Economy

Special Report

Dear Client, The attached report on China’s just-completed nineteenth National Party Congress marks the culmination of six years of political analysis by BCA’s Geopolitical Strategy. In it, my colleague Matt Gertken posits that President Xi Jinping’s domestic political constraints have significantly eased, allowing his administration to intensify its preference for structural reform. Our cardinal analytical rule holds that policymaker preferences are optional and subject to constraints, whereas constraints are neither optional nor subject to preferences. As a matter of methodology, we focus on constraints. In China, Xi faced formidable constraints when he took power five years ago, which is why we pushed against the enthusiastic narrative at the time that he would transform China through supply-side reforms. This narrative, strongest in the wake of the October 2013 Third Plenum, has not materialized in line with investor expectations thus far. In this report, we argue that it is time to adjust the view on China. Xi has amassed substantial political capital thanks to his anti-corruption campaign, centralization of power, and other actions largely popular with the middle class. Investors are today missing this point because they are disappointed with the lack of genuine progress since 2012. We expect that President Xi will begin spending this political capital by favoring supply-side reforms, especially by reining in the rampant credit growth that has underpinned China’s investment-led economic model. In the short term, this means that politics in China will evolve from a tailwind to a headwind to growth. In the long term, it is too soon to say what it means. For investors, however, it means that today’s synchronized global growth recovery may be at risk of a policy-induced growth slowdown in China. I sincerely hope you enjoy our report. If you are interested in similar investment-relevant geopolitical analysis, please do not hesitate to contact us for a sample of our work. Kindest Regards, Marko Papic, Senior Vice President Chief Geopolitical Strategist Highlights Xi Jinping has shed domestic political constraints that have been in place since 2012; The lack of constraints suggests his reform agenda will intensify over the next 12 months; The use of anti-corruption agencies to enforce economic policy suggests that reform implementation will become more effective; Chinese politics are shifting from a tailwind to a headwind for global growth and EM assets. Feature Chart 1Stability Continues After Party Congress? China's nineteenth National Party Congress concluded on October 25 with the new top seven leaders - the members of the Politburo Standing Committee (PSC) - taking the stage in the Great Hall of the People. The party congress is a five-year leadership reshuffle that, in this case, marks the halfway point of President Xi Jinping's term in office.1 President Xi was the center of attention throughout the event. It is widely perceived that he is the most powerful Chinese leader since Deng Xiaoping. The Communist Party chose to elevate his personal power in conspicuous ways that raises political uncertainties about the succession in 2022 as well as about the future trajectory of Chinese policy, including economic policy. BCA's Geopolitical Strategy has awaited this transition since 2012, when President Xi and Premier Li Keqiang took over the top two positions in China.2 While we are inherently skeptical of Xi's grandiose reform agenda, we are also deeply aware of the importance of political constraints in determining economic policy outcomes - and Xi has just overcome significant domestic constraints. If Xi accelerates and intensifies his reforms next year - particularly deleveraging and industrial restructuring - he will add volatility to Chinese risk assets and create a drag on Chinese growth. Xi's personal concentration of power could be an enabling factor in driving reforms. But it will certainly be a source of higher political uncertainty over the next five years (Chart 1), especially as the 2022 succession approaches. Therefore a lack of reform would be a noxious combination. Finally, China's ascendancy increases the phenomenon of global multipolarity - it is a challenge to the U.S.-led system and will eventually produce a reaction, most likely a negative one.3 In short, Chinese political and geopolitical risk is understated. This situation presents a range of risks and opportunities for investors, but it is broadly a headwind for global growth and EM assets. A Chinese "policy mistake" is also a risk to our House View of being overweight equities and underweight bonds for the next 12 months. Back To 2012 When Xi rose to power in 2012, it was widely known that China's economy had reached a pivotal moment. Exports were declining as a share of GDP in the wake of the Great Recession and end of the U.S. "debt super-cycle," and investment was weakening as the country's massive fiscal and credit stimulus wore off (Chart 2). Meanwhile the Communist Party faced a crisis of legitimacy, with an emergent middle class making ever greater demands on the system (Chart 3). The rapid rise in household income over preceding years, combined with high income inequality and poor quality of life, raised the prospect of serious socio-political challenges to single-party rule.4 President Hu Jintao searched for ways to strengthen state control over an increasingly restless society, while outgoing Premier Wen Jiabao warned openly that China's economy was unsustainable and imbalanced and that political reform would be an "urgent task." Hu Jintao's farewell address at the eighteenth party congress (2012) reflected the party's grave concerns. His successor, Xi Jinping, was in charge of drafting the report. This relationship highlighted an important degree of party consensus. The report called for fighting corruption and disciplining the party, while doing more to protect households from the negative externalities of the past decade's rapid growth, including pollution (Chart 4). Chart 2Xi Took Power Amid Economic Transition Chart 3The Communist Party's Newest Constraint Chart 4Xi Took Power Amid Instability Risks It also outlined China's hopes of becoming a more consequential global player through acquiring naval power and forging a new, peer relationship with the United States. The overriding imperative was to win back support and legitimacy for the party, lest it fall victim to the fate of the world's other Marxist-Leninist regimes - i.e. internal socio-economic sclerosis and external pressure from the U.S.-led, democratic-capitalist world order. Xi Jinping took over at this juncture, using the 2012 work report as his guideline for an ambitious policy agenda. Xi's main goals centered on power: namely, ensuring regime survival at home and increasing China's international clout abroad. Specifically, the Xi administration sought to (1) centralize political control so that difficult choices could be made and implemented effectively; (2) improve governance so that public discontent could be mitigated over the long run; and (3) restructure the economy so that productivity growth could remain robust in the face of sharply declining labor force growth, thus stabilizing the potential GDP growth rate.5 Obviously there was no guarantee that Xi would be successful. China's response to the Global Financial Crisis had required a large-scale decentralization of control: local governments, banks, state-owned enterprises and shadow lenders were encouraged to lever up and grow amid the global collapse (Chart 5). This created imbalances and liabilities for the central leadership while also creating new economic (and hence political) centers of power outside Beijing. Chart 5aLocal Government Spending Unleashed... Chart 5b...And Shadow Lending Too The central leadership also seemed to be losing control of the provinces: regional and institutional powerbrokers had emerged, challenging the party's hierarchy, and there was even reason to believe that the armed forces were deviating from central leadership.6 Without control of the local governments and other key institutions, any reform agenda would get bogged down. Finally, the political cycle was not particularly favorable to Xi. While the line-up of the all-powerful PSC looked favorable from 2012-17, the next crop of Communist leaders set to move up the ladder in 2017 seemed likely to constrain him. Moreover, the previous two presidents had chosen Xi's successors for 2022, according to party norms. Xi had very little room for maneuver - and this was negative for his policy outlook overall. As such, BCA's Geopolitical Strategy poured cold water on the more enthusiastic forecasts of economic reforms throughout Xi's first term. Our assessment was that he would focus on anti-corruption and governance reforms first and only attempt genuine economic reforms once his political capital grew significantly. Bottom Line: Xi Jinping faced major obstacles to his policy agenda of centralization, governance and economic reform in 2012. He faced a large and restless middle class, the difficulty of reining in local governments and state institutions, and the likelihood that China's previous top leaders would constrain his maneuverability in 2017 and 2022. Xi's First Term A lot has changed over the past five years. First, both global demand for Chinese goods and Chinese domestic demand have held up rather well, giving China a badly needed cushion during its economic transition. Steady consumption growth has partially offset the blow from declining investment, while Chinese exports have grown well, often faster than global trade (Chart 6).7 Second, Xi has consolidated power extensively within the party, the army, and other institutions. He executed the most aggressive purge that the party has seen in decades, enabling him to rebuild some public trust among a middle class worn out by corruption, as well as to remove political rivals (Chart 7). He also launched an extensive restructuring of the People's Liberation Army, its organizational structure and personnel, ensuring that "the party controls the gun."8 And he intensified social control, particularly in the online realm. Chart 6Changing The Economic Model Chart 7Anti-Corruption Campaign Still Going Symbolically, Xi was anointed the "core" of the Communist Party by the political elite in late 2016. Economic reform, however, has been compromised by Xi's focus on consolidating political power. True, he and Premier Li Keqiang tinkered with various policies to cut red tape, simplify domestic taxes, attract foreign investment, and encourage better SOE management, but none of the reforms launched over the past five years were painful and thus none were significant.9 Nowhere was this more apparent than during 2015-16, when economic and financial instability caused the Xi administration to delay reform initiatives and focus on reforming the economy. Beijing increased infrastructure spending, bailed out the local governments, depreciated the RMB, and imposed capital controls (Chart 8). "Old China," state-owned China, was the primary beneficiary. The stimulus-fueled rebound helped stabilize the global economy in 2016-17, particularly commodity-producing emerging markets, but it exacerbated China's internal problems - slow productivity growth, excessive debt creation, weak private sector investment, and waning foreign investment (Chart 9). Chart 8State Interventions In 2015-16 Chart 9Economic Reforms Still Needed The upside, however, was stability, which enabled Xi to approach the nineteenth National Party Congress from a position of strength. Now that the party congress has concluded, we can say that Xi has notched a series of significant "victories" and that his political capital is overflowing: Xi Jinping Thought: The congress voted to enshrine Xi's name into its constitution (Table 1), with a phrasing that echoes "Mao Zedong Thought," hence elevating Xi to immense moral authority within the party. The name of Xi's philosophy, "Socialism with Chinese Characteristics for a New Era," makes a slight adjustment to Deng Xiaoping's market-friendly philosophy. In other words, Xi's authority stems from his providing a synthesis of the regime's greatest two leaders: Mao's single-party Communist rule is being reaffirmed, but Deng's attention to economic reality and the need for pragmatic policies has also been preserved. As we have argued, this constitutional change is a reflection of the fact that Xi has already positioned himself to be the most influential leader well into the 2020s. Table 1Xi Jinping Thought Xi removes his successors: Xi managed to exclude any of China's "sixth generation" of leaders from the Politburo Standing Committee. He thus broke a very important (albeit informal) party norm. The norm was created under Deng Xiaoping to ensure a smooth transition of power, unlike the power struggle that occurred upon Mao's death. Now Xi will have a greater hand in choosing his successor, or even staying in power beyond 2022. This aids in the process of centralization, but it may well prove a step backwards in terms of governance and reform - that remains to be seen. It is a source of higher political uncertainty going forward. Xi dominates the Politburo: Xi prevented his predecessor Hu Jintao's loyalists from gaining a majority on the Politburo Standing Committee, as they seemed lined up to do in 2012. The line-up of the new Politburo and Politburo Standing Committee broadly indicates that Xi and his faction are the dominant force (Table 2). Taken with Xi's personal power, this is significant political capital with which the new administration can push its priorities, whatever they may be. Xi gets a new inquisitor: The Central Commission for Discipline Inspection (CDIC) is the party's internal watchdog. It has taken the leading role in the sweeping party purge and anti-corruption campaign over the past five years. Xi removed its chief, the hugely influential Wang Qishan, by reinforcing the retirement age and two-term PSC limit - a notable case of institutional norms being upheld. He put one of his loyalists, Zhao Leji, in this role instead. The CDIC will have a huge role over the next five years, and a market-relevant one, as we discuss below. Table 2The Magnificent Seven: China's New Politburo Standing Committee The above conclusions raise the possibility that Xi has become excessively powerful, that political institutions in China are being eroded by personal rule, and that political risks are set to explode upward in the near future. However, it is too soon to declare that Xi has staged a Maoist "power grab." There are reasons to think that Xi's accumulation of power has not overturned the delicate internal balances within the top leadership bodies.10 The result is in keeping with what we expected in our Strategic Outlook last December: Xi Jinping has amassed formidable political capital, but he has not destabilized the Chinese political system.11 He is a strongman leader within the established political system of an authoritarian state - he is not a tyrant seizing power in a bloodless revolution. (At least, not yet.) This is broadly positive for China's policy continuity and political framework - and in this sense it is also broadly market-positive, being an outgrowth of the status quo rather than a disruptive break from it. China's leaders continue to be career politicians, trained in law or economics, with considerable executive experience in governing and limited business or military experience, all unified in the name of regime preservation (Chart 10). Over the long run, this suggests that China's "Socialist Put" remains intact, i.e. that the state will intervene to prevent a crash landing.12 Nevertheless, an important corollary of the above is that Xi holds the balance, and hence there are no longer any major domestic political or governmental constraints to prevent him from pursuing his policy agenda - especially over the next 12 months, when his political capital is still fresh and the economic backdrop is favorable. The fact that Xi emphasized "sustainable and sound" growth, deliberately excluded GDP growth targets beyond 2021, and altered the definition of the Communist Party's so-called "principal contradiction" in order to prioritize quality-of-life improvements, suggests that the reform agenda is about to get rebooted. Bottom Line: Xi Jinping has consolidated power extensively, but he has not staged a silent coup d' état or overthrown the balance of power within the Communist Party. This suggests that Xi's policies and reforms will intensify over the next year. Chart 10Characteristics Of Chinese Rulers Mostly Unchanged Since 2012 Xi's Second Term: What To Expect Instead of playing it safe in the lead-up to the all-important party congress over the past twelve months, Xi surprised the markets with a series of regulatory actions designed to tamp down the property bubble, regulate the financial markets, punish speculation, and reduce industrial overcapacity and pollution (Chart 11).13 This tightening of policy strongly signaled that Xi's appetite for political risk is rising in keeping with his growing political capital. Beijing is signaling that it aims to continue with tougher financial, industrial and environmental reforms in the aftermath of the party congress. In particular, systemic financial risk has been identified as a risk to the state's overall stability. Of course, China is unlikely to sharply reduce the ratio of total debt-to-GDP out of an ill-advised, self-imposed bout of austerity. But the Xi administration is likely to suppress its growth rate (Chart 12), as well as to continue cracking down on specific institutions and financial practices deemed to be excessively risky or under-regulated, as has occurred this year in insurance and shadow lending.14 Chart 11China's Borrowing Costs Rising Chart 12Debt Growth Faces Tougher Controls This financial focus is clear from top-level appointments and meetings in 2017, including a special Politburo meeting on financial risks in April and the once-in-five-years Central Financial Work Conference in July.15 The latter declared new regulatory powers for the central bank that will be put into place in the coming 12 months. The head of the new Financial Stability and Development Committee to oversee this work will likely be named, along with a replacement for the long-serving People's Bank of China Governor Zhou Xiaochuan. This change will initiate a new generation of leadership in the central bank, and one ostensibly directed at overseeing stricter macro-prudential controls.16 Another outcome of the financial conference was the warning that, going forward, local government officials will be held accountable over the course of their entire lives if they allow excessive financial risks and debt to build up under their watch.17 These developments suggest that policy will become a headwind to growth next year. We would expect downside risks to China's implicit 6.5% growth target. Why should the new deleveraging campaign have any more effect than similar efforts in the past? Aside from Xi's stronger position to enforce policies - explained above - the nineteenth party congress reinforced an important trend in policy implementation. The Xi administration has been using the CDIC, the party's anti-corruption unit, as a political tool to ensure broader policy enforcement. We have observed this trend over the past year both in the financial regulatory crackdown and the anti-pollution and overcapacity crackdown.18 Anti-corruption officials can compel more serious implementation from local governments, SOE managers, and others because they threaten to impose job losses or jail time, rather than mere fines. The CDIC appointed two new officials to oversee its operations in China's financial regulators just as the party congress was getting underway. Moreover, on the final day of the party congress, officials have announced that corruption investigations will be conducted into the commercial housing sector.19 The message is that the regulatory storm will expand - and will have teeth. Xi went a step further at the party congress by declaring the creation of a National Supervisory Commission, which will oversee the next phase of the anti-corruption campaign.20 This commission will expand the campaign outside the ranks of the Communist Party - where it has operated so far - to the government as a whole, i.e. the state administration and bureaucracy. It implies that every official from China's top ministries down to its lowest-level governments will be subjected to new forces of scrutiny. If this effort resembles the CDIC's role in hastening compliance in other areas of economic policy, then it will be a powerful tool for the Xi administration as it attempts to engineer a top-down restructuring of China's governance and economy. An aggressive new regulatory push, with the threat of corruption charges, in China's financial and industrial sectors would create a powerful drag on economic growth. It could easily send a chill down the spines of government officials, prompting them to cut or delay key investment decisions, as the initial anti-corruption campaign did in 2013-14.21 China's leaders will eventually attempt to offset any disorderly slowdown from reform measures with additional stimulus. However, given that the deleveraging campaign cuts to the heart of the financial sector, and that sharp new tools are being put to use, we would think that the probability of a "policy mistake" is going up. Bottom Line: Risks to Chinese economy and assets are rising as politics shifts from being a tailwind to a headwind. Xi Jinping faces few policy constraints and has shown appetite for greater political risk in the pursuit of his reform agenda. His administration has signaled that China's financial imbalances pose a threat to overall stability and require tougher regulation. New enforcement mechanisms - particularly those connected with anti-corruption efforts - threaten to bring the financial sector, as well as local government debt, under the spotlight and to create a chilling-effect among local officials. Investment Conclusions On one hand, any genuine attempt to hasten the transition of China's economy to consumer-led growth, de-emphasize GDP growth targets, and pare back overbuilt and heavy-polluting industry is highly consequential and will redistribute global growth.22 Table 3Post-Party Congress Scenarios And Probabilities Broadly speaking, the transition is negative for Chinese growth in the short term, but positive in the long term, as productivity trends would improve. It is negative for China's heavy industry, yet positive for technology, health and education; negative for commodities tied to the old economy (e.g. coal, iron ore, and diesel), but positive for commodities tied to consumers (oil/gasoline, aluminum, nickel, and zinc); negative for emerging markets that are commodity- and export-reliant and China-exposed, yet positive for domestic-oriented and/or China-insulated EMs. On the other hand, there is no longer a convincing excuse for poor implementation of central government policies. If China does not take concrete steps in pursuit of Xi's reform agenda - an agenda of "supply-side reform" that is now enshrined in the party's constitution - then it follows that Xi himself is unwilling to practice what he preaches. The first big test will be whether, when the economy starts to wobble, policymakers stimulate the "old economy" with the usual fervor, or whether they hold true to a course of re-ordering the economy and concentrating any stimulative credit flows more heavily into the social safety net and consumer-led industries and services. Given Xi's and China's rare opportunity, a failure to undertake difficult reforms in the coming months and years would be a clear sign that China will never pursue significant reforms of its own accord. It would have to be forced to do so by an internal or external crisis. This would mean that China's potential GDP would continue to decline for the foreseeable future (Table 3). Chart 13China's Ascendancy Challenges The U.S. If that were the case, declining potential GDP growth would combine with political uncertainty over Xi's 2022 succession to create a noxious brew of social malaise. A final and very important consideration is China's relationship with the United States and its allies, given the ongoing strains over U.S.-China trade, North Korea's nuclear and missile advances, China's militarization of the South China Sea, Taiwan's widening ideological distance from the mainland, and Japan's accelerating re-armament. The party congress was a highly visible display of Chinese power and self-confidence, in which Xi broke with the past to suggest that China is moving into "center stage" in the world. Xi not only reaffirmed state-led growth but also emphasized that China's foreign policy assertiveness is here to stay over the long run. This is a poignant reminder of our long-term investment theme of global multipolarity. The United States is not likely to relinquish global or even regional leadership easily. So while relations may be pacified in the short term, the risk of conflict, whether economic or military, is rising over time (Chart 13). Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "China's Nineteenth Party Congress: A Primer," dated September 13, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy, "China: Two Factions, One Party," dated September 2012, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 4 Popular unrest was boiling up due to grievances over corrupt officials, mismanagement of internal migration, local government land seizures, a weak justice system, and a host of labor disputes and environmental incidents. 5 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. See also BCA Geopolitical Strategy Monthly Report, "Reflections On China's Reforms," in "The Great Risk Rotation - December 2013," dated December 11, 2013. 6 The arrest and excommunication of Chongqing Party Secretary Bo Xilai in 2012 epitomizes the regional and institutional challenge, since Bo had a network of alliances that fell under Xi Jinping's anti-corruption dragnet and sprawled across the energy sector and public security agencies. The regional problem was highlighted again this year when one of Bo's successors, Chongqing Party Secretary Sun Zhengcai, was ousted for allegedly failing to extirpate Bo's influence. Meanwhile, the People's Liberation Army became more vocal and independent in ways that raised concerns among foreign observers, such as U.S. Defense Secretary Robert Gates, who suggested that the PLA took China's civilian leadership by surprise when it conducted a test flight of its stealth J-20 fifth generation fighter during Gates's visit to Beijing in January 2011. 7 Please see BCA China Investment Strategy Weekly Report, "China's Economy - 2015 Vs Today (Part I): Trade," dated October 26, 2017, available at cis.bcaresearch.com. 8 For the military reshuffle, please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, available at gps.bcaresearch.com. 9 The most important reform was the loosening of the one-child policy, which was a social change with long-term economic benefits. Reforms to household registration, land rights, the property sector, SOEs, fiscal policy, private property, and the judicial system have moved slowly. 10 The PSC has a three-way balance of sorts, with two representatives of each faction (Jiang Zemin, Hu Jintao, and Xi Jinping), plus Xi presiding over all. Please see Cheng Li, "The Paradoxical Outcome Of China's 19th Party Congress," Brookings Institution, October 26, 2017. Our own analysis of the 2017 result, drawing on Cheng Li's work, shows that the party bureaucracy, state bureaucracy and the military are represented at roughly the same levels as before on the 25-member Politburo. Further, the profile of the PSC members is relatively continuous with the previous PSC profiles. Namely, the relatively high share of leaders who have spent their careers ruling the provinces, or who have mostly worked in central government, is no higher than it was before, while the relatively low share of leaders who served on the military or managed state-owned enterprises is no lower than it was before. The division between rural and urban regions on the PSC is also the same as before. Thus, the only substantial change in the character profile of the PSC is the fact that China's leaders are increasingly coming from an educational background in the "soft sciences" rather than the "hard sciences": which is to be expected as the society evolves from manufacturing and construction to a services-oriented economy, even though it also suggests growing ideological orthodoxy. 11 Please see BCA Geopolitical Strategy, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Monthly Report, "The Socialism Put," dated May 11, 2016, available at gps.bcaresearch.com. 13 Please see BCA China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010," dated October 13, 2016, available at cis.bcaresearch.com. 14 Please see BCA China Investment Strategy Weekly Report, "China: Financial Crackdown And Market Implications," dated May 18, 2017, available at cis.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, available at gps.bcaresearch.com. 16 Please see "China: A Preemptive Dodd-Frank," in BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "How To Read Xi Jinping's Party Congress Speech," dated October 18, 2017, available at gps.bcaresearch.com. 18 Please see note 15 above. See also Barry Naughton, “The General Secretary’s Extended Reach: Xi Jinping Combines Economics And Politics,” dated September 11, 2017, available at www.hoover.org. 19 Please see "China To Launch Nationwide Inspection On Commercial Housing Sales," Xinhua, October 25, 2017, available at www.chinadaily.com. 20 Supervisory commissions will be created at every level of administration in all regions to ensure that the anti-corruption campaign is enforced across all government, not only within the Communist Party. The commissions will be based on experiences gained from trial programs in Beijing, Zhejiang, and Shanxi. Please see Viola Zhou, "Super anti-graft agency pilot schemes extended across China," South China Morning Post, October 30, 2017, available at www.scmp.com. 21 Please see note 5 above, "Taking Stock," and BCA China Investment Strategy, "Policy Mistakes And Silver Linings," dated October 7, 2015, available at cis.bcaresearch.com. 22 Please see note 5 above, "Taking Stock," and BCA China Investment Strategy, "Understanding China's Master Plan," dated November 20, 2013, available at cis.bcaresearch.com.

Special Report

Highlights Xi Jinping has shed domestic political constraints that have been in place since 2012; The lack of constraints suggests his reform agenda will intensify over the next 12 months; The use of anti-corruption agencies to enforce economic policy suggests that reform implementation will become more effective; Chinese politics are shifting from a tailwind to a headwind for global growth and EM assets. Feature Chart 1Stability Continues After Party Congress? China's nineteenth National Party Congress concluded on October 25 with the new top seven leaders - the members of the Politburo Standing Committee (PSC) - taking the stage in the Great Hall of the People. The party congress is a five-year leadership reshuffle that, in this case, marks the halfway point of President Xi Jinping's term in office.1 President Xi was the center of attention throughout the event. It is widely perceived that he is the most powerful Chinese leader since Deng Xiaoping. The Communist Party chose to elevate his personal power in conspicuous ways that raises political uncertainties about the succession in 2022 as well as about the future trajectory of Chinese policy, including economic policy. BCA's Geopolitical Strategy has awaited this transition since 2012, when President Xi and Premier Li Keqiang took over the top two positions in China.2 While we are inherently skeptical of Xi's grandiose reform agenda, we are also deeply aware of the importance of political constraints in determining economic policy outcomes - and Xi has just overcome significant domestic constraints. If Xi accelerates and intensifies his reforms next year - particularly deleveraging and industrial restructuring - he will add volatility to Chinese risk assets and create a drag on Chinese growth. Xi's personal concentration of power could be an enabling factor in driving reforms. But it will certainly be a source of higher political uncertainty over the next five years (Chart 1), especially as the 2022 succession approaches. Therefore a lack of reform would be a noxious combination. Finally, China's ascendancy increases the phenomenon of global multipolarity - it is a challenge to the U.S.-led system and will eventually produce a reaction, most likely a negative one.3 In short, Chinese political and geopolitical risk is understated. This situation presents a range of risks and opportunities for investors, but it is broadly a headwind for global growth and EM assets. A Chinese "policy mistake" is also a risk to our House View of being overweight equities and underweight bonds for the next 12 months. Back To 2012 When Xi rose to power in 2012, it was widely known that China's economy had reached a pivotal moment. Exports were declining as a share of GDP in the wake of the Great Recession and end of the U.S. "debt super-cycle," and investment was weakening as the country's massive fiscal and credit stimulus wore off (Chart 2). Meanwhile the Communist Party faced a crisis of legitimacy, with an emergent middle class making ever greater demands on the system (Chart 3). The rapid rise in household income over preceding years, combined with high income inequality and poor quality of life, raised the prospect of serious socio-political challenges to single-party rule.4 President Hu Jintao searched for ways to strengthen state control over an increasingly restless society, while outgoing Premier Wen Jiabao warned openly that China's economy was unsustainable and imbalanced and that political reform would be an "urgent task." Hu Jintao's farewell address at the eighteenth party congress (2012) reflected the party's grave concerns. His successor, Xi Jinping, was in charge of drafting the report. This relationship highlighted an important degree of party consensus. The report called for fighting corruption and disciplining the party, while doing more to protect households from the negative externalities of the past decade's rapid growth, including pollution (Chart 4). Chart 2Xi Took Power Amid Economic Transition Chart 3The Communist Party's Newest Constraint Chart 4Xi Took Power Amid Instability Risks It also outlined China's hopes of becoming a more consequential global player through acquiring naval power and forging a new, peer relationship with the United States. The overriding imperative was to win back support and legitimacy for the party, lest it fall victim to the fate of the world's other Marxist-Leninist regimes - i.e. internal socio-economic sclerosis and external pressure from the U.S.-led, democratic-capitalist world order. Xi Jinping took over at this juncture, using the 2012 work report as his guideline for an ambitious policy agenda. Xi's main goals centered on power: namely, ensuring regime survival at home and increasing China's international clout abroad. Specifically, the Xi administration sought to (1) centralize political control so that difficult choices could be made and implemented effectively; (2) improve governance so that public discontent could be mitigated over the long run; and (3) restructure the economy so that productivity growth could remain robust in the face of sharply declining labor force growth, thus stabilizing the potential GDP growth rate.5 Obviously there was no guarantee that Xi would be successful. China's response to the Global Financial Crisis had required a large-scale decentralization of control: local governments, banks, state-owned enterprises and shadow lenders were encouraged to lever up and grow amid the global collapse (Chart 5). This created imbalances and liabilities for the central leadership while also creating new economic (and hence political) centers of power outside Beijing. Chart 5aLocal Government Spending Unleashed... Chart 5b...And Shadow Lending Too The central leadership also seemed to be losing control of the provinces: regional and institutional powerbrokers had emerged, challenging the party's hierarchy, and there was even reason to believe that the armed forces were deviating from central leadership.6 Without control of the local governments and other key institutions, any reform agenda would get bogged down. Finally, the political cycle was not particularly favorable to Xi. While the line-up of the all-powerful PSC looked favorable from 2012-17, the next crop of Communist leaders set to move up the ladder in 2017 seemed likely to constrain him. Moreover, the previous two presidents had chosen Xi's successors for 2022, according to party norms. Xi had very little room for maneuver - and this was negative for his policy outlook overall. As such, BCA's Geopolitical Strategy poured cold water on the more enthusiastic forecasts of economic reforms throughout Xi's first term. Our assessment was that he would focus on anti-corruption and governance reforms first and only attempt genuine economic reforms once his political capital grew significantly. Bottom Line: Xi Jinping faced major obstacles to his policy agenda of centralization, governance and economic reform in 2012. He faced a large and restless middle class, the difficulty of reining in local governments and state institutions, and the likelihood that China's previous top leaders would constrain his maneuverability in 2017 and 2022. Xi's First Term A lot has changed over the past five years. First, both global demand for Chinese goods and Chinese domestic demand have held up rather well, giving China a badly needed cushion during its economic transition. Steady consumption growth has partially offset the blow from declining investment, while Chinese exports have grown well, often faster than global trade (Chart 6).7 Second, Xi has consolidated power extensively within the party, the army, and other institutions. He executed the most aggressive purge that the party has seen in decades, enabling him to rebuild some public trust among a middle class worn out by corruption, as well as to remove political rivals (Chart 7). He also launched an extensive restructuring of the People's Liberation Army, its organizational structure and personnel, ensuring that "the party controls the gun."8 And he intensified social control, particularly in the online realm. Chart 6Changing The Economic Model Chart 7Anti-Corruption Campaign Still Going Symbolically, Xi was anointed the "core" of the Communist Party by the political elite in late 2016. Economic reform, however, has been compromised by Xi's focus on consolidating political power. True, he and Premier Li Keqiang tinkered with various policies to cut red tape, simplify domestic taxes, attract foreign investment, and encourage better SOE management, but none of the reforms launched over the past five years were painful and thus none were significant.9 Nowhere was this more apparent than during 2015-16, when economic and financial instability caused the Xi administration to delay reform initiatives and focus on reforming the economy. Beijing increased infrastructure spending, bailed out the local governments, depreciated the RMB, and imposed capital controls (Chart 8). "Old China," state-owned China, was the primary beneficiary. The stimulus-fueled rebound helped stabilize the global economy in 2016-17, particularly commodity-producing emerging markets, but it exacerbated China's internal problems - slow productivity growth, excessive debt creation, weak private sector investment, and waning foreign investment (Chart 9). Chart 8State Interventions In 2015-16 Chart 9Economic Reforms Still Needed The upside, however, was stability, which enabled Xi to approach the nineteenth National Party Congress from a position of strength. Now that the party congress has concluded, we can say that Xi has notched a series of significant "victories" and that his political capital is overflowing: Xi Jinping Thought: The congress voted to enshrine Xi's name into its constitution (Table 1), with a phrasing that echoes "Mao Zedong Thought," hence elevating Xi to immense moral authority within the party. The name of Xi's philosophy, "Socialism with Chinese Characteristics for a New Era," makes a slight adjustment to Deng Xiaoping's market-friendly philosophy. In other words, Xi's authority stems from his providing a synthesis of the regime's greatest two leaders: Mao's single-party Communist rule is being reaffirmed, but Deng's attention to economic reality and the need for pragmatic policies has also been preserved. As we have argued, this constitutional change is a reflection of the fact that Xi has already positioned himself to be the most influential leader well into the 2020s. Table 1Xi Jinping Thought Xi removes his successors: Xi managed to exclude any of China's "sixth generation" of leaders from the Politburo Standing Committee. He thus broke a very important (albeit informal) party norm. The norm was created under Deng Xiaoping to ensure a smooth transition of power, unlike the power struggle that occurred upon Mao's death. Now Xi will have a greater hand in choosing his successor, or even staying in power beyond 2022. This aids in the process of centralization, but it may well prove a step backwards in terms of governance and reform - that remains to be seen. It is a source of higher political uncertainty going forward. Xi dominates the Politburo: Xi prevented his predecessor Hu Jintao's loyalists from gaining a majority on the Politburo Standing Committee, as they seemed lined up to do in 2012. The line-up of the new Politburo and Politburo Standing Committee broadly indicates that Xi and his faction are the dominant force (Table 2). Taken with Xi's personal power, this is significant political capital with which the new administration can push its priorities, whatever they may be. Xi gets a new inquisitor: The Central Commission for Discipline Inspection (CDIC) is the party's internal watchdog. It has taken the leading role in the sweeping party purge and anti-corruption campaign over the past five years. Xi removed its chief, the hugely influential Wang Qishan, by reinforcing the retirement age and two-term PSC limit - a notable case of institutional norms being upheld. He put one of his loyalists, Zhao Leji, in this role instead. The CDIC will have a huge role over the next five years, and a market-relevant one, as we discuss below. Table 2The Magnificent Seven: China's New Politburo Standing Committee The above conclusions raise the possibility that Xi has become excessively powerful, that political institutions in China are being eroded by personal rule, and that political risks are set to explode upward in the near future. However, it is too soon to declare that Xi has staged a Maoist "power grab." There are reasons to think that Xi's accumulation of power has not overturned the delicate internal balances within the top leadership bodies.10 The result is in keeping with what we expected in our Strategic Outlook last December: Xi Jinping has amassed formidable political capital, but he has not destabilized the Chinese political system.11 He is a strongman leader within the established political system of an authoritarian state - he is not a tyrant seizing power in a bloodless revolution. (At least, not yet.) This is broadly positive for China's policy continuity and political framework - and in this sense it is also broadly market-positive, being an outgrowth of the status quo rather than a disruptive break from it. China's leaders continue to be career politicians, trained in law or economics, with considerable executive experience in governing and limited business or military experience, all unified in the name of regime preservation (Chart 10). Over the long run, this suggests that China's "Socialist Put" remains intact, i.e. that the state will intervene to prevent a crash landing.12 Nevertheless, an important corollary of the above is that Xi holds the balance, and hence there are no longer any major domestic political or governmental constraints to prevent him from pursuing his policy agenda - especially over the next 12 months, when his political capital is still fresh and the economic backdrop is favorable. The fact that Xi emphasized "sustainable and sound" growth, deliberately excluded GDP growth targets beyond 2021, and altered the definition of the Communist Party's so-called "principal contradiction" in order to prioritize quality-of-life improvements, suggests that the reform agenda is about to get rebooted. Bottom Line: Xi Jinping has consolidated power extensively, but he has not staged a silent coup d' état or overthrown the balance of power within the Communist Party. This suggests that Xi's policies and reforms will intensify over the next year. Chart 10Characteristics Of Chinese Rulers Mostly Unchanged Since 2012 Xi's Second Term: What To Expect Instead of playing it safe in the lead-up to the all-important party congress over the past twelve months, Xi surprised the markets with a series of regulatory actions designed to tamp down the property bubble, regulate the financial markets, punish speculation, and reduce industrial overcapacity and pollution (Chart 11).13 This tightening of policy strongly signaled that Xi's appetite for political risk is rising in keeping with his growing political capital. Beijing is signaling that it aims to continue with tougher financial, industrial and environmental reforms in the aftermath of the party congress. In particular, systemic financial risk has been identified as a risk to the state's overall stability. Of course, China is unlikely to sharply reduce the ratio of total debt-to-GDP out of an ill-advised, self-imposed bout of austerity. But the Xi administration is likely to suppress its growth rate (Chart 12), as well as to continue cracking down on specific institutions and financial practices deemed to be excessively risky or under-regulated, as has occurred this year in insurance and shadow lending.14 Chart 11China's Borrowing Costs Rising Chart 12Debt Growth Faces Tougher Controls This financial focus is clear from top-level appointments and meetings in 2017, including a special Politburo meeting on financial risks in April and the once-in-five-years Central Financial Work Conference in July.15 The latter declared new regulatory powers for the central bank that will be put into place in the coming 12 months. The head of the new Financial Stability and Development Committee to oversee this work will likely be named, along with a replacement for the long-serving People's Bank of China Governor Zhou Xiaochuan. This change will initiate a new generation of leadership in the central bank, and one ostensibly directed at overseeing stricter macro-prudential controls.16 Another outcome of the financial conference was the warning that, going forward, local government officials will be held accountable over the course of their entire lives if they allow excessive financial risks and debt to build up under their watch.17 These developments suggest that policy will become a headwind to growth next year. We would expect downside risks to China's implicit 6.5% growth target. Why should the new deleveraging campaign have any more effect than similar efforts in the past? Aside from Xi's stronger position to enforce policies - explained above - the nineteenth party congress reinforced an important trend in policy implementation. The Xi administration has been using the CDIC, the party's anti-corruption unit, as a political tool to ensure broader policy enforcement. We have observed this trend over the past year both in the financial regulatory crackdown and the anti-pollution and overcapacity crackdown.18 Anti-corruption officials can compel more serious implementation from local governments, SOE managers, and others because they threaten to impose job losses or jail time, rather than mere fines. The CDIC appointed two new officials to oversee its operations in China's financial regulators just as the party congress was getting underway. Moreover, on the final day of the party congress, officials have announced that corruption investigations will be conducted into the commercial housing sector.19 The message is that the regulatory storm will expand - and will have teeth. Xi went a step further at the party congress by declaring the creation of a National Supervisory Commission, which will oversee the next phase of the anti-corruption campaign.20 This commission will expand the campaign outside the ranks of the Communist Party - where it has operated so far - to the government as a whole, i.e. the state administration and bureaucracy. It implies that every official from China's top ministries down to its lowest-level governments will be subjected to new forces of scrutiny. If this effort resembles the CDIC's role in hastening compliance in other areas of economic policy, then it will be a powerful tool for the Xi administration as it attempts to engineer a top-down restructuring of China's governance and economy. An aggressive new regulatory push, with the threat of corruption charges, in China's financial and industrial sectors would create a powerful drag on economic growth. It could easily send a chill down the spines of government officials, prompting them to cut or delay key investment decisions, as the initial anti-corruption campaign did in 2013-14.21 China's leaders will eventually attempt to offset any disorderly slowdown from reform measures with additional stimulus. However, given that the deleveraging campaign cuts to the heart of the financial sector, and that sharp new tools are being put to use, we would think that the probability of a "policy mistake" is going up. Bottom Line: Risks to Chinese economy and assets are rising as politics shifts from being a tailwind to a headwind. Xi Jinping faces few policy constraints and has shown appetite for greater political risk in the pursuit of his reform agenda. His administration has signaled that China's financial imbalances pose a threat to overall stability and require tougher regulation. New enforcement mechanisms - particularly those connected with anti-corruption efforts - threaten to bring the financial sector, as well as local government debt, under the spotlight and to create a chilling-effect among local officials. Investment Conclusions On one hand, any genuine attempt to hasten the transition of China's economy to consumer-led growth, de-emphasize GDP growth targets, and pare back overbuilt and heavy-polluting industry is highly consequential and will redistribute global growth.22 Table 3Post-Party Congress Scenarios And Probabilities Broadly speaking, the transition is negative for Chinese growth in the short term, but positive in the long term, as productivity trends would improve. It is negative for China's heavy industry, yet positive for technology, health and education; negative for commodities tied to the old economy (e.g. coal, iron ore, and diesel), but positive for commodities tied to consumers (oil/gasoline, aluminum, nickel, and zinc); negative for emerging markets that are commodity- and export-reliant and China-exposed, yet positive for domestic-oriented and/or China-insulated EMs. On the other hand, there is no longer a convincing excuse for poor implementation of central government policies. If China does not take concrete steps in pursuit of Xi's reform agenda - an agenda of "supply-side reform" that is now enshrined in the party's constitution - then it follows that Xi himself is unwilling to practice what he preaches. The first big test will be whether, when the economy starts to wobble, policymakers stimulate the "old economy" with the usual fervor, or whether they hold true to a course of re-ordering the economy and concentrating any stimulative credit flows more heavily into the social safety net and consumer-led industries and services. Given Xi's and China's rare opportunity, a failure to undertake difficult reforms in the coming months and years would be a clear sign that China will never pursue significant reforms of its own accord. It would have to be forced to do so by an internal or external crisis. This would mean that China's potential GDP would continue to decline for the foreseeable future (Table 3). Chart 13China's Ascendancy Challenges The U.S. If that were the case, declining potential GDP growth would combine with political uncertainty over Xi's 2022 succession to create a noxious brew of social malaise. A final and very important consideration is China's relationship with the United States and its allies, given the ongoing strains over U.S.-China trade, North Korea's nuclear and missile advances, China's militarization of the South China Sea, Taiwan's widening ideological distance from the mainland, and Japan's accelerating re-armament. The party congress was a highly visible display of Chinese power and self-confidence, in which Xi broke with the past to suggest that China is moving into "center stage" in the world. Xi not only reaffirmed state-led growth but also emphasized that China's foreign policy assertiveness is here to stay over the long run. This is a poignant reminder of our long-term investment theme of global multipolarity. The United States is not likely to relinquish global or even regional leadership easily. So while relations may be pacified in the short term, the risk of conflict, whether economic or military, is rising over time (Chart 13). Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "China's Nineteenth Party Congress: A Primer," dated September 13, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy, "China: Two Factions, One Party," dated September 2012, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 4 Popular unrest was boiling up due to grievances over corrupt officials, mismanagement of internal migration, local government land seizures, a weak justice system, and a host of labor disputes and environmental incidents. 5 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. See also BCA Geopolitical Strategy Monthly Report, "Reflections On China's Reforms," in "The Great Risk Rotation - December 2013," dated December 11, 2013. 6 The arrest and excommunication of Chongqing Party Secretary Bo Xilai in 2012 epitomizes the regional and institutional challenge, since Bo had a network of alliances that fell under Xi Jinping's anti-corruption dragnet and sprawled across the energy sector and public security agencies. The regional problem was highlighted again this year when one of Bo's successors, Chongqing Party Secretary Sun Zhengcai, was ousted for allegedly failing to extirpate Bo's influence. Meanwhile, the People's Liberation Army became more vocal and independent in ways that raised concerns among foreign observers, such as U.S. Defense Secretary Robert Gates, who suggested that the PLA took China's civilian leadership by surprise when it conducted a test flight of its stealth J-20 fifth generation fighter during Gates's visit to Beijing in January 2011. 7 Please see BCA China Investment Strategy Weekly Report, "China's Economy - 2015 Vs Today (Part I): Trade," dated October 26, 2017, available at cis.bcaresearch.com. 8 For the military reshuffle, please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, available at gps.bcaresearch.com. 9 The most important reform was the loosening of the one-child policy, which was a social change with long-term economic benefits. Reforms to household registration, land rights, the property sector, SOEs, fiscal policy, private property, and the judicial system have moved slowly. 10 The PSC has a three-way balance of sorts, with two representatives of each faction (Jiang Zemin, Hu Jintao, and Xi Jinping), plus Xi presiding over all. Please see Cheng Li, "The Paradoxical Outcome Of China's 19th Party Congress," Brookings Institution, October 26, 2017. Our own analysis of the 2017 result, drawing on Cheng Li's work, shows that the party bureaucracy, state bureaucracy and the military are represented at roughly the same levels as before on the 25-member Politburo. Further, the profile of the PSC members is relatively continuous with the previous PSC profiles. Namely, the relatively high share of leaders who have spent their careers ruling the provinces, or who have mostly worked in central government, is no higher than it was before, while the relatively low share of leaders who served on the military or managed state-owned enterprises is no lower than it was before. The division between rural and urban regions on the PSC is also the same as before. Thus, the only substantial change in the character profile of the PSC is the fact that China's leaders are increasingly coming from an educational background in the "soft sciences" rather than the "hard sciences": which is to be expected as the society evolves from manufacturing and construction to a services-oriented economy, even though it also suggests growing ideological orthodoxy. 11 Please see BCA Geopolitical Strategy, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Monthly Report, "The Socialism Put," dated May 11, 2016, available at gps.bcaresearch.com. 13 Please see BCA China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010," dated October 13, 2016, available at cis.bcaresearch.com. 14 Please see BCA China Investment Strategy Weekly Report, "China: Financial Crackdown And Market Implications," dated May 18, 2017, available at cis.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, available at gps.bcaresearch.com. 16 Please see "China: A Preemptive Dodd-Frank," in BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "How To Read Xi Jinping's Party Congress Speech," dated October 18, 2017, available at gps.bcaresearch.com. 18 Please see note 15 above. See also Barry Naughton, “The General Secretary’s Extended Reach: Xi Jinping Combines Economics And Politics,” dated September 11, 2017, available at www.hoover.org. 19 Please see "China To Launch Nationwide Inspection On Commercial Housing Sales," Xinhua, October 25, 2017, available at www.chinadaily.com. 20 Supervisory commissions will be created at every level of administration in all regions to ensure that the anti-corruption campaign is enforced across all government, not only within the Communist Party. The commissions will be based on experiences gained from trial programs in Beijing, Zhejiang, and Shanxi. Please see Viola Zhou, "Super anti-graft agency pilot schemes extended across China," South China Morning Post, October 30, 2017, available at www.scmp.com. 21 Please see note 5 above, "Taking Stock," and BCA China Investment Strategy, "Policy Mistakes And Silver Linings," dated October 7, 2015, available at cis.bcaresearch.com. 22 Please see note 5 above, "Taking Stock," and BCA China Investment Strategy, "Understanding China's Master Plan," dated November 20, 2013, available at cis.bcaresearch.com.

Dear Clients, Please note there was an error in the Recommend Asset Allocation table published on November 1, 2017. This has now been amended. We apologize for the confusion and any inconvenience it may have caused. Best Regards, Garry Evans Senior Vice President Global Asset Allocation Reflation Trade Returns Recommended Allocation The market mood has shifted remarkably quickly over the past couple of months. The probability of a December Fed rate hike has moved up from 20% in early September to close to 100%, pushing the 10-year Treasury bond yield from 2.0% to 2.4% and causing the trade-weighted U.S. dollar to appreciate by 2%, and Emerging Market equities to underperform. We expect this trend to continue. Global growth continues to surprise to the upside (Chart 1). The softness in U.S. inflation this year is likely to reverse over coming quarters - an argument supported by the New York Fed's new Underlying Inflation Gauge, which indicates that sustained movements in inflation continue to trend higher (Chart 2). This makes it likely that the Fed will move ahead with its forecast three rate hikes in 2018, which the market has not yet priced in (Chart 3) - the implied probability of this is only 10%. Consequently, rates have further to rise: our fair value for the U.S. 10-year Treasury yield currently is 2.7%. And the increasing gap between U.S. and euro zone interest rates suggests that the dollar can appreciate further (Chart 4). All this supports our view that risk assets (equities and corporate credit) should outperform over the next 12 months, with developed government bonds producing a negative return, and emerging markets lagging because of rising rates and the stronger dollar (and a possible slowdown in China, as it focuses on reforming its economy and cleaning up the debt situation). Chart 1Growth Surprising To The Upside Chart 2Underlying Inflation Still Trending Up Chart 3Market Expects Fed To Move Only Slowly Chart 4Rate Gap Suggests Dollar Appreciation The key question, though, is how long this positive scenario can continue. With stock market valuations expensive (Chart 5) and investors fully invested, though not yet euphoric (Chart 6), we are clearly in late cycle. Rising rates could put a dampener on growth. Chart 5 Equities Close To Extremely Overvalued Chart 6Investors Are Fully Invested, But Cautious We find the Fed policy cycle a useful tool for thinking about probable investment returns from different assets (Chart 7). The best quadrant for risk assets is when the Fed is easing and policy is easy (with the Fed Funds Rate below the neutral rate). Currently we are in the bottom-right quadrant (Fed tightening, but not yet in the tight zone), which also has produced attractive returns for equities and credit. But once the Fed Funds Rate (FFR) moves above the neutral rate, returns from risk assets are on average poor and, historically, recession often followed quite quickly. How much longer do we have before Fed policy moves into the top-right quadrant? The Fed's own estimate of the neutral rate, in real terms, is 0.3%. The current real FFR (using core PCE inflation, 1.3%, as the deflator) is -0.17 (Chart 8). This implies that it will take only two further Fed hikes to move into the tight zone, which could happen as soon as March. This is why the outlook for inflation is critical. If, as the Fed forecasts and we also expect, core PCE inflation rises to 2%, it will be another five hikes before policy turns tight - we are unlikely to get there until early 2019. Chart 7The Fed Policy Cycle Chart 8How Far From The Tight Zone? For now, therefore, we continue to recommend an overweight on risk assets and pro-cyclical portfolio tilts. Global monetary policy remains easy and we see no indicators that suggest growth is slowing or that the risk of recession over the next 12 months is rising. The risks to this optimistic scenario (a hawkish Fed, over-eager structural reform in China, provocation from North Korea) seem limited. But we also continue to warn of the possibility of a recession in 2019 or 2020 caused, as so often, by excessive Fed tightening. We see, therefore, the possibility of our turning more defensive somewhere in mid-2018. Equities: We prefer developed over emerging market equities. Rising interest rates and an appreciating dollar will be headwinds for EM. Moreover, Xi Jinping's speech at the Communist Party Congress hinted at supply side structural reforms, overcapacity reduction, and deleveraging efforts. A renewed reform effort could dampen Chinese growth somewhat which, as in 2013-15, would negatively impact EM equities (Chart 9). Within DM, we are overweight euro zone and Japanese equities, which are higher beta, have stronger earnings momentum, and benefit from looser monetary policy. Fixed Income: We expect bonds to underperform over coming quarters, as U.S. inflation picks up and the Fed moves raises rates in line with its "dots". Corporate credit still has some attractions, provided the economic expansion continues. U.S. sub-investment grade bonds, in particular, have an attractive default-adjusted yield, as long as a strong economy keeps the default rate over the next 12 months to the historically low 2% our model suggests (Chart 10). The pick-up in inflation we expect would mean inflation-linked bonds outperform nominal bonds. Chart 9Slowing China Would Hurt EM Equities Chart 10Junk Attractive If Defaults Stay This Low Currencies: The ECB delivered a dovish tapering last month, extending its asset purchases until at least September 2018 and emphasizing that its current low interest rates will continue "well past the horizon of our net asset purchases". Given this, and the gap between U.S. and euro zone interest rates (Chart 4), we expect moderate further euro weakness over coming months. The dollar is likely to appreciate even more against the yen. There are the first tentative signs of inflation emerging in Japan (Chart 11) which, combined with the Bank of Japan sticking to its 0% 10-year JGB target and rising global interest rates, could push the yen to 120 against the dollar over coming months. Commodities: BCA's energy strategists recently revised up their crude oil forecasts on the back of strong demand, a likely extension of the OPEC agreement until at least end-2018, and possible supply disruptions in Iraq, Venezuela and other troubled regions.1 They see inventories continuing to draw down until at least 2H 2018 (Chart 12). Accordingly, they forecast $65 a barrel for Brent and $63 for WTI and flag upside risk to those projections. The outlook for industrial and precious metals, however, is less positive. A stronger dollar and a shift in the growth drivers in China will depress prices for base metals. Rising real interest rates will hurt gold, although we still like precious metals as a long-term hedge. Chart 11First Signs Of Inflation In Japan? Chart 12Oil Inventory Drawdowns Support Higher Price Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report "Oil Forecast Lifted As Market Tightens," dated 19 October 2017, available at ces.bcaresearch.com GAA Asset Allocation

Highlights Duration: Treasury yields likely have another 50-60 basis points of upside during this cycle, and at least for now their uptrend should not be constrained by unreasonably elevated economic expectations. Stay at below-benchmark duration. Economy & Inflation: GDP growth remains firmly entrenched above levels necessary to ensure that the unemployment rate continues to fall and inflation is pressured higher. Weakness in residential investment presents a risk to the view that above-trend growth will persist, but leading housing indicators suggest it will bounce back in the coming quarters. Municipal Bonds: State & Local government net borrowing declined in the third quarter, but the improvement is already reflected in historically tight Muni / Treasury yield ratios. Remain underweight municipal bonds. Feature Chart 1Discounting An Inflation Rebound In last week's report we pointed out that a flat yield curve is incompatible with core inflation so far below the Fed's target and that the bond market is fast approaching a day of reckoning where either inflation will rise quickly enough to justify the Fed's rate hike expectations, or those expectations will be revised lower.1 Meantime, the Treasury curve has been bear-steepening since early September, and the 37 basis point increase in the 10-year yield has been driven both by higher real yields and a higher cost of inflation compensation (Chart 1). This suggests that the market is pricing-in a rebound in inflation rather than a capitulation from the Fed. Yesterday's PCE inflation report didn't do much to justify those expectations, coming in at only 1.33% year-over-year, not far above the 1.30% reading from August. However, we have previously noted mounting evidence that we are past the worst of the inflation downtrend.2 This raises the question of how much higher Treasury yields can rise, and this is the question we tackle in this week's report. Data Surprises & Playing The Odds Longer run, the 10-year cost of inflation compensation (currently 1.88%) will likely settle into a range between 2.4% and 2.5% by the time that core inflation returns to the Fed's 2% target. Assuming that inflationary pressures are sufficiently strong for that outcome to be achieved with the Fed lifting rates at a pace of about 50 bps per year, then long-dated real yields should stay roughly flat. This means that the nominal 10-year Treasury yield can move another 50-60 bps higher before the end of the cycle. But in the meantime, depending on swings in the macroeconomic data, bonds could experience several playable rallies and sell-offs. Is there a way for us to get a handle on when those might occur? One way might be to examine the economic surprise index (ESI). This index tracks whether economic data are over- or under-shooting consensus expectations. In this way it is very much like a financial market price. It moves higher when the incoming data suggest a rosier outlook than is currently anticipated, but then falls once expectations become so bullish they can no longer be surpassed. This is exactly what happened at the beginning of the year when the 10-year Treasury yield peaked at 2.62% following an extended period of elevated data surprises (Chart 2). Chart 2Economic Surprises Are Mean Reverting More specifically, we observe that when the ESI ends a month above (below) the zero line, it is very likely that the 10-year Treasury yield increased (decreased) during that month (Chart 3). The same is also true for 3-month and 6-month investment horizons, although the correlation is less robust, particularly for values close to zero (Charts 4 & 5). It follows that if we know whether the economic data will surprise on the upside or on the downside in a given month, then we can predict whether Treasury yields will rise or fall. Chart 3Economic Surprise Index & ##br##1-Month Change In Yields Chart 4Economic Surprise Index & ##br##3-Month Change In Yields Chart 5Economic Surprise Index & ##br##6-Month Change In Yields Unfortunately that is not a very profound statement. It is similarly easy to decide how much to bet on a hand of blackjack if you already know what cards will be dealt. But while it is obviously impossible to predict whether data surprises will be positive or negative in a given month, much like a card counter in blackjack, a study of events that have just occurred can help us make inferences that tilt the odds in our favor. In other words, we know that the ESI is mean reverting. A long sequence of elevated readings means it is more likely to fall, and a long sequence of depressed readings means it is more likely to rise. We can even use an AR(3) model to quantify the extent of mean reversion in the index. Using monthly data we run a regression of the ESI on its three most recent lags and get the following result which explains 55% of the variation since 2003: Notice that the index is positively correlated to its reading from the prior month, but negatively correlated with its readings from two and three months ago. Let's now consider that the most recent reading from the ESI is 38.2. One month ago it was -7.9 and two months ago it was -23.1. Using our formula, our best prediction for where the surprise index will be next month is 39. This is still deep in positive territory, meaning that if the model is correct, Treasury yields will remain under upward pressure. More decisively, we conclude from our model that it is unlikely that investor expectations have become so elevated that markets are set up for disappointment. The Appendix to this report provides a reference table for different ranges of the surprise index based on the above formula. It can be used as a quick reference guide for predicting where the ESI is likely to fall next month based on its readings from the prior three months. Bottom Line: Treasury yields likely have another 50-60 basis points of upside during this cycle, and at least for now their uptrend should not be constrained by unreasonably elevated economic expectations. Stay at below-benchmark duration. Economy & Inflation No Signs Of A Slowdown Last week we learned that GDP grew at an annualized rate of 3.0% in the third quarter, well above the Fed's 1.8% estimate of trend. The number was boosted by strong contributions from inventory accumulation (+0.73%) and net exports (+0.41%), but even stripping out those more volatile components to focus on real final sales to domestic purchasers reveals that growth is firmly above trend (Chart 6). Above-trend GDP growth will ensure that the unemployment rate continues to decline, which in turn will ensure that inflation moves higher. The unemployment rate had come close to flattening off late last year as growth decelerated toward 1.8%, but has since started to fall more rapidly alongside the re-acceleration in GDP (Chart 6, bottom panel). In fact, we attribute this year's decline in inflation to last year's growth deceleration and expect inflation will soon follow GDP growth higher (Chart 7). Chart 6Growth Is Steady, And Well Above Trend Chart 7Inflation Lags Growth Considering the contributions from the more stable sources of growth, we observe the following (Chart 8): Consumer spending remains firm, still above its post-2010 average. Nonresidential investment is accelerating back toward its post-2010 average, following a period of weakness that was driven by the mid-2014 commodity price collapse. Leading capex indicators, such as new orders surveys, suggest the acceleration will continue. Residential investment is a source of concern. It had already decelerated to well below its post-2010 average even prior to the hurricanes that depressed its contribution to growth in Q3. We are not yet concerned that the weakness in residential investment will morph into a broader slowdown. In fact, it appears quite likely that residential investment will bounce back in the coming quarters. Growth in residential investment is correlated with changes in the inventory of outstanding homes (Chart 9). Typically, large slowdowns in residential investment are preceded by a big run-up in supply. But at the moment, supply continues to contract, whether or not we include the shadow inventory from properties that were foreclosed upon during the housing bust. This shadow inventory has mostly evaporated in any case (Chart 9, panel 3). Chart 8Housing Not Keeping Pace Chart 9Inventories Still Falling Further support for residential investment comes from homebuilder sentiment which remains very strong (Chart 9, bottom panel). Bottom Line: GDP growth remains firmly entrenched above levels necessary to ensure that the unemployment rate continues to fall and inflation is pressured higher. Weakness in residential investment presents a risk to the view that above-trend growth will persist, but leading housing indicators suggest it will bounce back in the coming quarters. An Improvement In State & Local Government Balance Sheets Assuming that corporate tax revenues were the same in Q3 as in Q2, we can estimate that state & local government net borrowing declined to $163 billion in the third quarter. This represents a substantial improvement from prior quarters, but one that has already been discounted in Municipal / Treasury (M/T) yield ratios (Chart 10). M/T yield ratios are extremely tight, even compared to average pre-crisis levels (Chart 11), and the unattractive valuation underscores our negative stance on the sector. However, at least for now, there are no signs of an imminent surge in state & local government net borrowing that could cause a credit premium to get priced into muni yields. Chart 10Less Borrowing Is In The Price Chart 11Muni / Treasury Yield Ratios Until last quarter, growth in state & local current expenditures had been running consistently above growth in current revenues (Chart 12). However, the weakness in current revenues was mostly attributable to a slowdown in transfers from the federal government. When we look at growth in state & local government tax revenues only, we find that it is substantially outpacing expenditure growth (Chart 12, panel 2). Chart 12Tax Revenue Growth Greater Than Expenditure Growth The acceleration in transfers from the federal government that started in mid-2014 reflected the expansion of Medicaid under the Affordable Care Act. Now that most eligible individuals have signed up, we would expect growth in federal transfer payments to level-off. Unless legislation is passed to further curb transfers from the federal government, state & local borrowing should continue its decline in the coming quarters. Bottom Line: State & Local government net borrowing declined in the third quarter, but the improvement is already reflected in historically tight Muni / Treasury yield ratios. Remain underweight municipal bonds. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "The Fed Must Fall Behind The Curve", dated October 24, 2017, available at usbs.bcaresearch.com. 2 Please see U.S. Bond Strategy Weekly Report, "Living With The Carry Trade", dated October 17, 2017, available at usbs.bcaresearch.com. Appendix Table 1 Table 2 Table 3 Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Risk assets are responding well to better data and rising rates. Q3 EPS results beating lowered expectations, but growth earnings will peak soon. The conditions are in place for robust capital spending. Financial assets are adhering to the post-Hurricane playbook, with a few notable exceptions. Feature Chart 1Risk Assets Higher Despite Higher Rates Risk assets rose last week for the 6th week in a row (Chart 1). A solid start to Q3 earnings season, more legislative progress on the GOP's tax plan and a narrowing of President Trump's choice for Fed Chair (Jerome Powell, John Taylor and incumbent Janet Yellen) all added to the positive backdrop. The 4 bps rise in the 10 year Treasury yield last week (and 37 bps since early September) was not an impediment to higher equity and oil prices, and gains for small caps and high yield bonds. The positive reaction likely reflected the fact that yields rose more because of increased growth expectations than higher inflation expectations. Despite the impact of Hurricanes Harvey and Irma, Q3 GDP posted an impressive 3% gain. The composition of the Q3 readings suggests an even stronger report in Q4 (Chart 2). At 2.3%, the year-over-year change in real GDP is close to the Fed's 2017 forecast (2.4%) and above the long run forecast (1.8%). The implication for investors is that because U.S. economic growth is faster than its long-term potential, the labor market is tightening and inflation is poised to move higher. Accordingly, market odds for a Fed hike in December are near 90% and participants expect 51 bps more hikes in the next 12 months (Chart 1, panel 3). BCA's view is that U.S. economic growth is set to accelerate in the coming quarters aided by a post hurricane rebound in housing. The Fed will raise rates in December and three more times next year as inflation returns to 2% and perhaps beyond. Corporate profit growth will peak in the next few quarters, but remain supportive of higher stock prices for now. The rise in the Economic Surprise Index will continue for another few months, and provide another lift for risk assets. A surge in capital spending adds to the upbeat tone. Chart 2GDP Growth Remains Below Average, But Above Fed's Long Run Target Capital Spending Blasts Off Business capital spending is on the upswing. The robust readings in September on core durable goods orders (7.8% year-over-year) and shipments reported last week were paybacks for the Hurricane-weakened August report. Nonetheless, the impressive soundings on the three -month change in both orders and shipments were not distorted by the storms. Moreover, the durable goods report was one of the latest in a series of data points brightening capex's outlook (Chart 3). Both BCA's real and nominal capex models, driven by surging capital goods orders along with elevated ISM readings and soaring sentiment on business spending, indicate strong investment in plant and equipment in the next few quarters. CEO confidence soared to a 13-year high in Q1 according to the latest Duke University/CFO Magazine Business Outlook, but retreated modestly in Q2 and Q3 (Chart 4). Surveys by the Conference Board and Business Roundtable show a similar pattern. Notably, readings on all three surveys have climbed since Trump's election in November 2016, but then retreated as his pro-business agenda stalled. The drop in sentiment reflects the lack of legislative progress in Washington (Chart 5). The dip in CEO sentiment in Q2 and Q3 is in sharp contrast with the easing of policy concerns in the Beige Book. Chart 3Bright Outlook For Capital Spending Chart 4Capital Spending Plans Upbeat Chart 5Managements Remain Upbeat The upbeat numbers in the regional Federal Reserve Banks' surveys of capital spending intentions further support rising capex spending in the next few quarters. The average readings from the New York, Philadelphia and Richmond Feds' capex survey plans are close to cycle highs, despite a modest pullback in the summer months. Moreover, the regional Feds' capex spending plans diffusion index hit an eight-year high in October (Chart 5, panel 3). Bottom Line: Stay overweight stocks versus bonds, and underweight duration. Rising capex will drive up GDP, employment and EPS in the coming quarters. Q3 Earnings Beating Lowered Expectations The Q3 earnings reporting season is off to a strong start, with both EPS and sales growth well ahead of consensus expectations as we forecast in our October 2 preview. Moreover, the counter-trend rally in profit margins is still in place. Just under 55% of companies have reported results so far, with 74% beating consensus EPS projections just above the long-term average of 55%. Furthermore, 67% have posted Q3 revenues that topped expectations, which exceeded the LT average of 69%. The surprise factor for Q3 stands at 5% for EPS and 2% for sales. These compare favorably with the average EPS (4.2%) and sales (1.2%) in the past five years. We anticipate the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning early in 2018. Nonetheless, initial results imply that Q2 will be another quarter of margin expansion. Average earnings growth (Q3 2017 versus Q3 2016) is solid at 7% with revenue growth at 5%. Strength in earnings and revenues is broad based (Table 1). Earnings per share increased in Q3 2017 versus Q3 2016 in eight of the 11 sectors. The 7.3% year-over-year drop in the financial sector is linked to the impact of the hurricanes on the insurance and reinsurance industries. Excluding those industries, financial EPS is up 4.7% from a year ago. EPS results are particularly stout in energy (164%), technology (18%) and healthcare (7%). Those sectors likewise experienced significant sales gains (16%, 9% and 5% respectively). Corporate managements are more focused on the message in Washington than on the President (Chart 6). Trump's name was mentioned just once in the Q3 earnings calls held through October 27, matching Q2's reporting period. CEOs and CFOs have cited Trump's name at least once in each earnings season since Q2 2016. The peak in mentions occurred immediately after Trump took office in early 2017. Table 1S&P 500:##BR##Q3 2017 Results* Chart 6Managements Focused On##BR##The Message Out Of DC In contrast, the words "tax" and "reform" have appeared 39 times thus far in Q3 conference calls, most often in a positive light. There were only five mentions in Q2, when there was skepticism that a tax plan would pass this year. In the Q4 2016 reporting season following the November election, tax and reform were cited 16 times. BCA's Geopolitical Strategy service has consistently expected a tax package to pass by the end of Q1 2018.1 We are encouraged by the upward trajectory of EPS estimates for 2017 and 2018 (Chart 7). It is odd that the recent downtick in 2017 EPS is mirrored by an uptick in the 2018 figure. That said, the divergence can be explained by the impact of the hurricanes on the financial sector's earnings in 2017 and probable snapback in early 2018. Analysts expect 2019 EPS growth to slow from 2018's clip, which matches BCA's view. However, unlike estimates for 2017 and 2018, we anticipate that EPS estimates for 2019 will move lower throughout 2018 and 2019, ahead of a recession in late 2019.2 Bottom Line: The BCA earnings model shows that S&P 500 EPS growth is peaking and should decelerate through 2018 toward a level commensurate with 3 ½-4% nominal GDP growth (Chart 8). Accordingly, BCA believes that the earnings backdrop will remain a tailwind for the equity market, albeit a smaller tailwind. This forecast excludes any positive effect on growth from tax cuts, which would be positive for EPS and the S&P 500 price index in the short term, although this would also bring forward Fed rate hikes. The entire Treasury curve has readjusted to reflect this view. Chart 7Stability In '17 & '18 EPS Estimates,##BR##But '19 Likely To Move Lower Chart 8Strong EPS Growth Ahead,##BR##Will Start To Slow Soon 10-Year Treasury Update BCA's view is that the 10-year Treasury yield will head higher in the coming months. However, is the move from 2.03% in early September to 2.43% last week sustainable? BCA's fair value model for the 10-year Treasury yield (based on Global PMI and dollar sentiment) places fair value at 2.65% (Chart 9, panel 1). Moreover, BCA's three-factor version of the model (that includes the Global Economic Policy Uncertainty Index), puts fair value slightly higher at 2.63% (Chart 9, panel 3). Investors should continue to position for a steeper curve by favoring the 5-year bullet versus a duration-matched 2/10 barbell. Chart 9Treasury Fair Value Models BCA's U.S. Bond Strategy service will publish updated fair models after the November 1 release of October's global PMI data. The latest readings on Citi's Economic Surprise index also support BCA's stance on rates. How Long Can The Economic Surprise Index Stay Positive? The Citi Economic Surprise Index crossed into positive territory on October 2nd, remaining above zero for 20 business days, and risk assets are responding (Chart 10). Since 2010, once the Index turns positive, it continues to rise for 46 days. The implication for investors is that the economic data will continue to be remarkable for another two months. Table 2 shows that risk assets outperform as the economic surprise index rises from zero toward its zenith. Risk assets have also outperformed since the June bottom in economic surprises, matching the historical performance.3 Oil (+17%), small caps and investment grade corporates are all standouts and the gains may not be over. The track record of risk assets as the Economic Surprise Index climbs suggests that additional increases are in prospect for risk assets. On average, equities (relative to treasuries) and oil are the best performers during these intervals. Chart 10May Still Be Room To Run On Economic Surprise Table 2Risk Assets Perform Well As Economic Surprise Rises Post-Hurricane Macro Backdrop The strength of the Citi Economic Surprise Index following the hurricanes duplicates the historical trend and supports the rise in risk assets. The Index moves higher for the first month post-storm, and then remains above zero for an additional three weeks (Chart 11, panel 4). This bolsters BCA's stance that the direction of the Index will continue to lift risk assets in the next few months. Financial assets are also adhering to the post-Hurricane playbook,4 with a few notable exceptions (Chart 12). The stock-to-bond ratio moved higher and the VIX has declined since Hurricane Harvey, matching the typical post-storm performance. However, the 10-year Treasury yield, the S&P 500 and the Fed funds rate, all have bucked historical trends. The S&P 500 rose by 5.6% since late August; stocks typically drift lower in the first few months after a major storm. In addition, the 10-year Treasury yield climbed but it usually moves down in the two months following a hurricane. Post- storm, the Fed typically continues to do whatever it was doing prior to the storm. Accordingly, we expect the Fed to hike rates at its December meeting. Chart 11Major Hurricane Impact##BR##On Activity Data Chart 12Major Hurricane Impact On##BR##Financial Markets And The Fed The economic, inflation and sentiment data are also mixed. Housing data frequently lags in the wake of a storm, but both new and existing home sales moved up in the month after Harvey and Irma; housing starts declined in recent months which is counter to the historical pattern (Chart 13). Both IP and employment plunged after the storms, however, these indicators tend to rise after major weather. Initial claims for unemployment insurance were typically volatile in the six weeks since Harvey hit Texas, but have resumed their downtrend. Average hourly earnings in inflation climbed after Harvey and Irma, while consumer confidence dipped, matching history. However, the bump in gasoline prices since late August runs counter to historical precedent. Gasoline prices tend to decline after major storms (Chart 14). Chart 13Major Hurricane Impact##BR##On Housing Data Chart 14Major Hurricane Impact On##BR##Sentiment And Inflation Data Investment Conclusions: The macro backdrop remains bullish for risk assets, especially since synchronized growth has reduced fears of secular stagnation. Bond yields will rise, but won't be a headwind for stocks yet.5 Rising bond yields because of growth, without rising inflation, are bullish for risk assets, but this will change as inflation reaches 2% and inflation expectations start to rise. At that point, the Fed will be behind the curve. This will lead to faster Fed rate hikes, historically a headwind for equities. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA's Geopolitical Strategy Weekly Report, "Xi Jinping: Chairman Of Everything," October 25, 2017. Available at gps.bcaresearch.com. 2 Please see BCA's Global Investment Strategy Weekly Report, "Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear," October 4, 2017. Available at gis.bcaresearch.com. 3 Please see BCA's U.S. Investment Strategy Weekly Report, "Global Monetary Policy Recalibration," April 17, 2017. Available at usis.bcaresearch.com. 4 Please see BCA's U.S. Investment Strategy Weekly Report, "Shelter From The Storm," September 5, 2017. Available at usis.bcaresearch.com. 5 Please see BCA's U.S. Investment Strategy Weekly Report, "Still In The Sweet Spot" June 19, 2017. Available at usis.bcaresearch.com.

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A capex revival is underway, powered by exceptionally strong business and consumer sentiment, the breadth of which covers virtually all developed economies. This global capex upcycle should underpin top-line growth and margin expansion for the industrial conglomerates index, whose product and geographic diversification ensures exposure to the global upswing. However, the index has underperformed the broad market, dragged down by heavyweight GE and its specific headwinds. Further, the index's highest exposure sectors (namely aerospace, health care equipment, energy equipment & services and utilities) are mostly weighted negatively in our overall sector view. Adding it up, the negatives offset the positives and, in the context of fair valuations, we expect the S&P industrial conglomerates index to perform in line with the overall market. We are initiating coverage with a neutral rating. The key theme that has been driving our investment thesis in U.S. Equity Strategy in the past quarter has been accelerating global industrial production and trade, with a corresponding rotation out of defensive and into cyclical stocks. We have been adjusting our portfolio accordingly and it now has a deep cyclical bent with leverage to a burgeoning capex cycle. Enticing Macro Outlook Industrial conglomerates capitalize on most of these themes: they are globally-oriented and capex-driven, and leading indicators of final demand suggest that earnings should accelerate in the near-term. Capex Upcycle On the domestic front, regional Fed surveys of domestic capex intentions and the ISM manufacturing survey are hitting modern highs; both have been excellent indicators of a capex upcycle and the signal is unambiguously positive (Chart 1). Our Capex Indicator also corroborates this message. Durable goods orders have already surged and inventories have reverted to a more normal level, coming out of the late-2015/early-2016 manufacturing recession (Chart 2). This implies increasingly resilient pricing power from a demand-driven capital goods upcycle. Further, the capital goods cycle has significant room to run as new orders remain well below the 2013-2014 levels. Chart 1Exceptionally Strong Sentiment... Chart 2...Is Already Reflected In A Capex Upcycle Chart 3Capital Goods Demand Is Globally Synchronous The global picture echoes the domestic, with the global manufacturing PMI surging to a six-year high. The global strength is remarkably broad: all 46 of the economies tracked by the OECD are expected to see gains in 2017, a first since the GFC, and the BCA global leading economic indicator is signaling all-clear (Chart 3). U.S. Dollar Reflation The greenback's slide in 2017 should further boost global demand for domestic exports. In fact, given the diversity of industries served by the industrial conglomerates and the relatively high proportion of foreign sales (Table 1), the U.S. dollar is the single largest driver of both sales and earnings (Chart 4). Due to the lagged impact on results from the currency, industrial conglomerates margins should benefit from translation gains in the next two quarters, regardless of where the U.S. dollar moves. Table 1Conglomerates More Global Than Industrial Peers Chart 4U.S. Dollar Drives Conglomerate Profits But GE Weighs On The Index With the enormously supportive demand environment in mind, one could safely assume that the globally integrated niche industrial conglomerates index has been a strong performer in 2017. That would be true were it not for index heavyweight (and laggard) General Electric. Excluding GE from this index, industrial conglomerates have outperformed the S&P 500 by 20% since the start of the year (Chart 5). However, GE represents 40% of the index (Chart 5) and its current transformation continues to weigh heavily on its share price and, hence, the index at large. The new CEO, who took over earlier this month, has stated that "everything is on the table" as part of a $20 billion target for divestitures over the coming two years. The current fear among investors is that GE will need to reduce its dividend to preserve enough liquidity to continue growing despite the fairly synchronous storm in its end-markets. In March, 2009, GE's share price reached its modern nadir, a level not seen since the recession of the early 1990's, a week following its dividend cut announcement. While hardly analogous to GE today (recall that a cash crisis at GE Capital threatened to bankrupt the entire firm), the risk of a dividend cut will keep GE's share price suppressed, and likely hold the overall index hostage. Payout ratios in the industrial conglomerates index reflect GE's cash flow woes and have now surpassed the pre-dividend cut level during the GFC (Chart 6). This largely reflects cash contraction, combined with an unwillingness to even halt dividend growth. Regardless, GE investors clearly anticipate the new CEO will reduce the dividend, having pushed the yield to its highest level since the last dividend cut (Chart 6). Chart 5GE Still Dominates The Index Chart 6A Dividend Cut Looks To Be In The Cards Soft End-Markets Backdrop From the mid-1990's until 2007, the narrative of the S&P industrial conglomerates index was the rise and fall of GE Capital, as evidenced by the index' price. In 2015, the now largely complete sale of the majority of GE Capital was announced, realigning the company as an industrial manufacturer. Accordingly, analyzing the key end-market industries that the S&P industrial conglomerates cater to is in order: aerospace, healthcare, oil & gas and utilities. Chart 7Aerospace Profits Look Set To Fall Chart 8Health Care Equipment Pricing Collapsing Aerospace (Underweight recommendation) - We downgraded the BCA aerospace index to underweight at the end of 2015, corresponding fairly closely to the peak of the aerospace orders cycle (Chart 7). Since then, orders have fallen by half reflecting a downturn in the commercial aerospace cycle. While shipments have been falling, the decline has been much less precipitous as manufacturers have been running down backlogs. Historically, maintenance has buffered aerospace profits, repair and consumables activity, though weak current pricing power suggests that this may prove less sustainable than in previous cycles. Both GE & HON share extensive exposure to aerospace demand as it represented 23% and 38% of 2016 revenues, respectively. Health Care Equipment (Neutral recommendation) - We reduced our recommendation to neutral earlier this year as weaker demand no longer supported the thesis of an earnings-led outperformance. Since then the industry's outlook has not improved as demand has downshifted and pricing has cooled substantially; orders and production both crested last year and pricing power has contracted relative to overall since December 2016 (Chart 8). This bodes ill for medical equipment margins. Health care equipment represented 16% and 18% of GE & MMM 2016 revenues, respectively. Energy Equipment & Services (Overweight recommendation) - Energy Equipment & Services is our only overweight recommended sector relevant to the industrial conglomerates analysis. We upgraded in late 2016 (and doubled down on June 2) based on three key factors: troughing rig counts, cresting global oil inventories and falling production growth. Two of these factors have come to fruition: the global rig count bottomed in 2015, and has staged its best recovery since 2009 (Chart 9) and the growth in total OECD oil stocks is moderating rapidly with recent large storage draws. The key missing ingredient has been pricing power, which should eventually turn up if rig counts prove resilient. Energy equipment & services represented 11% of GE's 2016 revenues. Utilities (Underweight recommendation) - As previously noted, a key macro theme in U.S. Equity Strategy is accelerating global industrial production and trade. Utilities tend to move in the opposite direction of that theme given their safe haven status (top panel, Chart 10). Combined with falling domestic electricity production and capacity utilization, and rising turbine & generator inventories, the industry's outlook is bleak (middle & bottom panels, Chart 10). GE's Power segment is one of the world's largest gas and steam turbine manufacturers and delivered 24% of 2016 revenues. Investment Recommendation A roaring, globally synchronous capital goods upcycle should mostly keep sales and profits buoyant in this industrials subsector. However, high concentration in one stock, which is experiencing a greater than normal amount of flux, adds significant specific risk. Further, we are less optimistic about the key industries served by the industrial conglomerates than we are for the economy at large, implying more opportunity for outperformance from other, more focused, S&P industrials peers. If valuations were particularly compelling they could provide a cushion to any profit mishap, but this is not the case. Our Valuation Indicator is in the neutral zone and, while our Technical Indicator is in oversold territory, it has shown an ability to remain at these levels for prolonged periods (Chart 11). Chart 9Energy Services Is A Bright Spot Chart 10Utilities Are In A Deep Cyclical Decline Chart 11Valuations Are Not Compelling Bottom Line: Netting it out, we think the S&P industrial conglomerates index should perform broadly in line with the overall market. Accordingly, we are initiating coverage with a neutral rating. The ticker symbols for the stocks in this index are: BLBG: S5INDCX - GE, MMM, HON, ROP. Chris Bowes, Associate Editor U.S. Equity Strategy chrisb@bcaresearch.com

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Dear Client, In addition to this Special Report, we are publishing our monthly Tactical Asset Allocation table and supporting indicators today. These can be accessed directly from our website. Best regards, Peter Berezin, Chief Global Strategist Highlights Megatrend #1: Population Aging. Aging has been deflationary over the past few decades, but will become inflationary over the coming years. Megatrend #2: Global Migration. International migration has the potential to lift millions out of poverty while boosting global productivity. However, if left unmanaged, it poses serious risks to economic stability. Megatrend #3: Social Fragmentation. Rising inequality, cultural self-segregation, and political polarization are imperilling democracy and threatening free-market institutions. On balance, these trends are likely to be negative for both bonds and equities over the long haul. Feature In today's increasingly short-term oriented world, it is easy to lose track of megatrends that are slowly shifting the ground under investors' feet. In this report, we tackle three key social/demographic trends. Megatrend #1: Population Aging Fertility rates have fallen below replacement levels across much of the planet. This has resulted in aging populations and slower labor force growth (Chart 1). In the standard neoclassical growth model, a decline in labor force growth pushes down the real neutral rate of interest, r*. This happens because slower labor force growth causes the capital stock to increase relative to the number of workers, resulting in a lower rate of return on capital.1 The problem with this model is that it treats the saving rate as fixed.2 In reality, the saving rate is likely to adjust to changes in the age composition of the workforce. Initially, as the median age of the population rises, aggregate savings will increase as more people move into their peak saving years (ages 30 to 50). This will put even further downward pressure on the neutral rate of interest. Eventually, however, savings will fall as these very same people enter retirement. This, in turn, will lead to a higher neutral rate of interest. If central banks drag their feet in raising policy rates in response to an increase in r*, monetary policy will end up being too stimulative. As economies overheat, inflation will pick up, leading to higher long-term nominal bond yields. Contrary to popular belief, spending actually increases later in life once health care costs are included in the tally (Chart 2). And despite all the happy talk about how people will work much longer in the future, the unfortunate fact is that the percentage of American 65 year-olds who are unable to lead active lives because of health care problems has risen from 8.8% to 12.5% over the past 10 years (Chart 3). Cognitive skills among 65 year-olds have also declined over this period. Chart 1Our Aging World Chart 2Savings Over The Life Cycle Chart 3Climbing Those Stairs Is Getting More And More Difficult We are approaching the inflection point where demographic trends will morph from being deflationary to being inflationary. Globally, the ratio of workers-to-consumers - the so-called "support ratio" - has peaked after a forty-year ascent (Chart 4). As the support ratio declines, global savings will fall. To say that global saving rates will decline is the same as saying that there will be more spending for every dollar of income. Since global income must sum to global GDP, this implies that global spending will rise relative to production. That is likely to be inflationary. The projected evolution of support ratios varies across countries. The most dramatic change will happen in China. China's support ratio peaked a few years ago and will fall sharply during the coming decade. Nearly one billion Chinese workers entered the global labor force during the 1980s and 1990s as the country opened up to the rest of the world. According to the UN, China will lose over 400 million workers over the remainder of the century (Chart 5). If the addition of millions of Chinese workers to the global labor force was deflationary in the past, their withdrawal will be inflationary in the future. The fabled "Chinese savings glut" will eventually dry up. Chart 4The Ratio Of Workers To Consumers Has Peaked Chart 5China On Course To Lose More Than 400 Million Workers Rising female labor force participation rates have blunted the effect of population aging in Europe and Japan. This has allowed the share of the population that is employed to increase over the past few decades. However, as female participation stabilizes and more people enter retirement, both regions will also see a rapid decline in saving rates. This could lead to a deterioration in their current account balances, with potential negative implications for the yen and the euro. Population aging is generally bad news for equities. The slower expansion in the labor force will reduce the trend GDP growth. This will curb revenue growth, and by extension, earnings growth. To make matter worse, to the extent that lower savings rates lead to higher real interest rates, population aging could reduce the price-earnings multiple at which stocks trade. This could be further exacerbated by the need for households to run down their wealth as they age, which presumably would include the sale of equities. Megatrend #2: Global Migration Economist Michael Clemens once characterized the free movement of people across national boundaries as a "trillion-dollar bill" just waiting to be picked up from the sidewalk.3 Millions of workers toil away in poor countries where corruption is rife and opportunities for gainful employment are limited. Global productivity levels would rise if they could move to rich countries where they could better utilize their talents. Academic studies suggest that less restrictive immigration policies would do much more to raise global output than freer trade policies. In fact, several studies have concluded that the removal of all barriers to labor mobility would more than double global GDP (Table 1). The problem is that many migrants today are poorly skilled. While they can produce more in rich countries than they can back home, they still tend to be less productive than the average native-born worker. This can be especially detrimental to less-skilled workers in rich countries who have to face greater competition - and ultimately, lower wages - for their labor. Chart 6 shows that the share of U.S. income accruing to the top one percent of households has closely tracked the foreign-born share of the population. Table 1Economic Benefits Of Open Borders Chart 6Immigration Versus Income Distribution Low-skilled migration can also place significant strains on social safety nets. These concerns are especially pronounced in Europe. The employment rate among immigrants in a number of European countries is substantially lower than for the native-born population (Chart 7). For example, in Sweden, the employment rate for immigrant men is about 10 percentage points lower than for native-born men. For women, the gap is 17 points. The OECD reckons that a typical 21-year old immigrant to Europe will contribute €87,000 less to public coffers in the form of lower taxes and higher welfare benefits than a non-immigrant of the same age (Chart 8). Chart 7Low Levels Of Immigrant Labor Participation In Parts Of Europe Chart 8Immigration Is Straining Generous European Welfare States All of this would matter little if the children of today's immigrants converged towards the national average in terms of income and educational attainment, as has usually occurred with past immigration waves. However, the evidence that this is happening is mixed. While there is a huge amount of variation within specific immigrant communities, on average, some groups have fared better than others. The children of Asian immigrants to the U.S. have tended to excel in school, whereas college completion rates among third-generation-and-higher, self-identified Hispanics are still only half that of native-born non-Hispanic whites (Chart 9). Across the OECD, second generation immigrant children tend to lag behind non-immigrant students, often by substantial margins (Chart 10). Chart 9Hispanic Educational Attainment Lags Behind Chart 10Worries About Immigrant Assimilation Immigration policies that place emphasis on attracting skilled migrants would mitigate these concerns. While such policies have been adopted in a number of countries, they have often been opposed by right-leaning business groups that benefit from cheap and abundant labor and left-leaning political parties that want the votes that immigrants and their descendants provide. Humanitarian concerns also make it difficult to curtail migration, especially when it is coming from war-torn regions. Chart 11The Projected Expansion In Sub-Saharan Population Europe's migration crisis has ebbed in recent months but could flare up at any time. In 2004, the United Nations estimated that sub-Saharan Africa's population will increase to 2 billion by the end of the century, up from one billion at present. In its 2017 revision, the UN doubled its projection to 4 billion. Nigeria's population is expected to rise to nearly 800 million by 2100; Congo's will soar to 370 million; Ethiopia's will hit 250 million (Chart 11). And even that may be too conservative because the UN assumes that the average number of births per woman in sub-Saharan Africa will fall from 5.1 to 2.2 over this period. For investors, the possibility that migration flows could become disorderly raises significant risks. For one, low-skill migration could also cause fiscal balances to deteriorate, leading to higher interest rates. Moreover, as we discuss in greater detail below, it could propel more populist parties into power. This is a particularly significant worry for Europe, where populist parties have often pursued business-sceptic, anti-EU agendas. Megatrend #3: ­­­Social Fragmentation In his book "Bowling Alone," Harvard sociologist Robert Putnam documented the breakdown of social capital across America, famously exemplified by the decline in bowling leagues.4 There is no single explanation for why communal ties appear to be fraying. Those on the left cite rising income and wealth inequality. Those on the right blame the welfare state and government policies that prioritize multiculturalism over assimilation. Conservative commentators also argue that today's cultural elites are no longer interested in instilling the rest of society with middle-class values. As a result, behaviours that were once only associated with the underclass have gone mainstream.5 Technological trends are exacerbating social fragmentation. Instead of bringing people together, the internet has allowed like-minded people to self-segregate into echo chambers where members of the community simply reinforce what others already believe. It is thus no surprise that political polarization has grown by leaps and bounds (Chart 12). Chart 12U.S. Political Polarization: Growing Apart When people can no longer see eye to eye, established institutions lose legitimacy. Chart 13 shows that trust in the media has collapsed, especially among right-leaning voters. Perhaps most worrying, support for democracy itself has dwindled around the world (Chart 14). It would be naïve to think that the public's rejection of the political establishment will not be mirrored in a loss of support for the business establishment. The Democrats "Better Deal" moves the party to the left on many economic issues. Nearly three-quarters of Democratic voters believe that corporations make "too much profit," up from about 60% in the 1990s (Chart 15). Chart 13The Erosion Of Trust In Media Chart 14Who Needs Democracy When You Have Tinder? Chart 15People Versus Companies The share of Republican voters who think corporations are undertaxed has stayed stable in the low-40s, but this may not last much longer. Wall Street, Silicon Valley, and the rest of the corporate establishment tend to lean liberal on social issues and conservative on economic ones - the exact opposite of a typical Trump voter. If Trump voters abandon corporate America, this will leave the U.S. without any major party actively pushing a pro-business agenda. That can't be good for profit margins. The fact that social fragmentation is on the rise casts doubt on much of the boilerplate, feel-good commentary written about the "sharing economy." For starters, the term is absurd. Uber drivers are not sharing their vehicles. They are using them to make money. Both passengers and drivers can see one another's ratings before they meet. This reduces the need for trust. As trust falls, crime rises. The U.S. homicide rate surged by 20% between 2014 and 2016 according to a recent FBI report.6 In Chicago, the murder rate jumped by 86%. In Baltimore, it spiked by 52%. Chart 16 shows that violent crime in Baltimore has remained elevated ever since riots gripped the city in April 2015. The number of homicides in New York, whose residents tend to support more liberal policing standards for cities other than their own, has remained flat, but that is unlikely to stay the case if crime is rising elsewhere. The multi-century decline in European homicide rates also appears to have ended (Table 2). Chart 16Do You Still Want To Move Downtown? Table 2Crime Rates Are Creeping Higher In Europe Chart 17Homicides And Inflation Much has been written about how millennials are flocking to cities to enjoy the benefits of urban life. But this trend emerged during a period when urban crime rates were falling. If that era has ended, urban real estate prices could suffer tremendously. It is perhaps not surprising that the increase in crime rates starting in the 1960s was mirrored in rising inflation (Chart 17). If governments cannot even maintain law and order, how can they be trusted to do what it takes to preserve the value of fiat money? The implication is that greater social instability in the future is likely to lead to lower bond prices and a higher equity risk premium. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 2 Another problem with the neoclassical model is that it assumes perfectly flexible wages and prices. This ensures that the economy is always at full employment. Thus, if the saving rate rises, investment is assumed to increase to fully fill the void left by the decline in consumption. In the real world, the opposite tends to happen: When households reduce consumption, firms invest less, not more, in new capacity. One of the advantages of the traditional Keynesian framework is that it captures this reality. And interestingly, it also predicts that aging will be deflationary at first, but will eventually become inflationary. Initially, slower population growth reduces the need for firms to expand capacity, causing investment demand to fall. Aggregate savings also rise, as more people move into their peak saving years. Globally, savings must equal investment. If desired investment falls and desired savings rise, real rates will decrease. At the margin, lower real rates will encourage investment and discourage saving, thus ensuring that the global savings-investment identity is satisfied. As savings ultimately begins to decline as more people retire, the equilibrium real rate of interest will rise again. 3 Michael A. Clemens, "Economics and Emigration: Trillion-Dollar Bills on the Sidewalk?" Journal of Economic Perspectives Vol. 25, no.3, pp. 83-106 (Summer 2011). 4 Robert D. Putnam, "Bowling Alone: The Collapse And Revival Of American Community," Simon and Schuster, 2001. 5 Charles Murray has been a leading proponent of this argument. Please see "Coming Apart: The State Of White America, 1960-2010," Three Rivers Press, 2013. 6 Federal Bureau of Investigation, "Crime In The United States 2016" (Accessed October 25, 2017). Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Feature This week we are sending you a shorter-than-usual market update, as we are also publishing a Special Report exploring the outlook for USD cross-currency basis swap spreads. This report argues that USD basis swap spreads should widen over the next 12 months. Being a phenomenon associated with higher FX vols, this should hurt carry trades, including EM and dollar bloc currencies. It will also potentially create additional support for the USD. Also, next week, we will provide a deeper analysis of the fallout from the New Zealand government's dynamics. ECB Tapers? European Central Bank President Mario Draghi refused to call it "tapering," but he nonetheless announced that the ECB will be cutting back its asset purchases to EUR30 billion per month until at least September 2018. However, because the ECB will continue to proceed with re-investment of the stock of assets it holds, the monthly total presence of the ECB in European bond markets will stay above EUR 30 billion. Moreover, the ECB is keeping the door open to leaving its purchases in place beyond September 2019, if inflation does not keep track with the central bank's forecasts, and thus referred to the adjustment as being open-ended. Ultimately, the ECB does think that the recent rebound in inflation has been and remains a function of maintaining a very accommodative monetary setting. We think this option to keep the asset purchases in place beyond September 2018 is just this: an option. However, we do believe that yesterday's change in policy means the ECB will not increase interest rates until well into 2019. We also anticipate U.S. core inflation to begin outperforming euro area core inflation as U.S. financial conditions have eased significantly relative to the euro area - a key factor to redistribute inflationary pressures among these two economies (Chart I-1). As a result, because we anticipate that the Federal Reserve will increase the fed funds rate by more than the 67 basis points currently expected over the next two years, there could be some downside risk in EUR/USD. This downside risk is already highlighted by the large gap that has recently emerged between the 1-year/1-year forward risk-free rate spread between Europe and the U.S. versus the euro itself (Chart I-2). Chart I-1U.S. Inflation Set To Outperform Euro Area Prices Chart I-2Forward Interest Rates Point To A Lower Euro Moreover, the elevated long positioning right now further highlights the downside risk present in the euro (Chart I-3), probably explaining the European currency's rather violent reaction to what was a well-anticipated policy move. This means that EUR/USD could end 2017 in the 1.15 neighborhood, and fall further in 2018. Chart I-3Positioning Risk In EUR/USD Bottom Line: The ECB delivered exactly what was anticipated, yet the euro sold off. The ECB is unlikely to increase interest rates until well into 2019, suggesting the first anticipated rate hike in Europe is fairly priced. Thus, in order to justify any downside in the euro, one needs to be more positive on the Fed than what is currently priced into the U.S. interest rate curve. We fall into this camp. Moreover, positioning remains too long the euro. We expect EUR/USD to fall toward 1.15 by year end, and display more downside in 2018. Bank Of Canada The Bank of Canada (BoC) surprised the market this week by expressing a reversing of its recent pronounced hawkish bias, instead expressing a much more cautious tone. Where a closed output gap was once driving the need for tighter policy, residual labor market slack now warrants a more restrained approach to tightening. What has changed? NAFTA. The most recent and tenuous NAFTA negotiation round raised the specter of an end to the North American FTA. While NAFTA is still not dead, the rising probability that Canada-U.S. trade falls backs under the umbrella of the previous CUSFTA or even maybe something worse is causing a headache for Canadian policymakers. Some 20% of Canadian GDP is made up of products destined to be exported to the U.S., and this large chunk of GDP could be under some risk. Additionally, as the BoC highlighted, future investment decisions by firms in Canada may become investments in the U.S. to bypass regulatory uncertainty. Ultimately, if the Canada / U.S. trade relationship falls back under the CUSFTA umbrella, the impact on Canadian growth will be limited. Nonetheless, we think the BoC is correct to play its hand carefully, especially as the Canadian housing market is cooling. Moreover, a recent IPSOS survey revealed that around 40% of Canadian households would face financial difficulties if rates moved up significantly, which may justify a slower pace of hiking. With all this uncertainty looming, it is logical for the BoC to take its time before tightening policy anew. But in the end, we do anticipate the Canadian central bank to increase rates around two times next year, which is in line with the market's assessment: Canada's output gap is closing, and inflation is moving in the right direction. Thus, the outlook for the CAD is likely to be dominated by the outlook for oil. Robert Ryan, who runs BCA's Commodity And Energy Strategy service, expects WTI to move toward US$63/bbl next year, with upside risk to his forecast.1 This could help the CAD. However, the CAD does not seem particularly cheap against the USD when Canada's poor productivity performance is taken into account (Chart I-4), and speculators are now quite long the CAD (Chart I-5). As a result, our preferred medium to express positive views on the CAD is to be short AUD/CAD, where a valuation advantage is still present for the loonie (Chart I-6). Moreover, the AUD is more likely to suffer from China moving away from its investment-led growth model, while the CAD is less exposed to this risk. Chart I-4The CAD Is Not That Cheap Chart I-5Speculators Are Very Long The CAD Chart I-6Short AUD/CAD Bottom Line: The BoC is rightfully concerned that a breakdown of NAFTA would negatively affect the Canadian economy. While a return to CUSFTA would minimize any impact, the current high degree of uncertainty warrants that the BoC takes a more cautious stance. Ultimately, the BoC will increase rates next year, potentially two times. We continue to prefer to short AUD/CAD. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report, titled "Upside Risks Dominate BCA's Oil Price Forecast", dated October 26, 2017, available at ces.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data has been strong: Manufacturing PMI came out at 54.5, stronger than expected; Services PMI came out at 55.9, also stronger than expected; Durable goods orders increased by 2.2%; New home sales increased by 18.9% monthly, the highest growth rate in 25 years; Initial jobless claims declined and beat expectations. Crucially, the DXY is above its 100-day moving average and has broken the reverse head-and-shoulders neckline, with momentum in the greenback's favor. The ECB's tapering weakened the euro by 1.4%. Further weakness in commodity currencies also allowed the dollar to gain momentum. We expect this momentum to continue as inflation in the U.S. re-emerges over the next six to twelve months. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The ECB's decision was largely in line with market consensus, but the euro nonetheless fell significantly. The ECB will halve its rate of purchases to EUR 30 bn a month starting next year until at least September 2018. However, President Mario Draghi stated that this could be extended beyond September, or even increased, if conditions warrant it. Draghi noted that "domestic price pressures are still muted overall and the economic outlook and the path of inflation remain conditional on continued support from monetary policy", also stating that rates would remain low for an extended period of time, and possibly even "past the horizon of the net asset purchases". Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: The Leading Economic Index increased from 105.2 to 107.2 in the month of August. Nikkei Manufacturing PMI surprised to the downside, coming in at 52.5, declining from 52.9 the month before. However, corporate service prices year-on-year growth came in at 0.9%, against expectations of 0.8%. Following the overwhelming victory of Prime Minister Shinzo Abe, the USD/JPY traded above 114, before stabilizing just below later in the week. Now that Abe has won the election, he is freer to implement loose fiscal policy in order to increase his chances to amend the pacifist Japanese constitution. This, accompanied by 10-year JGB rates anchored around zero, and a Federal Reserve that is likely to hike more than expected, should push USD/JPY higher. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in Britain has been mixed: Gross Domestic product yearly and quarterly growth surprised to the upside, coming in at 1.5% and 0.4% respectively. Moreover, public sector net borrowing was also lower than expected coming in at 5.236 billion pounds for the month of September. However, BBA mortgage approvals came below expectations, coming in at 41.584 thousand, which is lower than the month before. The pound has gone up following the positive GDP reading. As of now the market considers there is a 91% probability that the Bank of England hikes rates in November. However any hikes beyond that would require a significant improvement in economic activity. Thus, we would tend to fade any strength in GBP/USD, as the Fed is more likely to hike rates than the BoE on a sustainable basis. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The AUD declined on weak consumer price numbers. The trimmed mean CPI remained steady at 1.8% annually, below the expected 2% rate, and weakened to 0.4% quarterly, down from 0.5%. The largest yearly decline was in communication (services or equipment) of 1.4%, although declines in food prices and clothing were also substantial at 0.9%. This is largely in line with our view that the consumer sector is handicapped with poor wage growth. We believe inflation is unlikely to move much higher; this will keep the RBA at bay. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been negative: Imports surprised to the upside, coming in at 4.92 billion dollars. This figure also increased form last month's reading. However exports underperformed expectations, coming in at 3.78 billion dollars for the month of September. Finally the trade balance, also underperformed expectations, coming in at -1.143 billion dollars. After the election of new Prime Minister Jacinda Ardern the kiwi has plunged, and now has a negative return year-to-date. The government is trying to implement three measures which significantly affect the value of the kiwi: a dual central bank mandate, restrictions on immigration, and a stop to foreign real estate purchases. All these measures lower the terminal rate for the RBNZ. With this being said, we are still shorting AUD/NZD given that commodity dynamics will dominate the movements of this cross. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 CAD had an eventful week as the Bank of Canada came out with a monetary policy decision. The decision was in line with the consensus, but the statement was not. The Bank was particularly concerned "about political developments and fiscal and trade policies, notably the renegotiation of the North American Free Trade Agreement". Additionally, it was also noted that "because of high debt levels, household spending is likely more sensitive to interest rates than in the past". The Bank also made a U-turn in its view of the labor market, stating that "wage and other data indicate that there is still slack in the labor market". These unexpected remarks dropped the CAD's value by 1% against USD. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 The Franc continues to depreciate against the Euro, even as EUR/USD has gone down more than 2.5% since peaking early in December. Meanwhile, as the franc has depreciated, economic variables have improved. The KOF Industry Survey Business Climate indicator is now positive for the first time since 2011. Meanwhile, core inflation has reached 2011 highs as well. Additionally multiple components of PMI are at their highest level in the past 6 years. All of these factors bode well for the Swiss economy, and prove that the SNB's ultra-loose monetary policy and currency intervention is working. That being said, we would like to see more strength from key economic variables to consider shorting EUR/CHF, given that the recovery is still too fragile for the SNB to change policy. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The Norges Bank left their key policy rate unchanged at 0.5% yesterday. The central bank highlighted that capacity utilization was below normal levels and that inflation was expected to be below 2.5% in the coming years. Furthermore, the comittee highlighted that although the labor market appears to be improving, inflation has been lower than expected, while the krone is also weaker than projected. The bank has reassured our view that even in the face of strong oil prices, slack is still too big in the Norwegian economy for the Norges Bank to start raising rates. Furthermore, a hawkish fed will further put upward pressure on USD/NOK. Than being said, EUR/NOK should depreciate, given that this cross is much more sensitive to oil than it is to rate differentials. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The SEK has depreciated considerably in recent weeks owing to somewhat weaker inflation figures. It has weakened particularly against the EUR, as markets are expecting the Riksbank to follow the ECB in its rate path. This was confirmed by a particularly dovish tone from the recent monetary policy statement which exacerbated this decline, with the board expecting to maintain the current monetary policy until mid-2018, and even discussed a possible extension of asset purchase programs beyond December. The Board has "also taken a decision to extend the mandate that facilitates a quick intervention in the foreign exchange market". Finally, they lowered their inflation forecasts for both 2017 and 2018. Stefan Ingves is firmly in control. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades