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Highlights Chart 1Targeting 2% The Fed did its best to avoid roiling markets so close to today's election, but still managed to hint at a December rate hike. The post-meeting statement was tweaked so that now only "some further evidence" rather than "further evidence" is required in order to lift the funds rate. We remain below benchmark duration in anticipation of a December rate hike. Before the end of the year we expect our 12-month discounter to reach at least 40-50bps (meaning the market will expect a further 1-2 hikes in 2017) from its current level of 28bps, and for the 10-year Treasury yield to reach 1.95-2%. While our global PMI model pegs fair value for the 10-year Treasury yield at 2.27%, the uptrend in the 10-year yield will face severe technical resistance as it approaches 2% (Chart 1). Positioning has already moved to net short duration, signaling that the bond sell-off is becoming stretched. While a Clinton victory would all but ensure a December rate hike, a Trump victory could cause a large enough market riot that the Fed delays until 2017. This would only be a brief hiccup in the return of the 10-year yield to the 1.95-2% range, and would not signal a long-lasting trend reversal. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by +56bps in October, but have already given back -26bps of those gains so far this month (Chart 2). The index option-adjusted spread is -2bps tighter than at the end of September and, at 136bps, it remains very close to its historical average. Corporate credit performance faces two immediate risks. The first is today's election and the second is the prospect of a Fed rate hike in December. A Clinton victory would likely prompt a knee-jerk rally in risk assets and virtually ensure a rate hike next month. In that case we would be inclined to further trim exposure to credit risk in the coming weeks as the rate hike approaches. Already, we recommend investors avoid the Baa credit tier within a neutral allocation to investment grade corporates. In a recent report we pointed out that highly-rated credit (A-rated and above) performed well in the initial stages of last year's run-up in rate hike expectations, but then started to suffer once market-implied rate hike probabilities approached 100%.1 Conversely, a Trump victory would likely prompt a flight-to-safety event in markets which, depending on its severity, could also cause the Fed to delay the next rate hike into 2017. In that event, the prospect of delayed Fed tightening would make us more likely to increase credit exposure in the near term, especially if any knee-jerk sell-off in risk assets creates better value in corporates. Table 3Corporate Sector Relative Valuation And Recommended Allocation* (Continued) Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Maximum Underweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by +92bps in October, but has already underperformed the Treasury benchmark by -108bps so far in November. The index option-adjusted spread is +25bps wider since the end of September and, at 505bps, it is 16bps below its historical average. In a Special Report2 published last week we noted that while the default rate will not re-visit its previous lows (at least until after the next recession), it should decline from 5.4% to close to 4% during the next 12 months (Chart 3). However, even a slightly brighter default outlook will not be enough for junk bonds to sustain their current pace of outperformance. A simple model of lagged junk spreads and default losses explains more than 50% of the variation in 12-month high-yield excess returns. This model suggests that even with lower default losses, excess junk returns will be +264bps during the next 12 months (panel 3). The reason is that lower default losses are more than offset by the lower starting point for spreads. Junk spreads should also come under widening pressure in the very near term, as a December Fed rate hike spurs an increase in implied volatility. Maintain a maximum underweight allocation to high-yield and await a better entry point for spreads in the New Year. MBS: Overweight Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by +2bps in October, but are underperforming the benchmark by -7bps so far in November. Year-to-date, MBS have outperformed the duration-equivalent Treasury index by a mere +22bps. Since the end of September, the conventional 30-year MBS yield has risen +23bps, driven by a +21bps increase in the rate component. The option-adjusted spread has widened +2bps, while the compensation for prepayment risk (option cost) has remained flat. Unattractive option-adjusted spreads and the prospect of further increases in issuance make for bleak long-run return prospects in MBS. However, the likelihood that Treasury yields will continue to rise in the near-term means that MBS could outperform due to a decline in the option cost component of spreads (Chart 4). We will likely reduce exposure to MBS once a December rate hike has been fully digested by the market, and the uptrend in Treasury yields starts to taper off. The Fed's Senior Loan Officer Survey for the third quarter, released yesterday, showed that banks continue to ease standards on GSE-eligible mortgage loans, while demand for these same loans continues to increase. The combination of easing lending standards and strengthening demand means that issuance is likely to continue its march higher, as does the persistent uptrend in existing home sales (bottom panel). Government Related: Overweight Chart 5Government Related Market Overview The government-related index outperformed the duration-equivalent Treasury index by +5bps in October, but has already underperformed the Treasury benchmark by -9bps so far in November. The Foreign Agency and Local Authority sub-sectors drove October's outperformance, returning +24bps and +14bps in excess of Treasuries respectively. Domestic Agency debt outperformed the Treasury benchmark by +3bps, while Supranationals (-7bps) and Sovereigns (-10bps) both underperformed. After adjusting for differences in credit rating and duration, Foreign Agency and Local Authority bonds still appear attractive relative to investment grade U.S. corporate debt. Sovereigns, on the other hand, appear modestly expensive. We continue to recommend avoiding Sovereign issues while remaining overweight the other sub-sectors of the government related index. In a recent report,3 we observed that the performance of sovereign debt relative to equivalently-rated and duration-matched U.S. corporate credit tends to track movements in the U.S. dollar. As such, a continued bull market in the U.S. dollar will remain a significant headwind for sovereigns. At the country level, the only nations whose USD-denominated debt offers a spread advantage over Baa-rated U.S. corporate debt are Hungary, South Africa, Colombia and Uruguay. Unusually, bullet agency debt outperformed callable agency debt last month even though Treasury yields moved higher (Chart 5). Within Domestic Agency bonds, we continue to favor callable over bullet issues on the expectation that this divergence will not persist. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by -12bps in October, dragging year-to-date excess returns down to -152bps (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio is largely unchanged since the end of September, and remains close to its post-crisis average. In recent months, trends in M/T yield ratios have fluctuated alongside the betting market odds for today's Presidential election. A Trump victory would cause yield ratios to widen sharply, as President Trump's promised tax cuts would substantially de-value the tax advantage in municipal bonds. We expect yield ratios to tighten in the event that Clinton prevails, as any expectation of a Trump victory works its way out of the price. Due to attractive yield ratios relative to recent history, we are inclined to remain overweight municipal bonds in the near-term. However, we will likely downgrade the sector if yield ratios move back to previous lows. As we detailed in a recent Special Report,4 historical lags between the corporate and municipal credit cycles suggest that municipal bond downgrades will start to increase in the second half of next year, alongside a deterioration in state & local government balance sheets. Further, state & local government investment spending is poised to move higher next year, regardless of the election result, leading to even greater muni issuance (Chart 6). Elevated fund flows have offset the impact of strong issuance this year, the risk is that they will not keep pace going forward. Treasury Curve: Stay In Flatteners Chart 7Treasury Yield Curve Overview The Treasury curve has bear-steepened significantly since the end of September. The 2/10 Treasury slope has steepened +16bps and the 5/30 slope has steepened +14bps. As a result, our two curve flattener trades have struggled. Our 2/10 Treasury curve flattener has returned -41bps since initiation on September 6. Our 10/30 Treasury curve flattener has returned -25bps since initiation on September 20. Our other tactical trade - short December 2017 Eurodollar - has returned +16bps since initiation on July 12. All three of the above tactical trades are premised on the view that the Fed will deliver a rate hike in December, and that such a rate hike has not yet been fully discounted by the market. At present, we calculate that the market-implied probability of a December rate hike is 62%, as discounted in fed funds futures. The historical pattern suggests the yield curve should bear flatten as the rate hike probability approaches 100%. Unusually, the correlations between both the 2/10 and 10/30 Treasury slopes and the level of Treasury yields have moved into positive (bear-steepening) territory (Chart 7). This is especially unusual for the 10/30 slope, where the correlation has been firmly in negative (bear-flattening) territory since 2013. We continue to recommend holding curve flatteners, and expect both correlations to revert into negative (bear-flattening) territory in advance of a December rate hike, as they did last year. Any surge in bullish dollar sentiment between now and December would only increase the flattening pressure on the curve (bottom panel). So far bullish dollar sentiment has remained relatively flat, but we cannot discount a large increase in the run-up to the next rate hike, as occurred last year. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by +112bps in October. The 10-year breakeven rate has increased +8bps since the end of September, and currently sits at 1.68%. The 10-year TIPS breakeven rate has increased substantially during the past couple months, and has now converged with the fair value reading from our TIPS Financial model (Chart 8). Rising expectations of a Fed rate hike and a flatter Treasury curve will weigh on TIPS during the next month, and we would not be surprised to see breakevens temporarily cease their uptrend as attention turns to Fed hawkishness following today's election. But we also expect that TIPS breakevens will resume their uptrend heading into next year. As we flagged in a recent report,5 the sensitivity of TIPS breakevens to core inflation has increased since the financial crisis. We posit that the reason for this increased sensitivity is that the Fed's ability to control long-dated inflation expectations has been impaired by the zero-lower bound on rates. As a result, the trend in breakevens is increasingly taking its cue from the realized inflation data. Realized inflation continues to trend steadily higher (bottom two panels), and diffusion indexes suggest that further gains are ahead (panel 4). Given that breakevens remain well below pre-crisis levels, we intend to remain overweight TIPS relative to nominal Treasuries and ride out any near-term volatility related to a Fed rate hike. ABS: Maximum Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by +10bps in October, bringing year-to-date excess returns up to +101bps. Aaa-rated ABS outperformed the Treasury benchmark by +8bps on the month, while non-Aaa issues outperformed by +24bps. The index option-adjusted spread for Aaa-rated ABS has tightened -3bps since the end of September and, at 45bps, is considerably below its pre-crisis average (Chart 9). According to our days-to-breakeven measure, there still exists a valuation advantage in Aaa-rated auto ABS relative to Aaa-rated credit card ABS, but that advantage is rapidly evaporating (panel 3). We calculate that it will take 12 days of average spread widening for Aaa-rated auto ABS to underperform Treasuries on a 6-month horizon and 10 days of average spread widening for Aaa-rated credit card ABS to underperform. Moreover, credit card ABS exhibit superior collateral credit quality relative to autos. Credit card charge-offs remain near all-time lows, while the auto net loss rate appears to have bottomed (bottom panel). Further, the Fed's senior loan officer survey shows that auto lending standards have tightened for two consecutive quarters, while credit card lending standards were unchanged in Q3 following 25 consecutive quarters of net easing (panel 4). We recommend investors favor Aaa-rated credit cards over Aaa-rated auto loans within a maximum overweight allocation to consumer ABS. CMBS: Underweight Chart 10CMBS Market Overview Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by +4bps in October, bringing year-to-date outperformance up to +194bps. The index option-adjusted spread for non-agency Aaa-rated CMBS has tightened -3bps since the end of September, and remains very close to its pre-crisis average (Chart 10). The Fed's Senior Loan Officer Survey for the third quarter, released yesterday, showed that banks continue to tighten standards on all classes of commercial real estate (CRE) loans (panel 3). The survey also shows that CRE loan demand continues to increase, though at a less rapid pace than in prior quarters. While CRE prices continue to march higher (bottom panel), tightening lending standards and a rising delinquency rate (panel 4) make us cautious on non-agency CMBS. Agency CMBS outperformed the duration-equivalent Treasury index by +4bps in October, bringing year-to-date excess returns up to +105bps. Agency CMBS still offer 56bps of option-adjusted spread. This is greater than what is offered by Aaa-rated consumer ABS (45bps) and conventional 30-year MBS (19bps) for a similar amount of spread volatility. We continue to recommend overweight positions in Agency CMBS. Treasury Valuation Chart 11Global PMI Model The current reading from our Global PMI Treasury model places fair value for the 10-year Treasury yield at 2.27% (Chart 11). This model is based on a linear regression of the 10-year Treasury yield on three factors, using a post-financial crisis time interval.6 The three factors are: Global Growth: Measured using the Global Manufacturing PMI (sourced from JP Morgan and Markit) Global Growth Divergences: Proxied by bullish sentiment toward the U.S. dollar (sourced from Marketvane.net) Economic Uncertainty: Measured using the Global Economic Policy Uncertainty Index (sourced from policyuncertainty.com) The correlation between the global PMI and the 10-year Treasury yield is strongly positive (panel 3). However, improving global growth is offset by any increase in bullish sentiment toward the U.S. dollar. For a given level of global growth any increase in bullish sentiment toward the dollar represents a drag on interest rate expectations. As such, bullish dollar sentiment enters our model with a negative sign (panel 4). The final component of our model - global economic policy uncertainty - captures changes in Treasury yields related to headline risk and "flights to quality". This factor enters our model with a negative sign - more uncertainty correlates with lower bond yields (bottom panel). Monetary Conditions And Rate Expectations The BCA Monetary Conditions Index (MCI) combines changes in the fed funds rate with changes in the trade-weighted dollar