Business Cycles

Highlights The biggest demand-side risk to base metals this year remains a larger-than-expected China economic slowdown. A managed slowdown appears to be under way, with Beijing giving every appearance of balancing macro-prudential policies in a way that does not severely derail the economy. It goes without saying a loss of control over this process could produce a hard landing in China, with more severe consequences for the economy in general, and base metals in particular. Energy: Overweight. The Kingdom of Saudi Arabia (KSA) and Russia appear to be negotiating a 10- to 20-year deal that would institutionalize OPEC 2.0 as a production-management coalition. This has global significance, which we will be exploring in future research.1 Base Metals: Neutral. Fears of a trade war between the U.S. and China following the announcement of up to $60 billion in tariffs - meant to redress alleged theft of U.S. intellectual property - sent copper prices below $3/lb last week. There are tentative signals this threat is receding; if confirmed, base metals, particularly copper, would rally. Precious Metals: Neutral. Gold prices rallied more than $50/oz over the past week, following the announcement of U.S. tariffs directed at China, only to fall ~ $25/oz by mid-week as trade tensions lessened. We remain long the metal as a portfolio hedge against such risks. Ags/Softs: Underweight. Chinese officials threatened to levy countervailing tariffs against imports of U.S. ags, steel pipes, and scrap aluminum in response to the $60 billion tariff package announced by the U.S. last week. Treasury Secretary Mnuchin attempted to calm rising tensions, with assurances the U.S. and China would reach an agreement that avoids the imposition of tariffs. Feature Once-hot metals markets are at risk of cooling (Chart of the Week). Despite the weak U.S. dollar and relatively strong - albeit more risky - global economic environment, investors have been hesitant to take large bullish positions in metals, largely because of fears of a slowdown in China. This fear is not unfounded, and this week we assess how likely such a slowdown is, and the consequences for metals markets. China accounts for ~ 50% of demand for most metals we cover (Chart 2). Construction, infrastructure, automotive, and manufacturing sectors have an outsized role as end users of metals, and their performance will be especially significant to the demand outlook going forward (Chart 3). Chart of the WeekMetals Markets At Risk Of Cooling Metals Markets At Risk Of Cooling Metals Markets At Risk Of Cooling Chart 2Don't Overlook China China's Managed Slowdown Will Dampen Base Metals Demand China's Managed Slowdown Will Dampen Base Metals Demand Chart 3Keep An Eye On Key Sectors China's Managed Slowdown Will Dampen Base Metals Demand China's Managed Slowdown Will Dampen Base Metals Demand China Intentionally Out Of Sync With Global Business Cycle? Chart 4China's Cycle Peaked Last Year China's Cycle Peaked Last Year China's Cycle Peaked Last Year Analysts generally believe commodities tend to outperform late in the business cycle as economies start to overheat and central banks move to restrain inflation. We believe these dynamics will pan out differently this time around. China's current business cycle likely peaked last year (Chart 4), and entered a moderation phase. As the single largest consumer of metals on the planet, it would be extremely important for global base metals markets if China's business cycle is out of sync with the rest of the world, which, based on the IMF's latest assessment, remains in a robust growth phase. This alone could justify a less bullish stance on metals this year, and could mute the late-cycle phase returns we would typically expect. Nevertheless, the synchronized global upturn being tracked by ourselves and the IMF is the first such upswing since the Global Financial Crisis (GFC).2 In a note exploring China's significance in global commodity markets, researchers at the IMF found that surprises in China's Industrial Production (IP) announcements - measured as the scaled deviation of actual year-on-year (y/y) IP growth from the median Bloomberg consensus estimate just before the announcement - have an important effect on metal prices.3 Given China's outsized role in global commodity markets, this result is intuitive. Another relevant finding from their research is that the impact of Chinese IP surprise is larger when global risk is elevated - measured by the VIX. This is especially significant in the case of negative surprises.4 These findings are all the more relevant now, given the higher likelihood of negative surprises from China as it sets in motion a managed slowdown on a scale never before seen. Provided the synchronized nature of global growth remains intact, we expect global demand ex-China will partially mitigate the negative impact of domestic policies in China aimed at slowing the economy. Nonetheless, we do expect volatility to be higher this year. The Backdrop Chart 5Secondary Industry Output Past Its Peak Secondary Industry Output Past Its Peak Secondary Industry Output Past Its Peak Both China's official manufacturing PMI and the Li Keqiang Index peaked in 2017 and have since weakened significantly, raising fears of softening demand fundamentals for metals this year. Even though growth in the services sector remains robust, it is not as relevant to metal demand as manufacturing and infrastructure (Chart 5). Nevertheless, it could help support metals demand indirectly as growth in the services sector - i.e., the so-called tertiary industries, which now account for more than half of Chinese GDP - could spur demand for physical goods, and in turn re-energize the manufacturing cycle. This will depend crucially on maintaining income growth to spur demand for consumer durables and discretionary purchases (e.g., automobiles requiring gasoline). Similarly, China's GDP came in above target last year, coinciding with a recovery in secondary industries - i.e., construction and manufacturing, which are big metals consumers. However, secondary industry output appears to have peaked, which we believe is further evidence a benign moderation is already underway in China. This is compounded by the ongoing transition in China's economic structure - a services-led Chinese economy is not as supportive for metals demand as a manufacturing one. At present, out of the indicators of the general health of China's economy we track, the sole beacon of hope comes from the Caixin manufacturing PMI, which currently stands above its 12-month moving average level. Given the slew of other series pointing to a benign slowdown, we are inclined to push this PMI strength aside as an exception rather than the rule. Oh, Don't Forget A Possible Trade War Our analysis of metals markets is made difficult by the possibility of a trade war between the U.S. and China. The Trump Administration already has pledged to impose tariffs of up to $60 billion on Chinese imports over alleged intellectual-property theft. The net effect of these tariffs would be a reduction in demand for Chinese products - propagating a slowdown in the manufacturing sector. Despite these grim data readings, we expect Chinese policy makers to continue holding the reins in this policy-induced slowdown. We expected a deceleration going into the year, which now is evident in the data, but a severe and unruly unwinding is not our base case scenario. Macro-Prudential Measures Driving Up Interest Rates Chart 6Market Rates Are Trending Higher Market Rates Are Trending Higher Market Rates Are Trending Higher The Peoples Bank of China's (PBOC) 1-week interbank repo rate has been the official policy rate since 2015. However, it does not reflect the reality of rising interest rates in China. Instead, BCA Research's China Investment Strategists point to the 3-month rate as the de facto indicator of the monetary policy environment in China.5 While the former is up ~50 bps since late 2016, the latter has increased by about 200 bps during the same period. The wide rate spread reflects Beijing's renewed regulatory efforts to crack down on shadow banking (Chart 6). Our China Strategists note that the main trigger for a China slowdown likely would be monetary-policy tightening. However, the uptrend in market interest rates has been driven by regulatory decisions - the implementation of macro-prudential policies - rather than direct monetary policy tightening. In their scenario-based analysis, BCA's China specialists conclude that since China's economy is already cooling, increases in the benchmark lending rate - the 1-week interbank repo rate - are not needed. If anything, such increases would pressure the average lending rates into tight-monetary-policy territory. Although a hawkish PBOC - absent a meaningful improvement in economic outlook - is on our analysts' list of risks to monitor this year, they do not expect aggressive policy tightening in China, as they do not foresee an inflationary breakout. The Impact The exceptional performance of metals last year was in part driven by infrastructure spending and a rebound in real estate investment in China. Since then, Beijing has also tightened the leash on the property sector. Additionally, a deceleration in infrastructure investment is now evident. This is unsurprising given that two of the three "critical battles" highlighted by Xi Jinping threaten the housing and infrastructure sectors. Furthermore, automobile production and sales do not suggest a reason for optimism. President Xi Jinping has been experimenting with various measures to rein in housing speculation including restrictions on home purchases, encouraging an affordable rental market, and the introduction of "joint-ownership" housing.6 In addition, a "long term property mechanism" as well as a national property tax are in the works. The objective is to discourage speculative home building and property speculation generally, while ensuring sufficient supply in the market to help alleviate shortages, thus curbing exorbitant price increases. The impact of these policies - in the form of a cooling housing market - is evident in home prices in Tier 1 cities. After having decelerated meaningfully at the end of last year, they recorded y/y declines in the first two months of this year (Chart 7). While not as pronounced, home prices in Tier 2 and 3 markets have also slowed considerably compared to 1H17. However, BCA Research's China investment strategists point out that although prices of homes in Tier 1 cities generally lead Tier 2 and 3 markets, this overlooks other significant indicators of the health of China's real estate sector.7 Our China specialists argue that residential floor space sold should be used as the leading gauge of the property market. They find that floor space sold leads Tier 1 prices which guides floor space started and land area purchased. While the latter two are relatively weak, the recent upturn in floor space sold may point toward a more positive future for the Chinese housing sector. A rebound in the House Price Diffusion Index as well as a falling floor-space-available-for-sale versus sales ratio makes them a little less pessimistic about the market's future, suggesting a potential pickup in construction if floor space started does in fact take its cue from the pickup in floor space sold. Nevertheless, it remains too early to get a clear reading on the future of China's real estate sector at this point. On a positive note, the percentage of Chinese households planning to buy a house in the next three months remains high (Chart 8). Further, while the percentage of total new bank loans that are housing mortgages and loans to real estate developers came down slightly last year, they have rebounded, and now make up roughly half of total new bank loans. However, new mortgage loans as a percent of home sales have decelerated sharply. Chart 7Pick Up In Floor Space Sold:##BR##A Positive Sign? Pick Up In Floor Space Sold: A Positive Sign? Pick Up In Floor Space Sold: A Positive Sign? Chart 8Large Number Of Households##BR##Plan To Purchase Homes Large Number Of Households Plan To Purchase Homes Large Number Of Households Plan To Purchase Homes While the slowdown in real estate may not turn out to be as severe as some of the data suggests, Beijing's government spending is decelerating (Chart 9). While spending in transportation infrastructure has decelerated from double-digit figures recorded earlier last year, spending on utilities has come down considerably. In line with other sectors, automobile production slowed considerably in China last year (Chart 10). It has been decelerating on a monthly basis since December, and most recent February data shows large y/y declines. Going forward, we expect the phasing out of tax breaks for small vehicles in China to continue slowing demand growth for cars there. Chart 9Government Spending##BR##Decelerated Significantly Government Spending Decelerated Significantly Government Spending Decelerated Significantly Chart 10Auto Production And Sales##BR##Not Lending Support Auto Production And Sales Not Lending Support Auto Production And Sales Not Lending Support Bottom Line: A tighter regulatory and credit backdrop is evident in recent readings on China's real estate, infrastructure, and automobile sectors. Given the importance of these industries as end users of metals, the above heralds a more tepid view of China's demand for metals going forward, as we continue to expect moderation in China's economy. Nevertheless, the global market will remain supported by strength elsewhere. On the supply side, disruptions remain an upside risk this year. Stay neutral for now. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 OPEC 2.0 is the producer coalition lead by the Kingdom of Saudi Arabia (KSA) and Russia, which, at the end of 2016, agreed to remove 1.8mm b/d of production from the market. The coalition has been remarkably successful in maintaining production discipline, which, together with strong global demand growth, has put OECD oil inventories on a steep decline path. Please see "Oil Price Forecast Steady, But Risks Expand" in last week's Commodity & Energy Strategy Weekly Report for our latest assessment of global supply and demand and our price forecaset. It is available at ces.bcaresearch.com. 2 Please see "Brighter Prospects, Optimistic Markets, Challenges Ahead," in the IMF's January 2018 World Economic Outlook Update. 3 Please see IMF Spillover Notes "China's Footprint in Global Commodity Markets," dated September 2016. 4 The IMF also found U.S. IP surprises have a similar impact on commodity markets, despite its smaller share of global imports. The Fund puts this down to the fact that the U.S. is an indicator for global growth. 5 Please see China Investment Strategy Special Report titled "Seven Questions About Chinese Monetary Policy," dated February 22, 2018, available at cis.bcaresearch.com. 6 Please see "What's Next In China's Bid To Cool Housing Market: QuickTake," available at bloomberg.com, dated March 4, 2018. 7 Please see China Investment Strategy's Weekly Report titled "Is China's Housing Market Stabilizing?," dated February 8, 2018, available at cis.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table China's Managed Slowdown Will Dampen Base Metals Demand China's Managed Slowdown Will Dampen Base Metals Demand Trades Closed in 2018 Summary of Trades Closed in 2017 China's Managed Slowdown Will Dampen Base Metals Demand China's Managed Slowdown Will Dampen Base Metals Demand

