by such an overvaluation is only likely to materialize once U.S. inflation turns the corner and U.S. interest rates pick up - a scenario we've mentioned for late 2017 and early 2018. This risk is most pronounced against DM currencies, the U.S. dollar in particular. The RUB remains one of our favorite currencies within the EM space, especially when compared to other EM commodity producers. The Russian central bank is pursuing very orthodox policy, despite the fall in realized inflation, and is maintaining very elevated real interest rates in order to fully tame inflation expectations. Moreover, oil prices are likely to experience upside in the coming months as oil inventories are drawn down. This could result in an increase in the ruble's equilibrium exchange rate, which would help correct some of the RUB's overvaluation. The Korean Won Chart 18KRW Is Where You Can Really See The North Korean Tensions The fair value of the Korean won continues to be lifted by the combined effect of lower Asian bond spreads and Korea's current account surplus. Yet, the KRW is trading at an increasingly large discount to its equilibrium (Chart 18). At first glance, this seems highly surprising as global trade is growing at its fastest pace in six years - a situation that always benefits trading nations like South Korea. Instead, political developments are to blame. Not only is North Korea ramping up its tests of intercontinental ballistic missiles and nuclear devices, but also Seoul is within range of Pyongyang's conventional artillery. BCA's Geopolitical Strategy service does not expect the current standoff to result in military conflict. Ultimately, North Korea is no match for the military might of the U.S. and its allies. Moreover, the capacity for Pyongyang's actions to shock financial markets is exhibiting diminishing returns. This suggests the risk premium imbedded in the won should dissipate. However, the won will remain very exposed to dynamics in the USD, global liquidity and global trade. Instead, a lower-risk way for investors to take advantage of the KRW's cheapness is to buy it against the Singapore dollar. While just as exposed to global liquidity as the won, the SGD is currently trading at a premium to fair value. The Philippine Peso Chart 19The PHP Has Over-Discounted The Fall In The Current Account The fair value of the Philippine peso is driven by the country's net international investment position and commodity prices. After falling 6% this year, the real effective PHP now trades at a 13% discount to its fair value (Chart 19). A deteriorating current account, which is now in deficit, has fueled a selloff in the peso, making the Philippine currency one of the worst performing in the EM space. Worryingly, this has occurred alongside faltering foreign exchange reserves. However, the deficit is mainly the mirror image of large capital inflows, fueled by the government's ambitious infrastructure spending. Remittances are growing again and, with a weaker peso, will support consumer spending going forward. Employment had a setback last year, but is growing again. Higher investment and consumer spending will likely push rates up. As inflation rebounded alongside commodity prices last year, it is now at its 3% target. Bangko Sentral ng Pilipinas will need to rein in inflationary pressures to avoid overheating the economy. While the Philippines economy should expand further, the 'Duterte Discount' remains in place. Negative net portfolio flows reflect negative investor sentiment, as policy uncertainty remains elevated. The Singapore Dollar Chart 20SGD Remains Expensive The fair value of the Singapore dollar is driven by commodity prices. This is because the exchange rate is the main policy tool used by the Monetary Authority of Singapore. As a result, when commodity prices rise, which leads to inflationary pressures, MAS tightens policy by spurring appreciation in the SGD. The opposite holds true when commodity prices weaken. Based on this metric, the SGD is currently 4.2% overvalued (Chart 20). Domestically, dynamics are quite mixed. Retail sales have picked up. However, both manufacturing and construction employment are contracting and labor market slack is increasing, pointing to continued subdued wage growth. Additionally, property prices are contracting and vacancy rates are on the rise, led by the commercial property sector. Thus, the recent pickup in inflation could soon vanish, especially as it has been driven by the rebound in oil prices in 2016. This combination suggests that Singapore still needs easy monetary conditions. USD/SGD closely follows the DXY. While the Fed will be able to increase interest rates by more than the 35 basis points priced over the next 24 months, Singapore still needs a lower exchange rate to maintain competitiveness and alleviate deflationary pressures. The Hong Kong Dollar Chart 21The Fall In The USD Has Helped The HKD The HKD remains quite expensive. However, being pegged to the USD, its valuation premium has decreased this year (Chart 21). The fall in the greenback has driven the HKD - which itself has fallen 0.75% versus the U.S. dollar - lower against the CNY and other EM currencies. If the U.S. dollar does resume its uptrend over the next six months, the valuation improvement in the HKD will once again dissipate. However, this does not spell the end of the HKD peg. With reserves of US$414 billion, or 125% of GDP, the Hong Kong Monetary Authority has the firepower to support the peg, which has been one of the cornerstones of Hong Kong economic stability since 1983. Instead, the HKMA will tolerate deep deflationary pressures that will cause a fall in the real effective exchange rate. This is the path that Hong Kong picked in the 1990s, and it will be the path followed again in the face of any broad-based USD appreciation. This suggests that Hong Kong real estate prices could experience significant downside in the coming years. The Saudi Riyal Chart 22The Riyal Is Still Expensive The Saudi riyal remains prohibitively expensive, even as its valuation premium has decreased this year (Chart 22). The SAR is afflicted by similar dynamics as the HKD: its peg with the USD means the greenback's gyrations are the main source of variation in the SAR's real effective exchange rate on a cyclical basis. However, on a structural horizon, the fair value of the riyal is dominated by Saudi Arabia's poor productivity. An economy dominated by crude extraction and processing and living on one of the most sizable economic rents in the world, Saudi Arabia has not endured the competitive pressures that are often the source of productivity enhancement in most nations. Additionally, Saudi capital expenditures are heavily skewed to the oil sector, a sector whose output growth has been limited for many decades by natural constraints. We do not believe the current valuation premium in the riyal will force the Saudi Arabian Monetary Authority to devalue the SAR versus the USD. Saudi Arabia, like Hong Kong, possesses copious foreign exchange reserves, and growth has improved now that oil prices have rebounded. Additionally, the KSA is also likely to tolerate deflationary pressures. Not only has it done so in the past, but Saudi Arabia imports most of its household products, especially its food needs. A fall in the SAR would cause a large amount of food inflation, representing a massively negative price shock for a very young population. This is a recipe for disaster for the royal family of a country with no democratic outlet. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Haaris Aziz, Research Assistant haarisa@bcaresearch.com Juan Manuel Correa, Research Analyst juanc@bcaresearch.com 1 For a more detailed discussion of the various variables incorporated in the models, please see Foreign Exchange Strategy Special Report, "Assessing Fair Value In FX Markets", dated February 26, 2016, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy and Global Alpha Sector Strategy Special Report, "Who Hikes Next?", dated June 30, 2017, available at fes.bcaresearch.com 3 For a more detailed discussion on the global liquidity environment, please Foreign Exchange Strategy Weekly Report, "Dollar-Bloc Currencies: More Than Just China", dated August 18, 2017, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Closed Trades

Highlights Portfolio Strategy A supply/demand imbalance has created a playable opportunity in the niche refining energy sub-index. Increase exposure to overweight. Safe haven demand is supporting gold mining equities, but shifting macro forces suggest that it will soon be time to move to the sidelines. Global gold miners are now on downgrade alert. Recent Changes Lift the S&P oil & gas refining & marketing index to overweight today. Put the global gold mining equity index (ticker GDX:US) on downgrade alert. Table 1 Feature The S&P 500 moved laterally last week as sustained geopolitical uncertainty offset encouraging economic data. Synchronized global growth coupled with the related global liquidity-to-growth transition remain the dominant macro themes. Dovish Fed speeches triggered a recalibration of market rate hike expectations and a lower 10-year Treasury yield. As long as lower bond yields reflect a less hawkish Fed rather than a deflationary relapse, they should underpin stock prices. Encouragingly, the latest ISM manufacturing survey catapulted higher to a level last seen in early 2011, diverging steeply from the bond market, as manufacturing optimism reigns supreme (Chart 1). The labor market confirmed this data. The most cyclical parts of the U.S. economy are firing on all cylinders, with manufacturing and construction job creation comprising 1/3 of nonfarm payroll growth last month (Chart 2). This is the highest reading since July 2011. Chart 1Unsustainable Divergence Chart 2Manufacturing Flexing Its Muscle Meanwhile, despite the Trump administration's shortcomings, America's CEOs are going against the grain. Capex is up smartly for the second consecutive quarter adding to real GDP growth and our capital spending model remains upbeat heralding additional outlays for the remaining two quarters of the year (Chart 3). Similarly, regional Fed surveys of capex intentions point to a sustainable pickup in capital spending in the coming months (Chart 3). Still generationally low interest rates, a less hawkish sounding Fed, coupled with a tamed greenback (Chart 4) and synchronized global growth have combined to revive animal spirits. The implication is that profit growth rests on solid foundations, a message corroborated by our S&P 500 EPS growth model (Chart 5). Chart 3CapEx To The Rescue Chart 4Dollar... Chart 5...And EPS Model Waving Green Flag Adding it up, the macro backdrop remains favorable for stocks. In fact, it represents a goldilocks equity scenario. This week we continue to add some cyclicality to our portfolio by further boosting a niche energy play. We also update our view on a portfolio hedge. Buy Refiners For A Trade In early July, we lifted refiners to neutral and locked in impressive gains for our portfolio, but three reasons kept us at bay and prevented us from turning outright bullish on this niche energy sub-sector.1 Namely, all-time high refining production, high refined product stocks and breakneck pace refinery runs were offsetting the nascent recovery in gasoline consumption, rising crack spreads and a mini V-shaped recovery in industry shipments. Net, we posited that a balanced EPS outlook would prevail in coming quarters. Hurricane Harvey has significantly changed this calculus and now clearly refiners are in a sweet earnings spot for at least the remainder of the year, compelling us to lift exposure to overweight. Severe refinery shutdowns are likely to return industry production levels to what prevailed early in the decade, representing a major, albeit temporary, setback (Chart 6). This production curtailment will result in sizable petroleum products inventory drawdowns and a likely halt (if not reversal) in refined product net exports in order to satisfy domestic demand. The longer it takes for refinery production to return to normalcy, the greater the inventory whittling down. Historically, relative share price momentum has been inversely correlated with inventory growth and the Harvey-related inventory clear-out is heralding additional relative performance gains (bottom panel, Chart 7). It is notable that both industry net exports and inventories had already been receding since the beginning of 2017, suggesting that hurricane Harvey will only accelerate a downtrend that was already in place. Chart 6Hurricane Related Blues... Chart 7... Are A Boon For Crack Spreads Taken together, this represents an ultra-bullish pricing power backdrop for the U.S. refining industry, at a time when capacity additions are also likely to, at least, pause for breath (bottom panel, Chart 6). Chart 8Brisk Demand Indeed, refining margins have jumped recently and will likely remain elevated as the Brent/WTI spread is widening anew (middle panel, Chart 7). Surging crack spreads are synonymous with higher earnings for this extremely capital-intensive and high operating leverage industry. Nevertheless, the refining supply disruptions only tell half the story. Refined product demand is exploding higher, pushing all-time highs and signaling that a substantial supply/demand imbalance is in the works (top panel, Chart 8). Typically this gets resolved via higher gasoline prices, further boosting industry EPS prospects (third panel, Chart 8). As a result, we expect a re-rating phase in relative valuations in the coming months, reversing the year-to-date deflation in the relative price-to-sales ratio. The second panel of Chart 8 shows that relative valuations and refined product consumption move in lockstep, and the current message is to expect a catch up phase in the former. In sum, a playable rally in refiners is in the offing on the back of a budding profit recovery that has yet to filter through analysts' EPS estimates (bottom panel, Chart 8). The longer-than-usual hurricane Harvey-related refining production disruptions, along with the spike in refined product demand, have created an exploitable opportunity. Bottom Line: Boost the S&P oil & gas refining & marketing index (PSX, VLO, MPC, ANDV) to overweight. What To Do With Gold Mining Equities? Gold and gold mining equities serve as great portfolio hedges especially in times of duress. Recent geopolitical jitters surrounding North Korea along with inaction in Washington and the substantial year-to-date selloff in the U.S. dollar have served as catalysts for gold to shine anew, hitting one-year highs. So is it time to trim exposure to shiny metal equities? The short answer is not yet. Real yields are sinking courtesy of a moderately less hawkish Fed (top panel, Chart 9). The probability of a December Fed hike has now collapsed to 30%, and the 5th hike this cycle is only priced in for next June. This is keeping a bid under gold and gold miners, as zero yielding bullion and near-zero yielding gold mining equities appear at the margin relatively more appealing. The equity risk premium has also stopped falling owing largely to the lower 10-year Treasury yield (bottom panel, Chart 9), representing another source of support for global gold miners. Meanwhile, policy uncertainty in the U.S. and around the globe is hooking up especially given North Korea's unpredictability, Washington's polarization, the upcoming German elections and, most importantly, the looming Chinese Congress. Historically, the policy uncertainty index and relative performance have been joined at the hip and the current message is positive for bullion related stocks (middle panel, Chart 9). Similarly, the Philly Fed's Partisan Conflict Index2 ("The Partisan Conflict Index tracks the degree of political disagreement among U.S. politicians at the federal level by measuring the frequency of newspaper articles reporting disagreement in a given month. Higher index values indicate greater conflict among political parties, Congress, and the President.") and bullion enjoy a tight positive correlation since the early 1980s (Chart 10), likely warning that the precious metal's run has more upside in the short term. Chart 9Shining Chart 10Increase In Partisanship Is Bullish Gold Moreover, demand for safe haven assets remains upbeat as evidenced by recent flows into gold-related ETFs. Positioning in the commodity pits are also signaling that more gains are in store for gold and the relative share price ratio (Chart 11). Nevertheless, there are some pockets of weakness that are pointing to a more cautious stance toward this portfolio hedge. The improving U.S. economic backdrop is weighing on gold mining equities (ISM manufacturing shown inverted, middle panel, Chart 12). Not only U.S. growth, but also synchronized global growth suggests that eventually demand for bullion will subside. In fact, global growth expectations continue to perk up (GDP expectations shown inverted, Chart 12), and G10 economic surprises are also shooting higher, anchoring gold and gold related equities (economic surprise index shown inverted, top panel, Chart 12). Chart 11Safe Haven Demand Comeback Chart 12Not All The Glitters Is Gold Tack on the inevitable liquidity withdrawal once the Fed starts to wind down its balance sheet later this month, and the handoff from liquidity-to-growth represents a bearish backdrop for gold and gold mining equities. Chart 13 shows that the Fed's balance sheet is positively correlated with bullion's relative performance versus the broad commodity complex, warning that the recent push toward multi-decade highs in relative performance are on borrowed time. Finally, our relative EPS model for the global gold mining index encapsulates most of these macro forces and suggests that relative profit growth will gravitate lower in the coming months (Chart 14). Chart 13Watch The Fed's Balance Sheet Chart 14EPS Model Is Outright Bearish Bottom Line: While our confidence in maintaining the gold-related equity portfolio hedge has fallen a notch, we are staying patient before moving to the sidelines. Put the global gold mining index (ticker GDX:US) on downgrade alert. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see the July 10, 2017 U.S. Equity Strategy Report titled "SPX 3,000?", available at uses.bcaresearch.com 2 https://www.philadelphiafed.org/research-and-data/real-time-center/partisan-conflict-index Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.