using a 10:1 ratio. Historically, economic downturns have been preceded by a break in this index above its equilibrium level - calculated using the Congressional Budget Office's estimate of potential GDP growth (Chart 12). Using assumptions for the time until the MCI converges with equilibrium and the annual appreciation of the trade-weighted dollar, it is possible to calculate the expected change in the fed funds rate for the cycle. The shaded region in Chart 13 shows the expected path for the federal funds rate assuming that the MCI reaches equilibrium at the end of 2019. The upper-end of the region corresponds to a scenario where the trade-weighted dollar depreciates by 2% per year and the lower-end of the region corresponds to a scenario where the dollar appreciates by 2% per year. The thick line through the middle of the region corresponds to a flat dollar. Chart 12Monetary Conditions Vs. Equilibrium Chart 13Fed Funds Rate Scenarios Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching", dated September 13, 2016, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Special Report, "Don't Chase The Rally In Junk", dated November 1, 2016, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching: An Update", dated October 25, 2016, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Special Report, "Trading The Municipal Credit Cycle", dated October 18, 2016, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching: An Update", dated October 25, 2016, available at usbs.bcaresearch.com 6 For additional details on the model please see U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Model", dated October 11, 2016, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights Portfolio Strategy Bank profits are unlikely to match those of the broad market if the Fed hikes interest rates and loan demand cools. Sell into strength. Gold shares are looking increasingly attractive, but we will refrain from upgrading until the U.S. dollar is closer to a peak. Drug pricing power is worse than government data suggests, warranting a downshift in our previously upbeat view toward pharmaceutical equities. Recent Changes S&P Health Care - Removed from our high conviction list. Upgrade Alert Gold Shares - Currently neutral. Downgrade Alert S&P Pharmaceuticals Index - Currently overweight. S&P Biotech Index - Currently overweight. Table 1 Feature Chart 1From Greed To Fear The gaping mismatch between fundamentals and broad market valuations remains intact, but will be in jeopardy of re-converging should the Fed signal an intention to tighten monetary conditions through next year. As previously outlined, our view is that the economy, particularly the corporate sector, will struggle further if financial conditions become more restrictive and/or election uncertainty persists. Indeed, investors have been scrambling to buy protection, aggressively bidding up near-term VIX contracts, especially relative to longer-term contracts. While it is tempting to view this increase in fear as a contrary positive, this measure typically sinks lower when investors turn cautious. Chart 1 shows that tactical broad market vulnerability still exists. On a more fundamental basis, the non-financial corporate sector's return on equity has already fallen to its lowest level in more than 60 years (Chart 2). Yet the median price/sales and price/earnings ratios are flirting with all-time highs (Chart 2). That divergence is not sustainable, given the direct link between ROE, profit growth and valuations. Central bank benevolence has underwritten this gap. Third quarter earnings have failed to impress thus far, keeping the equity market locked in a tight range. So far, one nascent trend is that domestic and consumer-linked equities appear to be gaining traction at the expense of global, business-dependent sectors. We expect the complexion of earnings contributions to become more lopsided in the quarters ahead, in support of most of these budding trend changes. The inevitable upshot of a strong U.S. dollar is deteriorating profit breadth. Chart 3 shows that the number of industry groups experiencing rising forward earnings estimates is likely to erode as the currency strengthens. Clearly, industries most reliant on exports and/or capital spending are most vulnerable. The corporate sector has run up debt levels and is struggling to generate profit growth. In turn, business spending has been compromised, as measured by the contraction in core durable goods orders (Chart 3). On the flipside, consumers have rebuilt their savings and are enjoying the benefits of a positive wealth effect. The increase in real wage and salary growth is underpinning real median household income. The latter surged 5.2%, posting the largest percentage increase in the history of the data. Consumer income expectations are well supported (Chart 3, top panel). The implication is that consumption-oriented plays should be well positioned to deliver profit outperformance, even if the labor market slows. From an investment theme perspective, the upshot is domestic-oriented areas are poised to make a comeback relative to globally-exposed sectors after a burst of speed in recent months (Chart 4). Net earnings revisions are already shifting in that direction, with more upside ahead based on U.S. dollar strength, as well as dirt cheap relative valuations (Chart 4). Chart 2A Disturbing Mismatch Chart 3Consumers Are Stronger Than Corporates Chart 4Favor Domestic Vs. Global One exception is the banking sector, where there is limited scope for earnings outperformance and/or valuation expansion. Bank Stocks Are Showing Signs Of Life, But... Bank stocks have moved higher, following the sell-off in global bond markets and steepening in yield curves sparked initially by the Bank of Japan's curve targeting shift and a reversal of incremental easing expectations from the Bank of England. However, we are not convinced that the relative performance bear market is over. A Special Report published on October 3 surveyed the performance of banks during Fed tightening cycles, to help put context around the widely held view that Fed rate hikes will bolster bank stocks on a sustained basis. History shows there has been only a loose relationship between the Fed funds rate and net interest margins. It would take rising rate expectations within the context of a steeper yield curve, improving credit quality and rapid loan growth to justify an optimistic profit outlook. Bank profits have not been able to outpace the broad corporate sector since the beginning of 2015 (Chart 5, top panel), even though loan growth has been healthy and overall earnings were crushed by the implosion in commodity prices during that period, allowing most other sectors to show earnings outperformance. Will another 25 bps interest rate hike remedy this? The Fed is keen to hike rates partially because it views them as being overly accommodative for an economy operating close to full employment, and is keen to reestablish firepower in advance of the next economic downturn. But there is scant evidence of economic overheating to support the view that rates have been 'too low'. Inflation and inflation expectations, while up from very depressed levels, are still historically low and the economy is struggling to grow at, let alone above, trend. Consequently, a strident Fed would boost the odds of a policy mistake. The market appears to share that view, given the failure of the yield curve to stop narrowing since the taper talk started, notwithstanding the recent blip up (Chart 5, bottom panel). Chart 5Why Would Bank Profits Outperform Now? Chart 6Beware U.S. Dollar Strength Now that the USD is strengthening anew, the odds of imported deflation have climbed, to the detriment of corporate profits and bank stock relative performance (Chart 6, top panel). While nominal yields have backed up, real 2-year yields have declined, which is not consistent with an upgrading in economic expectations. Indeed, C&I loan growth has dropped sharply in recent weeks (Chart 6). By extension, it is hard to envision long-term yields rising much, if at all, which will keep net interest margins thin. Furthermore, if overall earnings remain stuck in neutral, corporate credit quality will undoubtedly worsen given the debt binge in recent years. Non-performing loans have only just begun to increase. Higher interest rates will not solve these problems. Instead, the downturn in credit quality could accelerate via more onerous debt servicing requirements, given the lack of a corporate sector balance sheet cushion. Perhaps more worrying is that banks are no longer pruning cost structures, which is unusual given that credit standards are tightening on most credit products outside of traditional mortgages. In the last 25 years, or as far back as we have the data, bank stocks lagged the broad market after bank employment started rising. The only exception was in the aftermath of the tech bubble, when all non-TMT sectors outperformed (Chart 7). If banks continue to expand their wage bill, without a widening in net interest margins and/or reversal in increased loan loss reserving, bank profits will fail to match the growth rate of the overall S&P 500. The optimal, but not exclusive, time for banks to outperform is typically exiting recession, when policy is easing and the yield curve is steepening, and in the late innings of an expansion. In fact, productivity is sagging throughout the financial sector. Financial sector employment is probing new highs (Chart 8), reflecting a more onerous cost structure required to meet regulatory obligations. Employment is now growing faster than sales, a reliable indication of flagging productivity. The implication is that financial sector profits will continue to lag those of the broad market. Chart 7Beware Rising Bank Employment Chart 8Sectoral Productivity Drain Bottom Line: Strength in bank stocks is a chance to sell. Is It Time To Buy Back Gold Shares? Gold shares are bouncing after having been punished in the last few months. Overheated technical conditions and prospects for a more hawkish Fed led us to recommend taking profits in August, despite a positive long-term outlook. Indeed, the likelihood of a prolonged period of negative to ultra-low real interest rates is high given startlingly low potential GDP growth in most of the developed world. Gold shares typically do well in the aftermath of a debt binge, as proxied by our Corporate Health Monitor (CHM, shown advanced, Chart 9). It is unnerving that the CHM has suffered such a broad-based deterioration without any back up in interest rates. Low interest rates and tight credit spreads have cushioned what has otherwise been a stark erosion in debt servicing capabilities: there is little scope for a parallel upshift in the global interest rate structure. These are bullish conditions for gold shares, as captured by the upbeat reading in our Cyclical Gold Indicator (Chart 9, top panel). As such, when we took profits we advised that we would look to return to an overweight position once tactical downside risks had been reduced. Are we there yet? Chart 10 suggests that extreme bullishness toward the yellow metal has not yet fully unwound. While the share price ratio has dropped back to its 200-day moving average, cyclical momentum remains elevated, as measured by the 52-week rate of change. Sentiment in the commodity pits is still elevated, flows into gold ETFs are still strong and net speculative positions have not yet made a full retreat (Chart 10), especially in view of the recent politically-motivated pop in market volatility. The implication is that there could be additional selling pressure in the coming weeks. Chart 9Cyclically Appealing, But... Chart 10... Still Tactically Frothy Chart 11The Currency Is Critical In terms of potential buy triggers, anything that causes the U.S. dollar to lose its bid is a strong candidate. Ironically, a Fed rate hike could produce such an outcome, contrary to popular wisdom. In our view, the U.S. (and global) economy cannot handle tighter financial conditions, and a rise in interest rates would need to be offset by a weaker currency. Gold shares perform well when economic expectations are faltering (Chart 11, shown inverted), and a hawkish Fed would likely raise global economic fears. On the flipside, a go-slow Fed could keep the currency bid. That would allow the economy more time to heal and recover, and possibly overheat, thereby potentially boosting future returns on capital, certainly relative to other countries where output gaps remain larger. Bottom Line: Stay neutral on gold stocks, but put them on upgrade alert in recognition that an upgrade back to overweight could occur sooner rather than later, i.e. by yearend, depending on macro dynamics. What To Do With Drug Stocks? A number of drug wholesalers reported earnings misses and provided disappointing guidance, specifically citing worse than expected generic pricing pressure, enough to offset ongoing branded drug price increases. In the current environment of political uncertainty toward health care companies, the knee jerk reaction has been to abandon all pharmaceutical-related equities, regardless of exposure to branded or generic medicines. Our pharmaceutical equity view has noted that the time to worry about the pace of drug price increases would be if they sparked a change in consumption patterns and/or buyer behavior. The fact that major buying groups such as health insurers and pharmacy benefit managers are balking at generic drug price increases constitutes such a shift. Consumer spending on drugs has slowed, albeit that has not been confirmed by neither strong retail drug store sales nor booming hospital employment (Chart 12). Nor is there an unwanted inventory build (Chart 12). Nevertheless, in light of new information, which implies that company-reported pricing pressure is worse than current government data shows, we are downgrading our outlook for drug-related shares. Still, rather than sell after the index has already taken a large hit, pushing relative performance to oversold and undervalued levels (Chart 12), we will await a more opportune moment to lighten positions, especially in view of our preference for defensive equities. Keep in mind that the drug price increases are still well in excess of the overall rate of inflation as branded drug prices continue to rise (Chart 13), and earnings stability should be increasingly desirable as the U.S. dollar climbs. In the meantime, drug-related shares are now on downgrade alert and the overall health care sector is off our high-conviction list. The good news is that other parts of the health care sector should benefit if drug inflation cools. For instance, a reduction in the rate of drug price increases, and in the case of generics, outright price cuts, is a blessing for the S&P managed care industry. Cost inflation had been perking up, but should ease in the coming quarters as drug expenses abate. Health insurance premiums are growing at a faster rate than overall inflation, while job growth remains decent (Chart 14), underscoring that top-line growth is still outpacing that of the overall corporate sector. If cost inflation eases while revenue climbs, the index should move to at least a market multiple from its current discounted valuation. Importantly, technical readings have improved. Chart 12Under The Gun... Chart 13... But Pricing Power Remains Strong Chart 14Celebrating Reduced Cost Inflation Cyclical momentum has begun to reaccelerate from neutral levels after unwinding overbought conditions (Chart 14), suggesting that a breakout to new relative performance highs is in the offing. Bottom Line: The pain in drug-related shares should provide a gain to health care insurers. Stay overweight the S&P managed care index. However, look to lighten the S&P pharmaceutical and biotech indexes on a relative performance bounce in the coming weeks, both are now on downgrade alert. Current Recommendations Current Trades Size And Style Views Favor small over large caps and growth over value.

Highlights Bond yields have room to move higher in the near run, but a move above 2% would represent a buying opportunity. U.S. elections are too close to call. Even if Trump wins, we caution that federal fiscal spending programs will have to work hard to offset the ongoing drag from sluggish state and local spending. Economic and inflation data will not stand in the way of a Fed rate hike in December. But heightened market volatility associated with the elections could still derail their plans. Feature October was a tough month for Treasuries, as the 10-year climbed 25 basis points since October 1. The sell-off puts Treasury yields closely in line with our bond strategists' estimate of fair value. This week, we review the factors that argue for or against a further rise in bond yields. Our conclusion is that the Treasury sell-off is likely to continue in the near run. Yields above 2% would represent a buying opportunity. The primary bearish driver for Treasuries in the next two months is the Fed. As we discuss below, recent economic data has been decent enough to meet the Fed's threshold for a rate hike and inflation indicators are moving towards the Fed's 2% target. Indeed, the FOMC statement released last Wednesday sent a mildly hawkish signal by highlighting that growth has improved, while both inflation expectations and realized inflation are tracking higher. The statement very much keeps a December rate hike in play, but it does not elevate the odds. In the FOMC meeting just prior to last year's rate hike, the Fed specifically mentioned the "next meeting" as a possibility for a rate increase. The Fed did not go as far this time around1 as policymakers are no doubt wary of spooking the markets when uncertainty is running high ahead of the U.S. election. Whether the Fed actually pulls the trigger in December will continue to hinge on the incoming economic data and the behavior of the markets following the election, but our base case remains that the Fed will follow through with a rate hike. The market is currently priced for a 65% chance of a rate move before the end of the year. This is roughly the same as the probability of a 2015 rate hike at this time last year (Chart 1). As long as the economic data remain reasonably firm, as we expect, then rate hike probabilities should follow last year's path and move to 100% by the December 13-14 FOMC meeting. Last year, the revision in the rate hike probability from November-December corresponded with a 35 bps rise in the 10-year Treasury. Chart 1Room For Expectations To Move Higher Since last year, the Fed has drastically downgraded its long-term rate projections. Recall that ahead of the December 2015 FOMC meeting, the Fed projected that the Fed funds rate would reach 1.4% in 2016. Since then, the Fed has revised downward its interest rate forecast to two rate hikes in 2017. Assuming the Fed does not revise these forecasts, it is unlikely that Treasuries respond as negatively as they did in 2015. Moreover, as we noted above, at 1.8% today, Treasuries are already roughly at fair value. During last year's sell-off, bond yields were starting from a substantially overbought level. This argues for a somewhat more muted reaction to a Fed rate hike, although we still expect yields could move higher. Beyond December, i.e. once the rate hike is priced in, our base case is that yields trend sideways for a time. The Fed's forecast for growth in 2017 is 2.0%, which would represent an increase of 0.5% from the first three quarters of 2016. If economic growth meets the Fed's expectation of 2%, then it is reasonable to expect that policymakers would increase twice next year, i.e. in line with their current forecasts. As shown in Chart 1, the Treasury market is not yet priced for this outcome: market participants currently assign only 80% odds to one rate hike by the end of 2017. The message is that the Fed, even with a reasonable (for the first time in years!) forecast for growth, will end up being a source of upward pressure on bond yields beyond 2017. There is nonetheless an important mitigating factor for bond yields: the U.S. dollar. A stronger currency represents a tightening of financial conditions that acts to depress expectations of future economic growth. This can spell trouble for risk assets and also lower the market-implied odds of future rate hikes. Indeed, a central bank can tighten monetary conditions, but does not have control over how much of the tightening comes via interest rates and how much through currency appreciation. In the current environment, the Fed knows that the process of normalizing interest rates will trigger bouts of volatility, because its actions will be exaggerated by movements in the currency. The bottom line is that we expect the Fed to tighten in December, followed by two more quarter-point hikes in 2017. Given that the bond market is not yet priced for this, the recent sell-off in bond yields will continue, perhaps to as high as 2%. Thereafter, we would expect Treasuries to trade in a fairly narrow range, with 2% representing the higher end of the band. A Coin Toss Election In the very near term, the U.S. elections pose an important risk to the view expressed above. For the past several months, market odds of a Trump Presidency have been positively correlated with the uncertainty index and negatively correlated with Treasury yields (Chart 2 and Chart 3). On the eve of the election, the race is once again too close to call. Our expectation has been that any flight-to-quality related to a Trump victory will be short-lived. However, with equity market multiples stretched and the earnings outlook still leaving much to be desired, equity markets are ripe for a correction. Chart 2Bond Market Tracks Uncertainty Chart 3Trump And Uncertainty In our September 26 Weekly Report, we warned that investors may be assigning too low odds of a Trump Presidential win. We posited that if the polls remained tight, the potential for further volatility was high. We followed up in mid-October, advising clients how to implement portfolio insurance against downside market risks, and specifically against a Trump election win. One recommended vehicle for insurance that we highlighted was the U.S. dollar, which is part of our Protector Portfolio (Chart 4 and Chart 5). We believe the currency will rally due to the combination of coming fiscal expansion and risk aversion flows on the back of a Trump win. True, this strategy has not held up in recent days, as the U.S. dollar has softened while Trump improves in the polls and risk assets have corrected. Still, the dollar's reputation as a safe-haven currency is well-deserved. It has consistently outperformed during times of crisis - even when the U.S. itself was the source, as most recently demonstrated during the summer 2011 budget impasse. Chart 4Protector Portfolio Components Chart 5Protector Portfolio Returns In a recent report,2 our geopolitical strategists outline several things to watch for on November 8, the day of the election, and in its immediate aftermath. The immediate developments most relevant for investors are anything that prolongs the period of uncertainty regarding voting. For example, the 2000 election is a reminder that the results may not be clear immediately. Although the 2000 election was held on November 7, the official result was not declared until November 26; Al Gore did not concede until December 12. This time, any number of things could delay declaring a winner, including a tie in the electoral college, or a "faithless elector," i.e. an electoral college member that does not cast his/her ballot for the candidate chosen by popular vote, and therefore causes the Supreme Court to intervene. A delay in declaring the election result would increase uncertainty and therefore be negative for risk assets. Longer term, the margin of victory has become important for policy. It is now clear that a Clinton win, if it were to happen, will be a narrow one. According to our Geopolitical Strategy team, it is almost guaranteed at this point that the chances of a Democratic sweep in the House of Representatives are zero. This is a positive development for the market as a Democratic sweep would mean a slew of anti-business regulation out of Congress. Nonetheless, a narrow win - with sub-50% of the vote - would give Hillary Clinton an extremely weak mandate. The probability of a compromise between the White House and GOP in Congress is therefore declining and puts in jeopardy any possibility of modest fiscal stimulus under a Clinton White House, or of corporate tax reforms. The likelihood of more fiscal spending in 2017 has become common lore among investors. Thus, a disappointment on that front would be negative for risk assets. Post-Election Government Spending Throughout the twists and turns of the U.S. election campaign, one higher conviction view that has endured at BCA is that popular sentiment is shifting away from fiscal austerity and that 2017 would feature more ambitious spending programs. That would be quite welcome, given that real government consumption and investment - at all levels of government - has been a drag on growth during most of the recovery since the Great Recession. Ongoing weakness at the Federal level is due to restraint in defense expenditure, while state and local spending has been weak due to a significant downtrend in tax revenues. It is notable that the decline in state tax revenues is not confined to oil-producing states. A recent report by the Rockefeller Institute compiled state tax revenue forecasts for 2017 and concludes that the decline in tax revenues from all sources (sales, income and corporate) will be slow to recover next year.3 Remember that states can only spend what they take in outside of infrastructure spending. If state and local governments can manage to cut the drag on real GDP to 0%, that would still leave a major onus for government spending on the federal government. Assuming the contribution to real GDP from state and local spending is zero, it would require a 6% annual growth in federal spending to return total government spending as a contribution to GDP back to its historic average of 0.4% (Chart 6). As Chart 7 shows, fiscal spending of that magnitude rarely occurs outside of recession. Chart 6(Part 1) How Much Fiscal Spending? Chart 7(Part 2) How Much Fiscal Spending? Importantly, how much long-term effect a fiscal boost will deliver depends on how well fiscal multipliers - which measure how much a dollar of increased government spending or reduced taxes raises output - are working. Indeed, the magnitude of fiscal multipliers continues to be a massive source of disagreement in policy circles. Recent work by the IMF suggests that the multiplier, in some economies and under certain interest rate settings, could be as high as four: for each dollar the U.S. government spends, it will generate another $4 dollars of GDP!4 Other academics put the fiscal multiplier at less than 0.5. The wide range of forecasts is due to several factors, but there are nonetheless some generally held principles: Fiscal stimulus tends to be more effective when the output gap is large: when output is well below its potential, the monetary policy response to an increase in spending is likely to be limited. In other words, fiscal multipliers are larger in recessions than in expansions.5 The type of fiscal stimulus matters, a lot. Table 1 shows a range of CBO estimates for different types of government activity. For example, income tax cuts on high income earners tend to have a low multiplier effect (well below 1), while direct spending by government, e.g. infrastructure outlays, tends to have a much higher multiplier (above 1). Multiplier effects tend to last no more than eight quarters when output is close to potential. Fiscal stimulus tends to have a more impressive impact, although short-lived (four quarters) when the output gap is large. Table 2 shows the CBO-estimated effect of an increase in demand over eight quarters under two different economic scenarios. The first is when monetary policy is constrained, and the second is when monetary policy responds to the increase in demand from government stimulus. Our guess is that we are currently somewhere in between the two economic scenarios presented: there is still an output gap and monetary policy is already off the zero bound. Thus, the fiscal multiplier is likely a little above than one, meaning that government spending does not "crowd out" private spending. Table 1Ranges For U.S. Fiscal Multipliers Table 2The Effect Of A $1 Increase In Aggregate Demand Over Eight Quarters Overall, government expenditures will contribute positively to GDP next year, though the amount of fiscal expansion is dependent on the political configuration in Washington after the elections. Similarly, the impact of any spending will depend on what form new fiscal measures takes. CBO research suggests that the fiscal multiplier will be slightly above 1. Business Sentiment: Neither Euphoria Nor Misery Without further participation from the government sector, the economy is likely to achieve above 2% real GDP growth. A more optimistic scenario could unfold if capex improves substantially and/or a Trump win significantly opens the fiscal taps. Recent private sector data shows that businesses are continuing on a mild expansion path. The ISM surveys of business confidence were little changed in October - sentiment among manufacturers is broadly unchanged, while respondents from the service sector were slightly less optimistic than the previous month (Chart 8). Still, the major indices remain above their boom/bust lines and respondents' comments suggest neither euphoria nor misery. Meanwhile, payrolls increased by 161,000 in October. Although this was slightly below the consensus forecast of 175,000, there was a cumulative 44,000 in upward revisions to the prior two months. Elsewhere, wages accelerated more than expected and average hourly earnings rose 0.4% m/m, pushing the annual growth rate to a new cyclical high of 2.8% (Chart 9). Chart 8ISM Surveys Are Steady Chart 9Wage Growth Is Perking Up To paraphrase from this week's FOMC statement, the employment report provides some further evidence that the U.S. economy is progressing towards the Fed's dual mandate. In itself, it reinforces the case for the Fed raise interest rates in December. It seems now that the only thing that could derail the Fed is an election surprise and related heightened market volatility. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 https://www.federalreserve.gov/newsevents/press/monetary/20151028a.htm 2 Please see Geopolitical Strategy Special Report "It Ain't Over 'Till The Fat Man Sings," dated November 1, 2016, available at gps.bcaresearch.com 3 http://www.rockinst.org/pdf/government_finance/state_revenue_report/2016-09-21-SRR_104_final.pdf 4 https://www.imf.org/external/pubs/ft/wp/2014/wp1493.pdf 5 "How Powerful Are Fiscal Multipliers In Recessions? Alan Auerbach and Yuriy Gorodnichenko, NBER Reporter 2015, http://www.nber.org/reporter/2015number2/auerbach.html

Dear Client, In addition to this week's regular Weekly Report, you should have also received a Client Note written by my colleague Marko Papic discussing the upcoming U.S. presidential election. Marko argues that the election is now too close to call. Donald Trump's resilience in the polls continues to baffle most observers. Not us. Back in September of 2015, when most pundits were laughing off Trump's chances, we wrote a report arguing that Trump's rhetoric would resonate with voters much more than most people thought possible. That report, entitled "Trumponomics: What Investors Need To Know," is as relevant today as it was back then. Best regards, Peter Berezin Highlights Spare capacity has narrowed substantially within the developed world. Most of the decline in spare capacity is attributable to lackluster supply, rather than stronger demand. Potential GDP growth is likely to remain weak over the coming years. Narrowing output gaps will put upward pressure on inflation. We are long Japanese and German inflation protection. As spare capacity continues to dwindle, forward guidance will become a more effective tool for central banks. At least in this respect, central bankers may find themselves with a few more bullets in their arsenals. Stay long the dollar and position for gradually higher government bond yields. Global equities are highly vulnerable to a near-term correction, owing to a more hawkish Fed and growing U.S. election uncertainty. Once the dust has settled, European and Japanese stocks will outperform their U.S. peers. Feature Spare Capacity Is Dwindling A persistent shortfall of aggregate demand has been the defining feature of the global economic landscape ever since the financial crisis erupted. This chronic lack of spending has kept inflation below target in most developed economies, forcing central banks to adopt ever more radical easing policies. That is starting to change. Spare capacity continues to decline, allowing once dormant supply-side constraints to reimpose themselves. In this week's report, we take stock of where we are in this process. Mind The (Output) Gap The simplest measure of spare capacity is the so-called output gap, which estimates the difference between what economies are actually producing and what they are capable of producing without putting undue upward pressure on inflation. According to the IMF, the output gap for advanced economies has narrowed from a high of 3.8% of GDP in 2009 to 0.8% at present. The OECD's measure shows a similar decline (Chart 1). Chart 1AOutput Gaps Have Narrowed Chart 1BOutput Gaps Have Narrowed The IMF reckons that the output gap has nearly closed in the U.S. and the U.K. The Fund estimates that Japan's output gap currently stands at 1.5% of GDP. The OECD also sees the U.K. output gap as being fully closed. However, it calculates a smaller output gap for Japan but a larger output gap for the U.S. than the IMF does. Both institutions peg the euro area's output gap at around 1%-to- 1.5%. Not surprisingly, there is a fair bit of variation within continental Europe. The output gap in Germany has fully disappeared, but still stands at 2%-to-3% of GDP in Italy and Spain. Naturally, one should take these numbers with a grain of salt. Output gaps are notoriously difficult to calculate and are subject to large revisions. The OECD, for example, tends to rely on statistical approaches to estimate output gaps.1 These typically involve employing tools such as the so-called "Hodrick-Prescott filter" to smooth out historical GDP data and then treating the resulting trendline as an estimate for potential GDP. Such methods have their uses, but they can go badly awry in situations where GDP is slow to return to its "true" underlying trend. This is a particular worry in the current environment, considering that recoveries following burst asset bubbles tend to be lethargic even in the best of times. The fact that fiscal policy has been fairly tight and monetary policy has been constrained by the zero lower bound has further dampened the recovery. With that in mind, rather than relying on purely statistical techniques, it is useful to measure spare capacity directly. We do this by gauging the extent to which the existing factors of production - labor and capital - are being effectively deployed across the major developed economies. As we argue below, this approach suggests that slack may be modestly higher in Japan than what the IMF and the OECD calculate, and more meaningfully understated in peripheral Europe. The Message From Headline Unemployment Rates Unemployment has been falling in almost all major developed economies (Chart 2). In the U.S. and the U.K., the jobless rate is back to pre-crisis levels. In Germany and Japan, it is below where it was before the Great Recession. As such, it is unlikely that unemployment can decline much in these economies. Chart 2AUnemployment Rates Have Declined Chart 2BUnemployment Rates Have Declined In contrast, while unemployment rates in peripheral Europe have been trending lower over the past three years, they are still quite high by historical standards. There is some debate over whether they can fall much further. The OECD, for example, contends that Spain is already close to full employment, even though the country's unemployment rate still stands at nearly 20%. We find this implausible. The OECD essentially takes a moving average to calculate structural unemployment rates in various economies. As noted above, this can be highly misleading in circumstances where the forces pushing an economy towards full employment are impaired. In general, this suggests that both the IMF and the OECD estimates of labor market slack in the euro area are too low. This is consistent with a recent ECB research paper, which calculated that the euro area's output gap was 6% of GDP in 2015, a far cry from the European Commission's estimate of 1.1%.2 Disguised Unemployment The unemployment rate is probably the single best measure of labor market slack. However, it can understate the true amount of spare capacity during periods when many people have stopped looking for work, or when those who are employed are not working as much or as intensively as they would like. The nature of this additional labor market slack differs from region to region. In the U.S., it has mainly manifested itself in lower labor force participation rates; whereas in Europe - perhaps in keeping with the more egalitarian nature of European society - it has mainly taken the form of fewer hours worked and a higher incidence of involuntary part-time employment. Chart 3 shows that labor force participation rates among prime-age workers (those between the ages of 25-and-54) in Europe are generally higher now than they were before the financial crisis. In contrast, the share of workers who have part-time jobs but desire full-time employment remains elevated across most of continental Europe (Chart 4). The average annual number of hours worked per employee has also declined in most European economies (Chart 5). Chart 3ALabor Force Participation Rate ##br##Has Risen In Europe, But Fallen In The U.S. Chart 3BLabor Force Participation Rate ##br##Has Risen In Europe, But Fallen In The U.S. Chart 4AEurope: Higher Incidence Of ##br##Involuntary Part-Time Employment Chart 4BEurope: Higher Incidence ##br##Of Involuntary Part-Time Employment In the U.S., the prime-age labor force participation rate is still 1.9 points lower than it was in 2007. Part of this is cyclical. As long as the labor market continues to improve, participation rates among prime-age workers should continue to recover. That's the good news. The bad news is that ongoing structural forces are likely to prevent the participation rate from returning back to its pre-crisis levels. Chart 6 shows that labor force participation rates among U.S. prime-aged males has been trending lower since the 1960s. The decline has been particularly acute among less-educated workers. Why this has happened remains a source of intense debate. Conservative commentators have argued that cultural shifts have reduced the social pressure on men to maintain gainful employment. Liberal commentators have contended that falling real wages at the lower end of the skill distribution have reduced the incentive to work. Whatever the reason, it will be difficult to boost labor participation substantially from current levels. At present, 11% of U.S. prime-aged nonparticipants report wanting a job, only modestly higher than before the recession (Chart 7). It is possible that some fraction of those who do not want to work will change their minds - indeed, this year has seen a modest inflow of "disabled" people back into the labor force. Realistically, however, this is unlikely to boost labor participation by more than one percentage point. Chart 5Hours Worked ##br##In Europe Have Declined Chart 6U.S.: The Less Educated ##br##Are Shunning The Labor Force Chart 7U.S.: Fewer Potential Workers ##br##On The Sidelines Chart 8Japan's Underutilized Labor Force The incidence of involuntary part-time employment in Japan has returned to where it was prior to the Great Recession. However, in absolute terms, it remains quite high - in fact, nearly as high as in Europe. Japanese full-time employees may also not be as productively engaged as they could be. As evidence, note that output-per-hour in Japan is 37% lower than in the U.S. and 33% lower than in Germany (Chart 8). From this we conclude that there is somewhat more labor market slack in Japan than the headline unemployment rate suggests. Industrial Capacity Utilization Goods-producing sectors typically account for less than a third of GDP in most advanced economies. Nevertheless, because the demand for goods tends to be more volatile than the demand for services, fluctuations in industrial production often account for the bulk of the changes in output gaps. As Chart 9 shows, after a brisk recovery following the financial crisis, the U.S. industrial capacity utilization rate has been trending lower for the past two years. It currently stands at 75.4%, 5.6 percentage points lower than at its pre-recession peak. The Institute for Supply Management's semi-annual capacity utilization survey also suggests that many U.S. manufacturing businesses are operating substantially below potential (Chart 10). Much of the deterioration in U.S. industrial utilization reflects the effects of the energy bust and a stronger dollar. Business capex has decelerated sharply as a consequence of these forces, falling by over two-thirds in the case of energy capex. This should cut into excess capacity. Chart 9U.S.: Industrial Capacity ##br##Utilization Remains Low Chart 10U.S.: Less Slack In Services ##br##Than Manufacturing The dearth of new investment elsewhere in the world should also help prop up utilization rates (Chart 11). Industrial utilization is close to its historic average in Europe. Unlike in the case of labor markets, there is not a lot of regional variation in capacity utilization rates across the euro area. If anything, Italian spare capacity is actually closer to its pre-recession level than Germany's. Chart 11AEurope: Idle Industrial Capacity Is Shrinking Chart 11BEurope: Idle Industrial Capacity Is Shrinking Chart 12Excess Capacity Has Declined In Japan Capacity utilization has also returned to its long-term trend in Japan. Encouragingly, the Tankan Factor Utilization Index has risen to its highest level since the early 1990s (Chart 12). Nevertheless, the strong yen is starting to put pressure on Japan's industrial sector. This suggests that further monetary easing from the BoJ will be necessary. Economic And Investment Implications Our analysis suggests that spare capacity has narrowed substantially within the developed world, although for some countries not quite as much as output gap estimates from the IMF and the OECD indicate (particularly in the case of peripheral Europe). Unfortunately, most of the decline in spare capacity is attributable to lackluster supply, rather than faster demand growth (Chart 13). Interestingly, a cyclically-induced withdrawal of workers from the labor market has only played a modest role in explaining the slowdown in potential GDP growth and the resulting decline in output gaps. Instead, most of the deceleration in potential GDP growth stems from lower productivity gains. Chart 13AWeak Supply Growth Has Narrowed Output Gaps Chart 13BWeak Supply Growth Has Narrowed Output Gaps Some of the decline in productivity growth reflects cyclical factors, especially weak business investment. However, as we have discussed in past reports, much of it reflects structural forces such as declining educational achievement and a shift in focus of internet innovation away from business productivity applications towards consumer services such as social media.3 Looking out, narrowing output gaps will put upward pressure on inflation. We are long Japanese and German inflation protection via the CPI swap market. Governor Kuroda has made it clear that he wants Japanese inflation to rise above 2% to make up for the fact that inflation has perpetually undershot the BoJ's target. The Bundesbank may not want higher inflation, but the ECB's need to reflate Southern Europe all but guarantees such an outcome. As spare capacity continues to dwindle, forward guidance will become a more effective tool for central banks. The essence of forward guidance is the commitment to keeping monetary policy ultra loose even when the economy begins to overheat. If people believe that the central bank will keep the punch bowl filled, this could cause long-term inflation expectations to rise, leading to lower real yields and increased spending today. Such a commitment is likely to be regarded as more credible if people expect it to be carried out over the next few years, rather than at some distant point in the future. The Bank of Japan has already moved in that direction with its pledge to engineer an inflation overshoot by keeping the 10-year JGB yield anchored at zero. Chart 14China: On The Mend, Cyclically The U.S. has the smallest output gap, but the highest neutral interest rate, among the major developed economies. This week's FOMC statement strongly hinted at a December rate hike. As we discussed two weeks ago, in addition to one hike this year, we expect the FOMC to hike rates twice next year.4 This should cause the real broad trade-weighted dollar to appreciate by 10% over the next 12 months. A stronger dollar will mitigate some of the upward pressure on U.S. bond yields. Nevertheless, as slack continues to erode and inflation shifts higher, Treasury yields, along with bond yields elsewhere, should continue trending higher. Global equities are currently highly vulnerable to a near-term correction, owing to a more hawkish Fed and growing U.S. election uncertainty. We are currently short the NASDAQ 100 futures as a hedge, a trade that has gained 3.1% since we initiated it. Once the dust has settled, European and Japanese stocks will outperform their U.S. peers. This is partly because U.S. stocks are relatively expensive, but it is also because an ascending dollar will hurt U.S. multinationals. Investors should overweight Japanese and European stocks on a currency-hedged basis within the developed market universe. The outlook for emerging markets is mixed. On the one hand, the recent uptick in Chinese growth - as evidenced by this week's better-than-expected PMI data (Chart 14) - should provide some support to commodity prices and EM assets. On the other hand, a stronger dollar will weigh on commodities, while making it more onerous for some emerging market companies to refinance their dollar-denominated loans. Higher U.S. rates could also reduce the global pool of dollar liquidity, making it difficult for some emerging markets to finance their current account deficits. On balance, a modestly underweight stance towards EM assets is warranted. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 The IMF uses a more ad hoc approach. Desk economists have significant leeway in how they estimate output gaps for their respective economies. Most economists rely on statistical models and production function calculations, intermixed with educated guesswork. 2 Marek Jarocinski, and Michele Lenza, "How Large Is The Output Gap In The Euro Area," ECB Research Bulletin 2016, July 1, 2016. 3 Please see Global Investment Strategy Special Report, "Slower Potential Growth: Causes And Consequences," dated May 29, 2015; and Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com. 4 Please see Global Investment Strategy Weekly Report, "Better U.S. Economic Data Will Cause The Dollar To Strengthen," dated October 14, 2016, available at gis.bcaresearch.com. Strategy & Market Trends* Tactical Trades Strategic Recommendations Closed Trades

Highlights By now, the Kingdom of Saudi Arabia (KSA) and Russia have figured out that if each cuts 500k b/d of production, the revenue enhancement for both will be well worth the foregone volumes. Even without additional cuts from other OPEC and non-OPEC producers - most of whom already have seen output drop as a result of OPEC's market-share war - KSA and Russia benefit. A 1mm b/d cut would accelerate the draw in oil inventories next year, allowing U.S. shale-oil producers to quickly move to replace shut-in output. Importantly, shale producers' marginal costs will then begin to set market prices. Longer term, KSA and Russia would have to manage their production in a way that keeps shale on the margin. Whether they can continue to cooperate over the long term remains to be seen. Energy: Overweight. We are recommending investors go long February 2017 $50 Brent calls vs. short $55 Brent calls, in anticipation of a production cut from KSA and Russia. Base Metals: Neutral. We remain neutral base metals, despite the better-than-expected PMIs for China reported earlier this week. Precious Metals: Neutral. We are moving our gold buy-stop to $1,250/oz from $1,210/oz, expecting higher core PCE inflation. Ags/Softs: Underweight. We are recommending a strategic long position in Jul/17 corn versus a short in July/17 sugar. Feature The options market gives a 43% probability to Brent prices exceeding $50/bbl by the end of this year (Chart of the Week). We think these odds are too low, given our expectation KSA and Russia will announce production cuts of 500k b/d each at the OPEC meeting scheduled for November 30, 2016 in Vienna. Chart of the WeekOptions Probability Brent Exceeds $50/bbl By Year-End Is Less Than 50% A production cut totaling 1mm b/d - plus whatever additional volumes are contributed by GCC OPEC members - will, in all likelihood, send Brent prices back above $50/bbl by year end. This is a fairly high-conviction call for us: We are putting the odds prices will exceed $50/bbl by year-end closer to 80%. As such, we are opening a Brent call spread, getting long February 2017 $50 Brent calls vs. short $55 Brent calls, in anticipation of this production cut from KSA and Russia.1 There are two simple facts driving our assessment: KSA and Russia are desperate for cash - they're both trying to source FDI, and will continue to need external financing for years. They can't wait for supply destruction to remove excess production from the market, given all they want to accomplish in the next two years. The vast majority of income for these states is derived from hydrocarbon sales - 70% by one estimate for Russia, and 90% for KSA - and both have seen painful contractions in their economies during the oil-price collapse, which forced them to cut social spending, raise fees, issue bonds and sell sovereign equity assets.2 With the exception of KSA, Russia, Iraq and Iran, most of the rest of the producers in the world have seen crude oil output fall precipitously - particularly poorer non-Gulf OPEC states (Chart 2), and market-driven economies like the U.S. (Chart 3). Thus, KSA's insistence that others bear the pain of cutting production has already been realized. Iran and Iraq, which together are producing ~ 8mm b/d, maintain they should be exempt from any production freeze or cut, given their economies are in the early stages of recovering from economic sanctions related to a nuclear program and years of war, respectively. Chart 2GCC OPEC Production Surges, ##br##Non-Gulf OPEC Production Collapses Chart 3Russia' Gains Lift Non-OPEC Production;##br## U.S. Declines Continue Why Would KSA And Russia Act Now? Neither trusts the other, which is why neither cut production unilaterally to accelerate storage drawdowns. Any unilateral cut would have ceded market share to the arch rival. Both states have gone to great efforts to show they can increase production even in a down market, just to make the point that they would not give away hard-won market share (Chart 4). Chart 4KSA and Russia Devoted##br## Significant Resources to Lift Production These states are at polar-opposite ends of the geopolitical spectrum - KSA is supporting Iran's enemies in proxy wars throughout the Middle East, while Russia is supporting Iran and its allies. In the oil markets, they are both going after the same customers in Asia and Europe. Each state had to convince the other it could endure the pain of lower prices, which brought both to the table at Algiers, and allowed their continued dialogue since then to flourish. Globally, the market rebalancing already is mostly - if not completely - done. Excess production has been removed from the market, and very shortly we will see inventory drawdowns accelerate. But, if KSA and Russia leave this process to the market, we may be looking at 2017H2 before stocks start to draw hard. By cutting production now, KSA and Russia accelerate the stock draw and hasten the day when shale is setting the marginal price in the market. While shale now is comfortably in the middle of the global cost curve, it still sits above KSA's and Russia's cost curve, which means the marginal revenue to both will be higher than if their marginal costs are driving global pricing. Both states have a lot they want to do next year and in 2018: Russia is looking to sell 19.5% of Rosneft; KSA is looking to issue more debt and IPO Aramco. Both must convince FDI that the money that's invested in their industries will not be wasted because production has not been reined in. And, they both must keep restive populations under control. Cutting production by 1mm b/d or more would push prices back above $50/bbl, perhaps higher, resulting in incremental income of some $50mm to $75mm per day for KSA and Russia. Viewed another way, the incremental revenue generated annually by higher prices brought on by lower production would service multiples of KSA's first-ever $17.5 billion global debt issue brought to market last month. Both KSA and Russia will be able to lever their production more - literally support more debt issuance - by curtailing production now. KSA will need that leverage to pull off the diversification it is attempting under its Vision 2030 initiative. Russia would be able to do more with higher revenues, as well. Balances Point To Supply Deficit Next Year The meetings - "sideline" and otherwise - in Algiers, Istanbul and Vienna over the past month or so at various producer-consumer conclaves were attended mostly by producers that already have endured painful revenue cutbacks brought on by the OPEC market-share war declared in November 2014. Even those producers that did not endure massive production cuts - e.g., Canada, where oil-sands investments sanctioned prior to the price collapse continue to come on line despite low prices - will see far lower E&P investment activity going forward, given the current price environment. Chart 5Oil Markets Will Go Into Deficit Next Year Global oil supply growth will be relatively flat this year and next (Chart 5). This will create a physical deficit in supply-demand balances, even with our weaker consumption-growth expectation: We've lowered our growth estimate to 1.30mm b/d this year, and expect 1.34mm b/d growth next year. We revised demand growth lower based on actual data from the U.S. EIA and weaker projections for global growth.3 Among the major producers, only Iran, Iraq, KSA, and Russia increased output yoy. North America considered as a whole is down despite Canada's gains, and will stay down till 2017H2, based on our balances assessments. South America is essentially flat this year and next. The North Sea's up slightly this year, down more than 5% yoy in 2017, while the Middle East ex-OPEC is flat. Lastly, we expect China's production to be down close to 7% this year, and almost 4% next year. Managing The KSA-Russia Production Cut If KSA and Russia can cut 1mm b/d of production, they'd have to actively manage global balances so that the U.S. shale barrel meets the bulk of demand increases, while conventional reserves fill in decline-curve losses. Iran and Iraq together will be up 1mm b/d this year, but only 350k b/d next year. Both states are going to have a tough time attracting FDI to accelerate production gains, although ex-North America, these states probably have a higher likelihood of attracting investment than Non-Gulf OPEC, which is in terrible shape, and will have a hard time funding projects. Recently recovered Libyan and Nigerian output likely is the best they will be able to do until additional FDI arrives.4 At low price levels, even KSA can't realize the full value of the assets it is attempting to sell and the debt it will be servicing (lower prices mean lower rating from rating agencies). This is a worry for KSA, as it looks to IPO 5% of Aramco and issue more debt.5 Without higher prices, they will need to continue to slash spending, cut defense budgets, salaries and bonuses, and begin to levy taxes and fees. Below $50/bbl Brent, Russia faces similar constraints, and cannot expect to realize the full value of the 19.5% share of Rosneft it hopes to sell into the public market. Net, if KSA and Russia can get prices up above $50/bbl by cutting 1mm from their combined production and increase their gross revenues doing so, it's a major win for them. Such a cut would bring forward the global inventory drawdown we presently see picking up steam in 2017H2 without any reductions in production. In addition, because International Oil Companies (IOCs) are limited in terms of capex they can deploy to invest in National Oil Company (NOC) projects, conventional oil reserves will not be developed in the near term due to funding constraints. That, and higher capex being devoted to the U.S. shales, will keep a lid on production growth ex-U.S. Given how we see investment in production playing out over the medium term - i.e., 3 - 5 years - it will fall to the U.S. shales and Iran-Iraq production to find the barrels to meet demand increases and to replace production lost to natural declines. Given that we expect non-Gulf OPEC yoy production in 2017 to be down close to 1.3mm b/d (or -13%), and that we expect Brazil to be flat next year, cutting 1mm b/d from KSA and Russia's near-record levels of production is a bet both states will find worth taking, in order to lift and stabilize prices over the medium term. GCC OPEC production is expected to be up ~ 1% next year, or ~ 150kb/d, so these states have some scope for reducing output, as well. Price Implications If KSA and Russia Cut If we do indeed see KSA and Russia reduce output 1mm b/d as we expect, we expect storage draws will likely accelerate next year, which will flatten WTI and Brent forward curves, and send both into backwardation (Chart 6). We also would expect prices to move toward $55/bbl in the front of the WTI and Brent forward curves, once the storage draws start backwardating these curves. This would be a boon to KSA's and Russia's gross revenues, generating ~ $75mm a day of incremental revenue post-production cuts. Chart 6Expect Backwardation With ##br##A KSA-Russia Production Cut Given this expected dynamic, we recommend going long a February 2017 Brent call spread: Buy the $50 Brent call and sell the $55/bbl Brent call. We also recommend getting long WTI front-to-back spreads expecting a backwardation by mid-year or thereabouts: Specifically, we recommend getting long August 2017 WTI futures vs. short November 2017 WTI futures. This scenario also will be bullish for our Energy Sector Strategy's preferred fracking Equipment services companies, HAL and SLCA. ...And if They Fail to Cut Production? If KSA and Russia fail to cut production, and instead freeze it or raise output following the November OPEC meeting, the market will quickly look through their inaction and continue to price to the actual supply destruction we've been observing for the better part of this year. In such a scenario, prices will push into the lower part of our expected $40 to $65/bbl price range for a longer period of time, which not only will prolong the financial stress of OPEC and non-OPEC producers, but will keep the probability of a significant loss of exports from poorer OPEC states elevated. Either way, global inventories will be significantly reduced by the end of 2017, either because of a production cut by KSA and Russia, or because of continued supply destruction brought about by lower prices. Bottom Line: We expect KSA and Russia to announce a 1mm b/d production cut at the upcoming OPEC meeting at the end of this month. This will rally crude oil prices above $50/bbl, and accelerate the drawdown in global storage levels, which will backwardate Brent and WTI forward curves. We recommend getting long Feb17 $50/bbl Brent calls vs. short $55/bbl Brent calls, and getting long Jul17 WTI vs. short Nov17 WTI futures in anticipation of these cuts. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com SOFTS Sugar: Downgrade To Strategically Bearish, Look To Go Long Corn Vs. Sugar We downgrade our strategic sugar view from neutral to bearish, as we expect a much smaller supply deficit next year. We also downgrade our tactical sugar view from bullish to neutral, as prices have already surged over 120% since last August. We expect corn to outperform sugar in 2017. Brazil will likely increase its imports of cheaper U.S. corn-based ethanol. We look to long July/17 corn versus July/17 sugar if the price ratio drops to 17 (current: 17.94). If the position gets filled, we suggest a 5% stop-loss to limit the downside risk. Sugar prices have rallied more than 120% since last August on large supply deficits and an extremely low global stock-to-use ratio (Chart 7). Falling acreage and unfavorable weather have reduced sugarcane supplies from major producing countries Brazil, India, China and Thailand. Chart 7Sugar Tactically Neutral, Strategically Bearish Tactically, We Revise Our Sugar View From Bullish To Neutral. Sugar prices are likely to stay high over next three to six months on tight supplies. The global sugar stock-to-use ratio is at its lowest level since 2010 (Chart 7, panel 3). Inventories in India and China fell to a six-year low while inventories in the European Union (EU) were depleted to all-time lows. These three regions together accounted for 36.7% of global sugar consumption last year. However, we believe prices will have limited upside over next three to six months. Despite tight inventories, India and China likely will not increase imports. India currently has a 40% tax on sugar imports, and the government also imposed a 20% duty on its sugar exports in June to boost domestic supply. China started an investigation into the country's soaring sugar imports in late September. The probe will last six months, with an option to extend the deadline. In the meantime, other sugar importers likely will reduce or delay their sugar purchases because of currently high prices. Lastly, speculative buying is running out of steam, as traders already are deeply long sugar - net speculative positions as a percentage of total open interest is sitting at record-high levels (Chart 7, panel 4). Strategically, We Downgrade Our Sugar View From Neutral To Bearish. Assuming normal weather conditions across major producing countries next year, we believe the global sugar market will have a much smaller supply deficit over a one-year time horizon. Although sugar prices in USD terms reached their highest level since July 2012, prices in other currencies actually rose to all-time highs (Chart 8). Record high sugar prices in these countries will encourage planting and investment, which will consequently result in higher sugar production, especially in Brazil, India and Thailand. This year, due to adverse weather during April-September, the USDA has revised down its sugarcane output estimates for Brazil and Thailand by 3.2% and 7.1%, respectively. Assuming a return of normal weather next year, we expect sugarcane output in these two countries to recover. Farmers in China and India have cut their sown acreage for sugarcane this year on extremely low prices late last year and early this year. With prices up significantly in the latter half of this year, we expect sugar output in these two countries to rebound on acreage recovery as well. In addition, Brazilian sugar mills have clearly preferred producing sugar over ethanol so far this year on surging global sugar prices. According to the Brazilian Sugarcane Industry Association (UNICA), for the accumulated production until October 1, 2016, 46.31% of sugarcane was used to produce sugar, a considerable increase from 41.72% for the same period of last year. We expect this trend to continue in 2017, adding more sugar supply to the global market. Moreover, as the market becomes more balanced next year, speculators will likely unwind their huge long positions, which may accelerate a price drop sometime next year (Chart 7, panel 4). Where China Stands In The Global Sugar Market? China is the world's biggest sugar importer, the third-largest consumer and the fifth-biggest producer, accounting for 14.2% of global imports, 10.3% of global consumption and 4.9% of global production, respectively (Chart 9, panel 1). Chart 8Sugar Supply Will Increase In 2017 Chart 9Chinese Sugar Imports May Slow Sugar production costs are much higher in China than in Brazil and Thailand, due to higher wages and low rates of mechanization. Falling sugar prices in 2011-2015 further reduced the profitability of Chinese sugar producers. As a result, the sugarcane-sown area in China has dropped 24% in three years, resulting in a huge supply deficit (Chart 9, panel 2). Because domestic prices are much higher than global prices, the country has boosted its imports rapidly in recent years (Chart 9, panel 3). We believe, in the near term, the recently announced investigation into surging sugar imports will slow the inflow of sugar into the country, which will be negative for global sugar prices. In the longer term, the sugarcane-sown area in China will recover on elevated sugar prices, indicating the country's production is set to rebound, which likely will reduce its sugar imports. This is in line with our strategic bearish view. Chart 10Corn Is Likely To Outperform Sugar In 2017 Risks To Our Sugar View In the near term, sugar prices could rally further on negative weather news or if the USDA revises down its estimates of global sugar production and inventories. Prices also could go down sharply if speculators unwind their huge long positions before the year end. We will re-evaluate our sugar view if one of these risks materializes. In the long term, if adverse weather occurs and damages the Brazilian sugarcane yield outlook for next season, which, in general starts harvesting next April, we may upgrade our bearish view to bullish. How To Profit From The Sugar Market? In the softs market, we continue to prefer relative-value trades to outright positions. With regards to sugar, we look to go long corn vs. short sugar, as we expect corn to outperform sugar in 2017. Both sugar and corn are used in ethanol production. Ethanol is also a globally tradable commodity. While sugar prices rose to four-year highs, corn prices fell to seven-year lows, resulting in a significant increase in Brazilian sugar-based ethanol production costs and a considerable drop in U.S. corn-based ethanol production costs. We believe the current high sugar/corn price ratio is unlikely to sustain itself, as Brazil will likely increase its imports of cheaper U.S. corn-based ethanol (Chart 10, panels 1, 2 and 3). In addition, global ethanol importers will also prefer buying U.S. corn-based ethanol over Brazilian sugar-based ethanol. Eventually, this should bring down the sugar/corn price ratio to its normal range. Therefore, we look to long July/17 corn versus July/17 sugar if the price ratio drops to 17 (current: 17.94) (Chart 10, panel 4). If the position gets filled, we suggest a 5% stop-loss to limit the downside risk. In addition to the risks related to the fundamentals, this pair trade also faces the risk of a steep contango in the corn futures curve, and a steep backwardation in the sugar futures curve. The July/17 corn prices are 6.2% higher than the nearest futures prices and July/17 sugar prices are 5.2% lower than the nearest sugar futures prices. Long Wheat/Short Soybeans Relative Trade On another note, our long Mar/17 wheat/short Mar/17 soybeans relative trade was stopped out at a 5% loss on October 26. We still expect wheat to outperform soybeans over next three to six months. We will re-initiate this relative trade if the ratio drops to 0.41 (current: 0.426) (Chart 10, bottom panel). Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com 1 The Feb17 options expire 22 December 2016, three weeks after the OPEC meeting. 2 Please see Commodity & Energy Strategy Weekly Report "Ignore The KSA - Russia Production Pact, Focus Instead On The Need For Cash," dated September 8, 2016, available at ces.bcaresearch.com. 3 The IMF expects slightly slower global GDP growth this year (3.1%), and a slight pick-up next year (3.4%). Please see "Subdued Demand, Symptoms and Remedies," in the October 2016 IMF World Economic Outlook. 4 Please see "OPEC Special-Case Nations Add 450,000 Barrels in Threat to Deal," by Angelina Rascouet and Grant Smith, published by Bloomberg news service November 2, 2016. 5 Please see Commodity & Energy Strategy Weekly Report "Desperate Times, Desperate Measures: Aramco And The Saudi Security Dilemma," dated January 14, 2016, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Closed Trades

Highlights The RMB will continue to drift lower against a broadly stronger dollar, but the risk of chaotic depreciation is very low. The TWD will likely remain strong in the near term, mostly due to the unyielding strength in the JPY, but it should depreciate both against the dollar and in trade-weighted terms over the medium-to-long term. Hong Kong's currency peg will not be challenged, and will rise along with the greenback, but this will prove to be deflationary for its economy and asset prices. Feature The broad trend in the U.S. dollar will remain the dominant global macro force in the near term, which in turn will dictate the performances of the three currencies in the Greater China region. Historically these currencies have had a lower "beta" - i.e. systematically lower volatility than most of their global peers. This week we review the unique driving forces behind these currencies and the cyclical dynamics of their respective economies. In a nutshell, the fundamentals of these currencies are stronger than most of their global counterparts, which diminishes the odds of outsized depreciation. Therefore, they will remain "low-beta" plays, and may even appreciate in trade-weighted terms as the dollar strengthens. The RMB: Drifting With The Flow The USD/CNY has now approached 6.8, the level at which the RMB was essentially pegged to the dollar post the global financial crisis until late 2010 (Chart 1). This has raised speculation that the People's Bank of China (PBoC) may once again soft-peg the RMB around current levels to the U.S. dollar. While there is no doubt that the PBoC will maintain tight control over the exchange rate, it is impossible to predict how the central bank intends to control it in the near term. We suspect the path of least resistance is for the RMB to continue to drift lower against a broadly stronger dollar, but the risk of chaotic depreciation is very low. First, much of the RMB's valuation froth has been cleansed through a combination of nominal depreciation and lower inflation. The RMB's 12% depreciation against the dollar since its all-time peak in January 2014 has erased all the gains since 2010 and has weakened the currency by over 10% in real effective terms since its historical high in mid-2015 - non-trivial moves for a tightly managed currency. Our models suggest that the RMB is no longer overvalued either against the dollar or in real effective terms, as discussed in recent reports.1 Similarly the trade-weighted RMB has been oscillating around a well-defined uptrend in the past decade, and it depreciation since last year has pushed the currency from a two-sigma overshoot above its long-term trend to a two-sigma undershoot (Chart 2). Chart 1Will The RMB Be Re-pegged? Chart 2The RMB And Long Term Trend Second, most market participants have focused squarely on the destabilizing impact of the RMB depreciation, but have ignored the reflationary benefits of a weaker currency. For a large open economy, the exchange rate matters materially. The RMB's 10% depreciation in trade-weighted terms has significantly boosted profit margins of Chinese exporters. Even though export prices measured in dollar terms are still declining, they have increased sharply in RMB terms, boosting profits as well as overall industrial activity (Chart 3). The most recent readings of purchasing managers' surveys released early this week confirm that the manufacturing sector has continued to recover, and currency weakness may be an important factor behind the regained strength (Chart 4). In the near term, the performance of the USD/CNY is largely dictated by the dollar's trend, but the downside of the RMB should be self-limiting, as the reflationary impact of a weaker exchange rate will help boost Chinese growth, which in turn will reduce downward pressure on the Chinese currency. Chart 3A Weaker RMB Helps Exporters' Profits Chart 4A Weaker RMB Leads Cyclical Recovery Finally, the risk of major RMB depreciation largely hinges on whether China would suffer massive capital flight that depletes its foreign exchange reserves. The risk certainly cannot be ignored, but the odds are low for now. The lion's share of China's capital outflows in the past two years have been attributable to Chinese firms paying back borrowings in foreign currencies. Therefore, the pressure for capital outflows will diminish as foreign debts are paid back (Chart 5). In addition, we expect Chinese regulators to strengthen capital account restrictions. Early this week, the authorities further tightened regulations for residents purchasing overseas insurance products. It is likely they will further crack down on administrative loopholes to hinder capital outflows. Bottom Line: Expect further weakness in the RMB/USD, but odds of material depreciation are low. The Strong TWD Will Hurt In contrast to the RMB, the Taiwanese dollar has in fact appreciated both against the dollar and in trade-weighted terms so far this year, likely due to the strong Japanese yen (Chart 6). Taiwan competes with Japan in similar value-added segments in the global supply chain, and therefore their currencies have historically been closely correlated. In this vein, the Bank of Japan's failed attempts to further weaken the yen against the dollar has also effectively boosted the Taiwanese currency. Chart 5Chinese Companies Rushed To##br## Pay Back Foreign Debt Chart 6TWD And JPY: Joined At The Hip From a valuation perspective, the TWD appears cheap based on standard purchasing power parity assessment. Nonetheless, with exports accounting for over 50% of Taiwan's GDP, a strong currency is neither desirable nor affordable. Similar to Japan, Taiwan's headline consumer price inflation has been uncomfortably low, rising by a mere 0.33% in September from a year ago. Meanwhile, the rising TWD will continue to depress corporate sector pricing power. Wholesale prices of manufactured goods, after briefly moving into positive territory earlier this year, have crashed back into deflation in recent months alongside the strong TWD (Chart 7, top panel). Furthermore, the untimely strength in the exchange rate may short-circuit Taiwan's nascent growth recovery that has been budding in recent months. Export orders, after rising at an above 8% annual rate in previous months, have already begun to roll over, and will likely come under further downward pressure inflicted by the exchange rate (Chart 7, bottom panel). Furthermore, overall inventory levels in the economy have been rising in recent years. Chart 8 shows that manufacturers' inventory-to-shipment ratio has increased notably since 2011. The combination of a potential slowdown in new orders and elevated inventory levels bodes poorly for industrial production and overall business activity. Chart 7A Strong TWD Is Deflationary Chart 8Inventory Level Has Been Rising To be sure, with its chronic current account surplus and an outsized foreign exchange reserve, Taiwan is much better equipped than most of its global and EM peers to deal with external turmoil. As a large net creditor nation, the risk of a typical balance-of-payment crisis and chaotic currency depreciation is not in the cards. The problem for Taiwan is that the TWD has become unduly strong, which could lead to quick growth deterioration and in turn sow the seeds for currency depreciation. Bottom Line: In the near term we expect the TWD to remain strong, mostly due to the unyielding strength in the JPY, but it should depreciate both against the dollar and in trade-weighted terms over the medium- to long term. We will be looking for opportunities to short the TWD/USD in the coming months. The HKD Peg Will Remain Solid The Hong Kong dollar has remained remarkably strong against the dollar in recent months, despite the broad dollar bull market (Chart 9). In the spot market, the HKD/USD has been hovering around the stronger end of the convertibility undertaking. In the forward market, the HKD non-deliverable forward (NDF) contract's premium over the dollar has widened notably in recent weeks. We suspect stronger demand for the HKD is mainly from the mainland, as it is viewed as an alternative to the greenback. Furthermore, the RMB cash accumulated in Hong Kong in previous years is being unwound (Chart 10). RMB deposits at Hong Kong banks have almost halved in the past year, but remain elevated. They may continue to be converted back into HKD supporting its exchange rate. Chart 9The HKD Still Faces Upward Pressure Chart 10HK RMB Deposits May Continue To Unwind More fundamentally, compared with the late 1990s' episode when the HKD was under furious speculative attack, the HKD's current valuation is substantially cheaper. In 1997 when the Asian crisis erupted, the Hong Kong economy had just gone through a massive inflationary boom, which dramatically pushed up its real effective exchange rate (Chart 11). This in of itself created acute deflationary pressure, which had to be corrected by either nominal exchange rate depreciation or domestic price declines. By defending the currency peg, the Hong Kong authorities opted for price deflation to realign the then-overvalued HKD. This time around, Hong Kong's real effective exchange rate is just above its all-time low, and there are no clear signs that the economy is facing strong deflationary pressures that would call for meaningful exchange rate adjustment. Similar to China and Taiwan, a strong HKD pegged to a rising USD is not ideal for the Hong Kong economy due to its heavy dependence on external demand, particularly from the mainland. Already, mainland tourism to Hong Kong has begun to moderate, and average spending among foreign tourists has dropped significantly in the past few years - at least partially attributable to the strong HKD (Chart 12). More importantly, further HKD strength will continue to tighten Hong Kong's monetary conditions, which fundamentally matters for its asset prices. As discussed in detail in previous reports,2 tightening monetary conditions are particularly bearish for real estate prices, which are already in "bubble" territory. The downside in Hong Kong stocks should be limited due to their deeply depressed valuation parameters. Chart 11The HK Dollar Is Not Expensive Chart 12Tourists' Spending And Exchange Rate Bottom Line: Hong Kong's currency peg will not be challenged, and the trade-weighted HKD will rise along with the greenback, but this will prove to be deflationary for its economy and asset prices. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Can The RMB Withstand More Fed Rate Hikes?", dated September 1, 2016; and China Investment Strategy Weekly Report, "The RMB's Near-Term Dilemma And Long-Term Ambition", dated October 20, 2016, available at cis.bcaresearch.com 2 Please see China Investment Strategy Weekly Report, "Hong Kong: From Politics To Political Economy", dated September 8, 2016, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights Chile's economy is headed for recession. Facing strong external and domestic headwinds, any policy stimulus will be too late to prevent the impending contraction in economic activity. Investors should receive 3-year interest swaps and stay short CLP / long USD. South Africa's cyclical and structural outlook remains bleak. Banks have been selling foreign assets and repatriating capital which has helped the rand to appreciate. However, as this capital repatriation tapers, the rand will enter a renewed bear market. Stay short the rand versus the U.S. dollar and long MXN / short ZAR. Feature Chile: Stimulus Will Arrive Too Late To Prevent Recession Chart I-1Chile: From Stagflation To Recession? The stagflationary environment in Chile over the past two years - a combination of sluggish growth and high inflation - will give way to outright recession (Chart I-1). As economic activity downshifts further, we are doubtful that policymakers will be able to push through stimulus measures in time, and of sufficient size, to stave off recession. On the fiscal front, the government is unlikely to preemptively engage in a significant spending push. The deceleration in economic activity will soon translate into lower fiscal revenue at a time when the fiscal deficit is already quite wide, at 2.8% of GDP. Furthermore, a renewed fall in copper prices (more on this below) means mining revenue will also be weaker than currently expected, inflicting substantial damage on the government's budget. Meanwhile, monetary policy is unlikely to become stimulative in the near term. Having concluded a two-year battle to tame sticky core inflation, the central bank is unlikely cut interest rates too fast. Besides, as the current term of Central Bank President Rodrigo Vergara ends in December, chances of a new rate cut cycle before he is replaced are low. On the whole, the lack of imminent policy stimulus means economic growth is set to fall much further. Investors can profit by receiving 3-year swap rates (Chart I-2). Although the central bank will be late to cut rates, long-term interest rates will fall because Chilean growth is facing strong headwinds on several fronts: Copper prices have failed to rally amid the reflation trade of the past nine months, and are set to drop to new lows as Chinese property construction and demand for industrial metals contracts anew (Chart I-3). As a result, copper exports will continue to act as a serious drag on Chilean growth (Chart I-4). Chart I-2Receive 3-Year Interest ##br##Rate Swaps In Chile Chart I-3China's Industrial Metals ##br##Demand To Contract Chart I-4Exports Will Remain ##br##A Drag On Growth Capital expenditures will contract, partially due to very downbeat business confidence owing to the uncertain political environment created by the government's reforms agenda since 2014 (Chart I-5, top panel). As discussed in detail in our December 2014 Special Report on Chile,1 from a big-picture perspective, these reforms have shifted the structure of the economy toward higher government expenditures at the expense of the private sector. This has severely eroded business confidence. In addition, the downturn in the housing market will gain momentum, further depressing activity (Chart I-5, bottom panel). Meanwhile, employment growth has been weak and income growth has been decelerating steadily - and we foresee further downside ahead (Chart I-6). Importantly, the economy's credit impulse is now turning negative (Chart I-7). Higher delinquencies in turn will force banks to curtail lending going forward. Chart I-5Chile: Capex To Remain Weak Chart I-6Chile: Labor Market Will Weaken Further Chart I-7Negative Credit Impulse##br## Will Weigh On Growth Finally, narrow (M1) money supply growth, a very good leading indicator for economic activity, is now decelerating sharply (Chart I-8). Consistently, our marginal propensity to consume proxy points to weak spending and lower consumer price inflation (Chart I-9). Chart I-8Chile: Narrow Money Growth, ##br##Economic Activity And Inflation Chart I-9Consumption Is Set ##br##To Decelerate Further The economy has developed considerable downward momentum. Any policy stimulus is likely to come too late to prevent the economy from falling into recession. Therefore, local interest rates in Chile are headed to new lows. An economic recession and lower copper prices are clearly bearish for the Chilean peso, and we maintain that its 8.5% rally this year versus the U.S. dollar will be followed by new lows (Chart I-10). Turning to equities, lower interest rates will help only marginally as equity valuations are not cheap (Chart I-11). Moreover, as Chilean banks account for 20% of the MSCI market cap and, while they are better run and more conservative than many others in the EM, they are not immune to a decelerating credit and business cycle. Besides, this bourse's Latin American consumer plays will also likely disappoint. As such, dedicated EM investors should stay neutral on Chilean stocks relative to the EM equity benchmark (Chart I-12). Chart I-10Chilean Peso Valuation Chart I-11Chilean Equities Are At Fair Value Chart I-12Chilean Equities: Stay ##br##Neutral Relative To EM Benchmark Lastly, as highlighted in our recent in-depth Special Report on EM corporate credit,2 credit investors should stay long Chilean and Russian corporate debt versus China. Chilean corporate credit will likely outperform Chinese corporate credit, as the latter is more frothy - overbought and expensive. Bottom Line: The Chilean economy is heading into recession, and policymakers will be late with stimulus to prevent it. Fixed-income investors should receive 3-year interest rate swaps. Dedicated EM equity investors should maintain a neutral stance on the Chilean bourse versus the EM equity benchmark. Stay short CLP / long USD. Santiago E. Gomez Associate Vice President santiago@bcaresearch.com South Africa: Flows Versus Fundamentals Chart II-1Improving Trade Has Helped The ZAR The South African rand has rallied since the start of the year on the back of an improving trade balance (Chart II-1) and strong capital inflows. However, it is facing a key technical resistance level, as are many other EM assets. We expect these resistance levels to hold for EM risk assets in general and the South African rand in particular. The underlying reasons behind our outlook center around our expectations of a stronger U.S. dollar, rising U.S. and G7 bond yields and a relapse in commodities prices. This is in addition to a lack of cyclical recovery and poor structural fundamentals in South Africa. A well-known explanation as to how South Africa has been able to finance its wide current account deficit is that there have been strong foreign portfolio inflows stemming from the global search for yield. What is less known is that South African banks have in the past year been selling foreign assets and repatriating capital back into South Africa (Chart II-2). Over the past 12 months, this repatriation of capital has amounted to US$ 6.5 billion, which effectively allowed the country to fund 50% of its current account deficit. While there is no doubt that this repatriation of capital has aided the rally in the rand and domestic bonds, it remains to be seen whether these flows will continue. Our suspicion is that with South African banks' holdings of foreign bonds dropping from US$ 18 billion in December 2015 to US$ 12 billion at the end of June 2016, and G7 bond yields rising, the speed of capital repatriation will likely slow. In the meantime, fundamentals in South Africa remain weak: The household sector, which accounts for 60% of GDP, has been sluggish. Private consumption growth has been anemic and credit growth to households has been falling rapidly (Chart II-3). Chart II-2South Africa: Banks Have Been ##br##Repatriating Capital Enormously Chart II-3South African ##br##Consumption Is Anemic The corporate sector is not painting a reassuring picture either. South African firms are not investing; real gross fixed capital formation is contracting (Chart II-4, top panel) and business confidence is at an all-time low (Chart II-4, bottom panel). The ongoing dynamic of persistently high wage growth - despite negative productivity growth - only reinforces the gloomy outlook as it creates downward pressure on corporate profit margins, or upward pressure on inflation (Chart II-5). Chart II-4Contracting Capex And ##br##Record-Low Business Confidence Chart II-5Toxic Structural Dynamics: Contracting ##br##Productivity And High Wage Growth Along with renewed weakness in the rand, higher wage growth will raise interest rate expectations. The fixed-income market is currently discounting no policy rate hikes during the next 12 months making it vulnerable to potential depreciation in the rand. In addition to a poor economic backdrop, uncertainty regarding economic policy is considerable. Chart II-6South Africa's Central ##br##Bank's Liquidity Injections First, fiscal policy will not be market friendly. The poor performance of the ANC in the last municipal elections shows the ANC is clearly losing support from the population. This will lead President Zuma and ANC to adopt even more populist policies. This is bearish for both the fiscal accounts and the structural growth outlook. As such, this will cap the upside in the rand and put a floor under domestic bond yields. Second, the central bank will not defend the exchange rate if the latter comes under selling pressure anew. In fact, monetary policy remains somewhat unorthodox. Specifically, the Reserve Bank of South Africa continues to inject liquidity into the system to cap interbank rates (Chart II-6). This will facilitate ZAR depreciation. Investment Conclusions Stay short the rand versus the U.S. dollar. Three weeks ago we also initiated a long MXN / short ZAR trade, and this trade remains intact as the MXN is oversold and the ZAR is overbought. Dedicated EM equity investors should maintain a neutral allocation to South African stocks. On the back of a fragile and deteriorating consumer sector, we recommend staying short general retailer stocks. Their share prices seem to be breaking down despite the rebound in the rand and a drop in domestic bond yields (Chart II-7). Policy uncertainty and pressure for populist policies is still an overarching issue for South Africa, especially compared to Russia. As such we suggest fixed income investors continue to underweight South African sovereign credit within the EM sovereign credit universe (Chart II-8), and maintain the relative trade of being long South African CDS / short Russian CDS. Chart II-7Stay Short South ##br##African General Retailers Chart II-8Stay Underweight South ##br##African Credit And Short Rand Stephan Gabillard, Research Analyst stephang@bcaresearch.com 1 Please refer to the Emerging Markets Strategy & Geopolitical Strategy Special Report titled, "Chile: A New Economic Model?," dated December 3, 2014 available at ems.bcaresearch.com 2 Please refer to the Emerging Markets Strategy Special Report titled, "EM Corporate Health Is Flashing Red," dated September 14, 2016. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

GAA DM Equity Country Allocation Model The model significantly reduced the weight of France by six percentage points due to change in liquidity condition, the other downgrade, albeit much smaller, was the U.S. All other countries had been upgraded as a result, with Germany being the largest beneficiary. Japan and U.K. remain the two largest underweights (Table 1). Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Chart 1, Chart 2 and Chart 3, the overall model outperformed the MSCI World benchmark by 27 basis points (bps) in October, driven completely by the Level 2 model (as U.K and Australia underperformed the euro area). The Level 1 model was in line with the benchmark. Since going live, the overall model performed slightly better than its benchmark. Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. Table 2Performance (Total Returns In USD) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) Table 3Allocations Table 4Performance Since Going Live Chart 4Overall Model 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 GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of October 31, 2016. The momentum component has shifted Financials from underweight to overweight. For mode 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 Patrick Trinh, Senior Analyst patrick@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com

Special Report

Highlights Defaults: The default outlook is improving alongside a brighter forecast for economic growth. The corporate default rate will fall from 5.4% to close to 4% during the next 12 months. Valuation: The low starting point for spreads means the risk/reward trade-off in junk bonds remains poor, despite a more encouraging default outlook. Strategy: In addition to a poor longer run risk/reward trade-off, the risk of a Fed rate hike in December makes us extremely cautious on junk in the near term. Maintain a maximum underweight allocation to high-yield and await a better entry point for spreads in the New Year. Feature This year's rally in High-Yield has been nothing short of impressive. The average spread on the Barclays High-Yield index has narrowed to 467bps from a February high of 839bps, and excess junk returns have now recovered all the ground lost since the mid-2014 peak (Chart 1). Chart 1Back In The Black When considering the potential for further spread tightening we first observe that, despite this year's rally, the average junk spread remains 144bps above the cycle lows reached in June 2014. However, the credit cycle is also two years older, corporations are more highly levered and the default rate has started to increase. The dramatic sell-off and subsequent recovery in the price of oil has also had a large impact on junk bond performance since mid-2014, but now that the average spread on energy debt is within 100bps of the overall index (Chart 1, bottom panel), its influence will be much smaller going forward. In this week's report we consider the potential for further junk bond outperformance through three different analytical approaches. We conclude that: Junk spreads already discount a significant improvement in capacity utilization Junk spreads do not adequately reflect the risks from higher implied equity volatility Although the outlook for default losses has improved, current spreads do not offer adequate compensation Growth Rebound Is In The Price As we anticipated,1 last Friday's preliminary Q3 GDP print exceeded expectations. Further, we expect that a number of headwinds which have held back U.S. growth in 2016 will give way next year, generating 2.5% - 3% real GDP growth in 2017.2 This should bode well for junk bond performance, except that a relatively large growth acceleration has already been incorporated into high-yield spreads. Of all economic indicators high-yield spreads correlate most closely with capacity utilization (Chart 2), which bottomed in March of this year shortly after the peak in junk spreads. But capacity utilization has not kept pace with the tightening in junk spreads since then. Historically, a 100bps tightening in junk spreads during a 12-month period has coincided with a 0.4% improvement in capacity utilization. This would suggest that even if junk spreads remain flat, capacity utilization should reach 77.2% by next February (Chart 2, bottom panel). While industrial production will continue to improve, in large part because of rebounds in the oil price and rig count (Chart 3), it will be difficult for any rebound to surpass the expectations that have already been baked into the high yield market. Chart 2Junk Spreads & Capacity Utilization Chart 3Drag From Energy Has Dissipated The Risk From Rising Vol Is Understated Another well-known correlation is between junk spreads and the VIX. As was observed by Robert Merton in 1974,3 corporate bond investors effectively bear the risk from equity investors who own portfolio insurance against downside tail risk (see Box). In other words, an increase in the price of volatility can be thought of as a transfer of default risk from equity holders to bondholders. Unusually, junk spreads have tightened during the past three months while the price of volatility (VIX) has risen (Chart 4). Box - Merton Model Of Corporate Debt Robert Merton pointed out that holding a corporate bond is equivalent to holding a risk-free security plus a short put option on the value of the assets of the corporation. For a corporation with zero default risk, the option is worthless and the bondholder owns a risk-free security. However, the closer a corporation comes to default, the put option (which the bondholder is short and the equity holder is long) increases in value. If the value of assets of the corporation falls below the value of the debt outstanding, then the equity holders are better off defaulting on the debt than repaying it. The act of defaulting on debt is analogous to exercising the put option in that the shareholders put the assets of the corporation to the debt holders rather than repay the debt. Higher volatility increases the value of this put option, effectively reducing the value of corporate debt relative to equity. In other words, higher asset price volatility increases the risk of default. Similarly, a drop in volatility makes default less likely and so increases the value of corporate debt. Although asset volatility and equity volatility are not identical, they are closely related. Therefore, declining equity implied volatility is positive for corporate bonds since it reduces the value of the implicit short put option embedded in corporate debt. This divergence is not sustainable, and the near-term risks clearly favor a convergence via wider spreads rather than a lower VIX. A Trump victory in this month's election would obviously surprise markets and prompt a flight to safety. But the polling data suggest this is a low probability event. More likely is that the VIX rises in anticipation of a Fed rate hike in December. This process could begin as early as tomorrow afternoon, if the Fed teases a December rate hike in the statement from this week's meeting. We anticipate a December rate hike and would expect investors to bid up the price of vol between now and then. As a rate hike becomes more likely, investors will become increasingly worried about a repeat of last year when a Fed rate hike precipitated a large sell-off in risk assets. The trend in equity volatility is also biased higher in the longer run. While it is impossible to accurately forecast all of the wiggles in the VIX index, its long-run underlying trend tends to be driven by corporate health and monetary conditions (Chart 5). Chart 4Higher Vol A Near-Term Risk Chart 5Long Run Vol Drivers Easier monetary conditions tend to reduce investor risk aversion and send the VIX lower. But easy money also encourages the corporate sector to take on debt. Initially, a virtuous circle is created between a lower VIX and a re-levering corporate sector. To the extent that corporate credit growth fuels aggregate demand, risk aversion will decline even further leading to even lower volatility. Eventually, the virtuous circle is broken when either monetary conditions are tightened or leverage increases so much that investors question the sustainability of corporate balance sheets. Chart 5 suggests that the current level of the VIX does not reflect the reality of tightening monetary conditions or deteriorating corporate balance sheets. Bottom Line: A sizeable improvement in capacity utilization and persistently cheap equity volatility are required to sustain junk spreads at current levels. A Brighter Outlook For Defaults Around this time last year we called the beginning of the default cycle,4 and our view remains that we are one year into a prolonged grind higher in corporate defaults. Typically, once corporate defaults start to trend higher they do not peak until the next recession and we do not expect this cycle to be any different. This is because firms tend not to engage in voluntary de-leveraging. Rather, they tend to continue to add leverage until the economy forces retrenchment upon them. One exception to this trend is the small increase and subsequent reversal in defaults that occurred in the mid-1980s (Chart 6). In this instance it was not an improvement in corporate balance sheets that caused the uptrend in defaults to reverse. Instead, it was a dramatic easing of monetary conditions that gave banks the necessary confidence to keep the credit taps open, despite worsening corporate health. This episode can be contrasted with the mid-1990s cycle when corporate health continued to deteriorate but monetary conditions did not ease. This resulted in a persistent grind higher in defaults. Chart 6Defaults Will Moderate Next Year, But Long-Run Uptrend Is Still Intact In our view, the current cycle has the most in common with the mid-1990s. Corporate balance sheets are deteriorating and no monetary relief should be expected with the Fed in the midst of a rate hike cycle, albeit a shallow one. However, the prolonged nature of the recovery also means that the rise in corporate defaults will also be shallow and drawn out, with some fluctuations around an upward trend. Chart 7The Reason For Low Recoveries On that note, we forecast that the default rate will moderate during the next twelve months. Our default rate model is shown in the top panel of Chart 6. This model is based on industrial production growth, corporate profit growth, times-interest earned and lending standards. We forecast that both industrial production and corporate profit growth will improve next year, in large part due to the end of the drag from falling oil prices. The red line in the top panel of Chart 6 shows the Moody's baseline forecast for future defaults. This forecast calls for the default rate to be 4.09% during the next 12 months, down from 5.4% during the past 12 months. This forecast is consistent with our own base case expectation that calls for a return to modestly positive growth in both industrial production and corporate profits (on the order of 5% annualized). The thick grey line in the top panel of Chart 6 shows what the default rate would be in a pessimistic scenario where industrial production and corporate profit growth are held flat at current levels. This forecast has the default rate rising to 6.5% during the next 12 months. In order to forecast default losses we also need a forecast for the recovery rate. In the past we have modeled recoveries using the output from our default rate model. This simple observation that recoveries tend to fall when defaults rise, and vice-versa, had been sufficient to capture the major swings in recoveries, but has not performed well during the current cycle (Chart 7). In fact, recoveries have lagged well below levels that would be expected given the number of corporate defaults we have seen. The reasons for the low recovery rate are not well known, but we have collected some bottom-up data that may offer a partial explanation. The bottom two panels of Chart 7 show the Tobin's Q and net debt-to-assets ratio for the bottom decile of firms in our sample going back to 1990.5 We note that the Tobin's Q - the ratio of market value to replacement value of a firm's assets - has fallen to recessionary levels. Meantime, while net debt-to-assets is in a clear uptrend, it does not appear stretched relative to the early stages of past default cycles. This suggests that low recoveries are not the result of too much debt being supported by too few assets, but are the result of a low market value being placed on the assets in question. More fundamentally, we suspect that low recovery rates are actually explained by the divergence between the monetary and credit cycles (Chart 8). In past cycles, Fed tightening has tended to occur alongside a deterioration in corporate health. However, in this cycle corporate balance sheet re-leveraging is well advanced compared to monetary tightening. If we accept the premise that defaults themselves are caused by tighter money and tightening lending standards, while recoveries are more related to the state of corporate balance sheets at the time of default, then it makes sense that recoveries would be lower in this cycle since corporate balance sheets had been aggressively levering-up for several years before monetary conditions began to tighten and defaults started to rise. Chart 8The Diverging Credit And Monetary Cycles In both our baseline and pessimistic forecasts we assume that the recovery rate increases somewhat (from 28% to 35%), but remains low relative to where we would expect it to be based on the default rate alone. Adding it all up, our base case scenario calls for default losses of 266bps during the next 12 months. This results from a default rate of 4.09% and a recovery rate of 35%. Our pessimistic scenario calls for default losses of 423bps during the next 12 months. This results from a default rate of 6.5% and a recovery rate of 35%. The Default-Adjusted Spread & Expected Returns Individually, neither the average junk spread nor future default losses offer much explanatory power when it comes to forecasting high-yield returns. Rather, it is the combination of both - the default-adjusted spread - that explains the bulk of variation in junk returns. The top panel of Chart 9 shows 12-month high-yield returns in excess of duration-matched Treasuries alongside the average option-adjusted spread from the Barclays index, advanced by 12 months. The chart shows that there is some correlation between today's average junk spread and excess returns during the following 12 months, but the correlation is very weak. Chart 9Default-Adjusted Spread Predicts Lower Excess Returns The second panel of Chart 9 adjusts the average junk spread by realized default losses. Here we see a much stronger correlation. In fact, the starting spread on the High-Yield index less realized default losses during the next 12 months explains more than 50% of the variation in excess junk returns. This means that with knowledge of today's junk spread and an accurate forecast of future default losses, we can have a reasonably good idea about what excess junk returns will be during the next year. The bottom panel shows the results of a regression of excess junk returns versus the default-adjusted spread. It also shows what the default-adjusted spread implies in term of excess junk returns using both our base case and pessimistic default loss scenarios. In our base case scenario where the default rate improves during the next year, excess junk returns are predicted to be close to zero. In other words, the anticipated improvement in defaults is not sufficient to offset the low level of starting spreads. In our pessimistic scenario, where the default rate rises to 6.5%, excess returns during the next 12 months are predicted to be deeply negative. Bottom Line: The default outlook is improving alongside a brighter outlook for economic growth, but wider spreads are still required to make the risk/reward trade-off in junk bonds attractive. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching", dated September 13, 2016, available at usbs.bcaresearch.com 2 Please see The November 2016 Bank Credit Analyst, dated October 27, 2016, available at bca.bcaresearch.com 3 Merton, Robert C. 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates." Journal of Finance 29, pp. 449-470. 4 Please see U.S. Bond Strategy Weekly Report, "The Rising Risk Of Corporate Default", dated October 20, 2015, available at usbs.bcaresearch.com 5 We create a sample consisting of all the firms included in either the Barclays Corporate or High-Yield index (excluding financials) for which bottom-up data are available from Bloomberg. Data are retrieved on a quarterly basis and the sample is adjusted once per year based on changes in the composition of the Barclays indexes. The lowest sample size in any quarter is 53 firms, the largest is 101. On average, the sample size is 68 firms. Fixed Income Sector Performance Recommended Portfolio Specification

Highlights A poor fundamental backdrop for high yield is being offset by easy monetary conditions. A prolonged shallow uptrend in corporate defaults - and therefore spreads - is most likely. The relative performance of equities versus corporate credit has not been distorted by monetary policy: the high-yield debt market will remain a reliable indicator for equity market vulnerability. A December rate hike will not be problematic for the residential real estate market. Plenty of pent-up demand for housing exists, and this will provide long-term support, so long as the labor market remains robust. Feature High-yield (HY) corporate bond spreads have dramatically narrowed throughout 2016 (Chart 1). This trend should not go unnoticed, since beyond being an important asset class in its own right, we have long viewed the high-yield debt market as an early warning system for equities. The current message suggests an all-clear for stocks. Chart 1Dramatic Spread Narrowing In 2016, But... We have had a cautious stance on U.S. high yield since August 2015, based on the view that corporate balance sheet health has deteriorated to the point where defaults would continue to rise on a cyclical basis. This week, we explore whether this remains the right strategy, and also whether junk bond spreads are still a relevant leading indicator for the equity market. Our answer to both questions is: Yes. In our view, the HY comeback can be explained by three main factors. First, the recovery in energy-related junk bonds has led the rally, as rising oil prices have helped diminish the default risks among U.S. shale issuers. Second, the 2015 spike in junk bond yields - mainly due to contagion from energy-sector bankruptcy fears - created tactical value in high-yield. Throughout most of 2016, we have seen an unwinding of these previously oversold positions. And third, the high-yield market benefits from an ongoing and intense search for yield in a world of unattractive higher-quality interest rates. Looking ahead, the first two forces are unlikely to play much of a role in the outcome for junk bonds. Oil prices are likely to trade in narrow range, allowing energy-related company fundamentals to stabilize. The rally in junk bonds over the past several months has removed any perceived value in this sector. Thus, it is only the search for yield/accommodative monetary policy that still supports a narrowing in spreads. Over time, we believe junk bond performance will once again be aligned with balance sheet fundamentals, i.e. high-yield spreads will gradually widen. A Review Of Our HY Indicators Our fixed income strategists have developed three key indicators to gauge major turning points in corporate spreads (Chart 2): Corporate Health Monitor (CHM): An aggregate indicator of non-financial corporate balance sheet health. The CHM deteriorated further in the second quarter, and has reached levels that historically tend to only be seen during recessions. Of the indicator's six components, most of the weakness has occurred in measures of corporate profitability (Chart 3). One caveat is that our measure of leverage in the CHM remains low, but this understates the risks because it measures total debt as a percent of market value of equity. Leverage looks decidedly worse if measured using net debt/book value. Chart 2Key Corporate Credit Indicators Chart 3Corporate Health Monitor Components C&I bank lending standards: A Fed survey that measures how easy/difficult it is for the corporate sector to access bank loans. According to this gauge, banks have already been tightening credit conditions for the past three quarters. Deviation in monetary conditions from equilibrium: We use our Monetary Conditions Index (MCI), which incorporates movements in both the dollar and interest rates. Due to a very accommodative Fed, monetary conditions remain very easy according to this measure. At present, two of these three indicators are sending negative signals for corporate spreads. Our corporate health monitor is decidedly bearish, as are lending standards. Indeed, focusing on corporate balance sheets and fundamental credit quality metrics would almost unanimously lead investors to recognize that the credit cycle is in its late stages and to expect spreads to move wider. After all, spreads have widened in every episode of deteriorating balance sheet health since the mid-1990s. Or to put it more simply, a default cycle - leading to spread widening - has occurred each time that year-on-year profit growth has gone negative since 1984 (Chart 4). Chart 4Profit Contraction Spells Trouble For Junk Bonds Our Bank Credit Analyst service came to the same conclusion earlier this year. In a Special Report, our colleagues analyzed financial ratios for 770 companies from across the industrial and quality spectrum. Their work uncovered that the corporate re-leveraging cycle is far more advanced than is widely believed and that key financial ratios and overall corporate health look only mildly better excluding the troubled energy and materials sectors. Of course, there is an important salve this cycle at work and it is captured in our third indicator - monetary policy. As shown in Chart 2, easy monetary conditions have never persisted for this long and low rates have driven a colossal search for yield, causing high-yield bonds to become ever more divorced from fundamentals. This divergence between corporate bond spreads and balance sheet fundamentals is likely to persist for as long as monetary conditions remain supportive. Adding it up, a poor fundamental backdrop for high-yield is being offset by easy monetary conditions. This combination argues for a cautious long-term bias toward lower-quality corporate credit because a prolonged shallow uptrend in corporate defaults (and spreads) is most likely. Nimble investors may look to tactically buy junk bonds when spreads overshoot our forecast of default losses, although such an opportunity is not present at the moment (Chart 5). The equity market is suffering from the same dynamic. Chart 5No Value Here Will Junk Bond Yields Still Warn Of Stock Bear Markets? Junk bond yields have long been one of our early warning indicators for equity bear markets. Since the 1980s, junk yields (shown inverted in Chart 6) have consistently broken out to new highs 3-6 months before stock bear markets take hold. This is because in a typical cycle, junk yields tend to respond more quickly to an erosion in corporate health fundamentals and/or a credit event. Chart 6Junk Bonds Provide Early Warning For Stocks Chart 7Typical Behavior Here But, as we note above, in the current cycle, the reaction to worsening corporate health fundamentals has been far more subdued than historical relationships would have predicted, due to the salve effect of easy monetary policy. If corporate bonds are in a "bubble", does it mean that the behavior of junk bond spreads will no longer be an early predictor of stocks returns? We believe corporate bonds will still be a useful timing tool for equities. If equities are experiencing the same divorcing from fundamentals, courtesy of central bank largesse, then it stands to reason that what pops the bond bubble will also burst the equity balloon. The search for yield has affected the behavior of investors, and therefore returns, in a fairly systematic way. Due to the current extended period of ultra-low interest rates and central bank asset purchases, government bond prices have been pushed sky high (yields have sunk to rock-bottom lows). As a shortage of government bonds has taken hold, investors have sought to invest in "Treasury-like" products, first seeking out the safest corporate bonds, but eventually reaching further out on the risk spectrum to include high-yield bonds and (dividend yielding) stocks. Indeed, asset prices of all stripes have been distorted by the search for yield, which has fueled a broad inflation in all asset classes. The behavior of stocks relative to corporate bonds is telling (Chart 7). Since 2010, and until very recently, stocks outperformed junk bonds on a total return basis. Junk bonds outperformed investment-grade bonds over roughly the same period (although junk underperformed investment-grade in most of 2015 due to the collapse in energy prices and related energy company defaults). This is exactly what has occurred during every recovery phase since the 1980s. Over the past forty years, investment-grade bonds tended to outperform junk bonds and equities during economic recessions. Junk bonds beat equities during the early phases of recovery (i.e. when economic growth turns positive) and for as long as companies continue to repair balance sheets. And equity returns trump both investment-grade and high-yield corporate bonds when our Corporate Health Monitor is deteriorating, i.e. in the latter half of the economic cycle, such as now. This suggests that the relative performance of equities versus corporate credit has not been distorted by monetary policy. One key takeaway is that, although very easy monetary conditions mean that corporate credit performance is becoming divorced from fundamentals, monetary policy has had a similar effect on equity prices (we have written at length in past reports about equity market performance diverging from profit indicators). As in past cycles, once the monetary cover fades, it is most likely that corporate credit markets will once again respond most quickly to balance sheet fundamentals. The bottom line is that we believe the high-yield debt market will remain a reliable indicator for equity market vulnerability. The current message is that a bear market in stocks will be averted, although as we have written in recent reports, earnings disappointments amid dollar strength represent a potential trigger for a near-term correction. Housing Outlook: Room To Expand Over the past quarter, residential real estate data has been slightly disappointing. September housing starts slipped to the bottom end of the range that has held this year and are only marginally above year-ago levels. House price inflation, as measured by the Case Shiller index, is negative on a 3-month basis. Despite this mild disappointment, we continue to believe the housing market is a relative bright light and will continue to be a significant positive contribution to GDP growth. Most indicators show that the housing market continues to recover along the typical path of the classic boom/bust real estate cycle (Chart 8). Chart 8Housing And Its History Chart 9First-Time Homebuyers Entering The Market Moreover, both supply and demand conditions are supportive of further construction activity and upward pressure on house prices over the next several quarters. On the demand side, household formation and a pick-up in interest from first-time buyers are the largest positives. Household formation: The number of households being formed is the most basic measure of marginal new demand for housing units. Household formation was suppressed during the Great Recession and early recovery years, because very poor job prospects and restricted access to credit sorely limited prospective new households from entering both the rental and ownership market. From 2007-2013, the annual household formation rate was 625,000, compared to over 1.1 million in the pre-crisis period.1 Now that the unemployment rate is at 5% and job security is improving, household formation rates are accelerating, particularly among young adults who have hitherto delayed moving out on their own. Monthly numbers are choppy, but household formation could easily run on average at 1.1 million per year for the next few years, simply to make up for muted rates post-housing crisis. First-time buyers: After years of putting off purchases, first-time buyers appear to be finally coming back to the housing market (Chart 9). According to the National Association of Realtors, the proportion of first-time homebuyers for existing home sales has reached its highest mark since July 2012 (34%). But there is still room for this share to improve, as prior to 2007, first-time homebuyers averaged about 40% of total purchases. Once again, persistent income gains and job security will be the driving factors behind first-time homebuyers' decisions. Could a Fed interest rate rise slow housing demand? We don't think so. Mortgage payments relative to income will remain well below their long-term average even if rates are increased by 200bps, an extreme case scenario. Even under this scenario, housing affordability would still be above average, conservatively assuming that income is held constant (Chart 10). Income and employment prospects will continue to trump mortgage rates for consumers making housing decisions; the current employment backdrop is positive for continued housing market activity. Chart 10December Rate Hike Won't Bother The Housing Market Chart 11Supply Is Tight From a supply perspective, conditions remain ripe for more robust construction activity. As Chart 11 shows, the supply of new homes remains low both in absolute, and in terms of months of supply. The bottom line is that we do not fear that a December rate hike will be particularly onerous for the residential real estate market. Plenty of pent-up demand for housing still exists, and this will provide long-term support, so long as the labor market remains robust, as we expect. The recent soft patch in housing will give way to stronger home building activity in the coming months, helping to boost real GDP growth in 2017. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 The State Of the Nation's Housing 2016, Joint Centre For Housing Studies of Harvard University http://jchs.harvard.edu/research/publications/state-nations-housing-2016