Highlights Continue to underweight the most cyclical sectors - Banks, Basic Materials, and Energy. As predicted, global growth is losing steam. This implies that the Eurostoxx50 will struggle to outperform the S&P500. Continue with a currency pecking order of "yen first, euro second, pound third, dollar fourth." The sell-off in bonds is due a retracement, or at least a respite. Stock markets' rich valuations are contingent on low bond yields. Feature The views in this report do not necessarily align with the BCA House View Matrix. Chart I-2Cyclicals Were Underperforming##br## Long Before The Trade Skirmishes Cyclicals Were Underperforming Long Before The Trade Skirmishes Cyclicals Were Underperforming Long Before The Trade Skirmishes Stock markets have experienced turbulence this year, and it would be very simple to blame the first skirmishes of a global trade war. It would also be simplistic. The sharp underperformance of cyclical stocks started in January, well before any inkling of the Trump tariffs (Chart I-2). The trade skirmishes have merely accelerated a process that was already underway. In this week's report, we make sense of the market turbulence from three broad perspectives: the global economic mini-cycle; market technicals; and valuation. The Economic Mini-Cycle Has Likely Turned Down When bond yields rise, interest rate sensitive sectors in the economy feel a headwind, but this headwind is felt with a delay. Similarly, when bond yields decline, interest rate sensitive sectors feel a tailwind, but the tailwind is felt with a delay. This delay occurs because credit supply lags credit demand by several months. But if credit supply lags demand, an economic theory called the Cobweb Theorem1 points out that both the quantity of credit supplied and its price (the bond yield) must undergo 'mini-cycle' oscillations. The theory is supported by compelling empirical evidence (Chart I-3). Furthermore, as the quantity of credit supplied is a marginal driver of economic activity, economic activity will also experience the same mini-cycle oscillations (Chart I-4). Chart I-3Compelling Evidence For Mini-Cycles In##br## Credit Supply And The Bond Yield... Compelling Evidence For Mini-Cycles In Credit Supply And The Bond Yield... Compelling Evidence For Mini-Cycles In Credit Supply And The Bond Yield... Chart I-4...And ##br##Economic Activity ...And Economic Activity ...And Economic Activity These mini-cycles are remarkably regular with half-cycle lengths averaging around eight months. Their regularity creates predictability. And as most investors are unaware of these cycles, the next turn is not discounted in financial market prices - providing a compelling investment opportunity for those who do recognise the predictability. Mini half-cycles average eight months, and the latest mini-upswing started last April. Hence, on January 4 we predicted that "contrary to what the consensus is expecting, global growth will lose steam in the first half of 2018." The predicted deceleration is precisely what we are now witnessing, and we expect this to continue through the summer months. From an equity sector perspective, the relative performance of the most cyclical sectors - Banks, Basic Materials, and Energy - very closely tracks the regular mini-cycles in global growth. In a mini-downswing these cyclical sectors always underperform (Chart of the week). Accordingly, continue to underweight these sectors through the summer months. Chart of the weekCyclicals Always Underperform In An Economic Mini-Downswing Cyclicals Always Underperform In An Economic Mini-Downswing Cyclicals Always Underperform In An Economic Mini-Downswing For the time being, this implies that the Eurostoxx50 will struggle to outperform the S&P500 - because euro area bourses have an outsize exposure to the most cyclical sectors. From a currency perspective, the stark asymmetry of central bank 'degrees of freedom' favours the euro and the yen over the dollar. In essence, as the ECB and BoJ are at the realistic limit of ultra-loose policy, long-term expectations for their policy rates possess an asymmetry: they cannot go significantly lower, but they can go significantly higher. In contrast, long-term expectations for the Fed policy rate possess full symmetry: they can go either way, lower or higher. Hence, on January 18 we advised a currency pecking order of "yen first, euro second, pound third, dollar fourth." This currency pecking order has also worked perfectly this year, and we expect it to continue working through the summer months. Cyclical Sectors Had Bullish Groupthink Groupthink in any investment is a warning sign that the investment's trend is approaching exhaustion, because the liquidity that has fuelled the trend is about to evaporate. Liquidity is plentiful when market participants disagree with each other. Consider a stock whose price is rising strongly: a momentum trader wants to buy it, while a value investor wants to sell it. Hence, the market participants trade with each other with plentiful liquidity. Liquidity starts to evaporate when too many market participants agree with each other. Instead of dispassionately investing on the basis of value, value investors get sucked into chasing a price trend, and their buy orders fuel the trend. But when all the value investors have become momentum traders, the trend reaches a tipping point. If a value investor suddenly reverts to type and puts in a sell order, he will find that there are no buyers left. Liquidity has evaporated and finding new liquidity might require a substantial reversal in the price to attract a buy order from an ultra-long-term deep value investor. As regular readers know, our proprietary fractal analysis measures whether groupthink in a specific investment has become excessive, signalling the end of its price trend. Furthermore, using a 130-day groupthink indicator (fractal dimension), the fractal framework provides a powerful and independent reinforcement of our mini-cycle framework. This is because 130 (business) days broadly aligns with the mini half-cycle length. Fractal analysis reinforces our decision to underweight cyclical sectors, because it shows excessive (bullish) 130-day groupthink in these economically sensitive sectors (Chart I-5). Chart I-5Excessive Bullish Groupthink In Cyclical Sectors Excessive Bullish Groupthink In Cyclical Sectors Excessive Bullish Groupthink In Cyclical Sectors It also shows excessive (bearish) 130-day groupthink in government bonds, suggesting that the sell-off in bonds is due a retracement, or at least a respite (Chart I-6). Chart I-6Excessive Bearish Groupthink In Government Bonds Excessive Bearish Groupthink In Government Bonds Excessive Bearish Groupthink In Government Bonds Rich Valuations Are Contingent On Low Bond Yields On price to sales, world equities are as richly valued as they were at the peak of the dot com boom in 2000. The observation is important because price to sales has proved to be a near-perfect predictor of future 10-year returns. It shows that in 2010, world equities were priced to generate 8% a year compared with 4% a year available from global bonds. Today, richer valuations mean that both world equities and global bonds are priced to generate a paltry 2% a year (Chart I-7). Chart I-7World Equities As Richly Valued As At The Peak Of The Dot Com Boom World Equities As Richly Valued As At The Peak Of The Dot Com Boom World Equities As Richly Valued As At The Peak Of The Dot Com Boom Nevertheless, this makes perfect sense, because when bond yields are at 2%, bonds and equities are equally risky as each other. It follows that they must offer the same return as each other. One of the biggest errors in finance is to define an investment's risk in terms of its (root mean squared) volatility. This is incorrect because nobody fears sharp gains, they only fear sharp losses. Consider an investment whose price goes up sharply one day and then sideways the next day ad infinitum. The investment has a very high volatility, but it has no risk. You can never lose money, you can only make money. This leads us to the correct definition of risk, as defined by Professor Daniel Kahneman. He proved that investors are not concerned about volatility per se, they are concerned about the ratio of potential short-term losses versus short-term gains, a measure known as 'negative skew'. The important point is that at low bond yields, bond returns start to exhibit negative skew. Intuitively, this is because the lower bound to yields forces an unattractive asymmetry on bond returns: prices can fall a lot, but they cannot rise a lot. Specifically, at a bond yield of 2%, theoretical and empirical evidence shows that bonds and equities possess the same negative skew (Chart I-8). And as the two asset classes are equally risky, they must offer the same return, 2% (Chart I-9). Chart I-8At A 2% Bond Yield, 10-Year Bonds##br## Have The Same Negative Skew As Equities... Market Turbulence: What Lies Ahead? Market Turbulence: What Lies Ahead? Chart I-9...So At A 2% Bond Yield, ##br##Equities Must Also Offer A 2% Return Market Turbulence: What Lies Ahead? Market Turbulence: What Lies Ahead? Therefore, equities find themselves in a precarious equilibrium. Rich valuations are justified if bond yields remain at low levels or fall, but rich valuations become increasingly hard to justify if bond yields march higher. Seen through this lens, the rise in bond yields at the start of the year is one important reason why equities have experienced a turbulent 2018 so far. What lies ahead? The combination of our economic mini-cycle, market technicals and valuation perspectives suggests that the equity sector and currency trends established since the start of the year should persist into the summer. As for equities in aggregate, the greatest structural threat would arise if bond yields gapped upwards. But for the time being, this is not our expectation. Happy Easter! Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Special Report 'The Cobweb Theory And Market Cycles' published on January 11 2018 and available at eis.bcaresearch.com. Fractal Trading Model Given the Easter holidays, there are no new trades this week. But we are pleased to report that our long global utilities versus market trade achieved its 3.5% profit target and is now closed. Out of our four open trades, three are in profit with the short nickel / long lead trade already up sharply in its first week. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 Nickel vs. Lead Nickel vs. Lead * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights The global economic mini-cycle is set to weaken while the euro is set to grind higher. Upgrade Telecoms to overweight. Also overweight Healthcare and Airlines. Underweight Banks, Basic Materials and Energy. Overweight France, Ireland, U.K., Switzerland and Denmark. Underweight Italy, Spain, Sweden and Norway. The Eurostoxx50 will struggle to outperform the S&P500. Feature We are strong believers in Investment Reductionism, a philosophy synthesized from the Pareto Principle and Occam's Razor.1 Investment reductionism offers a liberating thesis - the incessant barrage of investment research, newsfeeds and ten thousand word commentaries is largely superfluous to the investment process. What seems like a complexity of investment choice usually reduces to getting a few over-arching decisions right. Chart of the WeekIn Quadrant 4, Overweight Domestic Defensives And Underweight International Cyclicals The Four Quadrants Of Cyclical Investing The Four Quadrants Of Cyclical Investing For equity sector and country allocation, two over-arching decisions dominate: Whether the global economic mini-cycle is set to strengthen or weaken (Chart I-2). Whether the domestic currency is set to strengthen or weaken. Chart I-2The Empirical Evidence For Credit And Economic Mini-Cycles Is Irrefutable The Empirical Evidence For Credit And Economic Mini-Cycles Is Irrefutable The Empirical Evidence For Credit And Economic Mini-Cycles Is Irrefutable The four permutations of these two decisions create the four quadrants of cyclical investing (Chart of the Week). Right now, European investors find themselves in quadrant four: the global economic mini-cycle is set to weaken while the euro is set to grind higher. This favours an overweight stance to defensives, especially domestic-focused defensives. Therefore today, we are upgrading Telecoms to overweight. We also recommend an underweight stance to the most cyclical sectors, especially international-focused cyclicals such as Basic Materials and Energy. Country allocation then just drops out of this sector allocation. The Global Economic Mini-Cycle Is Set To Weaken We can predict the changes of the seasons and the tides of the sea with utmost precision. How? Not because we have an ingenious leading indicator for the seasons and tides, but because we recognise that these phenomena follow perfectly regular cycles. Regular cycles create predictability. Significantly, global bank credit flows also exhibit remarkably regular cycles with half-cycle lengths averaging around eight months. Recognizing these mini-cycles is immensely powerful because, just as for the seasons and the tides, it creates predictability. Furthermore, if most investors are unaware of these cycles, the next turn will not be discounted in today's price - providing a compelling investment opportunity for those who do recognise the predictability. The empirical evidence for credit mini-cycles is irrefutable. The theoretical foundation is also rock solid, based on an economic model called the Cobweb Theory.2 This states that in any market where supply lags demand, both the quantity supplied and the price must oscillate. Given that credit supply clearly lags credit demand, the quantity of credit supplied and its price (the bond yield) must experience mini-cycles (Chart I-3). And as the quantity of credit supplied is a marginal driver of economic activity, economic activity will also experience the same regular oscillations. Today, the global 6-month credit impulse is turning from mini-upswing to mini-downswing, with all three subcomponents - the euro area, the U.S. and China - now in decline (Chart I-4). This is exactly in line with prediction. Mini half-cycles average eight months, and the latest mini-upswing started eight months ago. Chart I-3The Global Economic Mini-Cycle##br## Is Set To Weaken The Global Economic Mini-Cycle Is Set To Weaken The Global Economic Mini-Cycle Is Set To Weaken Chart I-4All Three Subcomponents Of The Global 6-Month ##br##Credit Impulse Are Now Declining All Three Subcomponents Of The Global 6-Month Credit Impulse Are Now Declining All Three Subcomponents Of The Global 6-Month Credit Impulse Are Now Declining More importantly, as we enter a mini-downswing, we can also predict that global growth is likely to experience at least a modest deceleration through the coming two to three quarters. The Euro Is Set To Grind Higher, Except Versus The Yen Chart I-5Lost In Translation Lost In Translation Lost In Translation Nowadays, mainstream stock markets tend to be eclectic collections of multinational companies which happen to be quoted on bourses in Frankfurt, Paris, New York, and so on. For example, BASF is not really a German chemical company, it is a global chemical company headquartered in Germany. For operational hedging, multinational companies like BASF will intentionally diversify their sales and profits across multiple major currencies, say euros and dollars. But of course, the primary stock market quotation will be in the currency of its home bourse, euros. Therefore, when the euro strengthens, the company's multi-currency profits, translated back into a stronger euro, will necessarily weaken (Chart I-5). Clearly, more domestic-focused companies like telecoms will not experience such a strong currency-translation headwind. We expect the main euro crosses to continue strengthening over the next 8 months, with the exception being the cross versus the Japanese yen. Our central thesis is that the payoff profile for a foreign exchange rate just tracks the bond yield spread. This means that when a central bank has already taken bond yields close to their lower bound, its currency possesses a highly attractive asymmetry called positive skew. In essence, as the ECB is at the realistic limit of ultra-loose policy, long-term expectations for the ECB policy rate possess an asymmetry: they cannot go significantly lower, but they could go significantly higher. Exactly the same applies to long-term expectations for the BoJ policy rate. In contrast, long-term expectations for the Fed policy rate possess full symmetry: they could go either way, lower or higher. This stark asymmetry of central bank 'degrees of freedom' favours the euro and the yen over the dollar. Which Sectors And Countries To Own And Which To Avoid? Pulling together the preceding two sections, the global economic mini-cycle is set to weaken while the euro is set to grind higher. This puts Europe in quadrant four of our four quadrant framework for cyclical investing. Unsurprisingly, the relative performance of the most cyclical sectors - Banks, Basic Materials and Energy - very closely tracks the regular mini-cycles in the global 6-month credit impulse. In a mini-downswing these cyclical sectors always underperform (Chart I-6, Chart I-7 and Chart I-8). Accordingly, underweight these three sectors on a two to three quarter horizon. Chart I-6In A Mini-Downswing, ##br##Banks Always Underperform In A Mini-Downswing, Banks Always Underperform In A Mini-Downswing, Banks Always Underperform Chart I-7In A Mini-Downswing,##br## Basic Materials Always Underperform In A Mini-Downswing, Basic Materials Always Underperform In A Mini-Downswing, Basic Materials Always Underperform Chart I-8In A Mini-Downswing,##br## Energy Always Underperforms In A Mini-Downswing, Energy Always Underperform In A Mini-Downswing, Energy Always Underperform Conversely, overweight the relatively defensive Healthcare sector. Also overweight the Airlines sector. Airlines' performance is a mirror-image of the oil price cycle, given that aviation fuel comprises the sector's main variable cost. Furthermore, as aviation fuel is priced in dollars, it also insulates European Airlines against a strengthening euro. Today, we are also upgrading the Telecoms sector to overweight given its relative non-cyclicality (Chart I-9), its domestic-focus, and the excessively negative groupthink towards it (Chart I-10). Chart I-9In A Mini-Downswing, ##br##Telecoms Always Outperform In A Mini-Downswing, Telecoms Always Outperform In A Mini-Downswing, Telecoms Always Outperform Chart I-10Telecoms Are Due ##br##A Trend Reversal Telecoms Are Due A Trend Reversal Telecoms Are Due A Trend Reversal In summary: Overweight: Healthcare, Telecoms, and Airlines Underweight: Banks, Basic Materials and Energy Then to arrive at a country allocation, just combine the cyclical view on the major sectors with the country sector skews in Box 1. The result is the following unchanged European equity market allocation. Overweight: France, Ireland, U.K., Switzerland and Denmark Neutral: Germany and Netherlands Underweight: Italy, Spain, Sweden and Norway Lastly, what is the prognosis for the Eurostoxx50 relative to the S&P500? Essentially, this reduces to a battle between the multinational cyclicals - especially banks - that dominate euro area bourses and the multinational technology giants that dominate the U.S. stock market. With the global economic mini-cycle set to weaken and the euro set to grind higher, the Eurostoxx50 will struggle to outperform the S&P500. Box 1: The Vital Few Sector Skews That Drive Country Relative Performance For major equity indexes in the euro area, the dominant sector skews that drive relative performance are as follows: Germany (DAX) is overweight Chemicals, underweight Banks. France (CAC) is underweight Banks and Basic Materials. Italy (MIB) is overweight Banks. Spain (IBEX) is overweight Banks. Netherlands (AEX) is overweight Technology, underweight Banks. Ireland (ISEQ) is overweight Airlines (Ryanair) which is, in effect, underweight Energy. And for major equity indexes outside the euro area: The U.K. (FTSE100) is effectively underweight the pound. Switzerland (SMI) is overweight Healthcare, underweight Energy. Sweden (OMX) is overweight Industrials. Denmark (OMX20) is overweight Healthcare and Industrials. Norway (OBX) is overweight Energy. The U.S. (S&P500) is overweight Technology, underweight Banks. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 The Pareto Principle, often known as the 80-20 rule, says that 80% of effects come from just 20% of causes. Occam's Razor says that when there are many competing explanations for the same effect, the simplest explanation is usually the best. 2 Please see the European Investment Strategy Special Report 'The Cobweb Theory And Market Cycles' published on January 11, 2018 and available at eis.bcaresearch.com. Fractal Trading Model* This week's recommended trade is to short the Helsinki OMX versus the Eurostoxx600. Apply a profit target of 3% with a symmetrical stop-loss. In other trades, we are pleased to report that short Japanese Energy versus the market achieved its 8% profit target at which it was closed. This leaves four open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart 11 Helsinki OMX Vs. Eurostoxx 600 Helsinki OMX Vs. Eurostoxx 600 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights BCA's view is that while a major trade war is unlikely, trade tensions will persist. The Fed, not protectionism, will end the cycle. There have been five episodes in the past 35 years when global growth surged and fiscal, monetary and regulatory policy were all aligned to boost the U.S. economy. The March Beige Book keeps the Fed on track to hike four times this year. Feature The Trump Administration's announcement last week to slap hefty tariffs on steel and aluminum runs the risk of provoking a "tit-for-tat" trade war. This proposed levy follows a similar move earlier this year to impose tariffs on washers and solar panels. The EU has retaliated with a threat to introduce tariffs on Harley Davidson motorcycles and Levi's jeans. Even if a trade war develops, our Global Investment Strategy team notes1 that the U.S. would suffer less in a trade war than other nations, and that higher tariffs may lead to more domestic demand, a more aggressive Fed and a stronger dollar. Certainly, the tariff issue does not signal the end of the U.S. economic expansion or equity bull market. BCA's view is that while a major trade war is unlikely, trade tensions will persist. Our Geopolitical Strategy service states2 that investors should closely monitor bellwether factors for trade policies, including Trump's position on NAFTA, exemptions granted on the steel and aluminum tariffs to countries (such as Mexico and Canada) and most importantly, the treatment of intellectual property trade with China. Bottom Line: The end of the equity bull market will probably be due to an overheated U.S. economy and rising financial imbalances, and not escalating trade protectionism. Investors should remain overweight global equities for now, but look to pare back exposure later this year. Policy Panacea The backdrop for U.S. economic growth remains solid. Consensus global GDP projections for 2018 and 2019 have perked up, in contrast with prior years when forecasters issued relentless lower GDP estimates (Chart 1). Moreover, global exports growth is in a persistent uptrend since the earlier part of 2016 (Chart 2). Chart 1U.S. & Global Growth Expectations Are Still Accelerating U.S. & Global Growth Expectations Are Still Accelerating U.S. & Global Growth Expectations Are Still Accelerating The surge in global growth occurs even as China's economy is poised to slow. Among the components of BCA's Li Keqiang Leading Indicator (an index designed to lead turning points in the Li Keqiang), all six series are in a downtrend, and five fell in January (the growth in M2 was the exception).3 Although China's economy is decelerating, BCA's view is that a repeat of the late 2015/early 2016 shock is unlikely (Chart 3). Chart 2Global Exports##BR##Are Booming... Global Exports Are Booming... Global Exports Are Booming... Chart 3Our Composite LKI Indicator Suggests##BR##A Benign Slowdown In Growth In China bca.usis_wr_2018_03_12_c3 bca.usis_wr_2018_03_12_c3 The U.S. economy and financial markets will benefit from the uptick in global growth, a large dose of fiscal policy, still accommodative monetary policy, and a decline in regulation. Table 1 and Chart 4 show that there have been four other junctures in the past 35 years when these factors all pulled in the same direction to boost the U.S. economy. The current episode of synchronized policy commenced in January 2016. All four previous periods occurred closer to the start and not the end of a business cycle; BCA's stance is that the U.S. economy is in the late stages of an economic expansion that began in 2009. These phases lasted, on average, for just under two years. The current phase is entering its third year. The longest was in the early 2000s (2002-2004), while the shortest was a 14-month interval in the first year of the 1991-2001 economic expansion. Three of the prior four periods ended as fiscal policy turned restrictive. In the early 1980s' chapter, a reversal in global IP signaled the end of the growth sweet spot. Performance Of U.S. Financial Assets, Gold, Oil And Earnings When Global Growth Is Increasing Alongside Stimulative Monetary, Fiscal And Regulatory Policy .... Policy Line Up Policy Line Up Chart 4Global Growth, Fiscal, Monetary And Regulatory Policy##BR##All Pulling In The Same Direction Global Growth, Fiscal, Monetary And Regulatory Policy All Pulling In The Same Direction Global Growth, Fiscal, Monetary And Regulatory Policy All Pulling In The Same Direction Not surprisingly, risk assets perform well during these "tailwind" points (Table 1 again and Chart 5). The S&P 500 rose in the previous four periods and again in the current one. However, BCA's stock-to-bond ratio fell in the early 1990s and early 2000s. Credit tends to outperform Treasuries when monetary, fiscal and regulatory policy are synchronized, and small caps outperform large. This is the case in the current episode that began in January 2016. Gold and oil also perform well when global growth is surging, fiscal and monetary policy is stimulative and regulations are on the wane. However, on average, the dollar falls during these intervals as demonstrated in the early 2000s and early 2010s. S&P 500 earnings growth is solid and well above average during these phases. Chart 5U.S. Risk Assets In Periods Of Strong Global Growth And Synchronized Policy Push U.S. Risk Assets In Periods Of Strong Global Growth And Synchronized Policy Push U.S. Risk Assets In Periods Of Strong Global Growth And Synchronized Policy Push Table 2 shows that U.S. risk assets tend to struggle in the year after these legs end, but the economy keeps flourishing. Stocks underperformed bonds a year after the end of two of the four periods, but none of those periods coincided with a recession. Investment-grade and high-yield credit underperforms Treasuries in the ensuing 12 months, while small caps struggle to keep up with large. Gold performs well in three of the four periods, but oil posts a mixed performance. The dollar rises and S&P 500 earnings per share increase in the year after stretches of synchronous policy, but at a much slower pace than when the stimulative fiscal policy, deregulation and easy monetary policy are all in place. Table 2... What Happens In The 12 Months After These Episodes End... Policy Line Up Policy Line Up Tighter Fed policy will end the current era of pro-growth policies. BCA's stance is that the Fed will raise rates four times this year and another three or four times next year, pushing monetary policy into restrictive territory. U.S. fiscal policy will likely add to growth into the next year, thanks to tax cuts and the lifting of spending caps, and Trump will continue to look for deregulation opportunities. Bottom Line: Fed tightening will end the latest era of deregulation, easy monetary policy and stimulative fiscal policy, but not until early next year. Until then, a favorable backdrop will persist for stocks over bonds, credit, S&P 500 earnings and oil. Stay long stocks and credit, and underweight duration. This forecast assumes that the trade spat does not degenerate into a trade war. If that occurs, we would recommend reducing our overweight to risk assets sooner than early next year. Beige Book: More Tailwinds Fed Chair Powell's February 27 testimony to Congress noted that "some of the headwinds the U.S. economy faced in previous years have turned into tailwinds."4 The Beige Book released on March 7 highlights many of those tailwinds, keeps the Fed on track to boost rates at least three times this year and highlights the impact of the tax bill on the economy. BCA's quantitative approach5 to the Beige Book's qualitative data points to underlying strength in GDP and a tighter labor market. Furthermore, the disconnect between the Beige Book's view of inflation and the market's stance has eased. Moreover, references to a stronger dollar have disappeared from the Beige Book and business uncertainty is significantly reduced, reflecting the tax cut bill and Trump's assault on regulation. The latest Beige Book ran from mid-January to February 26 and, therefore, did not capture the business community's reaction to the tariff announcement in early March. Chart 6, panel 1 shows that at 67% in March, BCA's Beige Book Monitor stayed near its cycle highs, which reconfirms that the underlying economy was upbeat in early 2018. The number of 'weak' words in the Beige Book returned to near four-year lows after ticking higher in the wake of last summer's hurricanes. Moreover, there were 15 mentions of the tax bill in the March Beige Book, up from 12 in January and only 3 in November 2017 (not shown). The tax bill was cast in a positive light in 87% of the remarks in March versus 75% in January. In November, the references to either the tax bill (or tax reform) cited the consequent uncertainty as a constraint on growth. Chart 6Latest Beige Book Supports##BR##The Fed's View On Rates, Inflation And Economy Latest Beige Book Supports The Fed's View On Rates, Inflation and Economy Latest Beige Book Supports The Fed's View On Rates, Inflation and Economy Based on the minimal references to a robust dollar in the past six Beige Books, the greenback should not be an issue in Q4 2017 or Q1 2018. This sharply contrasts with 2015 and early 2016 when there were surges in Beige Book mentions (Chart 6, panel 4). The last time that six consecutive Beige Books had so few remarks about a strong dollar was in late 2014. BCA's stance is that the dollar will move modestly higher in 2018. Business uncertainty over government policy (fiscal, regulatory and health) multiplied in the past few Beige Books as Congress debated the tax bill. However, in general, these comments have dropped since Trump took office in early 2017. The implication is that the business community is correctly focused on policy and not politics in D.C. (Chart 6, panel 5). However, the controversy associated with the tariffs on steel and aluminum will add to business unease in the coming months unless Trump reverses his position. The disagreement between the Fed and the market on inflation narrowed in the March edition of the Beige Book (Chart 6, panel 3). The number of inflation words in the Beige Book rose to an 8 month high in March, reflecting the abrupt change in sentiment on inflation in early 2018 both in the business community and the market. In the past year, inflation words in the Beige Book climbed as the readings on CPI and PCE rolled over. In the past, increased references to inflation have led measured inflation by a few months, suggesting that the CPI and core PCE may soon turn up. Bottom Line: The March Beige Book supports BCA's view that the U.S. economy is poised to expand above its long-term potential in the first half of 2018. Moreover, the elevated soundings on inflation in the Beige Book in recent years have again proved prescience, as price measures are poised to turn higher. While the first few Beige Books in 2018 showed that the business and financial communities welcomed tax cut legislation, the next edition will likely reflect elevated concern over the nation's trade policies. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's Global Investment Strategy Weekly Report "Trump's Tariffs: A Q&A", published March 9, 2018. Available at gis.bcaresearch.com. 2 Please see BCA Research's Geopolitical Strategy Client Note "Market Reprices Odds Of A Global Trade War", published March 6, 2018. Available at gps.bcaresearch.com. 3 Please see BCA Research's China Investment Strategy Weekly Report "China And The Risk Of Escalation", published March 7, 2018. Available at cis.bcaresearch.com. 4 https://www.federalreserve.gov/newsevents/testimony/powell20180226a.htm 5 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Great Debate Continues," published April 17, 2017. Available at usis.bcaresearch.com.

Feature The existence of 'mini-cycles' in economic and financial variables is an empirical fact. We encourage readers to plot for themselves the change in global bank credit flows, the global bond yield, global inflation, and metal price inflation. The very clear and regular mini-cycles should shout out at you (Chart I-2, Chart I-3, Chart I-4, Chart-5). Feature ChartThe Cobweb Theory Explains The Regular Mini-Cycles In Economic And Financial Variables The Cobweb Theory Explains The Regular Mini-Cycles In Economic And Financial Variables The Cobweb Theory Explains The Regular Mini-Cycles In Economic And Financial Variables Chart I-2Mini-Cycles In Global Credit Flows Mini-Cycles In Global Credit Flows Mini-Cycles In Global Credit Flows Chart I-3Mini-Cycles In The Global Bond Yield Mini-Cycles In The Global Bond Yield Mini-Cycles In The Global Bond Yield Chart I-4Mini-Cycles In Global Inflation Mini-Cycles In Global Inflation Mini-Cycles In Global Inflation Chart I-5Mini-Cycles In Metal Price Inflation Mini-Cycles In Metal Price Inflation Mini-Cycles In Metal Price Inflation Identifying these mini-cycles is very useful because it helps us to predict the future. Just as we know when the tide will go out and come back in, we can predict the mini-cycle's downswings and upswings. And if most market participants are unaware of the next turn in the mini-cycle, it will not be discounted in today's price - providing a compelling investment opportunity. The obvious question is: if the existence of mini-cycles is an empirical fact, what is its theoretical foundation? Dusting Down The Cobweb Theory A likely answer comes from an economic model called the Cobweb Theory, first proposed in the 1930s by several economists, among them Althus Hanau and Nicholas Kaldor. The Cobweb Theory is so called because when its predicted pattern of price and output mini-cycles is traced out on a standard price/quantity diagram, it resembles a cobweb (Chart I-6, Chart 7, Chart I-8). Chart I-6Cobweb Theory Case 1: ##br## Regular Mini-Cycles The Cobweb Theory And Market Cycles The Cobweb Theory And Market Cycles Chart I-7Cobweb Theory Case 2: ##br##Divergent Mini-Cycles The Cobweb Theory And Market Cycles The Cobweb Theory And Market Cycles Chart I-8Cobweb Theory Case 3: ##br##Convergent Mini-Cycles The Cobweb Theory And Market Cycles The Cobweb Theory And Market Cycles The Cobweb Theory is based on a simple premise: lagging supply. The demand for an item depends on its price in the current period, but the supply of the item depends on its price in the previous period. Or equivalently, the price in the current period influences the supply in the next period. In the 1930s, economists used the theory to explain the mini-cycles in agricultural output and prices. Most crops can be sown and reaped only once a year. Therefore, an unanticipated increase in demand will cause a sharp rise in price - because there can be no immediate increase in supply. This high price may lure farmers to increase their output more than is justified by future demand. So when this supply eventually comes on the market, it will cause a sharp fall in price. In turn this will result in a decrease in output for the next period to a greater extent than is justified. And so on. More generally, the Cobweb Theory applies in any market where supply lags demand. Under this simple premise, the market price will produce a two-period oscillation with the actual price being alternately above and below the equilibrium price. When the price is above equilibrium, it falls in the next period as supply adjusts upwards; and when the price is below equilibrium, it rises in the next period as supply adjusts downwards. But supply tends to over-adjust, causing both the quantity and price to overshoot and undershoot equilibrium repeatedly - effectively creating a mini-cycle (see Box I-1). Box I-1The Cobweb Theory Of Cycles The Cobweb Theory And Market Cycles The Cobweb Theory And Market Cycles The Cobweb Theory Of Credit Demand And Supply We now come to a key point: credit demand and supply often meet the conditions of the Cobweb Theory. Chart I-9 illustrates that the credit demand cycle is perfectly coincident with the bond yield cycle. Whereas Chart I-10 and Chart I-11 demonstrate that the credit supply cycle can often lag the credit demand cycle - and therefore the bond yield cycle - by several months. One obvious explanation is that unless you have an (unexpended) existing credit line to draw upon, there will be a lag between applying for credit and receiving it. Chart I-9The Credit Demand Cycle Is Coincident ##br##With The Bond Yield Cycle... The Credit Demand Cycle Is Coincident With The Bond Yield Cycle... The Credit Demand Cycle Is Coincident With The Bond Yield Cycle... Chart I-10...But The Credit Supply Cycle Lags ##br##The Credit Demand Cycle... ...But The Credit Supply Cycle Lags The Credit Demand Cycle... ...But The Credit Supply Cycle Lags The Credit Demand Cycle... Chart I-11...And The Bond ##br##Yield Cycle ...And The Bond Yield Cycle ...And The Bond Yield Cycle With credit demand and supply meeting the conditions of the Cobweb Theory, both the quantity and the price of credit (the bond yield) should exhibit mini-cycles. And as the charts in this report attest, they do. What about the mini-cycles in commodity inflation and broader CPI inflation? Given that these closely track the credit impulse mini-cycle (Feature Chart), we can deduce that they must be mostly a reflection of the mini-cycle in global demand growth. Still, could the commodity inflation mini-cycle also be impacted by the supply-side, as postulated for agricultural prices in the original Cobweb Theory? Interestingly, a recent paper, "The cobweb theorem and delays in adjusting supply in metals" markets,1 does "link the dynamics of raw material markets and commodity price fluctuations to a delayed adjustment of supply." However, the supply lags mentioned in the paper are too long to explain the half-cycle lengths typically observed in the commodity inflation mini-cycle. This would confirm that this mini-cycle is mostly a demand-side phenomenon. But the paper does also point out that speculation on futures markets may lead to higher volatility. This implies that while the phases of the mini-cycles should stay closely aligned, the amplitudes of the commodity inflation and credit impulse mini-cycles can deviate. Which is precisely what we observe in the data (Chart I-12). Chart I-12The Various Mini-Cycles Have Similar Periods But Different Amplitudes The Various Mini-Cycles Have Similar Periods But Different Amplitudes The Various Mini-Cycles Have Similar Periods But Different Amplitudes What Is The Current Message? Chart I-13The Bond Yield Cycle Explains##br## The Sector Selection Cycle The Bond Yield Cycle Explains The Sector Selection Cycle The Bond Yield Cycle Explains The Sector Selection Cycle To sum up, global credit flows, the global bond yield, global inflation, and metal price inflation exhibit clear and regular mini-cycles with a consistent half-cycle length averaging around 8 months, but not necessarily a consistent amplitude. We propose that all of these mini-cycles will continue indefinitely, and that they are manifestations of the lagging supply of credit and the Cobweb Theory. In the context of these clear and regular mini-cycles, the current mini-upswing in activity which started last May is getting long in the tooth, and we would expect it to end in early 2018. Having said that, given that the recent upswing in the global bond yield is quite modest, the next mini-downswing in the global credit impulse, and thereby activity, should be quite shallow. Nevertheless, in terms of investment implications, any mini-upswing in price since last May that has displayed an outsize amplitude would be more vulnerable to a setback. Industrial metal prices might be in this vulnerable category. Furthermore, the mini-cycle framework has been an important driver of cyclical versus defensive sector performance over the past few years (Chart I-13), and likely will continue to be an important driver. On a 6-9 month horizon, the current message would be to pare back exposure to cyclical sectors and to tilt towards defensive-biased equity markets such as Switzerland and Denmark. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 System Dynamics Review, April 2017: 'The cobweb theorem and delays in adjusting supply in metals' markets' by Glöser-Chahoud, Hartwig, Wheat and Faulstich. Fractal Trading Model* This week's trade is to expect a countertrend reversal in S&P500 versus Eurostoxx50 performance. Set a profit target of 2.0% with a symmetrical stop-loss. In other trades, long IBEX35 / short Eurostoxx50 closed in profit while short WTI crude closed at its stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart 14 Short S&P500 / Long Eurostoxx50 Short S&P500 / Long Eurostoxx50 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Dear Clients, This is the final publication for the year, in which we recap some of the key developments in 2017. We will resume our regular publishing schedule on January 4, 2018 with a brief market update. The China Investment Strategy team wishes you a very happy holiday season and a prosperous New Year! Best regards, Jonathan LaBerge, CFA, Vice President Special Reports Highlights 2017 served as a prime example of the periodic oscillation of Chinese economic policy between pursuing painful reforms and stimulating demand. While policymakers are merely attempting to control the private sector debt-to-GDP ratio, the risk of a tightening overshoot should not be discounted. Recent economic activity in China appears to have been driven by highly-polluting industries, in the context of strong public demand for an improvement in air quality. This raises the risk that environmental reforms over the coming few years could seriously curtail growth. The incredible returns from Chinese stocks this year means that investable equities are no longer "exceptionally cheap". Still, the range of valuation among Chinese investable sectors has increased, suggesting increased opportunity for alpha generation over the coming 6-12 months. Feature Following the publication of our special year end Outlook report for 2018,1 BCA's China Investment Strategy service recently expanded on our global view by outlining our three key themes for China over the coming year.2 As a year-end tradition, we dedicate this week's report to recapping some important developments of the past year and their longer-term implications. China's Mini Cycle In Requiem, From A Bigger Picture Perspective Chart 1Some Modest Deleveraging Achieved ##br##In The Corporate Sector Some Modest Deleveraging Achieved In The Corporate Sector Some Modest Deleveraging Achieved In The Corporate Sector 2017 saw the growth momentum of China's recent "mini cycle" peak, following a tightening in monetary conditions that began late last year. Part of the tightening in monetary conditions reflected normal countercyclical actions by the PBOC, but it also signified a strong desire on the part of policymakers to avoid significant further leveraging of the economy. As such, 2017 served as a prime example of the periodic oscillation of Chinese economic policy between promoting painful supply-side reforms and pushing demand-side countercyclical policies. Chart 1 highlights that policymakers did manage to achieve some modest outright deleveraging in the non-financial corporate sector in the first two quarters of the year, but at least half of this gain occurred because nominal GDP growth accelerated (i.e. the denominator of the debt-to-GDP ratio improved). No such deleveraging occurred in the household sector, which continued to see year-over-year debt growth of 24%. The struggling of Chinese policymakers to control the pace of credit growth reflects the inherent difficulty of China's new de-facto growth model, which shifted significantly in 2010. Chart 2 presents a stylized timeline of China's economic history over the past 15 years; rather than painting the rise in China's debt-to-GDP ratio in a sinister light, it underscores the unenviable lose-lose position facing Chinese policymakers in 2010. The chart describes how China's extremely rapid growth phase from 2002-2008 was followed by the global financial crisis and a normal rise in the debt-to-GDP ratio. This rise occurred due to a significant deceleration in nominal GDP growth, and standard counter-cyclical economic policy during an extremely challenging time for the global economy. However, following the onset of the economic recovery in 2009, it became clear that China's export-enabled catchup growth phase was durably over, and policymakers were faced with a hard choice: Either replace exports as a growth driver with debt-fueled domestic demand in order to buy the economy time to move up the value-added chain and to transition to a services-led economy (the "reflate" path), or allow the labor market to suffer the consequences of a sharp slowdown in export growth while preserving fiscal and state-owned firepower for some uncertain future opportunity (the "stagnate" path). Chart 2A Stylized Timeline Of China's Recent Economic History Legacies Of 2017 Legacies Of 2017 The well-known legacy of China's choice to pursue the "reflation" path is the significant and persistent gap between the growth rates of private non-financial credit and nominal GDP since 2010 (Chart 3). It is significant that this gap almost entirely closed in the first half of 2017, but a further deceleration in credit growth will be necessary to keep it closed given that nominal GDP growth is likely to decline over in the coming year. Chart 3No Overall Deleveraging,##br## But A Halt To Rising Leverage No Overall Deleveraging, But A Halt To Rising Leverage No Overall Deleveraging, But A Halt To Rising Leverage Table 1 underscores the lasting economic impact of the "sudden stop" experienced by China's external sector, even given the choice to pursue the "reflate" path, by presenting the contribution to real GDP growth by broad expenditure categories. Relative to the 2002-2008 average, the largest negative contributor to growth during the global financial crisis and its aftermath was from net exports, made up by a stimulus-induced acceleration in investment. However, over the following five years most of the deceleration in growth came from gross capital formation, as private producers adjusted to the new export environment by rapidly slowing their additions to new capacity. Absent new investment from China's state-owned sector (which occurred as part of the reflation plan), Table 1 strongly suggests that gross capital formation in China would have slowed much more aggressively than it did had policymakers not chosen to reflate the economy. Given this, many investors have a sanguine view on the risks posed by China's massive increase in debt-to-GDP, and are likely to view policymaker efforts to durably close this gap as a policy mistake. According to this perspective, global investors would be far less concerned if the post-2010 rise in debt had occurred explicitly on the government's balance sheet, and since most of the rise in non-financial corporate debt is attributable to the state-owned sector, it is quasi-sovereign in nature and thus not likely to be the source of a financial crisis. Table 1The Global Financial Crisis Caused A Lasting Economic Impact, ##br##Even Given China's Choice To Reflate Legacies Of 2017 Legacies Of 2017 Chinese policymakers would argue that their goal is simply to control China's debt-to-GDP ratio and to stop continued leveraging, not to put the financial system on an active deleveraging path that would risk destabilizing the economy. But even within this policymaker framework, there are two clear potential risks, both of which will need to be tracked over the coming year. The first is that the monetary tightening that has already occurred (and is still underway) causes debt service payments to become unbearable for state-owned firms, which forces a crisis that inflicts considerable short-term pain on the economy. The second is that other reform initiatives, those intended to pare back heavy-polluting industry (see below), to hasten the transition of China's economy to "consumer-led" growth, and to continue to crack down on corruption and graft end up negatively impacting the economy in a way that policymakers did not intend. Both of these risks will need to be monitored closely in 2018 and beyond. Bottom Line: 2017 served as a prime example of the periodic oscillation of Chinese economic policy between promoting painful supply-side reforms and pushing demand-side countercyclical policies. While policymakers are merely attempting to control the private sector debt-to-GDP ratio and are not pushing for active deleveraging, the risk of a tightening overshoot should not be discounted. Bumping Up Against The Environmental "Red Line" Another legacy of 2017 is the environmental impact of the recent economic mini cycle, and the lasting effect that poor air quality is likely to have on the country's reform agenda. Chart 4 presents one commonly used measure of air quality, termed PM2.5. It represents the concentration of airborne particulate matter that is 2.5 microns in size or smaller (smaller particles are more of a health risk), rescaled into an index. When using this measure, a value less than 50 is deemed to be good, whereas values above 50 are not ideal. At an index value of 150, PM2.5 concentrations become unhealthy for the entire population, not just sensitive groups. Chart 4Chinese Air Quality Deteriorated During ##br##This Growth Mini Cycle Chinese Air Quality Deteriorated During This Growth Mini Cycle Chinese Air Quality Deteriorated During This Growth Mini Cycle The chart shows the rolling 3-month average PM2.5 index for Beijing since 2010, along with the year-over-year change in the index. Three points are noteworthy: Over the past 8 years, Beijing's air quality has never been ranked as "good" for any significant period of time, and has typically contained moderate amounts of harmful particulate matter. Interestingly, at the onset of the recent growth mini-cycle in 2015, China's air quality deteriorated rapidly, nearly into unhealthy territory. This occurred again earlier in 2017, suggesting that the type of economic activity associated with growth over the past two years has been particularly negative for the environment. The slowdown in the Li Keqiang index over the past 6-9 months has corresponded with the largest year-over-year decline in Beijing's PM2.5 concentration since early-2015, when economic activity in China was slowing sharply. Given this, it is not surprising that President Xi's speech during the Party Congress in October emphasized the need to scale back highly-polluting heavy industry over the coming years. But if recent economic activity in China has been driven by these industries, this raises an obvious risk that environmental reforms over the coming few years could seriously curtail growth. This is especially true given that the Chinese public appears to be willing to sacrifice growth for an improvement in air quality (Chart 5). When outlining our key themes for 2018,3 we noted that next year's reform announcements will be highly significant not just because of the "what", but also the "how". We expect to see more details emerge in the lead up to the National People's Congress in March, but for now we are playing this theme by being long China's investable environmental, social, and governance (ESG) leaders index and short the investable benchmark (Chart 6). This trade is up 2% since we initiated it on November 16, and we expect further gains in 2018 if environmental reform remains a key priority for Chinese policymakers. Chart 5The Public Is Willing To Sacrifice Growth ##br##To Improve The Environment Legacies Of 2017 Legacies Of 2017 Chart 6Further Gains Likely##br## If The Environment Remains A Priority Further Gains Likely If The Environment Remains A Priority Further Gains Likely If The Environment Remains A Priority Bottom Line: Recent economic activity in China appears to have been driven by highly-polluting industries, in the context of strong public demand for an improvement in air quality. This raises the risk that environmental reforms over the coming few years could seriously curtail growth. A Year Of Spectacular Returns From Chinese Stocks. Now What? As of December 19, Chinese investable stocks (in US$) earned just over 50% in total return terms this year. Chart 7 shows that this ranks as the third largest annual gain among all major equity markets since 2010, behind only Russia and Brazil's commodity-fueled performance in 2016 (which was the mirror image of their spectacular losses in 2014/2015). Chart 7A Red Letter Year For Chinese Stocks Legacies Of 2017 Legacies Of 2017 There are two implications from China's amazing year-to-date equity market performance. First, it serves as a testament to the importance of tracking and playing economic mini cycles in China. BCA's China Investment Strategy service highlighted in February of this year that the economy would remain buoyant in the near term,4 and that investors should be overweight Chinese investable equities over the coming 6-12 months. Clearly this recommendation has panned out well. Second, it implies that Chinese stocks have re-rated significantly, and are no longer "exceptionally cheap". This means that the job of earning outsized returns from Chinese equities over the coming years will become more difficult, with investors possibly at some point needing to be selective in their allocation. The good news is that the range of valuation within China's investable market has increased, which implies more potential for alpha generation. In fact, Chart 8 highlights that this a global phenomenon, which appears to be at least somewhat related to the decline in intra-equity market correlation (panel 2). We plan on following up on the issue of sector-based alpha in the New Year, but for now there are no signs of a turnaround in the significant underperformance of investable value vs growth stocks (Chart 9). But given that the style dividend yield gap has grown to an elevated level (Chart 10), going long Chinese investable value / short investable growth is one of several potential trade ideas that we will be evaluating in the coming months. Stay tuned. Chart 8Lower Correlation Means Higher Valuation Dispersion Lower Correlation Means Higher Valuation Dispersion Lower Correlation Means Higher Valuation Dispersion Chart 9Chinese Value Stocks May Soon Attract Attentio Chinese Value Stocks May Soon Attract Attentio Chinese Value Stocks May Soon Attract Attentio Chart 10Value Is Now Particularly Valuable Value Is Now Particularly Valuable Value Is Now Particularly Valuable Bottom Line: The incredible returns from Chinese stocks this year means that investable equities are no longer "exceptionally cheap". Still, the range of valuation among Chinese investable sectors has increased, suggesting increased opportunity for alpha generation over the coming 6-12 months. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see BCA Special Report, "2018 Outlook - Policy And The Markets: On A Collision Course," dated November 20, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "Three Themes For China In The Coming Year", dated December 7, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "Three Themes For China In The Coming Year", dated December 7, 2017, available at cis.bcaresearch.com. 4 Pease see China Investment Strategy Weekly Report "Be Aware Of China's Fiscal Tightening", dated February 16, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Dear Client, I recorded a webcast with my colleague Caroline Miller earlier this week. Caroline and I discussed the recent tax legislation in the U.S. and other key investment topics. I hope you will find the time to listen in. I am also happy to announce that going forward, in addition to sending you my regular reports, I will be sharing my thoughts on the economy and markets through Twitter. Best regards, Peter Berezin, Chief Global Strategist Highlights Some profit taking is likely over the next few weeks as U.S. equities discount a more realistic assessment of how lower tax rates will affect corporate cash flows. The cyclical picture for the U.S. and the global economy remains bright, implying that any correction will be short-lived. History suggests that the 7th and 8th innings of business-cycle expansions are often the most profitable for equity investors. With another recession still at least a year away, it is too early to get bearish on stocks and other risk assets. Feature Tax Cuts Arrive Early We had expected the Republicans in Congress to deliver on their pledge to cut taxes, but thought that the legislative process would drag on for longer than it did. In the end, the Senate was able to pass a hastily negotiated bill, giving Donald Trump his first major political victory. The question is where things go from here. The Senate and House bills still need to be reconciled. We do not anticipate much drama in that regard, given the broad similarities between the two versions. The bigger issue is how the legislation will affect the economy and markets. The Joint Committee on Taxation (JCT) estimated in mid-November that the original Senate version of the bill would raise the level of real GDP by an average of 0.8% over the ten-year budget window.1 It is reasonable to assume that the final bill will boost GDP by a similar amount. The impact on growth is likely to be somewhat front-loaded, given that several provisions will either expire or be phased out after five years. We expect real GDP growth to be 0.2%-to-0.3% higher in 2018 and 2019 as a result of the legislation. This is not a particularly large effect, which explains why the bond market reaction has been fairly muted. The impact on corporate profits will be more pronounced, but even here, one should keep things in perspective. The final bill is likely to reduce corporate taxes by about $350 billion over the next ten years. The JCT's baseline assumes corporate tax receipts of $3.9 trillion over the next decade. Thus, the bill will probably reduce the effective corporate tax rate by a bit less than two percentage points, taking it down from 19% to 17%. This, in turn, implies an increase in after-tax corporate cash flows of about 2.5% (i.e., 83 divided by 81). The market ran up a lot more than that over the past few months. Thus, we would not be surprised to see some profit-taking over the coming weeks. Cyclical Picture Still Bright If such a stock market correction occurs, it would represent a buying opportunity. Historically, recessions and bear markets have gone hand in hand (Chart 1). Right now, none of our recession indicators are warning of an imminent downturn (Chart 2). Chart 1Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Chart 2ANo Imminent Risk Of A U.S. Recession No Imminent Risk Of A U.S. Recession No Imminent Risk Of A U.S. Recession Chart 2BNo Imminent Risk Of A U.S. Recession No Imminent Risk Of A U.S. Recession No Imminent Risk Of A U.S. Recession This reassuring conclusion is consistent with the signal from our forthcoming MacroQuant Model, which we will be discussing in greater detail in the months ahead. This ground-breaking model examines dozens of variables, including a number of BCA's proprietary indicators, in order to consistently and accurately project returns across the key asset classes, geographies, and time horizons. Currently, the model is flagging a somewhat elevated risk of a temporary pullback, but continues to give a highly bullish reading on the cyclical (6-to-12 month) outlook (Chart 3). Chart 3BCA's MacroQuant Model Still Likes Equities When To Get Out When To Get Out The model's auspicious assessment largely stems from the strength of recent economic data in the U.S. and around the world. Global growth estimates continue to grind higher (Chart 4). In the U.S., the new orders component of the ISM manufacturing index rose to 64 in November, while the inventory component sank to 47. We have found that the gap between the two is a powerful predictor of stock market returns (Chart 5). The current gap is in the 87th percentile of its historic range. By the same token, core durable goods orders, initial unemployment claims, capex intentions, consumer and business confidence, global PMIs, and most other leading indicators paint a fairly upbeat picture. Chart 4Global Growth Projections Are Trending Higher Global Growth Projections Are Trending Higher Global Growth Projections Are Trending Higher Chart 5ISM As A Predictor Of Market Returns When To Get Out When To Get Out The euro area and Japan also continue to grow at a robust pace (Chart 6). Somewhat worryingly, China has seen growth tick down a notch in recent months (Chart 7). However, the evidence so far suggests that growth has merely slowed from an above-trend pace back towards potential. Nominal GDP rose by 11.2% year-over-year in Q3 2017, up from 6.4% in Q4 2015. Producer price inflation has gone from as low as negative 5.9% in September 2015 to 6.9% at present. Core CPI inflation has also accelerated, rising to 2.3% in October (Chart 8). In this light, recent efforts by the authorities to expedite structural reforms are coming at an opportune time. Chart 6Positive Growth Momentum ##br##In The Euro Area And Japan Positive Growth Momentum In The Euro Area And Japan Positive Growth Momentum In The Euro Area And Japan Chart 7Growth Has Ticked Down##br## In China... Growth Has Ticked Down In China... Growth Has Ticked Down In China... Chart 8... But Merely From##br## An Above-Trend Pace ... But Merely From An Above-Trend Pace ... But Merely From An Above-Trend Pace Too Early To Bail Out Of Stocks Table 1Stocks And Recessions: Case-By-Case When To Get Out When To Get Out All good things must come to an end. As we discussed in our latest Strategy Outlook, the global economy is likely to fall into recession in late 2019.2 Markets will sniff out a recession before it happens, but in general, the lag time between when markets peak and when recessions begin does not tend to be very long. Table 1 shows that the lag has averaged seven months during the post-war era, with the past three recessions featuring an average gap of only four months. In fact, history suggests that the 7th and 8th innings of business-cycle expansions are often the most profitable for investors. The S&P 500 has delivered an average annualized real total return of 14.2% since 1950 in the 13-to-24 months prior to past U.S. recessions (Table 2). This exceeds the average return of 10.1% during business-cycle expansions. The S&P has returned 8% at an annualized pace in the 7-to-12 months prior to past recessions. While this is below the average return during past expansions, it is still well above the average return on bonds and cash during the corresponding periods. Moreover, the performance of stocks in the 7-to-12 month period preceding recessions has improved sharply over the past few business cycles. The S&P 500 generated an annualized real total return of 22.2%, 20%, and 13.6% in the 7-to-12 months prior to the beginning of the 1990-91, 2001, and 2007-09 recessions, respectively. Table 2How Have Stocks Performed Prior To Recessions? When To Get Out When To Get Out Stocks only begin to underperform in a meaningful way in the six months before the recession and continue to underperform in the initial phase of the downturn. Thus, even if one had known with complete certainty that a recession was coming, getting out of stocks more than six months in advance of the downturn would have been a mistake. Bottom line: With another recession still at least a year away, it is too early to get bearish on equities and other risk assets. Peter Berezin, Chief Global Strategist peterb@bcaresearch.com 1 Please see "Macroeconomic Analysis Of The "Tax Cut And Jobs Act" As Ordered Reported By The Senate Committee On Finance On November 16, 2017," The Joint Committee On Taxation, U.S. Congress (November 30, 2017). 2 Please see Global Investment Strategy Outlook, "A Timeline For The Next Five Years," dated December 1, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The growth momentum of China's recent mini-cycle has peaked, but the ongoing slowdown is likely to continue to remain benign in nature. A return to 2015-like conditions is not the most likely outcome over the coming year. Chinese policymakers are likely to increase their focus on reform efforts next year, but the pace will have to be modulated to avoid a repeat of the significant slowdown that occurred in 2014/2015. The risk of a policy mistake is a key theme to watch for 2018. Chinese ex-tech stocks have room to re-rate next year in a benign slowdown scenario. Investors should stay overweight Chinese investable equities vs EM and global stocks. Feature BCA recently published its special year end Outlook report for 2018,1 which described the macro themes that are likely to drive global financial markets over the coming year. In this week's China Investment Strategy report we expand on the Outlook, by reviewing our three key themes for China over the coming year. Key Theme # 1: A Benign End To China's Recent Mini-Cycle We presented our case that the cyclical slowdown of the Chinese economy will likely be benign in our October 12 Weekly Report. Chart 1 presents a stylized view of the Chinese economy over the past three years that was published in that report, which illustrated our framework of how cyclical growth conditions have evolved over this "mini-cycle". It also highlighted three possible scenarios for the coming 6-12 months, and noted that our bet was on scenario 2: A re-acceleration of the economy and a continuation of the V-shaped rebound profile A benign, controlled deceleration and settling of growth into the "stable" growth range, and An uncontrolled and sharp deceleration in the economy that threatens a return to the conditions that prevailed in early-2015 (or worse) Chart 1A Stylized View Of China's Recent "Mini-Cycle" Three Themes For China In The Coming Year Three Themes For China In The Coming Year Since we presented this framework, incoming evidence has been consistent with our call. Chart 2 shows that the Li Keqiang index has now decisively rolled over, but that economic conditions remain well away from their mid-2015 lows. We sketched out the basis for our benign slowdown view in our October 12 piece, but we followed up more formally in a two-part report that addressed the main factors arguing against a return to 2015-like conditions.2 Our view is grounded in the perspective that economic conditions in 2015 were not "normal", and we showed in these reports how a sharp slowdown in the economy was caused by an extremely weak external demand environment and overly tight monetary policy. On the trade front, Chart 3 highlights how Chinese export growth is likely to moderate over the coming several months, which argues against the re-acceleration scenario described above. Since mid-2011, Chinese export growth has lagged what most economic indicators would have predicted, and we noted in part I of our 2015 vs today comparison that this can be traced largely to two factors: a decline in global import intensity and, to a lesser extent, a decline in China's export "market share". Chart 2An Economic Slowdown In China##br## Is Now Underway An Economic Slowdown In China Is Now Underway An Economic Slowdown In China Is Now Underway Chart 3Chinese Export Growth Likely To##br## Converge To Global IP Growth Chinese Export Growth Likely To Converge To Global IP Growth Chinese Export Growth Likely To Converge To Global IP Growth Our analysis in that report suggested that China's 2018 export growth will converge to that of global industrial production, which implies a modest deceleration in the months ahead. Still, export growth of +4% would be a far cry from the significant contraction of exports that occurred in late-2015 / early-2016, which is consistent with a benign growth slowdown. On the monetary policy front, we showed how a monetary conditions approach captured the tightness of China's policy stance from 2012 to early-2015, which led to a material decline in China's industrial sector (Chart 4). Our Special Report last week further supported the view that monetary conditions matter enormously for China's economy; out of 40 macro data series that we tested to reliably predict the Chinese business cycle, only measures of money & credit passed our criteria.3 An aggregate indicator of these 6 series has a similar profile to the Bloomberg Monetary Conditions Index that we have shown in the past (Chart 4, panel 2), and neither suggests that a sharp further slowdown in China's economy is imminent. We will be watching these indicators closely in 2018 for signs of a more aggressive decline than we currently expect. Recently, some investors have pointed to a sharp rise in China's corporate bond yields as a sign that the monetary policy stance is, in fact, tighter than a standard monetary conditions approach would imply. Indeed, China's 5-year AA corporate bond yield has risen 230 bps since late-October 2016, from 3.6% to 5.9%, with most of this rise having occurred due to a rise in government bond yields. Corporate bond spreads have also risen, but relative to spreads on similarly-rated U.S. credit, the rise appears to reflect a rebound from extremely low levels late last year and is not (yet) symptomatic of major concerns over defaults (Chart 5). Chart 4The Ongoing Slowdown Is Likely ##br##To Be Benign The Ongoing Slowdown Is Likely To Be Benign The Ongoing Slowdown Is Likely To Be Benign Chart 5China's Corporate Bond Spreads ##br##Do Not Yet Look Onerous China's Corporate Bond Spreads Do Not Yet Look Onerous China's Corporate Bond Spreads Do Not Yet Look Onerous We are not complacent of the potential risk posed by rising corporate bond yields, and a further significant rise in 2018 could change our view that a benign economic slowdown is the most likely outcome. But for now, the fact that the stock of corporate bond issuance accounts for only 10% of ex-equity social financing suggests that the rise in yields this year is not likely to have an outsized impact on the economy in 2018, beyond the impact that monetary tightening has had on overall average interest rates (which, for now, is material but has not returned rates back to their 2015 levels). Chart 6The Rise In CPI Will Likely Soon Peak The Rise In CPI Will Likely Soon Peak The Rise In CPI Will Likely Soon Peak Finally, the 85 bps rise in Chinese core consumer price inflation that has occurred over the past year has also fed investor concerns that monetary policy will become even tighter next year. To us, this risk is probably overblown, given that demand-driven inflation lags growth (which has clearly peaked). Chart 6 shows the year-over-year change in Chinese core CPI vs that of the Li Keqiang index, and clearly suggests that the acceleration in core prices is likely to soon abate. Poor communication from the PBOC means that it is not clear how prominently core inflation features into the central bank's reaction function, but given that tighter monetary conditions have already caused a peak in both house prices and growth momentum, we doubt that policymakers will see the recent rise in consumer prices as a basis to aggressively tighten further. Bottom Line: The growth momentum of China's recent mini-cycle has peaked, but a return to 2015-like conditions is not the most likely outcome over the coming year. Key Theme # 2: Monitoring The Pace Of Renewed Structural Reforms We have written several reports concerning China's 19th Communist Party Congress over the past three months, both in the lead-up to the event and as a post-mortem.4 The Congress was significant because it likely heralds stepped-up reform efforts in 2018 and beyond. By "reforms", our Geopolitical Strategy team specifically means deleveraging in the financial sector accompanied by a more intense anti-corruption campaign focused on the shadow-banking sector, as well as ongoing restructuring in the industrial sector. Table 1 presents our geopolitical team's assessment of the likely reform scenarios and probabilities over the coming year. It should be clearly noted that the "reform reboot" scenario as described in Table 1 is likely negative for emerging market equities and other plays on China's industrial sector (such as industrial metals). Table 1Post-Party Congress Scenarios And Probabilities Three Themes For China In The Coming Year Three Themes For China In The Coming Year We agree that the "status quo" scenario of no significant reforms is highly unlikely given that President Xi has succeeded in amassing tremendous political capital and that he has an agenda for reform. But the intensity of reforms pursued over the coming year will have to be closely monitored by policymakers, to avoid a repeat of the significant slowdown that occurred in 2014/2015. As such, the view of BCA's China Investment Strategy service is that the reform efforts over the coming year will be structured at a pace that is sufficient to avoid a meaningful deceleration in China's industrial sector and is conducive to the outperformance of Chinese ex-technology stocks. However, the potential for a brisk pace of reforms to cause a more acute decline in industrial activity in 2018 is a risk to our view that China's ongoing economic slowdown is likely to be benign and controlled. We presented our framework for monitoring this risk in our November 16 Weekly Report,5 specifically our BCA China Reform Monitor (Chart 7). The monitor is calculated as an equally-weighted average of four "winner" sectors that outperformed the investable benchmark in the month following the Party Congress relative to an equally-weighted average of the remaining seven sectors. Significant underperformance of "loser" sectors could become a headwind for broad MSCI China outperformance (especially ex-tech), and we will be watching in 2018 for signs that our monitor is rising largely due to outright declines in the denominator. Chart 7Our Reform Monitor Will Help Us Judge ##br##Whether The Pace Of Reforms Becomes Too Burdensome Our Reform Monitor Will Help Us Judge Whether The Pace Of Reforms Becomes Too Burdensome Our Reform Monitor Will Help Us Judge Whether The Pace Of Reforms Becomes Too Burdensome For now, there is no indication that reform risk is affecting the performance of the MSCI China index. Panel 2 of Chart 7 highlights that recent movements in our Reform Monitor have been driven by the "winner" sectors, with the recent selloff largely reflecting a modest correction in global technology stocks sparked by the passage of the U.S. Senate's tax reform plan.6 But we will be watching the monitor closely in 2018, and will adjust it as needed in reaction to additional reform announcements over the coming months. Finally, next year's reform announcements will be highly significant not just because of the "what", but also the "how". It is difficult to see how China's leadership can aggressively pare back heavy-polluting industry and deleverage the financial sector without destabilizing the economy in the near term, but their goal to significantly raise China's per capita GDP and escape the "middle income trap" over the long-term is equally nebulous. We have noted in previous reports that a country's income level is fundamentally determined by its productivity, which is in turn determined by the level and sophistication of its capital stock. Chart 8 shows a clear positive correlation between a country's per capita output, a measure of productivity, and its per capita capital stock. In general, industrialized countries enjoy much higher levels of per capita capital stock than developing economies, leading to much higher productivity, income, and living standards. Therefore, the process of industrialization is fundamentally a process of accumulation of capital stock through investment. As shown in Chart 9, despite some remarkable achievements, the productivity level of the average Chinese worker is still just a fraction of the level in more advanced countries. Conventional economics would suggest that if China wishes to keep progressing on the productivity and income ladder, that it should remain on the path of growing the capital stock through savings and investment. If, however, it abandons its current growth model and "rebalances" towards a consumption-driven one, the risk that the country will stagnate and fail to advance beyond the "middle income trap" looms large. Chart 8Productivity Is Positively Correlated ##br##With Capital Stock Three Themes For China In The Coming Year Three Themes For China In The Coming Year Chart 9China's Catchup Process ##br## Has A Lot Further To Run Three Themes For China In The Coming Year Three Themes For China In The Coming Year Chart 10 makes this point from a different perspective. At root, China's leadership is describing the desire to rapidly transition towards an economy with a much higher level of tertiary industry (services) as a share of GDP, but the U.S. experience suggests that this is a long process that is not investment-oriented. The chart shows the evolution of U.S. investment in private services excluding real estate as a share of total private fixed assets since 1947, when the U.S. had only a slightly higher level of real per capita GDP than China today. It has taken almost 70 years for the share of private services ex real estate to rise by 16 percentage points in the U.S., and it has yet to account for the majority of private fixed investment.7 Services activity/investment also typically requires a highly educated workforce as an input, and rate of China's post-secondary educational attainment appears to be too low to fit the bill (Chart 11). In short, crucial details about China's reform plan should hopefully emerge in 2018, which are likely to have both near-term and multi-year implications. Bottom Line: Chinese policymakers are likely to increase their focus on reform efforts next year, but the pace will have to be modulated to avoid a repeat of the significant slowdown that occurred in 2014/2015. The risk of a policy mistake is a key theme to watch for 2018. Chart 10China Cannot Easily Replace 'Hard' Investment China Cannot Easily Replace 'Hard' Investment China Cannot Easily Replace 'Hard' Investment Chart 11China's Workforce Is Not Well Equipped To Transition To Services Three Themes For China In The Coming Year Three Themes For China In The Coming Year Key Theme # 3: The Relative Re-Rating Of Chinese Investable Ex-Tech Stocks Over the past several years, this publication argued strongly that the valuation discount applied to Chinese equities was unjustified. For the investable benchmark, the past two years of material outperformance vs emerging market and global stocks has removed a significant portion of this discount, and we noted in our August 31 Weekly Report that Chinese equities are no longer "exceptionally cheap".8 However, a good portion of this revaluation has been isolated to the tech sector. Chart 12 shows that while the 12-month forward P/E ratio for Chinese tech stocks is 70% higher than the global average, ex-tech shares still trade at a 37% relative discount. Chart 13 echoes this conclusion by showing the ex-tech price-to-book ratio for every country in MSCI's All Country World index; by this metric China's ex-tech cheapness currently ranks in the 85th percentile, behind only Israel, Colombia, Italy, Jordan, Korea, Russia, and Greece. Chart 12China: Expensive Tech, Extremely Cheap Ex-Tech China: Expensive Tech, Extremely Cheap Ex-Tech China: Expensive Tech, Extremely Cheap Ex-Tech Chart 13China's Ex-Tech P/B Ratio Among The Lowest In The World Three Themes For China In The Coming Year Three Themes For China In The Coming Year Charts 12 and 13 are weighted simply by the remaining market capitalization in each country's market after excluding the technology sector, meaning that the deep discount applied to Chinese banks wields a disproportionate influence (financials would make up 40% of China's MSCI ex-tech "index", if one officially existed). Although we agree that the magnitude of the rise in debt over the past several years warrants somewhat of a P/B discount, we would argue that the risk is more earnings and dilution-related rather than solvency-related. It is highly unlikely that the Chinese government would allow large banks to fail outright in the event of a serious financial crisis, but the potential for a rise in provisioning and significant new capital raising suggests that the risk premium for these stocks should be somewhat higher than what would otherwise be normal. Chart 14China's Banks Can Re-Rate ##br##In A Benign Slowdown Scenario China's Banks Can Re-Rate In A Benign Slowdown Scenario China's Banks Can Re-Rate In A Benign Slowdown Scenario Still, either the Chinese bank risk premium is excessive, or the banking sectors of several major DM countries are significantly overvalued. For example, Chinese investable banks trade at a P/B ratio of 0.8, but Canadian, Australian, and Swedish banks trade at an average P/B ratio of 1.7. If the concern over credit excesses is the source of the higher risk premium applied to Chinese banks, Chart 14 suggests that there is a major inconsistency in pricing; an equally-weighted average of Canadian, Australian, and Swedish private sector debt-to-GDP is higher than that of China's, at 214% vs 211% as of Q2 this year. Our bet is the former: In a world where outsized returns are scarce and U.S. equities are overvalued, a benign growth deceleration and a modulated pace of reforms favor a lessening of the substantial valuation discount currently applied to China's investable ex-tech stocks. Barring a more pronounced slowdown in China's economy than we currently expect, investors should stay overweight the MSCI China investable index in 2018, within both an emerging markets and global equity portfolio. Bottom Line: Chinese ex-tech stocks have room to re-rate in a benign slowdown scenario. Investors should stay overweight Chinese investable stocks in 2018. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see BCA Special Report, "2018 Outlook - Policy And The Markets: On A Collision Course," dated November 20, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Reports "China's Economy - 2015 Vs Today (Part I): Trade", dated October 26, 2017, and "China's Economy - 2015 Vs Today (Part II): Monetary Policy", dated November 9, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of China's Business Cycle", dated November 30, 2017, available at cis.bcaresearch.com. 4 Please see China Investment Strategy and Geopolitical Strategy Special Reports, "China's Nineteenth Party Congress: A Primer", dated September 14, 2017, "How To Read Xi Jinping's Party Congress Speech", dated October 18, 2017, and BCA Special Report "China: Party Congress Ends ... So What?", dated November 2, 2017, available at cis.bcaresearch.com. 5 Please see China Investment Strategy Weekly Report, "Messages From The Market, Post-Party Congress", dated November 16, 2017, available at cis.bcaresearch.com. 6 The Senate bill that was passed this week unexpectedly retained 20% alternative minimum tax (AMT) for corporations, which would disproportionately impact U.S. technology companies. Indications currently suggest that the final tax cut bill to be approved by both houses of Congress will repeal the AMT. 7 In 2016, real estate investment accounted for roughly 29% of total private investment in fixed assets, and the sum of primary and secondary industry (agriculture, mining, utilities, construction, and manufacturing) accounted for about 28%. 8 Please see China Investment Strategy Weekly Report, "A Closer Look At Chinese Equity Valuations", dated August 31, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights In this report we use a statistical approach to test the ability of a broad array of macro data series to reliably predict the Chinese business cycle. Out of 40 series that we examined, only 6 passed our test criteria. All 6 of these series are measures of money & credit, supporting the view that money growth deserves to be closely watched as an indicator for the Chinese economy. A composite leading indicator of the 6 "passing" series suggests that the Chinese economy will continue to slow over the coming months, but in a benign, controlled fashion. Investors should stay overweight investable Chinese stocks in US$ terms, versus both the EM and global equity benchmark. Feature Over the past two months we have significantly heightened our focus on the cyclical condition of China's economy. We presented our framework for tracking the end of China's mini-cycle in our October 12 Weekly Report,1 and recently followed up with a two-part report that examined the key differences facing China today from what prevailed in mid-2015, when the economy operated below what investors and market participants considered to be a "stable" pace of growth.2 All of these reports have been anchored by our view that China's economy suffered from a "double whammy" in 2015; a weak external demand environment and overly tight monetary conditions. In this report, we take a different approach to gauging the slowdown in China's economy by testing a wide range of commonly-watched macro data series for signs that they reliably lead economic activity. While our criteria for testing these series in our "data lab" are statistical in nature, they are not overly difficult for investors to grasp, and they help provide an empirical basis for understanding what data are relevant in predicting the direction and magnitude of China's economic growth trend. The conclusions of our study are revealing, in that they strongly point to measures of money & credit as the most reliable predictors of the Chinese economy since 2010. While a composite leading indicator of these predictors suggests that the Chinese economy will continue to slow over the coming months, the pace and magnitude of the decline are both consistent with our view that China will experience a benign, controlled deceleration. A Brief Methodological Overview Below we provide a brief overview of our approach, by addressing three key questions: what are we trying to predict, what series do we use as predictors, and how do we judge what series are "useful" in explaining the Chinese business cycle? What are we trying to predict? We use the Li Keqiang Index (LKI) as a proxy for the Chinese business cycle in this report, for three reasons (described below): Despite the potential to eventually become a consumer-oriented society, the Chinese economy remains highly geared to investment (and the industrial sector more generally). Investors are very familiar with the LKI, ever since a 2007 U.S. diplomatic cable (leaked in late-2010) quoted Li, then Communist Party Secretary of Liaoning, as saying to U.S. Ambassador Randt that China's GDP figures are "man-made" and unreliable. Li's focus on electricity consumption, rail cargo volume, and bank loans have since become a standard metric for China analysts to track. More importantly, however, we use the LKI as a proxy because it continues to provide important information about the Chinese economy: Chart 1 shows that it correlates well with the growth in earnings for the MSCI China index ex technology, and Chart 2 highlights that it also leads China's nominal import growth. As such, the index is particularly relevant for global investors, who are most concerned with China's investible stock performance and the country's impact on global exports. What series were used in our approach? Chart 1The Li Keqiang Index Predicts Investable EPS... The Li Keqiang Index Predicts Investable EPS... The Li Keqiang Index Predicts Investable EPS... Chart 2...And Nominal Import Growth ...And Nominal Import Growth ...And Nominal Import Growth In order to test the predictability of China's business cycle, we compiled a list of 40 highly-tracked macroeconomic variables (presented in Table 1) and grouped them into six distinct categories: Economy-wide measures, such as composite LEIs and models of GDP growth Measures related to investment and the corporate sector, such as PMIs, fixed-asset investment, and industrial production Variables related to the consumer sector, such consumer confidence, retail sales, and the employment component of the official PMIs Housing indicators, such as house price indexes and residential floor space sold Government spending, and A variety of money, credit, and financial conditions measures Table 1List Of Macroeconomic Data Series Included In Our Study The Data Lab: Testing The Predictability Of China's Business Cycle The Data Lab: Testing The Predictability Of China's Business Cycle As part of this analysis, all series, including the LKI, were smoothed with a 3-month moving average. Government spending was the exception, which was smoothed with a 6-month average. How do we judge which series help predict the business cycle? Using a sample of January 2010 to September 2017, we test whether any of these measures can reliably predict the LKI using two statistical concepts: a lead/lag correlation profile, and the Granger causality test. A summary of these concepts is presented below: Lead/Lag Correlation Profile: While most investors are quite familiar with the Pearson correlation coefficient, in this report we present it in a unique way. For each variable, we calculate the correlation between the Li Keqiang index and leading and lagged values of the variable, to create a series of correlations which we present as a function of time. Variables that reliably lead the LKI should have a higher correlation with future values of the LKI, and vice versa. Chart 3 presents the ideal correlation profile for a predictor of the LKI (which we will use as a reference point), given that it illustrates the correlation profile of the LKI with itself in six-months. Granger Causality Test: While somewhat technical, the concept of Granger causality is fairly simple and is similar to the correlation profile presented above. The logic of the test is that if one variable predicts another, lagged values of the predictor should help explain the dependent variable in a regression model. Granger causality simply takes the extra step of controlling for the possibility that the dependent variable predicts itself, by including lagged values of itself in the regression. Our criteria for a good leading indicator for the LKI is thus: A correlation profile that leads rather than lags (i.e., a profile that peaks in advance of t=0, like that shown in Chart 3) A relatively strong correlation profile, defined as a peak correlation coefficient that exceeds 0.5 A causality test result that suggests the indicator "Granger-causes" the LKI. Chart 3The Best Profile Will Look Like The Correlation Of The LKI With Future Values Of Itself The Data Lab: Testing The Predictability Of China's Business Cycle The Data Lab: Testing The Predictability Of China's Business Cycle The Importance Of Money & Credit: Results From The "Data Lab" Chart 4 presents the average correlation profiles for the six data categories described above, alongside the "ideal" profile. Individual correlation profiles for all 40 of the underlying macro series used in this report are available in Appendix I. Chart 4Measures Of Money & Credit Are ##br##The Best Predictors Of The LKI The Data Lab: Testing The Predictability Of China's Business Cycle The Data Lab: Testing The Predictability Of China's Business Cycle The chart presents several important conclusions: First, it highlights that while economy-wide measures and those related to investment and the corporate sector have tended to have a high correlation with the LKI, their correlation profiles lag rather than lead. In other words, the LKI tends to predict these variables, not the other way around. The Markit/Caixin and NBS manufacturing PMIs stand out as notable exceptions to this conclusion. Second, variables related to both consumer spending and government expenditure appear to have little ability to predict the Chinese business cycle as defined in this report. In fact, in the case of government spending, the evidence points to the fact that the LKI reliably leads expenditure by approximately a year, which suggests that fiscal policy in China is responsive and countercyclical (but not leading). Third, measures of money and credit, and housing indicators to a lesser degree, appear to fulfill the first two of our criteria for a good leading indicator of the LKI. Both profiles peak in advance of t=0, and at least in the case of money & credit, have a decently strong relationship. To test the third criterion listed above, we selected all of the individual macro series that passed the correlation profile test and subjected them to a Granger causality test. Table 2 presents the variables that were selected as well as the results of the test, expressed as a probability that the variable in question "Granger-causes" the LKI, and vice versa. Of the 12 variables that were selected, Table 2 highlights that only 6 passed, all of which belong to the money & credit category. This is noteworthy, especially given the focus of many investors on the private and official manufacturing PMIs. Among these 6 remaining variables, the relative strength of the probabilities shown in columns 3 and 4 suggest that monetary conditions and the Bloomberg China Credit Impulse Index (the flow of adjusted total social financing expressed as a percent of GDP) appear to be the most reliable, with money measures being the least. Table 2Granger Causality Test Results For Select Macro Series The Data Lab: Testing The Predictability Of China's Business Cycle The Data Lab: Testing The Predictability Of China's Business Cycle Still, our results show that it is more accurate to state that money supply measures "cause" the LKI than vice versa, supporting the view that money growth deserves to be closely watched as an indicator for the Chinese economy. Investment Implications Chart 5 presents a composite leading indicator for the Li Keqiang index based on the six variables presented above. The indicator is advanced by 4 months, and currently suggests that the LKI will end up retracing about 50% of its late-2015 to early-2017 rise. For now, this is consistent with our view that the Chinese economy will experience a benign, controlled deceleration. An additional factor that strengthens our conviction in this view is the fact that the weakest components of the indicator on a YoY basis, M2 and M3 (as defined by our Emerging Markets Strategy service), have been growing more rapidly over the past three months (Chart 6). Chart 5Our Composite LKI Indicator Suggests ##br##A Benign Slowdown In Growth Our Composite LKI Indicator Suggests A Benign Slowdown In Growth Our Composite LKI Indicator Suggests A Benign Slowdown In Growth Chart 6Money Supply Growth ##br##Has Recently Rebounded Money Supply Growth Has Recently Rebounded Money Supply Growth Has Recently Rebounded Given this economic outlook, our view is that investors should remain overweight Chinese investible stocks relative to the EM and global benchmarks. The first factor in favor of an allocation towards China is its tech sector weight; 42% of the index is made up of technology stocks, versus 29% and 19% in the EM and global benchmarks. While China's tech sector has already massively outperformed this year, Chart 7 highlights that it is a clear domestic/consumer play and thus unlikely to underperform significantly over the coming year. Chart 7Chinese Tech Companies ##br##Are A Domestic Play Chinese Tech Companies Are A Domestic Play Chinese Tech Companies Are A Domestic Play Excluding technology, we noted in our November 9 Weekly Report3 that while a deceleration in the LKI would weigh on the earnings growth of ex-tech investable stocks, we also expect earnings growth to moderate in the developed world. However, this ambiguous ex-tech relative earnings outlook is buttressed by the fact that Chinese ex-tech stocks are extremely undervalued compared to their global peers, a valuation gap that we believe will lessen if the end of China's recent mini-cycle is truly benign. Bottom Line: A broad test of China's macro data suggests that several money & credit measures have been the best predictors of the Chinese business cycle since early-2010. While these measures suggest that Chinese economic activity is set to decelerate even further, a return to 2015-like conditions does not appear to be likely. Investors should stay overweight Chinese investable stocks in US$ terms, versus both the EM and global equity benchmark. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Tracking The End Of China's Mini-Cycle", dated October 12, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Reports, "China's Economy - 2015 Vs Today (Part I): Trade", dated October 26, 2017, and "China's Economy - 2015 Vs Today (Part II): Monetary Policy", dated November 9, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "China's Economy - 2015 Vs Today (Part II): Monetary Policy", dated November 9, 2017, available at cis.bcaresearch.com. Appendix I Li Keqiang Lead/Lag Correlation Profile For All Variables In Our Study Chart A1 The Data Lab: Testing The Predictability Of China's Business Cycle The Data Lab: Testing The Predictability Of China's Business Cycle Chart A2 The Data Lab: Testing The Predictability Of China's Business Cycle The Data Lab: Testing The Predictability Of China's Business Cycle Chart A3 The Data Lab: Testing The Predictability Of China's Business Cycle The Data Lab: Testing The Predictability Of China's Business Cycle Chart A4 The Data Lab: Testing The Predictability Of China's Business Cycle The Data Lab: Testing The Predictability Of China's Business Cycle Chart A5 The Data Lab: Testing The Predictability Of China's Business Cycle The Data Lab: Testing The Predictability Of China's Business Cycle Chart A6 The Data Lab: Testing The Predictability Of China's Business Cycle The Data Lab: Testing The Predictability Of China's Business Cycle Chart A7 The Data Lab: Testing The Predictability Of China's Business Cycle The Data Lab: Testing The Predictability Of China's Business Cycle Chart A8 The Data Lab: Testing The Predictability Of China's Business Cycle The Data Lab: Testing The Predictability Of China's Business Cycle Cyclical Investment Stance Equity Sector Recommendations

Highlights The current mini-upswing in the global mini-cycle started in May and is likely to end around January. On a 6-month horizon, lean against the rally in industrial metals. Equity investors should underweight Basic Resources, and especially Industrial Metals and Mining. The contrasting economic fortunes of Spain and Italy may switch. The peak bank credit impulse for Spain is almost certainly behind it, while for Italy it likely lies ahead. On this hope, we will dip our toes into a small pair-trade: long Italian BTPs versus French OATs. Feature Key to the medium-term behaviour of markets is the existence of what we call 'mini-cycles' in global activity. The evolution of these perpetual mini-cycles explains much of what has happened, what is happening, and what will happen, to financial markets both in Europe and more broadly. Chart of the WeekExpect A Trend-Reversal In The Metals Market Expect A Trend-Reversal In The Metals Market Expect A Trend-Reversal In The Metals Market Mini-cycles are not a hypothesis. They are an indisputable empirical fact. Just look at the global bond yield (Chart I-2), metal price inflation (Chart I-3), global inflation (Chart I-4), and the bank credit impulse (Chart I-5 and Chart I-6). The regular mini-cycles shout out at you! Furthermore, given that these clearly observed mini-cycles show the same half-cycle length of about 8 months, Investment Reductionism strongly suggests that there is a common over-arching driver. Chart I-2The Global Bond Yield Exhibits Mini-Cycles The Global Bond Yield Exhibits Mini-Cycles The Global Bond Yield Exhibits Mini-Cycles Chart I-3Metal Price Inflation Exhibits Mini-Cycles Metal Price Inflation Exhibits Mini-Cycles Metal Price Inflation Exhibits Mini-Cycles Chart I-4Inflation Exhibits Mini-Cycles Inflation Exhibits Mini-Cycles Inflation Exhibits Mini-Cycles Chart I-5The Global Credit Impulse Exhibits Mini-Cycles The Global Credit Impulse Exhibits Mini-Cycles The Global Credit Impulse Exhibits Mini-Cycles Chart I-6Individual Credit Impulses Exhibit Mini-Cycles Individual Credit Impulses Exhibit Mini-Cycles Individual Credit Impulses Exhibit Mini-Cycles Explaining Mini-Cycles Previously,1 we explained that the distinct mini-cycles are interconnected parts of the same never-ending feedback loop. A lower bond yield accelerates bank credit flows... which boosts economic growth... which pushes up commodity inflation and overall inflation... causing the bond market to raise the bond yield, at which point the cycle reverses. And then the alternate cycles repeat ad perpetuam (see Box I-1). Box I-1The Mathematics Of Mini-Cycles How To Profit From Mini-Cycles How To Profit From Mini-Cycles One common question we get is: why focus on bank credit analysis and not on bond-intermediated credit analysis too? The simple answer is that bank credit expands the broad money supply whereas bond-intermediated credit usually does not. When a bank issues a new loan, fractional reserve banking allows it to create money 'out of thin air'. In contrast, when a company or government issues a new bond, no new money is created, unless the primary issue is financed by the central bank - which is generally forbidden. Usually, when a bond is issued, existing money just moves from one account - that of the bond buyer - to another account - that of the bond issuer. This means that bond-intermediated credit cannot increase demand by creating new money, but only by increasing the velocity of existing money. Whereas bank credit can increase demand by increasing both the amount of money and its velocity. Therefore, changes in bank credit are the much bigger driver of the mini-cycle in economic activity. If a bank issues 100 euros of credit today, then we know that this new money will be spent in the coming days and weeks - because nobody borrows money just to sit on it. If, in the previous period, the bank had issued 90 euros which was spent, it means that economic activity in the coming period will grow by 10 euros. But if the bank had previously issued 110 euros, it means that economic activity in the coming period will contract by 10 euros. In this way, the cycles in credit and activity are interconnected. Mini-upswings in the credit impulse mini-cycle tend to signal mini-upswings in commodity inflation (Chart I-7), overall inflation and bond yields. So if we can identify turning points in the credit impulse then we can correctly position the cyclical stance of our investment strategy. Chart I-7The Same Mini-Cycle: The Global Credit Impulse And Metal Price Inflation The Same Mini-Cycle: The Global Credit Impulse And Metal Price Inflation The Same Mini-Cycle: The Global Credit Impulse And Metal Price Inflation The problem is that the bank credit data is slow to come out. For example, although we are in the middle of November, the last bank credit data for the euro area refers to September. This means that if the mini-cycle is turning now, we might not find out until January. Nevertheless, we can still use the mini-cycle framework. We know that the current mini-upswing started in May and that mini-upswings have an average length of 8 months. Hence, we can infer that the mini-upswing is likely to end around January. That said, upswing lengths do have some degree of variation: the current upswing might be longer or shorter than the average. How to avoid being too early or too late? Combining Mini-Cycles With Fractal Analysis To optimise our proprietary mini-cycle framework, we propose combining it with our proprietary fractal analysis framework. As regular readers know, fractal analysis measures whether herding in a specific investment has become excessive, signalling the end of its price trend. The combined mini-cycle and fractal framework works best if we use a 130-day herding indicator (fractal dimension), as it broadly aligns with the mini half-cycle length. Excessive herding signals that an investment's trend is approaching exhaustion because the liquidity that has fuelled the trend is about to evaporate. Liquidity is plentiful when the market is split between different herds - say, short-term momentum traders and long-term value investors. This is because the herds disagree with each other. If the price fluctuates up, the momentum trader wants to buy while the value investor wants to sell; and vice-versa. So the herds trade with each other with plentiful liquidity. But liquidity starts to evaporate when too many value investors join the momentum herd. Instead of dispassionately investing on the basis of value, value investors get sucked into chasing a price trend, and their buy orders add fuel to the trend. The tipping point comes when all the value investors have joined the momentum herd. If a value investor then suddenly reverts to type and puts in a sell order, he will find that there are no buyers left. Liquidity has evaporated, and finding new liquidity might require a substantial reversal in the price to attract a buy order from an ultra-long-term deep value investor. Earlier this year, our combined frameworks signalled that the aggressive rise in bond yields was likely to reverse (Chart I-8). Therefore, on February 2 we correctly advised: "Lean against the rise in bond yields and bank equities." Chart I-8Excessive Herding In Bonds Always Signals A Trend Reversal Excessive Herding In Bonds Always Signals A Trend Reversal Excessive Herding In Bonds Always Signals A Trend Reversal Today, we see the same dynamic in parts of the commodity rally - and specifically the move in the LME Index (Chart of the Week). Hence, on a 6-month horizon, lean against the rally in industrial metals. Equity investors should underweight Basic Resources, and especially Industrial Metals and Mining. Could Italy Be A Good Surprise? Returning to the concept of the bank credit cycle, the evolution of longer-term impulses also explains the contrasting recent fortunes of Spain and Italy. In 2013, Spain recapitalized its banking system and ring-fenced bad assets within a 'bad bank'. In effect, it finally did what other economies - most notably the U.S., U.K. and Ireland - had done several years earlier in response to their own housing-related banking crises. As Spanish banks' aggressive deleveraging ended, the bank credit impulse rebounded very sharply and has remained positive for several years. This undoubtedly explains why Spanish real GDP has grown by 13% since mid-2013 (Chart I-9). In contrast, Italy's banking system remained dysfunctional - which meant that its own credit impulse stayed much more muted and barely positive over the past four years (Chart I-10). But now, the Italian banking system is slowly recuperating. Italian banks' equity capital is rising, their solvency is improving, and the share of non-performing loans has fallen sharply this year. Chart I-9Spain's Peak Credit Impulse##br## Is Probably Behind It Spain"s Peak Credit Impulse Is Probably Behind It Spain"s Peak Credit Impulse Is Probably Behind It Chart I-10Italy's Peak Credit Impulse##br## Is Likely Ahead Of It Italy"s Peak Credit Impulse Is Likely Ahead Of It Italy"s Peak Credit Impulse Is Likely Ahead Of It So the contrasting economic fortunes of Spain and Italy may switch. The peak bank credit impulse for Spain is almost certainly behind it, while for Italy it likely lies ahead. On this hope, we will dip our toes into a small pair-trade: long Italian BTPs versus French OATs. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Weekly Report 'Credit Slumps While Animal Spirits Soar. Why?' March 30, 2017 available at eis.bcaresearch.com Fractal Trading Model* There are no new trades this week, leaving us with six open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 Short Nikkei225/Long Eurostoxx50 Short Nikkei225/Long Eurostoxx50 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch -##br## Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - ##br##Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch -##br## Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch -##br## Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations