Equities

Highlights Economic Outlook: Global growth will stay strong over the next 12 months, with the U.S. surprising on the upside. Unfortunately, the global economy will succumb to a recession in 2019. Stagflation will become a major problem in the 2020s. Portfolio Strategy: We are sticking with our pro-risk stance for the time being, but are trimming our overweight recommendations to global equities and high-yield credit. Fixed Income: Maintain below benchmark duration exposure over the next 12 months. Underweight U.S., euro area, and Canadian government bonds; stay neutral the U.K., Australia, and New Zealand; overweight Japan. Equities: Favor cyclicals over defensives, but look to turn outright bearish on stocks late next year. For now, stay overweight the euro area and Japan relative to the U.S. in local-currency terms. In the EM universe, Chinese H-shares will outperform. Currencies and Commodities: While the recent dollar rebound has further to run, oil-sensitive currencies and the yuan will hold their ground against the greenback. It is too early to buy gold. Feature I. Global Macro Outlook: Reflation, Recession, And Stagflation The economic outlook over the coming years can be summarized in three words: reflation, recession, and stagflation. Reflation A Broad-Based Recovery Global growth is firing on all cylinders. The OECD estimates that all 46 of the economies that it tracks will see positive growth this year, the first time this has happened since 2007. Most leading economic indicators remain upbeat (Chart 1). This has left analysts scrambling to revise up their global GDP growth forecasts (Chart 2). Chart 1Most Leading Economic Indicators Remain Upbeat Chart 2Global Growth Has Accelerated The acceleration in global growth has occurred against the backdrop of tame inflation, which has allowed most central banks to keep interest rates at exceptionally low levels. Not surprisingly, risk assets have reacted positively. These goldilocks conditions should remain in place for the next 12 months. While most economies are growing at an above-trend pace, there is still plenty of spare capacity around the world. This means that inflation in countries such as the U.S. - where the labor market has returned to full employment - is likely to rise only gradually, as excess demand is satiated through higher imports. Such a redistribution of demand from countries with low levels of spare capacity to those with high levels is a win-win outcome for the global economy. Recession Running Out Of Room Unfortunately, all good things must come to an end. Weak productivity growth across most of the world is likely to cause bottlenecks to emerge over time, and this will cause inflation to move higher (Chart 3). Output gaps in the main developed economies would actually be higher today than at the height of the Great Recession had potential GDP grown at the rate the IMF projected back in 2008 (Chart 4). This is a testament to just how exceptionally weak potential growth has been. Chart 3Productivity Growth Has Slowed Across The Globe Chart 4Weak Supply Growth Has Narrowed Output Gaps U.S. growth will surprise to the upside over the next 12 months, leading to an unwelcome burst of inflation in late 2018 or early 2019. Financial conditions have eased sharply this year thanks to lower bond yields, narrower credit spreads, a weaker dollar, and a surging stock market. Changes in financial conditions lead growth by around 6-to-9 months, implying that U.S. growth could reach 3% early next year (Chart 5). This could take the unemployment rate down to 3.5% by end-2018, more than a full point below the Fed's estimate of full employment and even lower than the 2008 low of 3.8%. The unemployment rate could fall even further if Congress succeeds in passing legislation to cut taxes, as we expect it will. Our geopolitical team estimates that the GOP proposal would reduce federal revenues by $1.1-to-$1.2 trillion over ten years, or about 0.5% of GDP.1 In order to appease moderates, the final bill is likely to scale back the size of the tax cuts and shift more of the benefits to middle class households. Under the current proposal, the top 1% of taxpayers would receive 50% of the tax benefits (Chart 6). Our best bet is that the legislation will be enshrined into law in early 2018. Chart 5Easier Financial Conditions Will Boost U.S. Growth Chart 6Republican Tax Would Disproportionately Benefit The Top 1% Welcome To The Steep Side Of The Phillips Curve The so-called Phillips curve, which depicts the relationship between unemployment and inflation, tends to become quite steep once unemployment falls to very low levels (Chart 7). It is easy to see why: When spare capacity is high, a modest decline in slack will still leave many workers idle. In such a setting, inflation is unlikely to rise. However, once the output gap is fully closed, any further decline in slack will cause bottlenecks to emerge, pushing wages and prices higher. The 1960s provide a useful lesson in that regard. Just like today, inflation hovered below 2% during the first half of that decade, even though unemployment was trending downward over this period. To most observers back then, the Phillips curve would have also seemed defunct. However, once the unemployment rate fell below 4%, core inflation took off, rising from 1.5% in early 1966 to nearly 4% in 1967 (Chart 8). The kink in the Phillips curve had been reached. Inflation ultimately made its way to 6% in 1970, four years before the first oil shock struck. Chart 7U.S. Economy Has Moved Into The 'Steep' Side Of The Phillips Curve Chart 8Inflation In The 1960s Took Off Once The Unemployment Rate Fell Below 4% Many commentators have questioned the relevance of the sixties template on the grounds that the U.S. economy was less open to the rest of the world back then, trade unions had greater bargaining power, inflation expectations were not as well anchored, and the deflationary effects of new technologies were not as pervasive. We discussed these arguments in a report published earlier this month, concluding that they are not nearly as persuasive as one might think.2 The Difficulty Of Achieving A Soft Landing Rising inflation will compel the Fed to hike rates aggressively starting late next year in order to push the unemployment rate back towards NAIRU. A turn towards hawkishness is especially likely if Janet Yellen is replaced by someone such as former Fed Governor Kevin Warsh, whom betting markets now think has a 40% chance of becoming the next Fed chair (Chart 9). The problem for whoever ends up running the Fed is that it is very difficult to raise the unemployment rate by just a little bit. Modern economies are subject to massive feedback loops. When unemployment begins rising, households lose confidence and reduce spending. This prompts firms to slow hiring, leading to even less spending. The U.S. has never averted a recession in the post-war era whenever the unemployment rate has increased by more than one-third of a percentage point (Chart 10). Chart 9Who Will The Next Fed Chair Be? Chart 10Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Lofty valuations are likely to exacerbate the adverse feedback loop described above during the next downturn. As growth slows, risk asset prices will tumble. This will cause business investment spending to dry up. Given America's dominant role in global financial markets, the U.S. recession will spread like wildfire to the rest of the world. Stagflation The Doves Reassert Control The next recession will probably be more painful for Wall Street than for Main Street. Fed-induced downturns tend to be swift but short-lived. The subsequent recoveries are usually V-shaped, rather than the elongated U-shaped recoveries that follow financial crises. Nevertheless, central banks around the world will undoubtedly start slashing rates again, perhaps even restarting their QE programs. Traumatized by the Great Recession, central bankers will overreact. The hawks will be blamed for the recession and forced to turn tail. The doves will reassert control. Fiscal policy will be significantly eased. This will be particularly the case if the next recession coincides with Trump's re-election campaign, brewing populism in Europe, and the spectre of military conflict in a variety of hotspots around the planet. Structural Forces Will Boost Inflation Meanwhile, millions of baby boomers will be in the process of leaving the workforce. This will lead to slower income growth, but not to slower spending growth - spending actually rises late in life due to spiraling health care costs (Chart 11). An increase in spending relative to income tends to push up prices. A recent IMF research report estimated that population aging has been highly deflationary over the past few decades, but will be very inflationary over the coming years (Chart 12). Chart 11Savings Over The Life Cycle Chart 12Demographic Shifts: From Highly Deflationary To Highly Inflationary All this suggests that the dip in inflation during the next recession will be fleeting. As the recovery from the shallow recession unfolds, inflation will reaccelerate. Of course, at that point, central banks could step in to aggressively quell inflationary pressures. However, they are unlikely to do so. After the next recession-induced burst of fiscal stimulus, debt levels will be even higher than they are now. The temptation to inflate away this debt will intensify. And, in an environment of anemic real potential GDP growth, the means to generate inflation will become available: Central banks will simply need to keep rates below their "neutral" level. Central bankers will rationalize their actions on the grounds that higher inflation will allow them to bring real interest rates deeper into negative territory in the event of another economic downturn. A growing chorus of eminent economists has begun to argue that a 2% inflation target is too low. For example, just this week, Larry Summers stated that "I think we probably need to adjust our monetary policy framework ... to [one] that provides for higher nominal rates during normal times, so there's more room to cut rates during downturns."3 II. Financial Markets As with the economic outlook, the three words reflation, recession, and stagflation guide our views of where financial markets are heading over the coming years. We continue to maintain a pro-risk stance, but are trimming our overweight recommendation to equities and high-yield credit due to the fact that valuations have gotten stretched and we are entering the last innings of the business-cycle expansion (Table 1). Table 1BCA's Tactical Global Asset Allocation Recommendations* Equities Sticking With Bullish ... For Now Recessions and bear markets tend to go hand-in-hand (Chart 13). None of our recession timing indicators are warning of an imminent downturn, suggesting that the cyclical global equity bull market has further room to run (Chart 14). Chart 13Recessions And Bear Markets Usually Overlap Chart 14AThis Business Cycle Has Further To Run Chart 14BThis Business Cycle Has Further To Run Strong growth in corporate earnings continues to underpin the rally in equities. The MSCI All-Country World index has increased by 11.9% in the first 9 months of the year, only slightly more than the 9.1% gain in earnings. As a result, the forward P/E ratio has only risen from 15.7 at the start of the year to 16.1 (Table 2). Table 2Earnings-Backed Price Appreciation Favor Cyclicals Over Defensives Above-trend global growth should boost profits over the next 12 months. We favor cyclical sectors over defensives, and are expressing this view through our long global industrial stocks/short utilities trade recommendation. The trade is up 0.9% since we initiated it last Friday and up 2.3% since I previewed it at BCA's annual New York Investment Conference earlier the same week. Capital spending tends to accelerate in the mature phase of business-cycle expansions, as a growing number of firms realize that they have insufficient capacity to meet rising demand. Our model predicts that global capex will grow at the fastest pace in six years (Chart 15). This should benefit industrial stocks. On the flipside, rising global yields will hurt rate-sensitive utilities (Chart 16). Chart 15Global Capex On The Upswing Chart 16Higher Bond Yields Will Hurt Utilities Financials should also outperform. Banks, in particular, will benefit from steeper yield curves, faster credit growth, and ongoing declines in nonperforming loans. Energy stocks are also attractive. As discussed below, we continue to maintain a generally upbeat view on the direction of oil prices. Prefer DM Over EM, Europe And Japan Over The U.S. While it is a close call, we see more upside for DM than EM stocks, as the former are less vulnerable to a dollar rebound and an increasingly hawkish Fed. Emerging market equities have had a good run over the past year, and are due for a breather. Our favorite EM equity idea for the fourth quarter is to be long Chinese H-shares. H-shares are heavily tilted toward financials and deep cyclicals, two sectors that we like. They also trade at a mere seven-times forward earnings and one-times book value (Chart 17). Within the DM space, European and Japanese equities should outperform U.S. stocks in currency-hedged terms. The sector composition of both the European and Japanese market is tilted toward stocks that will gain the most from strong global growth and increased capital spending. As our European strategists have documented, the European stock market is dominated by large multinationals whose fortunes are tied more to the global economy than to domestic prospects. This is largely true for the Japanese stock market as well. If our prediction for a somewhat weaker euro and yen comes to pass, profits in both regions will benefit from the currency translation effect. Valuations in Europe and Japan are also generally more attractive than in the U.S, even if one adjusts for different sector weights (Chart 18). Chart 17Chinese H-Shares: A Valuation Snapshot Chart 18U.S. Stocks Look Pricey Small Cap Value Trumps Large Cap Growth Style-wise, we prefer small cap value over large cap growth. Value stocks generally do better in environments where cyclicals are outperforming defensives, while small caps tend to be high-beta bets on global growth (Chart 19). U.S. small caps will disproportionately benefit from cuts to statutory corporate taxes, since smaller companies typically have less ability to game the tax code in their favor. Timing The Next Bear Market As one looks beyond the next 12 months, the skies begin to darken for global equities. The stock market usually sniffs out recessions before they happen, but the lead time is quite variable and generally not that long (Table 3). For example, the S&P 500 peaked only two months before the start of the Great Recession in December 2007. Chart 19Favor Cyclicals And Value Plays Table 3Stocks And Recessions: Case-By-Case Chart 20Stagflation Was Devastating For Stocks Stagflation Is Not A Stock-Friendly Environment If the next recession begins in the second half of 2019, global equities will probably peak earlier that year or in late 2018. Given the starting point for valuations, U.S. equities are likely to fall 20%-to-30% peak-to-trough. While other global bourses are generally not as expensive, their higher-beta nature means that they will probably face similar if not worse declines. The fact that correlations tend to rise during risk-off episodes will only add to the bloodshed. Stocks And Stagflation If the experience of the 1970s is any guide, equities perform poorly in stagflationary environments (Chart 20). Investors tend to see stocks as a riskier substitute for bonds. When nominal bond yields rise, the dividend yield offered by stocks becomes less attractive. In theory, the increase in the nominal value of corporate net worth resulting from higher inflation should generate enough capital gains over time to compensate for the wider gap between dividend yields and bond yields. In practice, due to "money illusion" and other considerations, that does not fully occur, requiring that stocks become cheaper so that their expected return can rise. The Long-Term Outlook For Profit Margins A complicating factor going into the next decade will be what happens to profit margins. S&P 500 operating margins are close to their all-time highs (Chart 21). While margins will undoubtedly fall during the next recession, their subsequent recovery is likely to be encumbered by a number of shifting structural forces. A slew of labor-saving technological innovations depressed labor's share of income over the past few decades. So did the entry of over one billion new workers into the global labor force following the collapse of the Berlin Wall and China's transition to a capitalist economy. The fixation of central banks on bringing down inflation may have led to higher unemployment than what would otherwise have been the case, thereby undermining the bargaining power of workers. All this may change during the next decade. China's labor force has peaked and is on track to decline by over 400 million workers by the end of the century - a larger decline than the entire U.S. population (Chart 22). A shift towards persistently more expansionary monetary policy could also keep the labor market fairly tight. Chart 21U.S. Profit Margins Are Close To All-Time Highs Chart 22China On Course To Lose More Than 400 Million Workers Technological innovation will persist, but the firms that benefit from it are likely to attract more scrutiny from regulators. Republican voters - the traditional defenders of corporate America's God-given right to make a buck - are growing increasingly wary of big business. Wall Street, Silicon Valley, and the rest of the corporate establishment tend to be liberal on social issues and conservative on economic ones. Very few voters actually share this configuration of views (Chart 23). The Democratic Party's "Better Deal" moves it to the left on many economic issues. This runs the risk of leaving the U.S. without any major party actively pushing a pro-business agenda. That can't be good for profit margins. Bottom Line: Investors should stay overweight global equities, but trim exposure from moderate overweight to small overweight due to rising business-cycle risk, and look to get outright bearish late next year. The long-term outlook for equities is poor, especially in the U.S. where valuations are highly stretched. Chart 24 presents a stylized sketch of how we think the major stock market indices will evolve over the coming years. Chart 23An Absence Of Libertarians Chart 24Market Outlook: Equities Fixed Income Above-trend GDP growth and rising inflation are likely to push up long-term bond yields in most economies over the next few quarters, as flagged by our Central Bank Monitors (Chart 25). Bond yields will fall during the next recession and then begin to inexorably rise higher as stagflationary forces intensify (Chart 26). Looking out over the next 12 months, our regional allocation recommendations are as follows: Chart 25Our Central Bank Monitors Point To Growing Pressures To Tighten Chart 26Market Outlook: Bonds Underweight The U.S., Euro Area, And Canada Chart 27Canada Enjoys Robust Growth We remain underweight U.S. Treasurys in a global fixed-income portfolio. The market is pricing in only 44 basis points in Fed hikes between now and the end of next year, well below the 100 basis points of hikes implied by the dots in the Summary of Economic Projections. The U.S. yield curve has flattened since the start of the year. This should change over the next 12 months, as inflation expectations rebound from currently depressed levels. The yield curve in the euro area should steepen more than in the U.S., since the ECB has pledged not to raise rates until well after its asset purchase program is complete - something that is unlikely to happen until the end of next year. This implies that the 2-year spread between the two regions will widen in favor of the U.S., which should be bullish for the dollar. Canadian bond yields are likely to rise further (Chart 27). The unemployment rate has fallen to a nine-year low and the Bank of Canada expects the output gap to be fully closed by the end of this year. The economy grew by 3.7% year-over-year in the second quarter, well above the BoC's estimate of potential real GDP growth of 1.5%. The Bank's most recent Business Outlook Survey points to continued robust growth ahead. The bubbly housing market remains a concern, but delaying withdrawal of monetary accommodation risks exacerbating the problem. Neutral On Gilts And Aussie And Kiwi Bonds In contrast to most other developed economies, leading indicators point to slower U.K. growth in the months ahead (Chart 28). This undoubtedly reflects the ongoing uncertainty over Brexit negotiations, which are likely to drag on for quite some time. Core inflation has surged to 2.7% on the back of the sharp depreciation of the pound, but market expectations suggest that it is about to roll over. Nevertheless, with 10-year gilts fetching just 1.35%, the downside for yields is limited. The cheap pound should also prop up exports, partly offsetting the impact of diminished market access to the rest of the EU. The unemployment rate stands at 4.3%, slightly below the Bank of England's estimate of NAIRU. One way or another, the uncertainty over Brexit will fade, allowing gilt yields to move higher. As with gilts, the outlook for Australian and New Zealand bonds is mixed. Strong global growth should boost commodity prices. This will help the Australian economy. The unemployment rate in Australia has fallen to 5.6%, but involuntary part-time employment is high and wage growth has been stagnant. Industrial capacity utilization remains low, as reflected in a fairly large output gap (Chart 29). The market expects the RBA to deliver 38 basis points in rate hikes over the next 12 months. We think that's about right. New Zealand's 10-year yield stands at a relatively generous 2.96%, which makes it difficult to be too bearish on kiwi bonds. However, we do not see much scope for yields to fall from current levels. Nominal GDP is growing at over 5% and retail sales are expanding at nearly 7% (Chart 30). The terms of trade have risen to their highest level since the 1970s. The output gap is now fully closed and core inflation is edging higher. Despite this good news, the policy rate remains at a record low of 1.75%. We concur with market expectations that the RBNZ will start raising rates next year. Chart 28U.K. Growth Is Slowing Chart 29There Is Still Slack In The Australian Economy Chart 30New Zealand: Upbeat Indicators Overweight JGBs CPI swaps predict that inflation in Japan will average only 0.5% over the next twenty years. As we argued last week, this is far too low.4 The secular drivers of deflation are fading and inflation will begin to surprise to the upside over the coming years (Chart 31). However, the path between here and there will be a choppy one. Considering that deflationary expectations remain deeply entrenched, the Bank of Japan is unlikely to abandon its yield curve targeting regime for at least the next few years. As government bond yields rise elsewhere in the world, 10-year JGBs will be the default winners. Investors thinking of going short Japanese government bonds should focus on 20-year or 30-year maturities, which are not subject to the BoJ's cap. Credit: Still Overweight, But Trimming Back Exposure High-yield credit spreads have fallen back near their post-recession lows after widening in the wake of the global manufacturing recession (Chart 32). We see little scope for further spread compression. Our U.S. Corporate Health Monitor remains in deteriorating territory (Chart 33), and higher Treasury yields will put downward pressure on corporate bond prices even if spreads remain constant. Nevertheless, the default-adjusted spread on U.S. high-yield debt of 212 basis points is still large enough to warrant a modest overweight to credit, especially since banks have started to loosen lending standards again. Chart 31Japan: Fading Deflationary Forces Chart 32High-Yield Spreads Have Narrowed Chart 33U.S. Corporate Health Continues To Deteriorate Our Global Fixed Income Strategists prefer U.S. over European credit, given that spreads are lower in Europe, and the tapering of ECB asset purchases could reduce the demand for spread product. Currencies And Commodities The Dollar: Comeback Kid? Charts 34 and 35 show our expectations about the future path of the major currencies and commodities. Chart 34Market Outlook: Currencies Chart 35Market Outlook: Commodities BCA's Global Investment Strategy service went long the dollar in October 2014. We reiterated our bullish stance before the U.S. presidential elections, controversially arguing that "Trump Will Win And The Dollar Will Rally."5 Unfortunately, we remained long the dollar over the course of this year, which turned out to be a mistake. Strong growth abroad, weaker-than-expected inflation readings in the U.S., and the fizzling of the "Trump Trade" all contributed to dollar weakness. Technicals also played a role. Sentiment was extremely bullish towards the dollar at the start of the year, but extremely bearish towards the euro (Chart 36). The reversal of these technical trends helps explain why the euro appreciated a lot more than what one would have expected based simply on changes in interest rate differentials (Chart 37). Chart 36Euro: Long Positions Are Getting Stretched Chart 37The Euro Has Overshot Interest Rate Spreads Of course, if the spread between U.S. and euro area interest rates continues to narrow, it is likely that EUR/USD will strengthen. We are skeptical that it will. For one thing, financial conditions have eased sharply in the U.S. since the start of the year, but have tightened in the euro area (Chart 38). This suggests that U.S. growth will surprise on the upside whereas euro area growth could begin to disappoint. Chart 38U.S. Versus Euro Area Diverging Financial Conditions The five-year, five-year forward OIS spread between the two regions stands at 87 basis points in nominal terms, and 25 basis points in real terms. The five-year forward spread is even lower if one calculates a GDP-weighted bond yield for the euro area rather than looking at the expected path of interbank rates. Such a small spread is inconsistent with the fact that the neutral rate is substantially higher in the U.S.6 We expect EUR/USD to fall to $1.15 by the end of 2017, and potentially decline further in 2018 as the Fed picks up the pace of rate hikes. The dollar is also likely to strengthen against the yen, as Treasury yields rise relative to JGB yields. We see less downside for the British pound and the Swedish krona against the greenback. This is reflected in our long GBP/EUR and long SEK/CHF trade recommendations, both of which remain in the black. Upside For Oil-Sensitive Currencies Our energy strategists still see further upside for crude oil prices, owing to favorable supply and demand conditions. They point to the fact that official forecasts by the EIA have consistently underestimated oil demand. They also note that compliance with OPEC 2.0 production cuts has been remarkably good, and that estimates of how much new shale output will hit the market over the next 12 months are too optimistic. Additionally, they believe that the decline in production from conventional oil fields around the world - especially offshore fields, where there has been a dearth of new investment in recent years - could be larger than expected.7 Geopolitical risks in Iraq, Libya, and Venezuela could also adversely affect supply. Firmer demand and lackluster supply will lead to further drawdowns in OECD oil inventories, which should be supportive of prices (Chart 39). We recently took profits of 13.8% on our recommendation to go long the December-2017 Brent oil futures contract, but are maintaining exposure to oil through our long CAD/EUR and RUB/EUR positions, as well as through our bias towards cyclical equities. Resilient Chinese Economy Should Support Metal Prices And The RMB Recent Chinese data have been on the soft side, giving rise to fears that the economy is heading towards a major slowdown. We are more optimistic. While growth has clearly slowed since the start of the year, it remains at an above-trend pace, as evidenced by numerous real-time measures of economic activity (Chart 40). Chart 39Falling Oil Inventories Should Lead To Higher Crude Prices Chart 40Chinese Economy: No Need To Be Pessimistic Even the housing market has managed to stay resilient, despite widespread predictions of imminent doom (Chart 41). The share of households planning to buy a new home remains close to all-time highs. The amount of land purchased by developers - a good leading indicator for housing starts - is accelerating. Reflecting these developments, property stocks are surging. Financial conditions have tightened, but so far this has largely bypassed the real economy. In fact, long-term bank lending to nonfinancial institutions has accelerated since the start of the year (Chart 42). The recently announced cuts to reserve requirements for small business loans should facilitate this trend. Chart 41Chinese Housing Market Remains Resilient Chart 42Credit To Real Economy And Profit Rebound Bode Well For Capex Meanwhile, industrial profits have rebounded, as rampant producer price deflation last year has given way to modest price gains this year. Increased retained earnings will give Chinese companies the wherewithal to spend more on capital equipment. A recovery in global trade should also help stoke export growth. (Chart 43). Despite strengthening this year, our indicators suggest the yuan is still in undervalued territory (Chart 44). Buoyant economic growth should alleviate capital flight and reduce the pressure on the authorities to engineer a further depreciation of the currency. This, in turn, should help support metal prices and other EM currencies, even in a setting where the dollar remains well bid. Chart 43Positive Global Trade Momentum: A Tailwind For Chinese Exports Chart 44The Chinese Yuan Is Undervalued Chart 45Gold: Waiting For Drivers Of Sustained Price Appreciation Buy Gold ... But Not Yet Lastly, a few words on gold. Gold does well in situations where real rates are falling and the dollar is weakening (Chart 45). That's not the environment we find ourselves in today. Gold will have its day in the sun, but probably not before the stagflationary era begins in earnest after the next recession. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 This revenue loss is measured against a baseline where a number of tax breaks, which are currently set to expire, are extended. Please see BCA Geopolitical Strategy Weekly Report, "Is King Dollar Back?" dated October 4, 2017, available at gps.bcaresearch.com. 2 Please see Global Investment Strategy Weekly Report, "Is The Phillips Curve Dead Or Dormant?" dated September 22, 2017. 3 Summers, Lawrence, H. (@LHSummers). "Great piece by @jasonfurman in today's @WSJ: The U.S. can no longer afford deficit-increasing tax cuts." 01 Oct 2017. Tweet. 4 Please see Global Investment Strategy Weekly Report, "Three Tantalizing Trades," dated September 29, 2017. 5 Please see Global Investment Strategy Special Report, "Three (New) Controversial Calls," dated September 30, 2016. 6 Please see Global Investment Strategy Weekly Report, "Central Bank Showdown," dated September 8, 2017. 7 Please see Commodity & Energy Strategy, "OPEC 2.0 Will Extend Cuts to June 2018," dated September 21, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Either China's growth will slump soon, capping budding inflationary pressures, or policymakers will have to hike interest rates meaningfully to tackle inflation. If the PBoC drags its feet and does not hike interest rates amid rising inflation, the RMB will come under major selling pressure. EM/China corporate profits have expanded predominantly due to price increases. However, rapid price increases warrant higher interest rates. The latter is a formidable risk to share prices. The U.S. dollar has made a major bottom. Stay short select EM currencies. The EM equity rally momentum remains strong but the risk-reward is quite unfavorable. We expect the external backdrop - metals prices and portfolio flows to EM - to deteriorate inhibiting the current easing cycle in Peru. Stay underweight this bourse within the EM universe (page 13). Feature A key question for investors at the current juncture is whether the global economic backdrop is moving toward inflation or deflation - or whether it will remain in its present "goldilocks" state. One can cite numerous examples that support each of the three scenarios. Proponents of deflation cite low consumer price inflation in the U.S., euro area and Japan, as well as very weak money growth in China and the U.S. as being leading indicators of budding deflationary pressures. Advocates of goldilocks - improving growth with low inflation - point to robust global trade and low consumer price inflation, as well as benign financial market dynamics in the form of higher share prices and low bond yields. Last but not least, inflationists can cite very tight labor markets among advanced economies as well as rising core and services consumer price inflation rates in China (Chart I-1). Chart I-1China: Inflation Is Grinding Higher At BCA's annual conference in New York held last week, the broad consensus was that there is a lack of considerable inflationary pressures worldwide amid improving global growth. This is consistent with the goldilocks outcome currently priced by the financial markets - i.e., a combination of robust growth and low inflation. Given the current pricing in financial markets, one economic variable that could disturb benign global financial dynamics is inflation. This report examines inflationary dynamics in China and briefly touches on the U.S. and euro area inflation outlooks. Our take is as follows: Unless China's money and credit growth slow further and generate another deflationary slump in China and world trade, the odds are that the balance both globally and within China will tilt toward inflation in the next 12 months. To be clear, our main theme remains that a material slowdown in China's growth will dampen China/EM growth, derail the EM corporate profit recovery and cap inflationary pressures in China, at least. Therefore, to some extent, this report is counter-factual - it examines what may happen if a meaningful growth deceleration in China does not transpire. Our analysis also addresses the question of what may happen if policymakers in China allow money/credit to accelerate again, without permitting the economy to slow too much. The short response: Inflation is already slowly but surely rising in China and it will soon become a constraint, limiting Chinese policymakers' options. China/Asia Recovery: Prices Or Volumes? China's industrial revival, as well as Asia's export recovery over the past 12-18 months, has largely been due to price increases amid modest volume growth. In particular: China's manufacturing production volume growth has not improved at all, but manufacturing producer prices have surged, producing substantial recovery in nominal output growth (Chart I-2). This is strictly within manufacturing, and does not include mining and ferrous metal production, where output cuts have led to surging prices for raw materials. In brief, one can observe higher inflation beyond the steel and coal industries. Furthermore, producer price inflation has improved for consumer goods (Chart I-3, top panel), and for the first time in 17 years ex-factory producer price deflation has ended in durable consumer goods as well as in electronics goods and communication equipment (Chart I-3, middle and bottom panels). Chart I-2China's Industrial Recovery: Surging ##br##Prices Amid Subdued Volume Growth Chart I-3China: Producer Price ##br##Inflation Is Broad-Based Notably, China's core (ex-food and energy) consumer price inflation has moved above 2%, and consumer services price inflation has risen to 3% (Chart I-1 on page 1). Importantly, these consumer inflation measures have risen, even though food prices are deflating in China and energy prices are stable. This entails that consumer price inflation pressures are genuine and reasonably broad-based. In Asian trade, the dichotomy between prices and volumes is especially apparent in the case of Korea's exports. The U.S. dollar value of Korean exports has mushroomed, but there has been only modest revival in export volumes (Chart I-4). Remarkably, both the 2014-'15 slump and the 2016-'17 recovery in Korean exports were largely due to prices, not volumes. The latter have been expanding modestly in recent years, while prices crashed in 2013-'15 and surged in 2016-'17. Finally, Korean and Taiwanese export prices as well as U.S. import prices from Asia have risen in the past 12-18 months, following years of deflation (Chart I-5). Chart I-4Korean Export Recovery: Prices Versus Volumes Chart I-5Asian Export Prices: A Reversal? Beyond higher prices for steel and other commodities, Korea's export prices are climbing because of skyrocketing DRAM semiconductor prices (Chart I-6). Price changes are much more important to corporate profits than volume changes. For example, a 5% rise in prices boosts corporate profits by much more than a 5% gain in output volume. By the same token, profits decline more when prices drop by 2% than when volumes fall by 2%. We discussed this phenomenon and illustrated an example in our January 28, 2016 report.1 Rising prices across various commodities and manufactured goods have allowed Chinese and Asian companies to deliver strong profits in the past 12 months. China's industrial profits have ballooned, even though output volume growth has been modest. On the whole, the enormous money/credit injection in China in the past two years has hindered lingering price deflation and led to rising prices for various goods and services. Chart I-7 illustrates that the recovery in corporate pricing power and, hence, mushrooming industrial corporate earnings can be attributed to the mainland's credit/money impulses. Chart I-6DRAM Semi Price Has ##br##Surged 4-Fold In Last 12 Months Chart I-7China: A Peak In Producer ##br##Prices And Industrial Profits? If pricing power deteriorates, as the money/credit impulse is signaling, corporate earnings will be at risk. In such a scenario, inflation will not be a problem, as deflationary pressures will resurface. However, corporate profits will shrink. Bottom Line: EM/China corporate profits have expanded predominantly due to price increases. Investors have celebrated it by flocking into EM/Chinese stocks. However, rapid price increases warrant higher interest rates. The latter is a formidable risk to share prices. Barring a material growth deceleration in China, which is our baseline view, odds are that inflation will rise further. Why Now? Inflation is rising in China because of rampant money/credit creation complemented with a weak productivity growth rate. In addition, policymakers have engineered a reversal in raw materials price deflation since early 2016. It is impossible to know if the Chinese economy has reached a point where growth rates of 6-6.5% and above will lead to inflation. It is hard to estimate potential GDP growth rates and output gaps for advanced countries, but it is practically impossible to do so in the case of China. Its economy has undergone multiple dramatic structural transformations in the past 30 years, changes that continue today. That said, it is possible to argue that China may have reached a point where further rampant money and credit creation leads to higher inflation. The key thesis is that productivity growth has slowed because of the following: Channeling credit to SOEs - which often misallocate capital - and to property markets does not boost productivity. Infrastructure projects will take years to produce productivity gains, even if they are well thought out. Chart I-8 illustrates that in recent years an increasing share of investment has been on structures and installations rather than equipment and new technologies. Investment in structures does not boost productivity as much as equipment purchases. Meanwhile, private capital spending has been in the doldrums over the past four years, as has been the case for manufacturing investment (Chart I-9). This argues for less efficiency/productivity and, thereby, diminished potential growth. Chart I-8Unfavorable Mix For Productivity Growth Chart I-9Private And Manufacturing Capex Remain Weak Historically, it was private investment and manufacturing capacity expansion that fostered productivity gains in China. Private projects are often more efficient than public investment, and it is much easier to achieve higher productivity in manufacturing than in the service sector. This is not to argue that there are no innovation and rapid technological changes in China. A lot of innovation and technological advancement is happening but it might not be sufficient to boost productivity growth above 6% (Chart I-10). China's extremely fast productivity gains in the past 20 years have largely been due to rapid expansion of manufacturing and construction. Manufacturing cannot rise fast because it is hard for China to gain more market share in global trade without causing political backslashes. In turn, construction has been driven by excessive credit expansion and property market speculation and policymakers want to reduce this. It is imperative to understand that in any country productivity is much lower in the service sector than in manufacturing and construction. A shift away from manufacturing and construction toward services will surely lead to much lower productivity and, hence, potential economic growth. If policymakers allow/encourage rapid money/credit expansion to achieve growth rates above 6-6.5% or so, the outcome will be inflation. Implications For Chinese Policymakers If economic growth does not slow, odds are that inflation will continue to rise in China due to a lower potential GDP growth rate. As such, policymakers will have to tackle inflation by raising interest rates. The deposit rate in China is at 1.5%, and is presently negative when deflated by core consumer price inflation (Chart I-11). This is occurring for the first time in ten years. Chart I-10Potential Growth = Labor Force + ##br##Productivity Growth Chart I-11China: Deposit Rate In ##br##Real Terms Is Negative If inflationary pressures continue building up and policymakers do not hike interest rates, households will become even more dissatisfied by negative deposit rates and opt for converting their RMB deposits into foreign currency, or buying real estate. Both scenarios will eventually lead to financial instability, which policymakers are trying to avoid. Chart I-12 demonstrates that the current level of foreign exchange reserves of US$ 3.3 trillion is equal to only 34% of household deposits and 15% of total (corporate and household) deposits, and 10% of our broad M3 money measure. In brief, the failure to proactively hike deposit rates will likely lead to capital flight. Policymakers realize that the Chinese banking system has created so much money that even the sheer size of foreign currency reserves is insufficient to defend the currency if and when households and companies choose to convert their liquid savings into foreign currency. This argues for higher interest rates in China, unless growth downshifts very soon and caps inflation. Bottom Line: Either China's growth will slump soon, capping budding inflationary pressures, or policymakers will have to hike interest rates meaningfully to avoid another run on the exchange rate. What About DM And Non-Asian EM? In the majority of non-Asian EM economies, inflation is either muted or under control. The exceptions are Turkey and central European economies. We have discussed the inflation outbreak in central Europe in detail in past reports (also see Chart I-13 below), and will be revisiting Turkey next week.2 Chart I-12Too Much Money Has Been Created Chart I-13Inflation Outbreak In Central Europe The basis is that there has been little recovery in Latin American economies as well as Russia and South Africa for inflationary pressures to transpire. While some may be prone to structural inflation, cyclical business conditions are still too weak to warrant rising pricing power. In the Euro Area, investors should closely monitor German wage dynamics. Manufacturing wages and core consumer price inflation in central Europe are ramping up (Chart I-13). If and when labor shortages and rising wages in central Europe discourage German manufacturing companies from relocating/outsourcing production to the former, it will put more pressure on the already very tight German labor market and will lead to higher wages. As a result, genuine inflation in the largest European economy will heighten. In the U.S., the tight labor market and vibrant growth argue for higher inflation ahead. The Trump administration's proposed tax cuts amid robust growth will boost demand and rekindle inflation. Bottom Line: Inflation expectations are very depressed worldwide, and it will not take much in the way of upward inflation surprises to re-price interest rate expectations and, consequently, financial assets. Financial Markets Ramifications The Foreign Exchange Market: The U.S. dollar has probably made a major bottom and will stage a multi-month rally (Chart I-14). Chart I-14Will The Greenback Find ##br##Support At Current Levels? The Federal Reserve will be the first central bank to hike interest rates if global inflation or inflation expectations rise. In turn, the European Central Bank and the People's Bank of China will likely move slower in tightening policy. Such a proactive policy stance of the Fed, especially relative to its peers, will benefit the greenback. Furthermore, the potential appointment of Kevin Warsh as Fed Chairman could lead to higher interest rate expectations in the U.S., and will be currency bullish. In short, the potential mix of tight monetary policies and easy fiscal policies is bullish for the dollar. In the interim, U.S. bond yields are likely to move higher. This is true in the near term, even if Chinese growth disappoints. It will take time until China's growth deceleration caps the upside in U.S./global bond yields. Consistent with our U.S. dollar view, we believe commodities prices have reached a major peak. In sum, the path of least resistance for the U.S. dollar is up. Stay long the U.S. dollar versus a basket of EM currencies: ZAR, TRY, MYR, IDR, BRL and CLP. Local Currency Bonds: As and when EM currencies depreciate versus the greenback and U.S. bond yields grind higher, EM high-yielding local currency bonds could sell off. Chart I-15 reveals that the spread between the EM-GBI local currency benchmark yield and five-year U.S. Treasurys has fallen to a 10-year low. The risk-reward is not attractive for U.S. dollar- and euro-based investors. EM credit versus U.S. investment grade bonds. On August 16, 2017, we advised shifting our underweight EM sovereign bonds recommendation away from U.S. high yield to U.S. investment grade corporate credit. This strategy remains intact. This is consistent with EM currencies depreciating versus the U.S. dollar, U.S. bond yields moving higher and commodities prices softening. Continue underweighting EM stocks versus DM: A stronger U.S. dollar and rising U.S. bond yields will reverse EM equities' relative outperformance versus DM. In fact, manufacturing PMIs certify that EM manufacturing growth remains subdued relative to DM (Chart I-16). Chart I-15EM Local Currency Bonds: Little Yield Advantage Chart I-16EM Equities Versus DM: A Sign Of Reversal? If this coincides with inflation or growth concerns in China, it will create a perfect storm for all EM risk assets. As to EM stocks' absolute performance, we are approaching a major top, even though the exact timing of a major relapse is uncertain. Flows into EM equities remain robust, but they will reverse if one or more of the following transpires: rising U.S. interest rate expectations, a stronger U.S. dollar, high and rising inflation in China and policy tightening, or the opposite - an imminent growth slump in China and a relapse in commodities prices. All in all, the EM equity rally momentum remains strong but the risk-reward is quite unfavorable. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Peru: External Backdrop Holds The Key The external environment has been and will remain key to the performance of Peruvian financial markets. The Peruvian bourse has rallied massively, outperforming the EM equity benchmark over the past year, even as domestic demand in Peru has been weakening. Despite stronger global growth and higher commodities prices, GDP growth along with consumer and capital growth have not recovered at all (Chart II-1). Meanwhile, bank loan growth remains very weak (Chart II-2). Chart II-1Peru: Weak Domestic Demand... Chart II-2...Corroborated By Weak Credit Growth If metals prices stay firm and strong capital flows in EM persist, Peru's currency will remain under appreciation pressure. This will provide the central bank with more room to ease policy by cutting interest rates and adding liquidity to the banking system as it accumulates foreign exchange reserves (Chart II-3). Continued policy easing by the central bank will in turn revive bank loan growth, and the economy will recover. Chart II-3FX Reserve Accumulation = Liquidity Easing Our baseline scenario, however, is that industrial metals prices in general and copper prices in particular will relapse materially in the next 12 months. Furthermore, odds are that U.S. bond yields will drift higher and the U.S. dollar will strengthen (as discussed on pages 11-12). Under such a scenario: The Peruvian sol would come under depreciation pressure if and when metals prices relapse (Chart II-4). With precious and industrial metals representing 60% of total exports, a drop in metals prices will lead to considerable deterioration in Peru's trade balance and FDI inflows will slump. The central bank is committed to maintaining a stable exchange rate due to high foreigner ownership of government local currency bonds and a still-partially dollarized economy. Hence, if the currency comes under attack, the central bank will defend the sol by selling its international reserves, which will deplete local currency liquidity (Chart II-3). Consequently, local rates will rise and banks will curtail bank loan growth, which in turn will preclude any recovery in domestic demand. Overall, the external environment and its impact on the exchange rate holds the key for a domestic-led recovery. A relapse in industrial metals and copper prices and ensuing depreciation pressure on the currency will undo the recent loosening in monetary policy and stall a potential domestic demand recovery. In terms of financial markets strategy, we recommend the following: Despite domestic demand weakness, the Peruvian equity market has been on a tear, led by banking and mining stocks. Given our negative view on industrial metals and copper prices, we recommend staying underweight Peruvian equities relative to the EM benchmark (Chart II-5). Chart II-4Terms Of Trade Dictate The Currency Chart II-5Has Peru's Relative Equity Performance Peaked? With respect to our absolute call on bank stocks and our relative trade versus Colombian banks, we recommend closing both trades with large losses. Finally, we recommend being long Peru credit relative to Brazilian sovereign credit. Public debt burden is much lower in Peru (24% of GDP) than in Brazil (74% of GDP). Andrija Vesic, Research Assistant andrijav@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report "Corporate Profits: Recession Is Bad, Deflation Is Worse," dated January 28, 2016, link available at ems.bcaresearch.com 2 Please see Emerging Markets Strategy Special Report "Central Europe: Beware Of An Inflation Outbreak," dated June 21, 2017, and Emerging Markets Strategy Weekly Report, dated September 6, 2017; pages 15-18; links are available on page 18. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

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

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

Highlights Oil prices have hit our target, but more upside is likely. President Trump's tax proposal has arrived and the Trump trades have responded. Surging M&A activity is not a sign of a market top. The supports are all in place for a robust period of U.S. capital spending. We expect another solid earnings season in Q3, with little impact from the hurricanes. Feature The S&P 500, Treasury yields and the dollar all rose last week, with the S&P hitting a new all-time high, even as 10-year Treasury yields hit a 2-month high. The sweet spot for risk assets has been extended by the rise in oil prices and rising prospects for tax cuts in the U.S. M&A activity will continue, which is market bullish because it has not yet reached frothy levels. Moreover, capex is blasting off, which will give growth (and EPS) another boost. The downtrends in both Treasury yields and the dollar this year are over, and they both have more upside given that economic growth and underlying inflation are both improving. Moreover, the FOMC is still in a position to deliver on a December rate hike with 2-3 additional hikes in 2018, which will be a wake-up call for bonds and will reverse this year's dollar weakness. More Upside In Oil Prices Last week, both Brent ($57.50/bbl) and WTI ($51.60/bbl) hit the midpoints of the ranges set by our commodity and energy strategists earlier this year. This milestone provides us with an opportunity to revisit BCA's stance on the oil market. OPEC's deal to cut production will be extended to at least June 2018. Based on BCA's latest assessment of the global oil market,1 OPEC 2.0 will fall short of reducing visible inventories to their 5-year average if the coalition's production cut agreement expires which was initially agreed upon in March 2018. Extending OPEC 2.0's cuts through December 2018 would nudge OECD commercial inventories closer to levels originally targeted by OPEC 2.0 at the end of last year (Chart 1). Therefore, in 2018 we expect WTI to average slightly less than $57.50/bbl and Brent to average just under $59/bbl. Accordingly, there is a higher risk that prices will exceed the upper end of our WTI range ($45/bbl to $65/bbl) with greater frequency next year. Furthermore, BCA's Commodity & Energy Strategy team has raised its global oil demand forecasts for both 2017 and 2018; increased demand will support prices in the next 12 months (Chart 2). Chart 1OPEC 2.0 Needs To Extend Cuts,##BR##To Reduce Global Inventories Chart 2Base Case For BCA Oil Supply-Demand Balances##BR##Reflects June 2018 Expiry Of OPEC 2.0 Cuts Geopolitical risks in Iraq and an escalation in supply disruptions add to BCA's bullish view. The Kurd's vote for independence from Iraq last week will elevate tensions in the region and could trigger a civil war. If a war breaks out over Kirkuk, it will lead to production cuts. Furthermore, civil war in Iraq would reduce the flow of FDI into Iraq's oil infrastructure, further crimping output. Moreover, Russia, which supports the Kurd's fight, would also benefit from high oil prices. Oil production wildcards in 2017 mostly favored more oil output. However, in 2018, supply disruptions will curtail global oil output. Bottom Line: Additional supply cuts, higher demand, elevated tensions in Iraq and a normal spate of supply disruptions, all suggest that there is upside risk to our $45-$65 stance on WTI. A risk to this forecast is a sharply higher dollar linked to expansionary fiscal policy. Tax Cuts Imminent Chart 3Trump Trades Making A Comeback As BCA's Geopolitical Strategy service predicted last month, President Trump's long-awaited tax plan will likely be enacted in Q1 2018. Trump and the Republicans in Congress, still desperate for a legislative win after again failing to repeal and replace Obamacare, introduced the proposal last week. However, the plan must clear several hurdles before it becomes law. First, the proposals may run afoul of both deficit hawks and moderates in the Congress' Republican caucus. The initial framework has tax decreases, but no revenue or spending offsets. The implication is that the package would blow out the deficit, alienating the fiscal conservatives. Moderates may not like the lack of cuts for the middle class. Democrats have not yet had their say. The CBO still must score the legislation, and even with dynamic scoring2 which counts on stronger economic growth to boost revenues and reduce outlays for automatic stabilizers and some social programs, it will add to the deficit. This may also cause an uproar in Congress. Nonetheless, on a positive note, Trump has the support of the influential House Ways and Means Committee, as well as the Senate Finance Committee. This was not the case with the Obamacare repeal and replace when the President and his GOP allies were at odds. First and foremost, the GOP-led Congress needs to pass a budget resolution, expected by the end of October. Congress considers the President's request as it formulates a budget resolution, which both houses of Congress must pass. Bottom Line: Investors should watch the response of Congressional Republicans to Trump's tax proposals. A lukewarm reception would indicate that investors' renewed optimism may be premature. The Trump trades have made a comeback in the past two weeks and will continue to be profitable if the current proposal (or something similar) is signed into law in Q1 2018 (Chart 3). If Trump and the GOP could extend the tax cuts into broader tax reform, it would provide a lift to corporate M&A activity. Little Froth From M&A Market U.S. merger and acquisition (M&A) volume peaked along with U.S. equity prices in the late 1990s and mid-2000s, but another top in the current deal market does not signal a top in equity prices. Deal volume (in dollars) and relative to market cap peaked in 1999, again in 2007, and more recently in mid-2015, before a 13% pullback in the S&P 500 in late 2015 and early 2016 (Chart 4). Although not shown on the chart, deal volume surpassed its late 1980s' pinnacle in 1995, five years before equity markets reached record highs in 2000. Through August, corporate takeovers relative to GDP matched those prior heights, but remained below the 1999, 2007 and 2015 tops as a percentage of market cap. Furthermore, global or cross-border M&A, a better indicator of market zest than U.S.-only activity, has not eclipsed the peaks in 2007. Measured against both global GDP and market cap, worldwide corporate combinations are below their 2015 zenith and well below the 2007 peak. At just 7% in 2016, the GDP-based metric was significantly under the mid-2000s pinnacle of 10%. That said, it is difficult to analyze this in context as the time series does not reach back to the late 1990s, which were the boom years for M&A. Bottom Line: Booming M&A activity is not a sign of froth in equity markets but it is a sign that animal spirts are stirring. Overall net equity withdrawal (which includes the net impact of IPOs, share buybacks, and M&A) has not been out of line with previous economic expansions (Chart 5). Stay overweight stocks versus bonds. The uptrend in capital spending is another sign of a shift in animal spirits. Chart 4Roaring M&A Volume Not##BR##A Sign Of A Market Peak Chart 5Comparison Of Corporate Outlays Across Four Economic Expansion Phases Capital Spending Blasting Off The capital spending outlook remains bright despite the recent loss of momentum in industrial production, as indicated by BCA's aggregate for IP in the advanced economies (Chart 6). This is disconcerting because global and regional industrial production are important indicators of both economic growth and corporate earnings. The recent softening is due to a few factors. Much of it is linked to weakness in the U.S. where hurricanes affected the August figures. However, most of our leading indicators remain constructive. Chart 7 presents simple models for real GDP growth for the G4 economies based on our household and capital spending indicators. Real GDP growth will continue to accelerate for the G4 economies, according to the model. BCA's aggregate consumer indicator for the G4 appears to have peaked, but the capex indicator is blasting off. The bullish capital spending reading is unanimous across the major economies. Robust capital goods imports for our 20-country aggregate supports the view that "animal spirits" are stirring in boardrooms in the advanced economies. These imports and BCA's capital spending indicators suggest that the small pullback in advanced-economy industrial production will not last, purchasing managers' indexes will remain elevated, and the acceleration in global export activity is only starting (Chart 7). Despite the lack of progress in Washington on repealing Obamacare and enacting tax cuts, even the U.S. small business sector has shifted into a higher gear in terms of hiring and capital spending, according to the NFIB survey (not shown). Moreover, both BCA's real and nominal U.S. capex models, driven by sturdy capital goods orders, elevated ISM readings and surging sentiment on capex, point to strong business spending in the next few quarters (Chart 8). Chart 6Animal Spirits Are Stirring... Chart 7...Contributing To Stronger G4 Economic Growth Chart 8Prospects For U.S. Capex Are Good Bottom Line: Business capital spending remains sturdy and it will lift overall GDP in 2H despite the recent severe weather. BCA's U.S. Equity Strategy strategists note3 that U.S. industrial machinery manufacturers should be particularly well positioned to see earnings growth outpace the rest of the S&P 500. Stay overweight industrials. Moreover, above-potential GDP growth will keep the Fed on track for gradual tightening this year, and supports BCA's position of stocks over bonds. Stout capital spending will be a theme as the Q3 earnings season unfolds in the next six weeks. Will Hurricanes Impact Q3 Earnings? Chart 9Strong EPS Growth Ahead,##BR##Will Start To Slow Soon The Q3 earnings season will be above average and the BCA Earnings model predicts EPS growth will hit roughly 20% later this year on a 4-quarter moving total basis, before moderating in 2018 (Chart 9). The consensus anticipates a 6% year-over-year increase in EPS in Q3 2017 versus Q3 2016, and 12% for 2017. Energy and technology will likely lead the way in earnings growth in Q3, and utilities and telecom will again be the laggards. The favorable profit picture for Q3 and the rest of the year partly reflects the rebound in oil prices, which are expected to swell the energy sector's EPS by 134%. The positive picture also mirrors the sweet spot of rising top-line growth and still muted labor costs, which are driving a countercyclical rally in profit margins. Investors and corporate executives will focus in Q3 on the improving economic conditions in Europe and the EM, the U.S. dollar, the sustainability of margins, and the impact of Hurricanes Harvey and Irma. President Trump's tax proposal will also be vetted during conference call Q&A's, as investors drill managements on the implications of tax cuts on their operations. Rising interest rates may also demand attention from some analysts because the 10-year Treasury yield in Q3 2017 was 45 bps above Q2 2016 and rose sharply in the final weeks of the third quarter. Guidance from CEOs and CFOs on trends in Q4 2017 and beyond are more important than the actual Q3 results (Chart 10). Investors should guard against managements' over-optimism because earnings growth forecasts almost always move lower over time. Chart 10Unusual Stability In '17 And '18 EPS Estimates In Q3, as in Q2, firms with elevated overseas sales should benefit from the improved growth profile in Europe, Japan and the EM. Global GDP growth projections for this year and next have steadily perked up, in sharp contrast with prior years when forecasters have relentlessly lowered GDP estimates. The U.S. dollar, which has been only a small drag on EPS in recent quarters, should become a modest plus in Q3; the dollar is down by 3% versus a year ago against a broad basket of currencies. Moreover, in the most recent Beige Book (September 6), mentions of a "strong dollar" declined by 4% compared with a year ago, indicating that the stronger currency has faded as a primary concern of managements in recent months. Nonetheless, BCA's view is that the dollar will appreciate by another 10% in the next 12-18 months. The appreciation would trim EPS growth by roughly 2.5 percentage points, although most of this would occur next year due to lagged effects. Another up leg in the dollar, on its own, should not provide a substantial headwind for the stock market. Indeed, the dollar would only climb in the context of robust U.S. economic growth and an expanding corporate top line. The timely enactment of Trump's tax proposal would boost the greenback. Investors are skeptical that margins can advance in Q3 for the fifth consecutive quarter. BCA's view is that we are in a temporary sweet spot for margins, which should continue for the next quarter or two, but the secular "mean reversion" of margins will resume beyond that time. The effect of Harvey and Irma on Q3 results will be muted for the S&P 500 and most sectors, but several weather-sensitive industries (insurance, airlines, chemicals, refining, leisure, etc.) will see significant disruptions. Charts 11A and 11B show that the impact of major hurricanes does not alter the pre-landfall trajectory of S&P 500 earnings forecasts. Earnings estimates for the energy, industrial and utilities sectors (relative to the S&P) tend to move higher after storms, while relative EPS growth in the materials and staples sectors lag behind. Chart 11AImpact Of Major Hurricanes##BR##On Forward EPS Estimates... Chart 11B...Is Muted For S&P 500##BR##And Most Sectors Bottom Line: Look for another solid performance for earnings and margins in Q3 and the rest of 2017, supporting our stocks-over-bonds stance for this year. However, it may be tougher sledding in 2018 when earnings growth begins to moderate and margins begin to "mean revert". Higher inflation, a more active Fed and a stronger dollar will be headwinds for earnings starting in the early part of 2018. FOMC Unified Yet Divided Chart 12Recent Inflation Readings##BR##Challenge The Fed's View U.S. inflation is likely to trend higher over the coming months as a variety of one-off factors that depressed inflation earlier this year fall out of the equation. That said, the August PCE deflator challenges that view (Chart 12). Core PCE inflation slowed further to 1.3%, down from 1.4% last month. In fact, core PCE inflation of 1.3% is at the exact same level as when the Fed delivered its first rate hike in December 2015. Moreover, the diffusion index dipped back to zero, implying the price weakness was widespread. The rollover in the PCE this year is consistent with the soft CPI readings. However, Fed officials highlight the trend in underlying inflation (Chart 12, panel 4) as they make the case for gradual rate hikes. Risk assets are unlikely to suffer if inflation rises towards the Fed's target against the backdrop of stronger growth. However, if inflation moves above the Fed's target due to brewing supply bottlenecks, the Fed will have little choice but to pick up the pace of rate hikes. This could unsettle markets and sow the seeds for the next recession, which we tentatively expect to occur in the second half of 2019. The market is pricing in only 42 basis points of hikes between now and the end of next year. FOMC voting members agree that the path for the normalization of monetary policy should be gradual. However, the path of inflation has provoked squabbling in the past month (Diagram 1) in the Fed and regional branches. Even though the Fed is path-dependent rather than data-dependent, the consensus remains that low inflation is due to temporary factors and higher consumer prices should soon rebound, justifying a December 2017 rate hike. FRBNY President William Dudley remains committed to further gradual rate hikes, although he has been recently surprised by the shortfall of inflation from the FOMC's 2% long-run objective. Fed Chair Janet Yellen confidently backed Dudley's optimism, stating that "low inflation likely reflects factors whose influence should fade over time." But she also struck a cautious tone by highlighting the risks around the uncertainty for the inflation outlook. Yellen even conceded that the Fed would not rule out pausing its gradual rate hike cycle given that they "may have misjudged the strength of the labor market, the degree to which longer-run inflation expectations are consistent with the inflation objective, or even fundamental forces driving inflation". Diagram 1Unified On Gradual Path But Divided On Inflation Path To manage risks, Chair Yellen offered a prescription of scenarios to strengthen the case for a gradual path: "Moving too quickly risks over adjusting policy to head off projected developments that may not come to pass. A gradual approach is particularly appropriate in light of subdued inflation and a low neutral real interest rate, which imply that the FOMC will have only limited scope to cut the federal funds rate should the economy be hit with an adverse shock. But we should also be wary of moving too gradually. Without further modest increases in the federal funds rate over time, there is a risk that the labor market could eventually become overheated, potentially creating an inflationary problem down the road that might be difficult to overcome without triggering a recession." In contrast, dovish FOMC members are apprehensive about the outlook for higher inflation. Governor Lael Brainard, known for her influence on the consensus at the FOMC, needs more confirmation that inflation is moving towards the 2% objective. FRB Chicago President Charles Evans, a dove, but mostly in line with the FOMC consensus, also is skeptical about inflation overshooting its 2% target and is worried about a potential policy mistake. Even FRB Minneapolis President Kashkari, the most dovish and a known dissenter, does not see inflation spiraling out of control given that the economy is unlikely to overheat anytime soon. Not surprising, FOMC hawks Esther George (Kansas City) and Patrick Harker (Philadelphia) noted in speeches late last week that policy was still accommodative and that gradual rate hikes are in order. Ultimately, a pickup in inflation is required to convince the doves at the Fed that even gradual rate hikes are required. BCA's stance is that inflation will pick up over the next year as the unemployment rate falls further and the output gap closes. Bottom Line: The Fed is likely to raise rates in December and three or four more times in 2018. We recommend investors remain underweight duration. Nonetheless, the Treasury market remains unconvinced about the Fed's view on rates and inflation. The implication for investors is that although 10-year Treasury bond yields have risen sharply in recent weeks, we see more upside in yields. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Will Extend Cuts To June 2018," September 21, 2017. Available at ces.bcaresearch.com. 2 Please see BCA Research's Geopolitical Strategy Weekly Report, "Reconciliation And The Markets - Warning: This Report May Put You To Sleep," May 31, 2017. Available at gps.bcaresearch.com. 3 Please see BCA Research's U.S. Equity Strategy Insight "Accelerating Global Manufacturing Means More Machines", dated September 22, 2017. Available at uses.bcaresearch.com.

Highlights Recommendation Allocation The global growth outlook remains strong, with corporate earnings likely to beat expectations for a couple more quarters. Inflation and Fed policy are key to asset allocation. We expect inflation to recover, which will push up interest rates and the dollar. But uncertainty is rising too: for example the composition of the FOMC next year, Chinese policy post the Party Congress, Geopolitics. We keep our pro-risk tilts, particularly overweights in euro area and Japanese equities, U.S. high-yield bonds, private equity, and cyclical sectors. But we reduce portfolio risk by bringing some allocations closer to benchmark, for example downgrading U.S. equities to neutral and reducing the underweight in EM. Feature Overview Growth Is Picking Up - But So Is Uncertainty The outlook for global economic growth remains almost unarguably positive (Chart 1). The key for asset allocation, then, comes down to whether inflation in the U.S. will rebound, and whether therefore the Fed will continue to tighten monetary policy in line with its current projections. This would likely cause long-term interest rates to rise and the dollar to appreciate, which would be positive for developed market equities and credit, but negative for government bonds, emerging market equities and commodities. This scenario has been our expectation - and the basis of our recommendations - for some time, and it remains so. In September, the market started coming around to our view - after months of pricing in that inflation would stay sluggish (which, therefore, had caused the euro and yen, government bonds, EM equities and commodities to perform well). In just a couple of weeks, the futures-market-priced probability of a December Fed hike has moved from 31% to 75%. This was triggered by little more than stabilization of core CPI (Chart 2), due mainly to shelter inflation, which anyway has a low weight in the core PCE inflation data that the Fed most closely watches. To us, this demonstrates just how sensitive the market is to any slight pickup in inflation, due to the fact that its expectations of Fed rate hikes over the next 12 months are so far below what the FOMC is signaling (Chart 3). Chart 1Lead Indicators Looking Good Chart 2Is The Softness In Inflation Over? Chart 3The Market Still Doesn't Believe The Fed However, a risk to BCA's view is that the Fed turns dovish. Even Janet Yellen, in the press conference after the FOMC meeting on 20 September, admitted that the Fed needs "to figure out whether the factors that have lowered inflation are likely to prove persistent". If they do, she said, "it would require an alteration of monetary policy." FOMC member (and notable dove) Lael Brainard, in an important speech earlier in September, laid out the argument that, since inflation has missed the Fed's 2% target for five years, inflation expectations have been damaged (Chart 4) and that only a period during which inflation overshot could repair them. With Yellen's term due to expire next February and four other vacancies on the FOMC, personnel changes could significantly change the Fed's direction. Online prediction sites give a somewhat high probability to President Trump's replacing Yellen, with (the rather more hawkish) Kevin Warsh, a Fed governor in 2006-11 (Chart 5). However, presidents tend to like loose monetary policy - President Trump has said as much himself - which raises the possibility of his trying to steer the Fed in a direction that is more tolerant of rising inflation. A possible scenario, then, is of an accommodative Fed which allows equities markets to have a final meltup for this cycle, similar to 1999. Chart 4Have Inflation Expectations Been Damaged? Chart 5Who Will Trump Choose To Lead The Fed? Another current source of uncertainty is China. Money supply growth there has slowed sharply this year, after being pushed upwards by the government's reflationary policies in late 2015. This historically has been a good lead indicator of growth and, indeed, many cyclical indicators have surprised to the downside recently (Chart 6). It is also hard to predict whether, after October's five-yearly Communist Party congress, newly re-elected President Xi Jinping will move ahead with implementing structural reforms, even at the expense of a short-term slowdown of growth.1 We continue to think that risk assets have further upside for this cycle. Growth is likely to remain strong, the probability of a U.S. tax cut is rising, and corporate earnings should surprise to the upside for another couple of quarters (Q3 S&P500 EPS consensus forecasts remain cautious at 5% YoY, versus our model which suggests double-digit growth). Nonetheless, the cycle is now mature, global equities have already produced a total return of almost 40% since their recent bottom in February last year, and valuations in almost every asset class are stretched (Chart 7). Moreover, geopolitical risks - such as that from North Korean missiles - will not disappear quickly. We continue to pencil in the possibility of a recession in 2019 or 2020, caused by a sharp rise in inflation, especially in the U.S., which the Fed - whoever is running it - would have to stamp on by raising rates above the equilibrium level. Chart 6Is A Downturn Coming In China? Chart 7Nothing Looks Cheap Therefore, on the 12-month horizon we continue to recommend pro-risk and pro-cyclical positioning, for example an overweight in equities versus fixed income. However, given the rising uncertainty, we are reducing the scale of our bets a little and so, for example among our equity country and regional recommendations, move a little closer to benchmark by lowering the U.S. to neutral and reducing the degree of our underweight in EM. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com What Our Clients Are Asking How worried should we be about North Korea? Chart 8Threats - But Eventually A Diplomatic Solution President Obama reportedly warned President Trump just prior to inauguration that North Korea would be his biggest headache. After 15 missile launches and a nuclear test this year (Chart 8, panel 1), investors are beginning to think the same. How big is the risk that the tension turns into warfare? BCA's Geopolitical strategists have written about the subject extensively.2 They conclude that military action is unlikely. An U.S. attack on North Korean missile or nuclear sites would simply provoke an attack with conventional weapons on Seoul, which is only 50 km from the border. Kim Jong-un undoubtedly knows that if he were to attack Guam or Japan, his country would be wiped out. In the end, then, a diplomatic solution is likely - but this will only be achieved after tension has risen sufficiently to force the two sides to the negotiating table. The analogy is Iran in 2012-15, where sanctions finally forced it to agree to a 10-year freeze in its nuclear plans. For the moment, sanctions seem unlikely to bite. North Korea's trade with China is not yet notably slowing (Chart 8, panel 2) and its GDP growth actually accelerated last year, albeit from stagnating levels, according to estimates from the Bank of Korea (Chart 8, panel 3). So the cycle of new threats and tougher sanctions will continue for a while. Historically, North Korean provocations caused related markets (such as South Korea stocks) to fall sharply for a few days, but this always represented a buying opportunity (Chart 8, panel 4). Given the likelihood of a diplomatic outcome, we think this remains a good rule of thumb. What will happen after China's 19th Party Congress, and will there be a slowdown in the economy? China's twice-a-decade National Party Congress will be held October 18-25. The outcome of the meeting could have important economic and market consequences. The key purpose of the Congress is to rotate China's political leaders. The 19th Party Congress is crucial because it marks the passing of a generation: President Xi Jinping will receive a second five-year term, but is predicted to consolidate his power by placing a younger generation of leaders who support his structural reforms into key positions. When Xi came to power, his reform agenda included de-emphasizing GDP targets; injecting private capital, competition and market discipline into the state-owned corporate sector; and fighting pollution. This agenda has since been compromised, with Xi reverting to infrastructure spending and credit growth to avoid painful adjustments. However, recently, there have been signs of a pullback in reflationary policies (Chart 9). Financial tightening is a key to reviving reform. Tighter controls on banks and leverage will translate into greater market discipline, and will put pressure on the sector most in need of change: SOEs. During the twice-a-decade National Financial Work Conference In late July, Yang Weimin, a key economic policymaker who is close to Xi, said, "The nation can't let leverage rise for the purpose of boosting economic expansion," signaling that the administration is willing to tackle difficult reform issues. He also mentioned the potential risks in the economy such as shadow banking, property bubbles, high leverage in SOEs, and local government debt, adding that the nation should set out its priorities and tackle them. Though it is impossible to predict the precise outcome of the Congress, the leadership reshuffle is likely to benefit Xi's reform agenda. The new leadership is likely to work on rebalancing growth toward consumption and services while encouraging private entrepreneurship and cutting back state-owned enterprises and, most importantly, deleveraging corporate debt. If China's credit impulse rolls over, the recent improvement in industrial profits and domestic demand will come under threat (Chart 9). As a result, China's cyclical growth is set to slow in 2018 as Xi reboots reform. Although economic risks will rise as the reform takes place, we still believe China H shares are attractive relative to other EM markets. In the long run, Xi's renewed reform drive should help China to get out of the "middle income trap'', which could help Chinese stocks to outperform EMs such as South Africa, Turkey and Brazil, where reforms are absent.3 Are Indian equities still a buy? In the three years since Prime Minister Narendra Modi's election, Indian stock prices have outperformed their emerging market peers by more than 20%. But the underlying growth dynamics do not justify this performance. We are turning cautious on India and downgrade Indian equities to neutral for the following reasons. India's GDP growth rate fell to a three-year low of 5.7% yoy in the April-June quarter. The administration's "Make In India" campaign is having limited impact, as seen in the near-zero growth of the manufacturing sector. Capital spending by firms has been dismal, further weighing on the outlook for productivity. Increasing layoffs and business shutdowns have produced considerable slack in the economy. Non-performing loans in the banking system have reached 11.8% of assets. As a result, credit growth to business has fallen almost to zero. This has slowed infrastructure development, as seen in the high level of stalled capital projects. The Reserve Bank of India has only just started the process of pushing banks to raise provisioning for distressed assets. The negative impact of last year's demonetization program is finally showing through. Less than 10% of Indians have ever used non-cash payment methods, and so demand for cyclical goods is slowing. Finally, Indian stocks have risen significantly in recent years, making them expensive relative to EM peers. In addition, profit growth has slowed, and return on equity converged with the EM average. Indian equities have been riding on expectations of reforms from the Modi administration. But, with the exception of the Goods & Services Tax (GST), the reform progress has been disappointing. We are turning cautious on Indian equities until we see improvements in the macro backdrop (Chart 10). Chart 9Sign of slowdown in Chinese Economy Chart 10India: Loosing Steam? How should global equity investors hedge foreign currency exposures? Chart 11Dynamic Hedging Outperforms Static Hedging There have been many conflicting views on how to hedge foreign currency exposures in a global equity portfolio. Full hedge,4 no hedge,5 or simply 50% hedge?6 Or should all investors hold the reserve currencies (USD, euro and Swiss Franc), avoid commodities currencies (AUD and CAD) while being neutral on GBP and JPY?7 As published in a Special Report 8 on September 29, 2017, our research has found that not only should investors with different home currencies manage their foreign currency exposures differently, but also a dynamic hedging framework based on the indicators from BCA's Foreign Exchange Strategy service's Intermediate Timing Model (ITTM)9 outperforms all the static hedging strategies for all investors with six different home currencies (USD, EUR, JPY, GBP, AUD and CAD) (Chart 11). A few key observations from Chart 11 Static hedges reduces risk with little impact on returns for the USD and JPY investors only. Unlike the CAD investors, the AUD investors are much better off to hedge than not to, on a risk adjusted basis, even though AUD is also a commodity currencies, like the CAD. The 50% "least regret" hedge ratio has lived up to its reputation as it reduced risk by more than 50% without severely jeopardizing returns. And for the USD based investors, the 50% static hedge has a similar risk/return profile as the dynamic hedge. For all other five home currencies, however, the 50% static hedge underperforms the dynamic hedge. Global Economy Overview: Globally growth has accelerated, with inflation quiescent. We expect growth to continue to be strong, but U.S. inflation will start to normalize, which should trigger further Fed hikes and a rise in long-term rates. Japanese and euro zone growth will be less inflationary, given continued slack in these economies. U.S.: Growth has rebounded sharply after the seasonally weak Q1 and excessive expectations following the presidential election. The Citi Economic Surprise Index (Chart 12, panel 1) shows strong upward surprises. First-half GDP growth came in at 2.2% (above trend, which is estimated at 1.8%), and the manufacturing ISM reached 57.7 in September. The two big hurricanes will probably knock around 0.5 points off Q3 growth but the lesson from previous disasters is that this will be more than made up over the following three quarters. Rebounding capex, and consumption aided by a probable acceleration in wages, should keep GDP growth strong. Euro Area: Due to Europe's greater cyclicality and dependence on the global cycle, growth momentum is unsurprisingly even stronger than in the U.S., with Q2 GDP growth 2.3% YoY and the manufacturing PMI at 57.4. German growth has been particularly robust with the IFO index at 115.9, close to an all-time high, and German manufacturing wages growing by 2.9% YoY. The credit impulse suggests that the strong growth should continue, although the euro appreciation this year (and consequent tightening of financial conditions) might dampen it a little. Japan: Growth continues to be good in the external sector (with exports rising 18% YOY and industrial production 5%), but weak in the domestic economy, where household spending and core inflation continue to flatline. We do, though, see some first tentative signs of inflation: the Bank of Japan's estimate suggests the output gap has now closed, and the tight labor market is showing through in part-time hourly wages, which are rising 2.9%. Emerging Markets: China's PMI has oscillated around 50 all year (Chart 13, panel 3), as the authorities tried to stabilize growth ahead of October's Party Congress. But money supply and credit growth have been slowing all year, and this is now showing through in downside surprises in fixed asset investment and retail sales data. Especially if the congress moves towards structural reform and short-term pain, growth may slow further. This would be negative for other emerging markets, which depend on China for growth. Bank loan growth and domestic consumption generally remain weak throughout EM ex China. Chart 12Global Growth Is Accelerating... Chart 13...Propelling Europe And Japan Interest Rates: Inflation has been soft this year in the U.S. but is likely to pick up in coming months reflecting stronger economic growth and dollar depreciation. We expect the Fed to raise rates in December and confirm its three hikes next year. That should be enough to push the 10-year Treasury yield up to close to 3%. In Japan and the euro area, however, underlying inflationary pressures are much weaker. So we expect the Bank of Japan to stick to its yield curve control policy, and for the ECB to emphasize, when it announces in October next year's (reduced) asset purchase program, that it will be cautious about raising rates. Global Equities Chart 14Earnings Have Been Strong... Q3 2017 was the second quarter in a row when the price appreciation in global equities was driven entirely by earnings growth, since the forward price-to-earnings ratio contracted by 2% compared to Q2 (Chart 14). Chart 15No Compelling Reasons To Make Large Bets The scope of the improvement in earnings so far in 2017 has been wide. Not only are forward earnings being revised up, but 12-month trailing earnings growth has also been very strong, with all 10 top-level sectors registering positive earnings growth. Margins have steadily improved globally from the lows in early 2016. Despite the slight multiple compression in Q3, equity valuations are not cheap by historical standards. As an asset class, however, equities are still attractively valued compared to bonds, especially after the recent safe-haven buying drove global bond yields to very depressed levels. We remain overweight equities versus bonds on the 9-12 month horizon. Within equities, however, we think it's prudent to reduce portfolio risk by bringing allocations closer to benchmark weighting because 1) equities are not cheap, 2) volatility is low, 3) geopolitical tension is rising, and 4) year-on-year earnings growth over coming quarters may not be as strong as it has been so far this year because earnings in the first half of the 2016 were very depressed. As such, we downgrade the U.S. to neutral from overweight (+3 percentage points), and reduce the underweight in EM (to -2 from -5). We remain overweight the euro area and Japan (but hedge the yen exposure). Within EM, we have been more positive on China and remain so on a 6-9 month horizon. Sector-wise, we maintain our pro-cyclical tilt. Country Allocations: Downgrade U.S. To Neutral We started the year being "cautiously optimistic" with a maximum overweight (+6 ppts) in U.S. equities.10 We added risk at the end of the first quarter by reducing by half the U.S. overweight in order to upgrade the higher-beta euro area to overweight (+3) from neutral.11 The change has worked well, as the euro area outperformed the U.S. by 542 basis points (bps) in Q2 and then by 370 bps in Q3 in unhedged USD terms. Our DM-only quant model also started the year with a maximum overweight in the U.S., but the overweight was gradually reduced each month until July when the model indicated a benchmark weight for the U.S. The model continued its shift away from the U.S. in August and September, and now the U.S. is the largest underweight in the model. As we have previously stated, we use the quant model as one key input into our decision-making process, but we do not follow it slavishly because 1) no model can capture all the ever-changing driving forces in the market, and 2) the model moves more often than we prefer. In light of the rising geopolitical risks and low levels of volatility in all asset classes, we conclude that there are no longer compelling reasons to make large bets among the countries (Chart 15). Valuation in the U.S. is stretched, but neither is it cheap in EM anymore; both trailing and forward earnings growth in the U.S. are below the global average. Forward earnings in the EM look likely to outpace the global average, but EM trailing earnings growth seems to be losing steam. As such, we recommend investors to be neutral in the U.S. and use the funds to reduce the underweight in EM. Sector Allocation: Stay Underweight Global Utilities Overall, our sector positioning retains its tilt towards cyclicals and against defensives (see Table 1). Our global sector quant model, however, in September reduced its underweight in defensives by upgrading utilities to overweight from underweight, mainly due to the momentum factor. We have decided to overwrite the model result and maintain our underweight recommendation for the following reasons. In October, the model again downgraded utilities to underweight. In the most recent cycle post the Global Financial Crisis (GFC), the relative performance of utilities has been closely correlated with the performance of bonds vs. equities (Chart 16, top panel). This is not surprising given the bond-like nature of the sector. The sector enjoys a higher dividend yield than the global average: other than during the GFC, the excess yield has been in the range of 1-2%. In a low bond-yield environment, this yield pick-up is no doubt attractive. However, our house view is for global bond yields to rise over the next 9-12 months and we maintain our overweight on equities vs. bonds. As such, underweight utilities is in line with our overall risk/return assessment. In addition, even though the utilities sector has a higher dividend yield, the current reading is not particularly attractive compared to the five-year average (panel 4); valuation measures such as price to book (panel 3) show a neutral reading as well. The other sector where we override our quant model is Healthcare, which we favor as a long-term play because of favorable demographic trends, while the quant model points to an underweight due to short-term factors such as momentum and valuation. Smart Beta Update Year-to-date, the equal-weighted multi-factor portfolio has outperformed the global benchmark by 54 basis point (bps). (Table 1 and Chart 17) Among the five most enduring factors - size, value, quality, minimum volatility, and momentum - momentum is the only factor that has prevailed in both DM and EM universes, while quality has outperformed in the DM, but underperformed in EM. (Table 1) Chart 16Maintain Underweight Utilities Chart 17MSCI ACW: Factor Relative Performance Value has underperformed growth across the board (Table 1). The size performance, however, has large regional divergences in both value and growth spaces. Small cap has outperformed large cap consistently in both the value and growth spaces in the higher-beta euro area, Japan and U.K., while underperforming in the lower-beta U.S. (Table 2) We maintain our neutral view on styles and prefer to use sector positioning to implement the underlying factors given the historically close correlation between styles and cyclicals versus defensives (Chart 17, bottom two panels). Year-to-date cyclicals have outperformed defensives (Table 1). Table 1YTD Relative Performance* Table 2YTD Total Returns* (%) Small Cap - Large Cap Government Bonds Maintain Slight Underweight Duration. U.S. bond yields declined significantly in Q3 to below fair-value levels in response to heightened geopolitical risks and hurricanes (Chart 18, top panel). This safe-haven buying spread globally, despite ample evidence of faster global growth (middle panel) and less accommodative monetary policies from the major central banks. There is now considerable upside risk for global bond yields from these current low levels. Maintain Overweight TIPS Vs. Treasuries. The fall in nominal U.S. Treasury yields, however, was concentrated in the real yields, as 10-year break-even inflation widened in Q3 (Chart 18, panel 3). In terms of relative value, TIPS are now fairly valued vs. nominal bonds. However, our U.S. Bond Strategy's core PCE model, which closely tracks the 10-year TIPS breakeven rate (Chart 18, panel 3), is sending the message that inflationary pressures are building in the economy and that core PCE should reach the Fed's 2% target by the end of this year. This suggests that the bond markets are not providing adequate compensation for the inflationary economic backdrop. Underweight Canadian Government Bonds. The Bank of Canada (BOC) delivered another surprise 25 bps rate hike in September, due to "the impressive strength of the Canadian economy" and "the more synchronized global expansion that was supporting higher industrial commodity prices." BCA's Global Fixed Income Strategy has been underweight Canada in its hedged global portfolio and recommends investors not to fight the BOC despite little inflation pressure in the Canadian economy (Chart 19). Chart 18Poor Value in Nominal Government Bonds Chart 19Bank of Canada: Shock Hawks Corporate Bonds As inflation recovers and the Fed moves ahead with rate hikes, we expect long-term risk-free rates to rise moderately. Fair value for the 10-year U.S. Treasury yield is currently close to 2.7%. In the context of rising rates and continued economic expansion, we continue to prefer spread product over government bonds. Investment grade bonds in the U.S. trade at an average option-adjusted spread over Treasuries of 110 bps. While Aaa corporate spreads are expensive, other investment grade credit tiers appear fairly valued. Given the deterioration in our U.S. Corporate Health Monitor (Chart 20), amid a rise in leverage, over the past two years (Chart 21) we do not expect the spread to contract further or fall back close to historic lows. However, investors should still be moderately attracted by the carry in a low interest rate environment. Our preference is for U.S. investment-grade corporate bonds over European ones, since the latter could be negatively impacted when the ECB announces its tapering of asset purchases in October. High-yield bonds look attractive after a small rise in spreads and an improvement in the cyclical outlook over the past quarter. The current spread of U.S. high-yield, 360 bps, translates into a default-adjusted yield (assuming a 2.6% default rate and 49% recovery rate over the next 12 months) of 250 bps - close to the long-run average (Chart 22). European junk debt looks less attractive from a valuation perspective. Chart 20Corporate Health Is A Worry In The U.S. Chart 21IG Spreads Unlikely To Contract Further Chart 22High-Yield Debt Valuations Look Attractive Commodities Chart 23Mixed View Towards Commodities Secular perspective: Bearish We hold a bearish secular outlook for commodities, mainly due to our view on China's slowing economic growth and the increasing shift from traditional energy sources to alternatives. Cyclical perspective: Neutral Our short-term commodities view remains neutral since oil inventory drawdowns will push up the crude oil price further, and because low real interest rates will keep gold from falling this year. But industrial metals are likely to react negatively to the winding down of China's reflation after the Party Congress in mid-October. Precious metal: Short-term bullish, long-term bearish. We expect the Fed to tighten rates only slowly which, over time, will mean the central bank finds itself behind the curve on inflation. Real rates are expected to remain relatively low for the foreseeable future, which will be supportive of gold. Rising tension between North Korea and the U.S. could also give gold a lift. Industrial metals: Bearish The copper price has rallied by 10% during Q3 2017, thanks to supply-side disruptions at some of the world's largest copper mines, along with better-than-expected performance of the Chinese economy. However, mine interruptions will be transitory, and the world copper market is already back in balance (Chart 23, panel 3). Although the rebound in the Chinese PMI is keeping metal prices up, we believe China after the Party Congress will try to reengineer its economy towards being more consumption and services-led, which will temper demand for industrial metals. Energy: Bullish We believe that market has been overly pessimistic on oil, and that this will change due to declining inventories and better demand and supply dynamics. (Chart 23) The U.S. Energy Information Administration revised down its shale production forecast for 2H 2017 by 200,000 barrels/day, which should lower investors' concerns over shale overproduction. Libyan oil production, the biggest threat to our bullish oil view, faltered by 300,000/day in August, keeping OPEC in compliance with its promised cuts. Currencies U.S. Dollar: Year to date, the dollar is down by 8% on a trade-weighted basis (Chart 24). However, after a period of underperformance, the U.S. economy is improving relative to its G10 peers, as seen by the strong rebound in the U.S. ISM manufacturing index. Additionally, the pick-up in money velocity points to a recovery in core inflation. As inflation starts to pick up again, markets will discount additional Fed rate hikes. Stay bullish U.S. dollar over the next 12 months. Chart 24U.S. Dollar Recovery? Pound: After a weak start to the year, sterling has recovered all its losses. Strong net FDI inflows have pushed the basic balance back into positive territory. However, Brexit negotiations will impact the financial sector, the largest target for FDI. Additionally, the recent sharp increase in inflation came from the pass-through effect of the weaker currency, and is not reflective of domestic economic activity. We expect increased political uncertainty to weigh down on future growth, forcing the Bank of England to maintain a dovish stance. Stay bearish over the next 12 months. Dollar: On a trade-weighted basis the currency is up 4% year to date, primarily driven by the rally in select metal prices. OECD's measure of output gap still points to substantial slack in the domestic economy, as seen in the downtrend in core inflation and nominal retail sales. However, despite improvements in global trade and domestic real estate activity, the Reserve Bank of Australia will keep policy easy in response to volatile commodity markets. Stay bearish over the next 12 months. Canadian Dollar: Driven by net portfolio inflows near record highs, the currency is up 6% on a trade-weighted basis so far this year. With improving economic activity, as seen in strong retail sales, the Bank of Canada expects the output gap to close in 2018. However, going forward, oil prices are unlikely to double again, and the combination of elevated indebtedness, bubby house prices and rising rates will create headwinds for the household sector. Stay bearish over the next 12 months. Alternatives Chart 25Favor PE, Real Assets Return Enhancers: Favor private equity vs. hedge funds In 2017 so far, private equity has returned 9%, whereas hedge funds have managed only a 3.5% return (Chart 25). Given their strong performance, private equity firms are raising near-record amounts of capital from investors starved for yield. By contrast, hedge funds continue to underperform both global equities and private equity, as is typical outside of recessions or bear markets. However, increasing concerns about valuations in private markets have pushed private equity dry powder to new highs of $963 billion. We continue to favor private equity over hedge funds, albeit with a more cautious outlook. Within the hedge fund space, we favor event-driven funds over the cycle, and macro funds heading into a recession. Inflation Hedges: Favor direct real estate vs. commodity futures In 2017 to date, direct real estate has returned 3.3%, whereas commodity futures are down over 10%. With energy markets likely to continue to recover lost ground over the coming months, we stress the structural nature of our negative recommendation on commodities. Depressed interest rates will keep financing cheap, making the spread between real estate and fixed income yields attractive. However, the slowdown in commercial real estate has made us more cautious on the overall real estate space. With regards to the commodity complex, the long term transition of China to a service-based economy will continue the structural decline in commodity demand. Continue to favor direct real estate vs. commodity futures. Volatility Dampeners: Favor farmland & timberland vs. structured products In 2017 to date, farmland and timberland have returned 2.2% and 1.5% respectively, whereas structured products have returned 1.4%. Farmland continues to outperform timberland given the latter's lower correlation with growth. Timberland returns have also lagged farmland given the weak recovery in the U.S. housing market. Investors can reduce the volatility of a multi-asset portfolio with the inclusion of farmland and timberland. With regards to structured products, rising rates and deteriorating credit quality in the auto loan market will weigh on returns. Given the Fed's plans to start unwinding its balance sheet this year, increased supply will put upward pressure on spreads. Risks To Our View Our pro-risk positioning would be incorrect if global growth were to slow sharply. But we see little sign that this is a significant risk over the next six to 12 months. Of our three favorite indicators of recession risk, global PMIs remain strong, and the U.S. 10-minus-2 year yield curve is still solidly positive at around 80 BP. Only a small blip up in junk bond spreads in August (Chart 26) is of any concern, and it was probably caused just by geopolitical tensions. With U.S. and European consumption and capex looking strong, probably the biggest risk to global growth would come from China, similar to 2015, if October's Party Congress signals a shift to short-term pain to achieve structural reforms. Perhaps more likely is an upside surprise to growth, with BCA's models - based on consumer and business sentiment - pointing to around 3% real GDP growth in the U.S. and 2½% in the euro area over the coming couple of quarters (Chart 27). Such an acceleration of growth would raise the risk of upside surprises to inflation, which could cause a bigger sell off in bond markets than we currently anticipate. Chart 26Any Need To Worry About Credit Spreads? Chart 27Could Growth Surprise On The Upside? Chart 28Suppose Inflation Stays Stubbornly Low Our positioning is not based on inflation remaining chronically low. But structural changes in the economy could cause this. While the Philips curve has not broken down completely, wage growth in the U.S. is 1-1½% lower than in previous expansions when the unemployment gap was at its current level (Chart 28). Could the Nairu be lower than the Fed's estimate of 4.6%? Has the gig economy somehow changed worker and employer behavior? 1 Please see What Our Clients Are Asking: "What Will Happen After China's 19th Party Congress, And Will There Be A Slowdown In The Economy?" of this report. 2 For their most comprehensive analysis, please see Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 3 Please see Geopolitical Strategy Special Report "China: Looking Beyond The Party Congress'' dated July 19, 2017. available at gps.bcaresearch.com). 4 Perold, A and E. Schulman, 1988, "The free lunch in currency hedging: Implications for investment policy and performance standards," Financial Analyst Journal 44, 45-50. 5 Froot K., 1993, "Currency hedging over long horizons," NBER working paper 4355. 6 Michenaud, S., and B., Solnik, 2008, "Applying Regret Theory to Investment Choices: Currency Hedging Decisions," Journal of International Money and Finance 27, 677-694. 7 Campbell, J., K. de Medeiros and L. Viceira, 2010, "Global Currency Hedging," Journal of Finance LXV, 87-122. 8 Please see Global Asset Allocation Special Report, "Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors," dated September 29, 2017, available at gaa.bcaresearch.com. 9 Please see Foreign Exchange Strategy "In Search of A Timing Model," dated July 22, 2016, available at fes.bcaresearch.com. 10 Please see Global Asset Allocation, "Quarterly - December 2016," dated December 15, 2016. 11 Please see Global Asset Allocation, "Quarterly - April 2017," dated April 3, 2017. GAA Asset Allocation

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

Special Report

Highlights In this report, we analyze both static and dynamic hedging strategies to hedge an identical global equity portfolio to six home currencies: the U.S. dollar, the British pound, the euro, the Japanese yen, the Canadian dollar and the Australian dollar. We propose an easy to implement dynamic hedging framework based on the proprietary currency indicators from BCA's Foreign Exchange Strategy (FES) service. It has outperformed all the static hedging strategies since 2001 on a risk-adjusted return basis. In addition, it levels out the playing field for all investors as the hedged returns are quite similar, no matter what their home currencies are. Among the static hedging strategies, the "least-regret" hedge ratio of 50% has lived up to its reputation, as it has reduced risk by more than 50% without severely jeopardizing returns. Over a four-year moving performance cycle (in line with how most portfolio managers are evaluated), the proposed dynamic hedging adds little career risk to portfolio managers compared to the "least regret" 50% static hedging, while provides superior returns most of the time. A global equity portfolio's currency exposure should be managed in a centralized currency overlay under the supervision of the Chief Investment Officer, so that equity and currency managers can both fully utilize their expertise in their respective field, and the organization can manage currency risk more efficiently at the total portfolio level. Feature Dynamic Hedging Outperforms Static Hedging We have received many client requests asking about currency hedging in global equity portfolios with different home currencies. This is not surprising given how currency movements have overwhelmed global equity portfolio returns of late. For example, this year the U.S. dollar's weakness against the major currencies has beefed up returns for U.S. investors who did not hedge their foreign exposure (Table I-1). Table I-1Year-To-Date Currency Movements Have Overwhelmed Equity Returns GAA's equity country allocation recommendations are by default unhedged on USD basis. When a hedge is required we make the recommendation explicit. There have been many conflicting views on whether global equity investors should hedge foreign currency exposure, and if so, what proportion of the exposure should be hedged. Perold and Schulman (1988) suggest fully hedging foreign currency exposure, because significant risk reduction can be achieved without a significant loss of return.1 This is based on their famous "free lunch" claim that average currency returns are zero over the long-term. At the other extreme, Froot (1993) suggests that foreign currencies should not be hedged at all for long-term investors, because purchasing power parity holds in the long term and exchange rates are mean reverting.2 There are many other views in between, including the universal hedge ratio proposed by Black (1989), which is estimated to be 77%.3 Campbell et al (2010) classify currencies into reserve currencies (USD, EUR and CHF), commodity currencies (AUD and CAD) and neutral currencies (JPY and GBP), and suggest that risk-minimizing investors should hold reserve currencies while hedging out commodity currencies, based on the correlations between the currencies and equity markets.4 Realizing the limitations of "static hedging," which assumes constant correlation, mean and variance, many academic researchers have explored "dynamic hedging models" that allow the mean and covariance to be time-varying by using complex econometric modelling techniques.5,6,7 These academic dynamic hedging strategies have shown improvement over the 50% static hedge, but it's very difficult for investors without a strong quantitative background to understand these very complex approaches. In fact, with all these confusing academic recommendations floating around, the "least regret" hedge ratio of 50% has been quite popular among practitioners.8 To help our clients better understand the role of currency management in global equity portfolios, we have joined forces with BCA's Foreign Exchange Strategy (FES) service to de-mystify the currency hedging process, and to propose a simple framework for clients with six different home currencies to dynamically hedge their foreign currency exposure based on the FES team's proprietary Intermediate-Term Timing Model (ITTM) indicators.9 These indicators have been used in their regular weekly publications. The ITTM-based dynamic hedging strategy is back-tested from 2001 because the ITTM indicators only date back to 2001 (See methodology). We have also back-tested a simple trend-following momentum-based dynamic strategy to see how a dynamic hedging methodology works in a longer period from 1976. For comparison we have back-tested ten different static hedging strategies that employ fixed hedge ratios across currencies and time. The test results not only clarify much of the confusion about static hedging, they also demonstrate that on a risk-adjusted return basis, BCA's ITTM-based dynamic hedging strategy has outperformed all static hedging strategies for all investors with six different home currencies since 2001 (Chart I-1). Even in the very long run of 41 years from August 1976, the simple momentum-based dynamic hedging outperforms the static strategies for investors with five home currencies, with only the AUD portfolio being worse off (Chart I-2). Chart I-1Identical Investment, But Different Risk/Return Profiles (3/2001-8/2017) Chart I-2Identical Investment, But Different Risk/Return Profiles (8/1976-8/2017) Now let's clarify some of the confusion: Does static hedging reduce portfolio risk at little expense of lowering returns? The answer is yes only for USD and JPY portfolios. For both the 41-year period from 1976 and the shorter 16-year period from 2001, a higher hedge ratio results in lower risk with slightly lower return. So fully hedged would be the "optimal" strategy for risk-minimizing investors with USD and JPY as home currencies (Panel 1 and 2 on left side in both Chart I-1 and Chart I-2). For the U.K. portfolio, the answer is a partial yes, because the "optimal hedge ratio" for risk-minizing investors, around 60%-80%, does produce the lowest risk, but the paths to that "optimal" point are totally opposite when different time periods are chosen. In the short period (Chart I-1, bottom left panel), it follows the same pattern as that for U.S. and Japanese investors up to the optimal point. As the hedge ratio increases, however, return drops and risk increases! In the longer period from 1976, as the hedge ratio increases, return increases and risk decreases until the "optimal point," after which risk and returns both increase (Chart I-2, bottom left panel). In the period from 2001, the AUD, CAD and EUR portfolios share a similar pattern to that of the GBP portfolio in the period from 1976. The AUD portfolio behaved the same in both the shorter period (Chart I-1, top right) and the longer period (Chart 2, top right), while the EUR and CAD portfolios behaved differently in the longer-term period from the shorter period. Overall, the CAD portfolio's "optimal" hedge ratio is around 0-30%, the AUD portfolio around 30-60% while the EUR portfolio is around 40% in the shorter period but around 90% in the longer period (Chart I-1 and Chart I-2). It is also worth noting that even though both the CAD and AUD are commodity currencies, AUD investors benefit significantly from hedging, while CAD investors' risk/return profile does not change much. This is because 1) currency returns for AUD investors do not average to zero in the long term due to positive carry, and 2) correlations between foreign currencies, foreign equities and domestic equities are not constant over time or across currencies (Appendix 2, Chart II-1 and Chart II-4) How does the "least regret" 50% static hedge do? The 50% hedge ratio fares quite well compared to the "optimal" static hedge ratio in terms of risk reduction for all portfolios in both periods, because more than half of the total risk reduction (the highest minus the lowest) occurs around the 50% hedge (Chart I-1 and Chart I-2). How does BCA's ITTM-based dynamic hedge do in terms of risk reduction? The ITTM produces better risk-adjusted returns for each portfolio than all the static hedges. In terms of risk, it generates the lowest risk for the EUR and GBP portfolios and is comparable to the 50% static hedge for other portfolios, while it generates a much higher return than all static hedges (Chart I-1 and Chart I-2). How does the BCA Dynamic Hedge (ITTM) compare to the 50% static hedge over time? Chart I-3 shows that the dynamic hedge consistently outperformed the 50% static hedge for all six home currencies since 2001 without significantly increasing hedging transactions, compared to the fixed 50% hedge ratio for all currency pairs. The dash line in each panel of Chart I-3 corresponds to the market cap-weighted aggregate of hedge ratios of foreign currencies for each home currency. On average, they are comparable to 50%. Most portfolio managers are measured on a moving four-year performance cycle. Chart I-4 shows that the ITTM-based dynamic hedging strategy has outperformed the 50% static hedging most of the time on a moving four-year basis, with only CAD, USD and JPY managers suffering brief drawdowns. Chart I-3BCA Dynamic Hedging Adds ##br##Value For All Investors Chart I-4Little Career Risk For ##br##Portfolio Managers In theory, if hedges were effective, then an identical global equity portfolio should have similar returns for all investors, no matter what home currency they hold. While neither the static hedging strategies nor the momentum-based dynamic hedging approach could pass this criteria, BCA's ITTM-based dynamic hedging approach does. It levels out the playing field for all investors globally. As shown in Chart I-5, in the period from March 2001 to August 2017, if left unhedged, the same global investment exhibits very different annualized returns for investors in different home currencies, with AUD investors at the low end at around 3.2%, and GBP investors at the high end at around 7%. With BCA's ITTM-based dynamic hedge, however, returns for all investors are very similar, no matter which currency is their home currency. Chart I-5BCA Dynamic Hedging Strategy Levels Out The Playing Field The BCA Dynamic Hedging Methodology To back-test all the hedging strategies, we use an identical global equity portfolio that is a market cap-weighted aggregate of nine countries/regions based on MSCI U.S., Japan, the euro area, U.K., Canada, Australia, Switzerland, Sweden and Norway. This universe accounts for about 97% of the current MSCI World index (Chart I-6). The history of the euro area before 1987 (when MSCI data were available) is calculated as a market cap-weighted aggregate of MSCI Germany, France, Spain, Italy, Austria, Belgium and the Netherlands. Chart I-6GAA Global Equity Universe We evaluate the same global portfolio for investors with six different home currencies: USD, JPY, GBP, EUR, CAD and AUD. The Measurement for Hedging Efficacy: All the academically claimed "optimal" hedge ratios, static or dynamic, are based on risk-minimizing in a mean-variance optimization framework. For practitioners, however, "not meeting return objectives" is a much higher risk priority than minimizing portfolio risk. This is why we advocate risk-adjusted return as our measurement for hedge efficacy. The Objective: We aim to find the hedging strategies that outperform the widely used 50% static hedging strategy on a risk-adjusted return basis. At BCA, our philosophy has always been not to strive to find the optimal solution, but to try our best to find a feasible solution that best meets the stated objective. Interestingly, this approach has produced superior results for the GBP and EUR portfolios, achieving the combination of "highest return - lowest risk." It also levels out the playing field for all investors by generating similar hedged returns for all investors, no matter what home currency they hold (Chart I-1 and Chart I-5). The Proprietary Currency Indicators: The indicators from Foreign Exchange Strategy service's Intermediate Term Timing Model (ITTM) are built under the assumptions that the uncovered interest rate parity (UIP) holds, and the fair value of a currency pair is a function of the real rate differential (using an average of two-year and 10-year real rates), Junk OAS (a proxy for global risk appetite), commodity prices and past-year trends (52-week moving average). When a currency pair deviates from its fair value to an extreme, then the likelihood for a trend reversal is high.9 The Simple Rule-Based Dynamic Hedging: For each home currency, we evaluate the other eight foreign currencies individually based on each pair's ITTM indicator. When a foreign currency overshoots fair value above the upper band of its historical range, then the currency is a short, and the short position is kept until the foreign currency value touches the lower band of its historical range that's below the fair value. The Implementation: We use one-month forward contracts and re-balance on a monthly basis. The gain or loss of the underlying equity index during the month is not hedged, but converted back to the home currency at the month-end spot rate. For history before 2001, we use one-month interest rates to calculate hedged returns (Please see Appendix 1 hedged return calculations using forwards and also interest rates). Example: Chart I-7 illustrates how a Canadian investor uses the ITTM indicator to decide when to hedge JPY exposure when they invest in the MSCI Japan equity index. Chart I-7Canadian Investor: Japanese Index Dynamically Hedged The top panel shows the hedging signal for JPY (solid line) versus our proprietary ITTM indicator for JPY/CAD exchange rate (dash line). The upper and lower band are set as 7% above fair value and 9% below fair value; the bottom panel shows the relative performance of the MSCI Japan hedged in CAD versus the MSCI Japan unhedged in CAD. Currently CAD investors should hedge their JPY exposure based on the ITTM indicator. Some Suggestions For Asset Allocators Use a centralized currency overlay portfolio to manage foreign currency exposure. The overlay portfolio should be managed by currency specialists (either in-house or using external managers) under the supervision of the CIO. The objective of the overlay portfolio is to manage currency exposure based on the underlying assets of the organization's Total Portfolio, such that the risk/return profile of the total portfolio is improved against its benchmark. Global equity portfolio manager performance should be measured on an unhedged basis in their respective home currency. Some have argued that a fully hedged benchmark such as the MSCI All Country Total Return Index in local currencies should be used to measure the performance of a global equity portfolio manager. We strongly disagree, even though in theory it does not really matter what benchmark is used. MSCI's "total return indexes in local currencies" for global equity aggregates are theoretical in nature. They cannot be replicated in the real world because they are calculated on a daily basis using the previous closing day's exchange rate to calculate foreign equity return10 - such that the "local return" for each foreign equity index is perfectly hedged. Unfortunately this "perfect hedge" is humanly impossible, because as shown in Formula (1) in Appendix 1, only when both the spot rate and forward rate at the time t are equal to the spot rate at time t+1, can the local returns be fully captured! Xiaoli Tang, Associate Vice President xiaolit@bcaresearch.com 1 Perold, A and E. Schulman, 1988, "The free lunch in currency hedging: Implications for investment policy and performance standards", Financial Analyst Journal 44, 45-50. 2 Froot K., 1993, "Currency hedging over long horizons", NBER working paper 4355 3 Black, F., 1989, "Universal hedging: optimizing currency risk and reward in international equity portfolios", Financial Analyst Journal 45, 16-22 4 Campbell, J., K. de Medeiros and L. Viceira, 2010, "Global currency hedging", Journal of Finance LXV, 87-122 5 Gagnon, L., T., McCurdy, and G., Lypny, 1998, " Hedging foreign currency portfolios", Journal of Empirical Finance 5, 197-220 6 Hautsch, N., and J. Inkmann, 2003, "Optimal hedging of the currency exchange risk exposure of dynamically balanced strategic asset allocations", Journal of Asset Management 4, 173-189 7 Brown, C., J., Dark, and W., Zhang, "Dynamic currency hedging for international stock portfolios", 2012, Ph.D. dissertation, University of Melbourn 8 Michenaud, S., and B., Solnik, 2008, "Applying regret theory to investment choices: Currency hedging decisions", Journal of International Money and Finance 27, 677-694 9 Please see BCA Foreign Exchange Strategy Special Report titled "In Search Of A Timing Model", June 22, 2016 available at fes.bcaresearch.com 10 "Note on index calculation in local currency", MSCI Bara Index Calculation Methodologies, p19, May 2010 11 MSCI uses 2 business days as described in "MSCI Index Methodology: MSCI Hedged Indexes", July 2013 Appendix 1 We use one-month forward contracts and re-balance on a monthly basis. The gain or loss of the underlying equity index during the month is not hedged, but converted back to the home currency at the month-end spot rate. Before reliable forward contract rates were available (Jan 2001), we use one-month interest rates instead to calculate hedged returns. Please note that for simplification we have ignored the bid-ask spread in all the quotations, and we do not take into account the time lag required to implement a hedge.11 In practice, however, these are valid considerations. Appendix 2: Dynamics Hedging For Six Home Currencies 2.1 The Australian Perspective Correlations: For Aussie investors, foreign currencies in aggregate have a negative correlation with the domestic equity index (especially in the period from 2001), and a mostly positive but low correlation to the unhedged foreign equities. (Chart II-1). So hedging away foreign currency exposure would increase total risk of the global portfolio. This is why a fully hedged portfolio has the highest risk (Chart II-2, Table II-1). Historical Performance: Since 2001, ITTM-based dynamic hedging has produced the highest risk-adjusted return for the global portfolio in AUD. The return profile looks similar to the fully hedged portfolio, but risk is much lower (Table II-1). Over the longer period, the optimal static hedge ratio is about 70%, which is actually quite close to the 50% hedge, as shown in Table II-2. On a five-year rolling basis, as shown in Chart II-2, the ITTM-based dynamic risk/return profile also prevails. Current State: Currently AUD investors should only be hedging their exposure in Swiss francs and U.S. dollars, the two "safe haven" currencies. Actually, our indicators show a close to 100% hedge of the Swiss franc, as shown in Chart II-3, which did hurt the risk/return profile during the GFC period despite an outstanding full-period performance. Table II-1Risk/Return Profile For Global Equity In AUD (2001-2017) Table II-2Risk/Return Profile For Global Equity In AUD (1976-2017) Chart II-1Australian Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies Chart II-2Australian Perespective: Dynamic Vs. Static Hedging Chart II-3Australian Perspective: Swiss Index Dynamically Hedged 2.2 The Canadian Perspective Correlations: For Canadian investors, foreign currencies on aggregate have a negative correlation with the country's domestic equity index, but the correlation with unhedged foreign equities has oscillated in both positive and negative territory. The correlation between Canadian equities and unhedged foreign equities has been always positive, in the range of 0.4-0.8 (Chart II-4). So hedging away foreign currency exposure will increase total risk within a global portfolio. This is why a fully hedged portfolio has the highest risk (Chart II-5, Table II-3 and Table II-4). Historical Performance: Since 2001, the ITTM-based dynamic hedging has produced the highest annualized return for the global portfolio in CAD without significantly increasing volatility from the unhedged scenario. In terms of risk-adjusted return, dynamic hedging has outperformed the best static hedging scenario (40% hedged) by about 46% (Table II-3). On a five-year rolling basis, as shown in Chart II-5, the dynamic risk/return profile also prevails. Current State: Currently Canadian investors should be hedging all foreign currencies except for the Australian dollar. Chart II-6 shows how CAD investors dynamically hedge their exposure to the Swedish krona. Table II-3Risk/Return Profile For Global Equity In CAD (2001-2017) Table II-4Risk/Return Profile For Global Equity In CAD (1976-2017) Chart II-4Canadian Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies Chart II-5Canadian Perspective: Dynamic Vs. Static Hedging Chart II-6Canadian Perspective: Swedish Index Dynamically Hedged 2.3 The Japanese Perspective Correlations: For Japanese investors, correlations among foreign currencies, foreign equities and domestic equities seem to have gone through regime changes since the GFC, as shown in Chart II-7. These regime changes in correlations explain the evolving risk/return profile of the static hedges in Chart II-8. Before the GFC, full hedge and 50% hedge had similar risk profiles, but after the GFC full hedge reduced total risk significantly due to the sharp increase in correlations. Historical Performance: Since 2001, the ITTM-based dynamic hedging has produced the highest risk-adjusted return for the global portfolio in JPY, with a much higher return and slightly higher risk (Table II-5). Fully hedged has the lowest risk in both periods, and 50% is close to the "optimal" static hedge in both periods as well (Table II-5 and II-6). On a five-year rolling basis, as shown in Chart II-8, the ITTM-based dynamic risk/return profile. The 50% static hedge has similar risk profile to the ITTM-based dynamic hedge, but with lower returns. Current State: Currently JPY investors should be only hedging their exposure in Swiss francs and U.S. dollars. Chart II-9 shows how Japanese investors should have hedged CAD exposure. Table II-5Risk/Return Profile For Global Equity In JPY (2001-2017) Table II-6Risk/Return Profile For Global Equity In JPY (1976-2017) Chart II-7Japanese Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies Chart II-8Japanese Perspective: Dynamic Vs. Static Hedging Chart II-9Japanese Perspective: Canadian Index Dynamically Hedged 2.4 The U.S. Perspective Correlations: For U.S. investors, correlations among foreign currencies, foreign equities and domestic equities seem to have gone through regime changes since the GFC, as shown in Chart II-10. These regime changes in correlation explain the evolving risk/return profile of the static hedges in Chart II-11. Before the GFC, full hedge and 50% hedge had similar risk profiles, but after the GFC full hedge exhibited significantly reduced total risk due to the sharp increase in correlations. Historical Performance: Since 2001, the ITTM-based dynamic hedging has produced the highest risk-adjusted return for the global portfolio in USD, with a much higher return and slightly lower risk compared to the 50%, which is the best static hedge for the period (Table II-7). Fully hedged had the lowest risk in both periods, but the return profiles of the static hedges were very similar, supporting the widely held belief that in the long run currency returns are close to zero (Table II-7 and II-8). On a five-year rolling basis, as shown in Chart II-11, the dynamic risk/return profile is close to that of the 50%. Current State: Currently U.S. investors should only be hedging their exposure in euros (Chart II-12). Table II-7Risk/Return Profile For Global Equity In USD (2001-2017) Table II-8Risk/Return Profile For Global Equity In JPY (1976-2017) Chart II-10U.S. Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies Chart II-11U.S. Perspective: Dynamic Vs. Static Hedging Chart II-12U.S. Perspective: EMU Index Dynamically Hedged 2.5 The Euro Perspective Correlations: For investors that call the euro home currency, the correlation and foreign equities has been positive. The correlation between foreign currencies and domestic equity index, however, has been changing signs over time, currently sitting at near zero! (Chart II-13). This explains the shape of the risk/return profile in Chart II-14 and Table II-9. Historical Performance: Since 2001, the ITTM-based dynamic hedging has produced the highest risk-adjusted return for the global portfolio in euros, which has a higher return and lower risk than the best static hedge of 80% (Table II-9). Over the longer period, the optimal hedge ratio is about 50% hedge, which is actually quite close to those between 40-70%, as shown in Table II-10. On a five-year rolling basis, as shown in Chart II-14, the dynamic risk/return profile definitely prevails. Current State: Currently euro investors should not be hedging any foreign exposure, based on our indicators. Chart II-15 shows how euro investors should have hedged JPY exposure over time since 2001. Table II-9Risk/Return Profile For Global Equity In Euro (2001-2017) Table II-10Risk/Return Profile For Global Equity In Euro (1976-2017) Chart II-13Domestic And Unhedged Foreign Equities Vs. Foreign Currencies Chart II-14Euro Area Perspective: Dynamic Vs. Static Hedging Chart II-15Euro area Perspective: Japanese Index Dynamically Hedged 2.6 The British Perspective Correlations: For British investors, correlations between foreign currencies and domestic equities have gone through several regime changes over time in both positive and negative territory, as shown in Chart II-16. The positive correlation between foreign and domestic equities has also increased over time. This would definitely make static hedging worse off (Table II-11 and II-12). Historical Performance: Not surprisingly, since 2001, dynamic hedging has produced the highest risk-adjusted return for the global portfolio in pounds, which has a higher return and lower risk than the best static hedge of 20% (Table II-11). Over the longer period, the optimal hedge ratio is about 90% hedge, Table II-12. On a five-year rolling basis, as shown in Chart II-17, the dynamic risk/return profile prevails, as it shares similar risk as the 50% hedge but with a higher return. Current State: Currently the British investors should not be hedging CAD and Swedish krona, while all six other currencies should be hedged. Chart II-18 shows how U.K. investors should have hedged their AUD exposure over time since 2001. Table II-11Risk/Return Profile For Global Equity In GBP (2001-2017) Table II-12Risk/Return Profile For Global Equity In GBP (1976-2017) Chart II-16Domestic And Unhedged Foreign Equities Vs. Foreign Currencies Chart II-17Dynamic Vs. Static Hedging Chart II-18U.K. Perspective: Australian Index Dynamically Hedged

Special Report

Dear client, I am on the road this week, attending BCA's New York Conference and teaching the BCA Academy. In lieu of a regular report, we are sending you a Special Report, a cooperation with our Global Asset Allocation service. In this piece, my colleague Xiaoli Tang tests the benefits of various currency hedging strategies for global equity portfolios. In addition to traditional hedging rules, Xiaoli deploys the Intermediate-Term Timing Models developed by the Foreign Exchange Strategy team to build dynamic hedging strategies, which result in superior risk/reward profiles. I trust you will find this report interesting and informative. Best regards, Mathieu Savary Highlights In this report, we analyze both static and dynamic hedging strategies to hedge an identical global equity portfolio to six home currencies: the U.S. dollar, the British pound, the euro, the Japanese yen, the Canadian dollar and the Australian dollar. We propose an easy to implement dynamic hedging framework based on the proprietary currency indicators from BCA's Foreign Exchange Strategy (FES) service. It has outperformed all the static hedging strategies since 2001 on a risk-adjusted return basis. In addition, it levels out the playing field for all investors as the hedged returns are quite similar, no matter what their home currencies are. Among the static hedging strategies, the "least-regret" hedge ratio of 50% has lived up to its reputation, as it has reduced risk by more than 50% without severely jeopardizing returns. Over a four-year moving performance cycle (in line with how most portfolio managers are evaluated), the proposed dynamic hedging adds little career risk to portfolio managers compared to the "least regret" 50% static hedging, while provides superior returns most of the time. A global equity portfolio's currency exposure should be managed in a centralized currency overlay under the supervision of the Chief Investment Officer, so that equity and currency managers can both fully utilize their expertise in their respective field, and the organization can manage currency risk more efficiently at the total portfolio level. Feature Dynamic Hedging Outperforms Static Hedging We have received many client requests asking about currency hedging in global equity portfolios with different home currencies. This is not surprising given how currency movements have overwhelmed global equity portfolio returns of late. For example, this year the U.S. dollar's weakness against the major currencies has beefed up returns for U.S. investors who did not hedge their foreign exposure (Table I-1). Table I-1Year-To-Date Currency Movements Have Overwhelmed Equity Returns GAA's equity country allocation recommendations are by default unhedged on USD basis. When a hedge is required we make the recommendation explicit. There have been many conflicting views on whether global equity investors should hedge foreign currency exposure, and if so, what proportion of the exposure should be hedged. Perold and Schulman (1988) suggest fully hedging foreign currency exposure, because significant risk reduction can be achieved without a significant loss of return.1 This is based on their famous "free lunch" claim that average currency returns are zero over the long-term. At the other extreme, Froot (1993) suggests that foreign currencies should not be hedged at all for long-term investors, because purchasing power parity holds in the long term and exchange rates are mean reverting.2 There are many other views in between, including the universal hedge ratio proposed by Black (1989), which is estimated to be 77%.3 Campbell et al (2010) classify currencies into reserve currencies (USD, EUR and CHF), commodity currencies (AUD and CAD) and neutral currencies (JPY and GBP), and suggest that risk-minimizing investors should hold reserve currencies while hedging out commodity currencies, based on the correlations between the currencies and equity markets.4 Realizing the limitations of "static hedging," which assumes constant correlation, mean and variance, many academic researchers have explored "dynamic hedging models" that allow the mean and covariance to be time-varying by using complex econometric modelling techniques.5,6,7 These academic dynamic hedging strategies have shown improvement over the 50% static hedge, but it's very difficult for investors without a strong quantitative background to understand these very complex approaches. In fact, with all these confusing academic recommendations floating around, the "least regret" hedge ratio of 50% has been quite popular among practitioners.8 To help our clients better understand the role of currency management in global equity portfolios, we have joined forces with BCA's Foreign Exchange Strategy (FES) service to de-mystify the currency hedging process, and to propose a simple framework for clients with six different home currencies to dynamically hedge their foreign currency exposure based on the FES team's proprietary Intermediate-Term Timing Model (ITTM) indicators.9 These indicators have been used in their regular weekly publications. The ITTM-based dynamic hedging strategy is back-tested from 2001 because the ITTM indicators only date back to 2001 (See methodology). We have also back-tested a simple trend-following momentum-based dynamic strategy to see how a dynamic hedging methodology works in a longer period from 1976. For comparison we have back-tested ten different static hedging strategies that employ fixed hedge ratios across currencies and time. The test results not only clarify much of the confusion about static hedging, they also demonstrate that on a risk-adjusted return basis, BCA's ITTM-based dynamic hedging strategy has outperformed all static hedging strategies for all investors with six different home currencies since 2001 (Chart I-1). Even in the very long run of 41 years from August 1976, the simple momentum-based dynamic hedging outperforms the static strategies for investors with five home currencies, with only the AUD portfolio being worse off (Chart I-2). Chart I-1Identical Investment, But Different Risk/Return Profiles (3/2001-8/2017) Chart I-2Identical Investment, But Different Risk/Return Profiles (8/1976-8/2017) Now let's clarify some of the confusion: Does static hedging reduce portfolio risk at little expense of lowering returns? The answer is yes only for USD and JPY portfolios. For both the 41-year period from 1976 and the shorter 16-year period from 2001, a higher hedge ratio results in lower risk with slightly lower return. So fully hedged would be the "optimal" strategy for risk-minimizing investors with USD and JPY as home currencies (Panel 1 and 2 on left side in both Chart I-1 and Chart I-2). For the U.K. portfolio, the answer is a partial yes, because the "optimal hedge ratio" for risk-minizing investors, around 60%-80%, does produce the lowest risk, but the paths to that "optimal" point are totally opposite when different time periods are chosen. In the short period (Chart I-1, bottom left panel), it follows the same pattern as that for U.S. and Japanese investors up to the optimal point. As the hedge ratio increases, however, return drops and risk increases! In the longer period from 1976, as the hedge ratio increases, return increases and risk decreases until the "optimal point," after which risk and returns both increase (Chart I-2, bottom left panel). In the period from 2001, the AUD, CAD and EUR portfolios share a similar pattern to that of the GBP portfolio in the period from 1976. The AUD portfolio behaved the same in both the shorter period (Chart I-1, top right) and the longer period (Chart 2, top right), while the EUR and CAD portfolios behaved differently in the longer-term period from the shorter period. Overall, the CAD portfolio's "optimal" hedge ratio is around 0-30%, the AUD portfolio around 30-60% while the EUR portfolio is around 40% in the shorter period but around 90% in the longer period (Chart I-1 and Chart I-2). It is also worth noting that even though both the CAD and AUD are commodity currencies, AUD investors benefit significantly from hedging, while CAD investors' risk/return profile does not change much. This is because 1) currency returns for AUD investors do not average to zero in the long term due to positive carry, and 2) correlations between foreign currencies, foreign equities and domestic equities are not constant over time or across currencies (Appendix 2, Chart II-1 and Chart II-4) How does the "least regret" 50% static hedge do? The 50% hedge ratio fares quite well compared to the "optimal" static hedge ratio in terms of risk reduction for all portfolios in both periods, because more than half of the total risk reduction (the highest minus the lowest) occurs around the 50% hedge (Chart I-1 and Chart I-2). How does BCA's ITTM-based dynamic hedge do in terms of risk reduction? The ITTM produces better risk-adjusted returns for each portfolio than all the static hedges. In terms of risk, it generates the lowest risk for the EUR and GBP portfolios and is comparable to the 50% static hedge for other portfolios, while it generates a much higher return than all static hedges (Chart I-1 and Chart I-2). How does the BCA Dynamic Hedge (ITTM) compare to the 50% static hedge over time? Chart I-3 shows that the dynamic hedge consistently outperformed the 50% static hedge for all six home currencies since 2001 without significantly increasing hedging transactions, compared to the fixed 50% hedge ratio for all currency pairs. The dash line in each panel of Chart I-3 corresponds to the market cap-weighted aggregate of hedge ratios of foreign currencies for each home currency. On average, they are comparable to 50%. Most portfolio managers are measured on a moving four-year performance cycle. Chart I-4 shows that the ITTM-based dynamic hedging strategy has outperformed the 50% static hedging most of the time on a moving four-year basis, with only CAD, USD and JPY managers suffering brief drawdowns. Chart I-3BCA Dynamic Hedging Adds ##br##Value For All Investors Chart I-4Little Career Risk For ##br##Portfolio Managers In theory, if hedges were effective, then an identical global equity portfolio should have similar returns for all investors, no matter what home currency they hold. While neither the static hedging strategies nor the momentum-based dynamic hedging approach could pass this criteria, BCA's ITTM-based dynamic hedging approach does. It levels out the playing field for all investors globally. As shown in Chart I-5, in the period from March 2001 to August 2017, if left unhedged, the same global investment exhibits very different annualized returns for investors in different home currencies, with AUD investors at the low end at around 3.2%, and GBP investors at the high end at around 7%. With BCA's ITTM-based dynamic hedge, however, returns for all investors are very similar, no matter which currency is their home currency. Chart I-5BCA Dynamic Hedging Strategy Levels Out The Playing Field The BCA Dynamic Hedging Methodology To back-test all the hedging strategies, we use an identical global equity portfolio that is a market cap-weighted aggregate of nine countries/regions based on MSCI U.S., Japan, the euro area, U.K., Canada, Australia, Switzerland, Sweden and Norway. This universe accounts for about 97% of the current MSCI World index (Chart I-6). The history of the euro area before 1987 (when MSCI data were available) is calculated as a market cap-weighted aggregate of MSCI Germany, France, Spain, Italy, Austria, Belgium and the Netherlands. Chart I-6GAA Global Equity Universe We evaluate the same global portfolio for investors with six different home currencies: USD, JPY, GBP, EUR, CAD and AUD. The Measurement for Hedging Efficacy: All the academically claimed "optimal" hedge ratios, static or dynamic, are based on risk-minimizing in a mean-variance optimization framework. For practitioners, however, "not meeting return objectives" is a much higher risk priority than minimizing portfolio risk. This is why we advocate risk-adjusted return as our measurement for hedge efficacy. The Objective: We aim to find the hedging strategies that outperform the widely used 50% static hedging strategy on a risk-adjusted return basis. At BCA, our philosophy has always been not to strive to find the optimal solution, but to try our best to find a feasible solution that best meets the stated objective. Interestingly, this approach has produced superior results for the GBP and EUR portfolios, achieving the combination of "highest return - lowest risk." It also levels out the playing field for all investors by generating similar hedged returns for all investors, no matter what home currency they hold (Chart I-1 and Chart I-5). The Proprietary Currency Indicators: The indicators from Foreign Exchange Strategy service's Intermediate Term Timing Model (ITTM) are built under the assumptions that the uncovered interest rate parity (UIP) holds, and the fair value of a currency pair is a function of the real rate differential (using an average of two-year and 10-year real rates), Junk OAS (a proxy for global risk appetite), commodity prices and past-year trends (52-week moving average). When a currency pair deviates from its fair value to an extreme, then the likelihood for a trend reversal is high.9 The Simple Rule-Based Dynamic Hedging: For each home currency, we evaluate the other eight foreign currencies individually based on each pair's ITTM indicator. When a foreign currency overshoots fair value above the upper band of its historical range, then the currency is a short, and the short position is kept until the foreign currency value touches the lower band of its historical range that's below the fair value. The Implementation: We use one-month forward contracts and re-balance on a monthly basis. The gain or loss of the underlying equity index during the month is not hedged, but converted back to the home currency at the month-end spot rate. For history before 2001, we use one-month interest rates to calculate hedged returns (Please see Appendix 1 hedged return calculations using forwards and also interest rates). Example: Chart I-7 illustrates how a Canadian investor uses the ITTM indicator to decide when to hedge JPY exposure when they invest in the MSCI Japan equity index. Chart I-7Canadian Investor: Japanese Index Dynamically Hedged The top panel shows the hedging signal for JPY (solid line) versus our proprietary ITTM indicator for JPY/CAD exchange rate (dash line). The upper and lower band are set as 7% above fair value and 9% below fair value; the bottom panel shows the relative performance of the MSCI Japan hedged in CAD versus the MSCI Japan unhedged in CAD. Currently CAD investors should hedge their JPY exposure based on the ITTM indicator. Some Suggestions For Asset Allocators Use a centralized currency overlay portfolio to manage foreign currency exposure. The overlay portfolio should be managed by currency specialists (either in-house or using external managers) under the supervision of the CIO. The objective of the overlay portfolio is to manage currency exposure based on the underlying assets of the organization's Total Portfolio, such that the risk/return profile of the total portfolio is improved against its benchmark. Global equity portfolio manager performance should be measured on an unhedged basis in their respective home currency. Some have argued that a fully hedged benchmark such as the MSCI All Country Total Return Index in local currencies should be used to measure the performance of a global equity portfolio manager. We strongly disagree, even though in theory it does not really matter what benchmark is used. MSCI's "total return indexes in local currencies" for global equity aggregates are theoretical in nature. They cannot be replicated in the real world because they are calculated on a daily basis using the previous closing day's exchange rate to calculate foreign equity return10 - such that the "local return" for each foreign equity index is perfectly hedged. Unfortunately this "perfect hedge" is humanly impossible, because as shown in Formula (1) in Appendix 1, only when both the spot rate and forward rate at the time t are equal to the spot rate at time t+1, can the local returns be fully captured! Xiaoli Tang, Associate Vice President xiaolit@bcaresearch.com 1 Perold, A and E. Schulman, 1988, "The free lunch in currency hedging: Implications for investment policy and performance standards", Financial Analyst Journal 44, 45-50. 2 Froot K., 1993, "Currency hedging over long horizons", NBER working paper 4355 3 Black, F., 1989, "Universal hedging: optimizing currency risk and reward in international equity portfolios", Financial Analyst Journal 45, 16-22 4 Campbell, J., K. de Medeiros and L. Viceira, 2010, "Global currency hedging", Journal of Finance LXV, 87-122 5 Gagnon, L., T., McCurdy, and G., Lypny, 1998, " Hedging foreign currency portfolios", Journal of Empirical Finance 5, 197-220 6 Hautsch, N., and J. Inkmann, 2003, "Optimal hedging of the currency exchange risk exposure of dynamically balanced strategic asset allocations", Journal of Asset Management 4, 173-189 7 Brown, C., J., Dark, and W., Zhang, "Dynamic currency hedging for international stock portfolios", 2012, Ph.D. dissertation, University of Melbourn 8 Michenaud, S., and B., Solnik, 2008, "Applying regret theory to investment choices: Currency hedging decisions", Journal of International Money and Finance 27, 677-694 9 Please see BCA Foreign Exchange Strategy Special Report titled "In Search Of A Timing Model", June 22, 2016 available at fes.bcaresearch.com 10 "Note on index calculation in local currency", MSCI Bara Index Calculation Methodologies, p19, May 2010 11 MSCI uses 2 business days as described in "MSCI Index Methodology: MSCI Hedged Indexes", July 2013 Appendix 1 We use one-month forward contracts and re-balance on a monthly basis. The gain or loss of the underlying equity index during the month is not hedged, but converted back to the home currency at the month-end spot rate. Before reliable forward contract rates were available (Jan 2001), we use one-month interest rates instead to calculate hedged returns. Please note that for simplification we have ignored the bid-ask spread in all the quotations, and we do not take into account the time lag required to implement a hedge.11 In practice, however, these are valid considerations. Appendix 2: Dynamics Hedging For Six Home Currencies 2.1 The Australian Perspective Correlations: For Aussie investors, foreign currencies in aggregate have a negative correlation with the domestic equity index (especially in the period from 2001), and a mostly positive but low correlation to the unhedged foreign equities. (Chart II-1). So hedging away foreign currency exposure would increase total risk of the global portfolio. This is why a fully hedged portfolio has the highest risk (Chart II-2, Table II-1). Historical Performance: Since 2001, ITTM-based dynamic hedging has produced the highest risk-adjusted return for the global portfolio in AUD. The return profile looks similar to the fully hedged portfolio, but risk is much lower (Table II-1). Over the longer period, the optimal static hedge ratio is about 70%, which is actually quite close to the 50% hedge, as shown in Table II-2. On a five-year rolling basis, as shown in Chart II-2, the ITTM-based dynamic risk/return profile also prevails. Current State: Currently AUD investors should only be hedging their exposure in Swiss francs and U.S. dollars, the two "safe haven" currencies. Actually, our indicators show a close to 100% hedge of the Swiss franc, as shown in Chart II-3, which did hurt the risk/return profile during the GFC period despite an outstanding full-period performance. Table II-1Risk/Return Profile For Global Equity In AUD (2001-2017) Table II-2Risk/Return Profile For Global Equity In AUD (1976-2017) Chart II-1Australian Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies Chart II-2Australian Perespective: Dynamic Vs. Static Hedging Chart II-3Australian Perspective: Swiss Index Dynamically Hedged 2.2 The Canadian Perspective Correlations: For Canadian investors, foreign currencies on aggregate have a negative correlation with the country's domestic equity index, but the correlation with unhedged foreign equities has oscillated in both positive and negative territory. The correlation between Canadian equities and unhedged foreign equities has been always positive, in the range of 0.4-0.8 (Chart II-4). So hedging away foreign currency exposure will increase total risk within a global portfolio. This is why a fully hedged portfolio has the highest risk (Chart II-5, Table II-3 and Table II-4). Historical Performance: Since 2001, the ITTM-based dynamic hedging has produced the highest annualized return for the global portfolio in CAD without significantly increasing volatility from the unhedged scenario. In terms of risk-adjusted return, dynamic hedging has outperformed the best static hedging scenario (40% hedged) by about 46% (Table II-3). On a five-year rolling basis, as shown in Chart II-5, the dynamic risk/return profile also prevails. Current State: Currently Canadian investors should be hedging all foreign currencies except for the Australian dollar. Chart II-6 shows how CAD investors dynamically hedge their exposure to the Swedish krona. Table II-3Risk/Return Profile For Global Equity In CAD (2001-2017) Table II-4Risk/Return Profile For Global Equity In CAD (1976-2017) Chart II-4Canadian Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies Chart II-5Canadian Perspective: Dynamic Vs. Static Hedging Chart II-6Canadian Perspective: Swedish Index Dynamically Hedged 2.3 The Japanese Perspective Correlations: For Japanese investors, correlations among foreign currencies, foreign equities and domestic equities seem to have gone through regime changes since the GFC, as shown in Chart II-7. These regime changes in correlations explain the evolving risk/return profile of the static hedges in Chart II-8. Before the GFC, full hedge and 50% hedge had similar risk profiles, but after the GFC full hedge reduced total risk significantly due to the sharp increase in correlations. Historical Performance: Since 2001, the ITTM-based dynamic hedging has produced the highest risk-adjusted return for the global portfolio in JPY, with a much higher return and slightly higher risk (Table II-5). Fully hedged has the lowest risk in both periods, and 50% is close to the "optimal" static hedge in both periods as well (Table II-5 and II-6). On a five-year rolling basis, as shown in Chart II-8, the ITTM-based dynamic risk/return profile. The 50% static hedge has similar risk profile to the ITTM-based dynamic hedge, but with lower returns. Current State: Currently JPY investors should be only hedging their exposure in Swiss francs and U.S. dollars. Chart II-9 shows how Japanese investors should have hedged CAD exposure. Table II-5Risk/Return Profile For Global Equity In JPY (2001-2017) Table II-6Risk/Return Profile For Global Equity In JPY (1976-2017) Chart II-7Japanese Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies Chart II-8Japanese Perspective: Dynamic Vs. Static Hedging Chart II-9Japanese Perspective: Canadian Index Dynamically Hedged 2.4 The U.S. Perspective Correlations: For U.S. investors, correlations among foreign currencies, foreign equities and domestic equities seem to have gone through regime changes since the GFC, as shown in Chart II-10. These regime changes in correlation explain the evolving risk/return profile of the static hedges in Chart II-11. Before the GFC, full hedge and 50% hedge had similar risk profiles, but after the GFC full hedge exhibited significantly reduced total risk due to the sharp increase in correlations. Historical Performance: Since 2001, the ITTM-based dynamic hedging has produced the highest risk-adjusted return for the global portfolio in USD, with a much higher return and slightly lower risk compared to the 50%, which is the best static hedge for the period (Table II-7). Fully hedged had the lowest risk in both periods, but the return profiles of the static hedges were very similar, supporting the widely held belief that in the long run currency returns are close to zero (Table II-7 and II-8). On a five-year rolling basis, as shown in Chart II-11, the dynamic risk/return profile is close to that of the 50%. Current State: Currently U.S. investors should only be hedging their exposure in euros (Chart II-12). Table II-7Risk/Return Profile For Global Equity In USD (2001-2017) Table II-8Risk/Return Profile For Global Equity In JPY (1976-2017) Chart II-10U.S. Perspective: Domestic And Unhedged Foreign Equities Vs. Foreign Currencies Chart II-11U.S. Perspective: Dynamic Vs. Static Hedging Chart II-12U.S. Perspective: EMU Index Dynamically Hedged 2.5 The Euro Perspective Correlations: For investors that call the euro home currency, the correlation and foreign equities has been positive. The correlation between foreign currencies and domestic equity index, however, has been changing signs over time, currently sitting at near zero! (Chart II-13). This explains the shape of the risk/return profile in Chart II-14 and Table II-9. Historical Performance: Since 2001, the ITTM-based dynamic hedging has produced the highest risk-adjusted return for the global portfolio in euros, which has a higher return and lower risk than the best static hedge of 80% (Table II-9). Over the longer period, the optimal hedge ratio is about 50% hedge, which is actually quite close to those between 40-70%, as shown in Table II-10. On a five-year rolling basis, as shown in Chart II-14, the dynamic risk/return profile definitely prevails. Current State: Currently euro investors should not be hedging any foreign exposure, based on our indicators. Chart II-15 shows how euro investors should have hedged JPY exposure over time since 2001. Table II-9Risk/Return Profile For Global Equity In Euro (2001-2017) Table II-10Risk/Return Profile For Global Equity In Euro (1976-2017) Chart II-13Domestic And Unhedged Foreign Equities Vs. Foreign Currencies Chart II-14Euro Area Perspective: Dynamic Vs. Static Hedging Chart II-15Euro area Perspective: Japanese Index Dynamically Hedged 2.6 The British Perspective Correlations: For British investors, correlations between foreign currencies and domestic equities have gone through several regime changes over time in both positive and negative territory, as shown in Chart II-16. The positive correlation between foreign and domestic equities has also increased over time. This would definitely make static hedging worse off (Table II-11 and II-12). Historical Performance: Not surprisingly, since 2001, dynamic hedging has produced the highest risk-adjusted return for the global portfolio in pounds, which has a higher return and lower risk than the best static hedge of 20% (Table II-11). Over the longer period, the optimal hedge ratio is about 90% hedge, Table II-12. On a five-year rolling basis, as shown in Chart II-17, the dynamic risk/return profile prevails, as it shares similar risk as the 50% hedge but with a higher return. Current State: Currently the British investors should not be hedging CAD and Swedish krona, while all six other currencies should be hedged. Chart II-18 shows how U.K. investors should have hedged their AUD exposure over time since 2001. Table II-11Risk/Return Profile For Global Equity In GBP (2001-2017) Table II-12Risk/Return Profile For Global Equity In GBP (1976-2017) Chart II-16Domestic And Unhedged Foreign Equities Vs. Foreign Currencies Chart II-17Dynamic Vs. Static Hedging Chart II-18U.K. Perspective: Australian Index Dynamically Hedged Trades & Forecasts Forecast Summary Core Portfolio Closed Trades

Dear Client, I had the pleasure of speaking at BCA's Annual New York conference on Monday, where I offered the following trade recommendations. This week's report is a summary of my remarks. Please note we will be publishing our Q4 Strategy Outlook and monthly tactical asset allocation recommendation table next Wednesday. Best regards, Peter Berezin, Chief Global Strategist Global Investment Strategy Highlights Go short the December 2018 fed funds futures contract. Go long global industrial stocks versus utilities. Go short 20-year JGBs relative to their 5-year counterparts. Feature Trade #1: Go Short The December 2018 Fed Funds Futures Contract The hurricanes are likely to dent activity in the third quarter, but leading economic indicators are pointing to faster growth starting in Q4. This can be seen in a variety of measures, including the Conference Board's LEI (Chart 1). U.S. financial conditions have eased sharply this year, thanks to a decline in government bond yields, narrower credit spreads, a weaker dollar, and rising equity prices. Changes in our FCI lead growth by about 6-to-9 months. If history is any guide, U.S. growth will rise to about 3% in the first half of 2018 (Chart 2). Growth could even temporarily rise above that level if Congress enacts significant unfunded tax cuts, as we expect it will. Chart 1U.S. Leading Economic Indicator Pointing Higher Chart 2Easier Financial Conditions Will Boost U.S. Growth Contrary to popular belief, the Phillips curve is far from dead. It has just been dormant for the better part of 30 years because the unemployment rate has hovered along the flat side of the curve. The closest the economy came to overheating was in the late 1990s, but any inflationary pressures back then were choked off by turmoil in emerging markets, a surging dollar, and collapsing commodity prices.1 If U.S. growth accelerates over the next few quarters, the unemployment rate is likely to fall to 3.5% by the end of next year - well below the Fed's end-2018 projection of 4.1%, and even below the low of 3.8% reached in 2000. At that point, the U.S. economy will find itself on the steep side of the Phillips curve (Chart 3). Chart 3U.S. Economy Has Moved Into The 'Steep' Side Of The Phillips Curve As Chart 4 illustrates, our wage survey indicator - a propriety measures that combines the results of 13 separate employer surveys - is pointing to faster wage growth. Rising wages should boost consumer spending. With the output gap all but extinguished, faster demand growth will lead to higher inflation. This is already being telegraphed by the ISM manufacturing index (Chart 5). Chart 4Survey Data Point To Higher Wage Growth Ahead Chart 5Strong ISM Signaling A Rise In Inflation If inflation accelerates, there is little reason why the Fed would not continue raising rates in line with the dots, which call for one more hike in December and three hikes in 2018. That's 100 basis points of hikes between now and the end of next year, considerably more than the 40 bps that the market is currently discounting. We went short the December 2018 fed funds futures contract three weeks ago. The trade has gained 20 basis points so far, but my discussion this morning suggests that it has plenty of juice left. Trade #2: Go Long Global Industrial Stocks Versus Utilities Economists are a bit like stock market analysts - they are generally too optimistic. As a result, they usually end up having to revise their growth estimates down over time. That has not been the case this year: Global growth estimates have been marching higher (Chart 6). Capital spending tends to accelerate in the mature phase of business-cycle expansions, as a growing number of firms realize that they have insufficient capacity to meet rising demand. We are starting to see that now. A variety of indicators - including capital goods orders and capex intention surveys - are pointing to further gains in business spending. This is captured in our model estimates, which project that global capex will grow at the fastest pace in six years (Chart 7). Chart 6Global Growth Estimates Accelerating Despite Stalled U.S. Growth Chart 7Global Capex On The Upswing A burst of capital spending should benefit global industrial stocks. Conversely, rising global yields will hurt rate-sensitive utilities (Chart 8). Industrials are no longer cheap, but relative to utilities, valuations do not seem especially stretched, implying further room for re-rating (Chart 9). Chart 8Higher Bond Yields Will Hurt Utilities Chart 9Relative Valuations Are Not Stretched Trade #3: Go Short 20-Year JGBs Relative To Their 5-Year Counterparts The deflationary mindset remains firmly entrenched in Japan. CPI swaps are pricing in inflation of only 0.5% over the next twenty years (Chart 10). Not only do investors expect the Bank of Japan to continue to miss its 2% target, they don't even think that inflation will rise from today's miserly levels. They could be in for a big surprise. Many of the structural drivers of deflation in Japan are fading. Land prices have stopped falling for the first time in 25 years, and bank balance sheets are in good shape (Chart 11). Goods prices are also rising again, thanks in part to a cheaper yen (Chart 12). Profit margins have soared, giving firms the wherewithal to pay their workers more. Chart 10Deflationary Mindset Remains Deeply Entrenched... Chart 11A...But Deflationary Pressures Are Abating Chart 11B Chart 12ACorporate Pricing Power Has Improved Chart 12B Companies have been reluctant to raise wages, but that may be starting to change. Our wage trend indicator is showing signs of life (Chart 13). As in the U.S., the Phillips curve in Japan tends to become kinked at very low levels of unemployment. Japan's unemployment rate now stands at 2.8%, almost a full percentage point below 2007 levels. As the labor market heats up, companies will have to compete more intensively for a shrinking pool of available workers. This could spark a tit-for-tat cycle where wage hikes by one company lead to hikes by others. Chart 13ATentative Signs of Wage Growth Chart 13B Chart 14Demographic Inflection Point? The government has been hoping for such a bidding war to break out. It will get its wish. The ratio of job openings-to-applicants has soared, and is now even higher than at the peak of the bubble in 1990 (Chart 14). Amazingly, Japan's labor market has tightened over the past few years despite tepid GDP growth and a steady influx of women into the labor force. However, now that female participation in Japan exceeds U.S. levels, this tailwind to labor supply will dissipate. Meanwhile, the retirement of aging Japanese baby boomers will accelerate. The largest number of births in Japan occurred between 1947 and 1949. These workers will reach 70 over the next two years, the age at which most Japanese retire. How should investors play this theme? Considering that inflation is still far from the Bank of Japan's 2% target, it is doubtful that the BoJ will abandon its yield curve targeting regime any time soon. But as inflation expectations begin to rise, ultra long-term yields - which are not subject to the BOJ's cap - will increase. This suggests that shorting 20-year JGBs relative to their 5-year counterparts will pay off in spades. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Is The Phillips Curve Dead Or Dormant?" dated September 22, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades