Precious Metals

Feature Table 1Recommended Allocation Don't Worry About The Tepid Data Risk assets are likely to continue to grind higher. Two of the catalysts we cited for this in our most recent Quarterly1 have half happened: European political risk is lifting now that Marine Le Pen looks most unlikely to win in the second round of the French presidential election (polls give her less than 40% of the vote); and the Trump administration announced its tax cut plan (which, though details are still sparse, we expect to be passed in some form this year). As a result, the MSCI All Country World Index hit a record high in late April and the S&P 500 is only 1% below its high. But both growth and inflation have surprised somewhat to the downside in the past couple of months. The Citi Economic Surprise Index for the U.S. has fallen sharply, though surprises remain fairly positive elsewhere (Chart 1).Q1 U.S. real GDP growth came in at an annualized rate of only 0.7%. This has pushed bond yields down (with the US Treasury 10-year yield falling back to 2.2%), consequently weakening the dollar. We are not unduly worried about the tepid data. It is mainly due to technical factors. Corporate loan growth in the U.S., for example (Chart 2), mostly reflects just the lagged effect of last year's slowdown on banks' willingness to lend, as well as energy companies repaying credit lines they tapped in early 2016 when short of working capital. The weakness in auto sales (Chart 3) is most likely caused by the end of the car replacement cycle which began in 2010, rather than reflecting any generalized deterioration in consumer behavior. Moreover, there seem to be problems with seasonal adjustment of data caused by the extreme swings in the economy in 2008 and 2009: Q1 has been the weakest quarter for U.S. GDP in six out of the past 10 years, and has on average been 2.3 ppts lower than Q2.2 There were no such distortions prior to 1996. Chart 1U.S. Growth Has Surprised To The Downside Chart 2Weaker Loan Growth Is Mostly Technical... Chart 3...And The Slowdown In Autos Is Just The End Of A Replacement Cycle A consequence of the wobbly data is that markets have become too complacent about the Fed raising rates, with futures markets now projecting only about 40 bps of hikes over the next 12 months (Chart 4). Our view is that wages will gradually move up this year, pushing core PCE inflation to 2% by year end, which will cause the Fed to raise rates twice before end-2017 and once early in 2018 (though the latter rise could be postponed if the Fed starts to reduce its balance-sheet and forgoes one quarter's hike to judge the impact of this on the market). By contrast, we do not see the ECB hiking before 2019 at the earliest, with ECB President Draghi reiterating that he sees core inflation staying low and remains concerned about the fragile banking systems in peripheral European markets and about Italian politics. We also believe Bank of Japan governor Kuroda when he says he has no plans to change the BoJ's 0% target for the 10-year JGB yield. All this implies that the dollar is likely to appreciate further in the next 12 months as interest rate spreads widen (Chart 5). Chart 4Fed Is Likely To Hike Faster Than This Chart 5Interest Differentials Suggest Further Dollar Strength The next catalyst for equities to rise further could be earnings. Q1 U.S. earnings are surprising significantly on the upside, with EPS growth of 11.7% year on year and 75% of companies beating analysts' estimates.3 BCA's proprietary model suggests that S&P 500 operating earnings this year could grow by over 20% (Chart 6). If anything, upside surprises to earnings have been even stronger in the euro zone and Japan. With none of the standard indicators signaling any risk of recession over the next 12 months (Chart 7), we remain overweight equities versus bonds. We continue to warn, though, that the Goldilocks scenario of healthy growth and stable inflation may not last for long. A combination of tax cuts, wage growth accelerating as labor participation hits a ceiling, and the Fed falling behind the curve (perhaps when President Trump - given that he recently confessed "I do like a low interest rate policy" - appoints a dovish replacement for Janet Yellen as Fed Chair) could cause inflation to rise unexpectedly next year, forcing the Fed to raise rates sharply, triggering a recession in 2019. Chart 6U.S. Earnings Could Grow 20% This Year Chart 7No Sign Of A Recession On The Horizon Equities: In a risk-on environment, euro zone equities should continue to outperform, due to their higher beta (averaging 1.3 against global equities over the past 20 years, compared to 0.9 for the U.S.), more cyclical earnings, and modestly cheaper valuations (forward PE is at a 18.9% discount to the U.S.). Japanese equities should also do well as interest rates rise again globally (except in Japan where the BoJ will stick to its 0% yield target on 10-year bonds), which should push down the yen and boost earnings. We remain overweight Japanese equities on a currency-hedged basis. We are underweight EM equities, which are likely to be weighed down over the next 12 months by the stronger dollar, and by a slowdown in China which should cause commodity prices to fall. Fixed Income: We expect the 10-year U.S. Treasury yield to reach 3% by year-end: a pickup in real growth, slightly higher inflation and two more Fed hikes can easily add 70 bps to the yield over the next eight months. Euro zone yields will also rise, though not by as much. This implies a negative return from G7 sovereign bonds for the first time since 1994. We continue to prefer corporate credit, with a preference for U.S. investment-grade debt over high-yield bonds (which have stretched valuations) and over European corporate debt (which will be negatively affected by the tapering of ECB purchases next year). Currencies: As described above, we do not believe that the dollar appreciation which began in 2014 is over, due to divergences in monetary policy. We would look for a further 5-10% appreciation of the dollar over the coming 12 months, though the rise is likely to be bigger against the yen and emerging market currencies than against the euro. Commodity currencies such as the Australian dollar also look vulnerable and overvalued. The British pound will be driven by the vicissitudes of the Brexit negotiations in the short-run but looks undervalued in the long run if, as we expect, the EU eventually agrees a moderately satisfactory trade deal with the U.K. Commodities: We continue to believe that the equilibrium level for oil is $55 a barrel, and that an extension of the OPEC production agreement beyond June and a drawdown in inventories in the second half will bring WTI crude back to that level - with the risk of even $60-65 temporarily if there are any unforeseen supply disruptions. We remain more cautious on industrial commodities, which will be hurt by a mild withdrawal of monetary and fiscal stimulus in China. Following its 6.9% GDP print in Q1, Chinese growth is likely to slow moderately. However, with the Party Congress coming up in the fall, growth will not be allowed to slow excessively - and, indeed, there are signs that central government spending has begun to accelerate recently (Chart 8). We remain positive on gold as a long-term hedge against the tail risk of inflation. As our recent Special Report on Safe Havens demonstrated,4 gold has historically provided good returns during recessions, particularly those associated with high inflation (Chart 9). Chart 8China Is Withdrawing Stimulus - Or Is It? Chart 9Gold Glisters When Inflation Rises Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see Global Asset Allocation, "Quarterly Portfolio Outlook: No Reasons To Turn Cautious," dated 3 April 2017, available at gaa.research.com 2 For detailed analysis of the problems with seasonal adjustment, please see U.S. Investment Strategy, "Spring Snapback?" dated April 24, 2017, available at usis.bcaresearch.com 3 So far about half of U.S. companies have reported. 4 Please see Global Asset Allocation, "Safe Havens: Where To Hide Next Time?" dated April 21, 2017, available at gaa.bcaresearch.com. Recommended Asset Allocation

Special Report

Highlights Safe-haven assets do not simply outperform equities on a relative basis during bear markets. In fact, the average return of nine safe-haven assets has been positive in every bear market since 1972. A safe haven should serve two purposes. First, it should have a negative correlation with equities during bear markets, not necessarily in all markets. Second, it should have an insurance-like payoff, surging during systemic crashes. Low intra-correlations between safe-haven assets, and substantial absolute differences between individual returns and the overall group average suggest that selection adds significant alpha. In the next bear market, we recommend positions in CHF over USD and JPY, due to its greater consistency as a safe-haven asset and more attractive valuations. Favor gold over farmland and TIPS, as gold offers a better hedge against political risks while still protecting against rising inflation. Overweight Treasuries relative to Bunds given a more appealing return distribution and high spreads. Feature Feature ChartSafe Haven Performance As the economic expansion approaches its 100th month, far longer than 38.7 month average1 of cycles starting from 1854, concerns continue to mount over the next recession and equity market crash. Memories of over 50% losses in stocks during the subprime crisis are still ingrained in investors' minds and the importance of capital preservation and safe-haven assets cannot be stressed enough. Safe-haven assets do not simply outperform equities on a relative basis during bear markets. In fact, during the subprime crisis, an equal-weighted portfolio of nine safe-haven assets actually increased in absolute value by 12% (Feature Chart)! This has held consistent through every bear market since 1972 and we expect the next crisis to be the same. While we do not expect a bear market in the next 12 months, we do stress the importance of being prepared and tactically flexible given the substantial relative and absolute performance of safe-haven assets. In this Special Report, we analyze behaviors of safe havens during past bear markets in order to recommend tilts to outperform during the next major equity selloff. Historical Perspective For our analysis, we used monthly return data to more accurately compare across asset classes. We used the following nine safe-haven assets: U.S. Dollar - As the world's reserve currency, the U.S. dollar benefits from massive trade volumes. Japanese Yen - Japan is still the world's 3rd largest economy and runs a current account surplus. Investors' perceptions of safety are intact and the currency benefits from unwinding of carry trades during risk-off environments. Swiss Franc - Switzerland has built a reputation for its international banking prowess, political neutrality and economic stability. U.S. Farmland - Farmland differs from the others in that it is a tangible, hard asset. With finite supply and an increasing population leading to higher needs for farming and food, demand will remain robust. U.S. Treasuries - Treasuries have essentially no default risk. Since its formation in 1776, the U.S. has never failed to pay back its debt. German Bunds - Germany benefits from being economically and politically stable. Bunds are extremely liquid and could receive capital inflows in the event of euro area disintegration. Gold - Gold has a longstanding history as a safe-haven asset, protecting against inflation, currency debasement and geopolitical risks. U.S. TIPS - TIPS are the purest inflation hedge; their historical performance has held a very tight correlation with realized changes in consumer prices. Hedge Funds - Hedge funds are attractive given their lack of restrictions and ability to short. We classified an equity bear market as a decline in the S&P 500, from peak to trough, larger than 19%.2 Using this definition, we recorded eight separate instances since 1972 (See Appendix). On average, these episodes lasted about 14 months and equity prices experienced declines of 34%. We examined returns, correlations and recession characteristics in order to draw conclusions about potential future behavior. Key Findings: During bear markets, the value of these nine safe havens increased on average by 9.2% (Table 1). This certainly does not offset the 34% average decline in equities, but it does provide a considerable buffer, particularly if allocators tilt asset class weightings. However, there is concern that safe havens as a whole will not provide as much protection in the next downturn as they have in the past, given weak equity inflows and still-considerable cash on the sidelines (Chart 2). The average absolute spread between the returns of the nine safe havens and their overall average return was 12.3%. While the correlations between financial assets tend to spike upwards during bear markets, they actually remain very low between safe-haven assets. This indicates a significant opportunity for alpha generation during equity downturns. The region from which a crisis stems has little impact on which safe haven outperforms. For example, U.S. Treasuries and the U.S. dollar both increased in value during the past two recessions, despite the tech bubble and subprime crisis originating from the U.S. (Chart 3). Capital inflows into those assets remained robust given their reputation for safety and quality. U.S. Treasuries and the Swiss franc always had positive absolute returns during the eight bear markets, and therefore have always had a negative correlation with equities (Table 2). These two assets have very stable reputations for safety. Nevertheless, other safe havens, such as gold, USD, JPY and Bunds, still maintained negative correlations with equities during most bear markets. U.S. farmland and U.S. TIPS also had positive returns in the three bear markets since their starting dates. Hedge funds, while known to outperform equities during bear markets, did not provide positive absolute returns in any of the four equity downturns since the index began. Table 1Bear Market Performance Chart 2Safe Havens: Less Protection Next Time? Chart 3Location Doesn't Matter Table 2Correlation With Equities Investment Implications Chart 4A Near-term Bear Market Is Unlikely It is crucial to understand the purpose of a safe-haven asset as it pertains to portfolio management. First, a safe-haven asset should have a negative correlation with equities during bear markets, not necessarily in all environments. Secondly, and more importantly, a safe-haven asset should have an insurance-like payoff, surging during systemic crashes. As safe havens naturally receive a smaller allocation in typical portfolios due to their underperformance versus equities in most years, it is imperative that relatively smaller weightings and minor tilts offset large declines in equity prices. It is important, however to note that we view the probability of a bear market as highly unlikely over the next twelve months (Chart 4). First, substantial stock price declines are not very common outside of recessions. As our colleague Martin Barnes points out, the yield curve is not inverted, there are no serious financial imbalances, and the leading economic indicator remains in an uptrend.3 Monetary conditions are still stimulative, and it generally requires Fed tightening to surpass equilibrium before recessions occur. Massive average absolute deviations for each individual safe haven from the overall group average and low intra-correlations suggest that selection adds significant alpha (Chart 5). Unlike most financial assets, intra-correlations between safe havens actually decline during bear markets. In order to best compare and contrast safe havens, we divided the assets into three buckets: currencies, inflation hedges and fixed income. Below, we recommend tilts within these buckets and will revisit these recommendations closer to the next bear market. Chart 5Intra-correlations Remain Low In Bear Markets Currencies: Overweight CHF relative to USD and JPY. As a zero-sum game, currency selection offers a critical avenue for alpha generation. As global growth continues to improve and capital flows to more cyclical currencies, or to the USD where policymakers are tightening, the Swiss franc should become even more attractively valued. The franc's considerable excess kurtosis, indicating higher likelihood of outsized returns, best fits the insurance-like payoff quality (Chart 6). It is the only currency to have outperformed, and therefore held a negative correlation with equities, during each of the eight recessions, indicating high reliability as a safe-haven asset. Going forward, we see no reason for Switzerland's reputation for economic stability or political neutrality to be compromised. The biggest risk to this view would be if the Swiss National Bank were to stick stubbornly to its peg of the CHF to the EUR during the next recession, thereby dampening the franc's risk-off properties. The USD has historically been able to outperform even when the crisis originated in the U.S. Historical bear market performance was greatest, however, following sharp Fed tightening such as the Volker crash, when the Fed increased rates in response to high inflation, or in the subprime crisis, when the Fed increased rates to slow growth (Chart 7). While we expect inflation and growth to grind upward over the cyclical horizon, our base case is not for a surge in consumer prices or for economic growth to expand significantly above trend. Chart 6Return Distributions Chart 7Fed Tightening = USD Outperformance In the next bear market, the JPY will likely benefit from cheap starting valuations as the BoJ is currently aggressively easing, and its current account surplus raises its fair value. Nevertheless, the yen's returns during equity downturns have not always been consistent with its safe haven reputation. Of the three currencies, since 1970, it has had the lowest probability for large returns. Inflation Hedges: Overweight Gold relative to TIPS and Farmland. Over most of the time frames we tested, gold had the highest correlation with both headline and core inflation (Tables 3 & 4). Table 3Correlation With Core Inflation Table 4Correlation With Headline Inflation The main differentiating factor with gold is its ability to hedge against political risk. Our geopolitical strategists found that of all of the safe-haven assets, gold offered the best protection against political shocks4 (Chart 8). As mentioned in one of our recent Special Reports,5 we believe that stagnation in median wages and wealth inequality will continue to fuel the rise in populism and social unrest. Chart 8Gold Is Best At Hedging Political Risk Farmland has historically offered decent inflation protection, but its history is limited, supply is scarce and the massive runup in prices is a cause for concern. While we currently favor TIPS over nominal bonds, their negative skew and excess kurtosis suggest that they are vulnerable to large negative returns, making them a less-than-ideal safe-haven asset. Fixed Income: Overweight Treasuries relative to Bunds. Concerns that, because government yields are starting at very low levels, bonds will not provide safety in the next bear market, are overblown. Recent history proves that yields can reach negative territory, and historical performance for government fixed income has been robust in almost every significant equity decline. Additionally, the end of the 35-year decline in interest rates should not negatively affect the protection capabilities of Treasuries. Yields actually rose leading up to, and during, the 1972 and 1980 bear markets, and Treasuries still provided positive absolute returns (Chart 9). One caveat is that starting yields are much lower today. If yields were to rise during the next recession, they may not achieve positive absolute returns, though government bonds would still certainly outperform equities by a wide margin. Overall, Treasuries have held a more negative correlation with equities during bear markets, spreads over Bunds will likely continue to rise given diverging monetary policy, and they have historically been more prone to outsized positive returns during crisis periods (Chart 10). Bunds are currently benefitting from flight-to-quality flows resulting from political and policy issues originating in the periphery. However, at some point, concerns that the euro crisis will spread to Germany may eliminate this advantage. Chart 9Rising Yields Were Not A Problem Chart 10Relative Treasury Valuations Will Become More Attractive Patrick Trinh, Associate Editor patrick@bcaresearch.com 1 http://www.nber.org/cycles.html. 2 While a 20% decline may be a more widely-used measure for bear markets, there have been three instances of 19% declines since 1972, one of which was a recession. We decided to include these in our analysis to increase the number of observations and improve the reliability of our analysis. 3 Please see The Bank Credit Analyst Special Report, "Beware The 2019 Trump Recession," dated 7 March 2017, available at bca.bcaresearch.com. 4 Please see Geopolitical Strategy Special Report, "Geopolitics and Safe Havens" dated November 11, 2015, available at gps.bcaresearch.com. 5 Please see Global Asset Allocation Special Report, "Refreshing Our Long-Term Themes," dated 5 December 2016, available at gaa.bcaresearch.com.

Global gold mining stocks are breaking out on the back of the bid in gold prices. The confluence of spiking geopolitical uncertainty, both in the U.S. and globally, rise in equity volatility and safe haven bid in U.S. Treasurys have raised the profile of gold-related hedges. Importantly, the top panel of the chart shows that the surge in the economic policy uncertainty index heralds additional relative gains for gold-related shares. Similarly, easing real interest rates are raising the profile of gold prices. This portfolio hedge has served our portfolio well since the broad market's peak in early-March and more gains are in store until this consolidation/correction phase fully runs its course. Bottom Line: We are reiterating our overweight stance in the global gold mining index via the GDX:US exchange traded fund.

Highlights The Fed's evident desire to lift its policy rate next week - presumably to get out ahead of inflation that has yet to show up in its preferred gauge - will weigh on gold. Oil ... not so much. This is because fundamentals once again are asserting themselves in the evolution of oil prices, something that has been evident even before markets balanced last year. Gold, meanwhile, remains exquisitely sensitive to Fed policy expectations and their effects on the USD and real rates, as with other currencies. Energy: Overweight. We are looking to re-establish our long WTI Dec/17 vs. short Dec/18 spread if it trades in contango again, i.e., if Dec/17 is less than Dec/18. We believe the combination of OPEC and non-OPEC adherence to their production Agreement will remain high, and demand likely will remain stout. Base Metals: Neutral. Spot copper is down ~ $0.10/lb on COMEX over the past week. We expect transitory supply issues in Chile and Indonesia to be resolved, and reflationary stimulus in China to wane going into the 19th National Congress of the Communist Party in the autumn, and, with it, copper demand. We remain neutral. Precious Metals: Neutral. Gold is weakening as the Fed's March meeting approaches next week, given the overwhelming expectation for a 25bp rate hike. We remain long volatility, expecting fiscal-policy uncertainty in the U.S. to be resolved over the next few months, and Fed policy drivers to become more focused. Ags/Softs: Underweight. We are not expecting significant changes in the USDA's estimates of stocks globally, and therefore remain underweight. Feature The choreographed messaging of voting and non-voting FOMC members asserting the need for a policy-rate hike over the past two weeks succeeded in pushing markets' expectations for such action to 88.6% as of Tuesday's close, up from 44.6% at the end of February. This despite the fact that the Fed's preferred inflation gauge - core PCE - has yet to show any sign of pushing up and thru the Fed's target of 2% growth yoy (Chart of the Week). Nor, for that matter, has core PCE shown any tendency to remain above 2% yoy growth over the past two decades (Chart 2). Chart of the WeekThe Fed's Preferred Inflation ##br##Gauge Still Quiescent Chart 2Core PCE Has Been ##br##Quiescent For Decades Between mid-December 2016 and the end of last month, gold prices rallied ~11.3% largely on the expectation the Fed would not raise rates until at least June, and, even then, would be constrained by uncertainty over what Congress and the Trump Administration would offer up in terms of fiscal policy later this year. Now, with the Fed succeeding in raising the market's expectation of a March rate hike, gold markets are left to re-calibrate the number of hikes to expect this year, and the likely implications for the USD and real rates. We believe the Fed will execute three rate hikes this year, but this will be highly dependent on how markets react to the now fully priced-in hike markets expect next week. Synchronized Growth, Inflation And Feedback Loops It is likely the Fed feels confident accelerating its rates normalization because, for the first time since the Global Financial crisis, we are getting a globally synchronized recovery in GDP. All else equal, this will give the U.S. central bank a bit of headroom to experiment with an earlier-than-expected rate hike. This synchronized growth also will provide a positive backdrop for commodity demand this year and next (Chart 3). The possibility of highly stimulative - or even just moderately stimulative - fiscal policy in the U.S. at a time when the economy is apparently at or close to full employment, will be positive for aggregate demand, and could be inflationary if its principal result is to lift real wages in the U.S. In addition to synchronized growth, we also are seeing evidence of synchronized inflation in the largest economies in the world (Chart 4). Chart 3Synchronized Global Growth ##br##Could Embolden The Fed Chart 4Synchronized Inflation Globally ##br##Likely Caught The Fed's Attention This synchronized growth and inflation is, we believe, important to the Fed, in that its effects constitute something of a global feedback loop. As we have noted in earlier research, the Fed is much more sensitive to how its policy actions affect other economies, given the deepening of global supply chains over the past two decades or so. Equally, policymakers are well aware the evolution of monetary policy and economic growth in other economies affects the U.S. growth and policy variables important to the Fed.1 Absent a policy shock in the U.S., Europe or China, the backdrop for EM growth should remain positive for at least 2017, even with reflationary stimulus waning in China, a left-tail risk to commodity prices that we identified in last week's publication.2 We expect the Fed's policy normalization to be tempered by continued monetary accommodation globally, which will be supportive of growth at the margin. This will keep global oil demand growth on track to average 1.50 - 1.60mm b/d this year and next, and, importantly for inflation and inflation expectations, keep EM oil demand growing. The income elasticity of per-capita oil consumption in EM economies typically is ~ 1.0, meaning a 1% increase in EM incomes is associated with a 1% increase in EM oil demand.3 EM growth accounts for close to 85% of the growth we expect in global oil demand this year. This is important, given EM oil demand, which we proxy with the U.S. EIA's non-OECD oil consumption time series, to be a common factor that explains the evolution of the CPI series shown above (Chart 5). EM oil demand is able to explain the synchronization of inflation in the three largest economies in the world is because incremental growth is occurring in the EM economies, and this is driving global growth. We continue to expect high compliance in the OPEC - non-OPEC production deal negotiated by the Kingdom of Saudi Arabia (KSA) and Russia at the end of last year, which will, against the backdrop of continued global growth, cause inventories to fall and for markets to backwardate. We believe last week's increase in U.S. crude oil inventories to be the last big build, and expect the decline to begin later this month. On average vessels leaving the Persian Gulf destined for the U.S. have a 45- to 50-day sailing period depending on multiple factors such route, weather and sea conditions. Therefore, the recent increase in U.S. crude oil inventories can be linked to the arrival of the final fleet of vessels in concert with the pre-OPEC agreement production surge undertaken by the GCC. Evidence of this phenomenon is apparent in the ~500k b/d increase in U.S. crude oil imports (374k b/d coming from Iraq) over the prior week. We expect OECD oil stocks to start declining this month and fall some 300mm bbl before the end of 2017. This supply-demand dynamic will continue to dominate financial-market influences on oil prices, as we argued in last week's publication (Chart 6).4 Gold, on the other hand, will continue to take its cue from Fed policy and policy expectations, particularly as regards expectations for the USD, which should strengthen at the margin, given the Fed's new-found hawkishness, and real rates, which also should strengthen (Chart 7). Chart 5EM Oil Demand Continues##br## To Drive Inflation Chart 6IF KSA And Russia Can ##br##Coordinate Production... Chart 7Gold Will Continue To Take##br## Its Cue From Fed Policy Bottom Line: Oil prices will continue to be dominated by supply-demand-inventory fundamentals, with monetary policy effects on the evolution of prices taking a secondary role. Gold prices will continue to take their cue from Fed policy and policy expectations. We look to re-establish our long Dec/17 WTI vs. short Dec/18 WTI spread if it trades thru flat (i.e., $0.00/bbl). Given our gold view, we remain long volatility via the put spreads and call spreads we recommended February 23 - i.e., long Jun/17 $1,200/oz puts vs. short $1,150/oz puts, and long $1,275/oz calls vs. short $1,325/oz calls. The position was up 15% as of Tuesday's close. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Reports "Global Inflation and Commodity Markets," dated August 11, 2016, and "Memo To The Fed: EM Oil, Metals Demand Key To U.S. Inflation," dated August 4, 2016, available at ces.bcaresearch.com. 2 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Gold's Known Unknowns, And Fat Tails," dated February 23, 2017, available at ces.bcaresearch.com. 3 Oil consumption frequently is employed to approximate EM income growth, given the income elasticity of demand for oil is ~ 1.0, meaning a 1% increase in income (GDP) produces an increase in demand for oil of approximately 1.0%. The OECD notes, "Non-OECD countries are found to have a higher income elasticity of oil demand than OECD countries. On average across countries, a one per cent rise in real GDP pushes up oil demand by half a per cent in OECD countries over the medium to long run, whereas the figure is closer to unity for most non-OECD countries." Please see "The Price of Oil - Will It Start Rising Again?" OECD Economics Department Working Paper No. 1031, p. 6 (2013). 4 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Days Of Oil Future's Past: Mean Reversion," dated March 2, 2017, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in

Highlights Gold volatility is trending lower, suggesting unresolved economic and political issues are diminishing, and investors' confidence in the global economy is improving. This is a false positive. Uncertainty is elevated. "Known unknowns" loom large: U.S. and Chinese fiscal policy, which drive USD dynamics and commodity supply and demand, are unresolved; The outcome of French and Italian elections could shock the euro zone; The reaction functions of systemically important central banks as they navigate these risks remain opaque. Given gold's exquisite sensitivity to political and policy nuances globally, our attention naturally turns to it when we look for ways to position in the face of this political and policy-related uncertainty. Our analysis suggests the low volatility in gold markets is the result of traders and investors being driven to the sidelines, where they await clarity re politics and policy. This is keeping trading volumes low: No one wants to be long or short lacking critical information necessary to take a view on the evolution of asset-price paths. Lower trading volumes, therefore, reflect a paucity of information in the price-discovery process, which, all else equal, will tend to keep commodity prices range bound until new information arrives to propel them in one direction or the other. With fewer prints going up across markets, realized and implied volatilities remain low ... for the moment. Energy: Overweight. We are taking profits basis today's close on our WTI Dec/17 vs. Dec/18 backwardation spread initiated February 9 at -$0.11/bbl. We also will be taking profits on our Dec/19 WTI vs. Brent spread, elected February 6 at +$0.07/bbl, after WTI traded premium to Brent in anticipation a U.S. border-adjusted tax would be enacted. Base Metals: Neutral. Copper remains well bid amid transitory supply outages. Workers resumed their strike at BHP's Escondida mine in Chile, while Anglo American temporarily suspended work at its El Soldado mine in a regulatory dispute, according to Metal Report. Freeport-McMoRan declared force majeure on Grasberg deliveries. Precious Metals: Neutral. We are withdrawing our gold buy-stop, and are recommending long gold options spreads to position for higher volatility (see below). Ags/Softs: Underweight. Corn and wheat came under selling pressure over the past week, but still are holding trend-line support from end-2016. We continue to monitor these markets for signs of a short-term rally. We remain strategically bearish, however. Feature While we believe the Efficient Market Hypothesis (EMH) holds most of the time - at least in semi-strong form (i.e., all public information is fully reflected in prices) - traders and investors now find themselves in something of a quandary.1 Much of the information needed to assess future paths for asset prices and form expectations for returns has yet to be revealed. In other words, there are large parts of markets' information sets made up of "known unknowns," which, once resolved, will be of enormous consequence to the paths taken by different asset prices. This is particularly true for gold. Our analysis suggests this lack of information is keeping trading volumes in gold markets low. As a result, the price-discovery process is stymied, which, all else equal, tends to keep prices range bound until new information arrives to propel them in one direction or the other. With fewer prints going up across markets, realized and implied volatilities remain low. Investors accustomed to viewing low volatility as an indication unresolved economic and political issues are diminishing therefore have to adapt to a new reality, one in which low volatility actually is the product of heightened uncertainty (Chart of the Week). Granted, financial stress is low. This contributes to lower volatility, particularly in gold, which is highly sensitive to U.S. real rates and USD levels. However, we find low trading volumes in gold markets also are responsible for the lower-trending realized and implied volatility prevailing in in gold markets (Chart 2).2 Chart of the WeekVolatility Is Low, Despite Uncertainty Being High Chart 2Realized And Implied Gold Vols Are Trending Lower This suggests there is an opportunity to position ahead of the resolution of these "known unknowns" in the gold market, given the low volatility levels we see. This is driven largely by our view that there are numerous risks in near- and longer-term price distributions, which imply much fatter tails than markets are pricing in at the moment.3 Indeed, the CBOE Gold VIX is running at ~ 13.5% presently vs. a post-Global Financial Crisis (GFC) average of 18.8% p.a.4 First, The Fat Left Tail There are a number of risks pumping up the left tails of many commodity price distributions - e.g., how long China will continue to tighten fiscal policy (Chart 3), and the effect this will have on the prices of base metals and bulk commodities like iron ore and steel. And, of course, markets will continue to hang on every utterance of Federal Reserve officials, attempting to discount rate-hike probabilities and their implications for the USD and real rates, the critical drivers of gold prices (Chart 4). Chart 3China Fiscal Stimulus Grinds To A Halt Near term, these risks will continue to loom large, but they are dwarfed by a possible border-adjusted tax (BAT) being imposed in the U.S. In our estimation, this is the largest left-tail risk we've identified for commodity markets over the near term. It is being championed by Republican leaders in the U.S. House of Representatives - led by Speaker Paul Ryan and Ways and Means Chairman Kevin Brady.5 A BAT would raise the price of commodities subject to the tax in the U.S. Domestically, producers of commodities subject to the tax would benefit from this increase in prices, since it would boost their revenues and incentivize increased domestic production. This would be used to displace imports and take market share from exporters to the U.S. Once the domestic market has been saturated with the higher domestic output, U.S. producers would turn to export markets to sell their increased output. A BAT would shrink the U.S. trade deficit, which would, all else equal, raise the trade-weighted value of the USD. Our expectation is there is a 50:50 chance a BAT is enacted, but that it will exclude oil and apparel. We expect the USD would appreciate ~ 10% on the back of this scheme, on top of the 5% increase in the value of the dollar we already were expecting from the Fed's continued push to normalize monetary policy. On the back of this 15% appreciation in the USD over the next year or so, commodity prices ex U.S. would increase in local-currency terms, which would crimp demand in EM and DM economies. On the supply side, the cost of producing commodities ex U.S. would fall in local-currency terms, which would increase supply at the margin. Net, net: A BAT would cause global commodity demand to fall and supply to increase, which would, all else equal, send a deflationary impulse back to the U.S., and DM and EM economies. Fat Right Tails Permanent and transitory commodity supply losses constitute large right-tail risks for investors, in our estimation, as does stronger-than-expected demand. Chief among these are ongoing losses in copper markets in the near term, which we believe to be transitory. The massive $1 trillion+ capex cuts registered in the oil markets in the wake of the price collapse induced by OPEC's market share war leave us with low confidence our oil-price expectation of $55/bbl will prevail beyond 2018. Near term, however, the timing and type of infrastructure projects that will be funded under the Trump administration's forthcoming fiscal roadmap, and whether Congress will be supportive represent the largest right-tail risk for gold markets. Highly expansive fiscal stimulus could spur inflation in the U.S., given this stimulus will be hitting an economy that already is at or near full employment. Given the synchronized global economic recovery currently underway, we believe an inflationary impulse could percolate into near-term inflation realizations, and into inflation expectations longer term. Chart 4Markets Will Continue To Hang On Every Fed Utterance This elevated inflation risk will be bullish for gold, as we showed in recent research.6 Indeed, we noted, "All else equal, with the U.S. labor market at or close to full employment, and the Trump administration signaling its desire for stimulative fiscal policy, we would be inclined to look for inflation hedges within commodities that are highly sensitive to rising inflation." Topping that list is gold, in our estimation. Taking A View On Volatility Chart 5Gold Provides A Good Hedge For Equity Volatility Volatility is trading-market shorthand for the annualized standard deviation of expected returns for an underlying asset. It is a parameter used to price options. Options markets are unique in that they allow investors to take a view on the dispersion of the expected returns of the asset against which the option is written.7 Volatility is a calculated value, whereas the other components of an option's price - i.e., the underlying asset's price, the strike price, time to expiration, and interest rates - all are known inputs. Volatility, like the price of the underlying asset, therefore is "discovered" when a trade occurs. After an option trades and its premium becomes known, an option-pricing model - e.g., the Black-Scholes-Merton model - can be run backwards, so to speak, to see what level of volatility solves the pricing model for the value that cleared the market. This is known as the option's implied volatility, because it is the expected standard deviation of returns implied by the price at which the option clears the market. One reason investors and traders buy and sell options is to express a view on implied volatility. Option buyers who think the market is underestimating the likelihood of sharply higher or sharply lower returns can express this view by buying out-of-the-money options - calls or call spreads on the upside, puts or put spreads on the downside. This can arise for any number of reasons, but they all boil down to one essential point: Option buyers think there is a higher probability returns will be higher or lower during the life of an option than what is being priced in the options market presently.8 Option sellers, on the other hand, are expressing the opposite view. We believe the fat-tail risks we've discussed in this article are not being fully reflected in the options markets most sensitive to this information, among them the gold market. Our own assessment of these risks implies much fatter tails than we currently observe in the out-of-the-money gold options, as noted above. For this reason, we are recommending investors consider buying put spreads and call spreads against June-delivery gold. We will look to get long Jun/17 $1,200/oz puts vs. selling $1,150/oz puts, and getting long $1,275/oz calls vs. selling $1,325/oz calls, basis tonight's closing levels for the underlying contract. This is a low-risk strategic recommendation, with the put and call spreads roughly equidistant from where the Jun/17 gold contract is trading. The motivation for this recommendation is simple: We believe volatility is low, given the "known unknowns" and their associated fat tails, which are not being accounted for in options prices. This makes these options cheap. Gold Can Hedge Equity Risk As Well Our analysis reveals gold provides a good edge against rising equity volatility, as measured by the CBOE's equity volatility index (CBOE VIX).9 From 1995 to the present, gold's monthly percentage returns outperformed those of the S&P 500 61% of the time when the VIX was increasing, and 36% of the time when the VIX was decreasing (Chart 5). Over the entire sample, gold outperformed the S&P 500 in average by 2.25% in periods of increasing equity volatility as measured by the VIX. However, if we focus only on sub-sample periods where the VIX was increasing but from an already-elevated level (20% or above), gold returns outperformed S&P 500 returns by 4.57% on average. Given our assessment that current volatility is abnormally low, particularly for gold, we believe the gold options exposure recommended here will provide investors protection against increasing equity volatility, as well. Moreover, if market sentiment changes and volatility begins to increase significantly, our analysis provides evidence that gold's volatility-risk-mitigation properties increase even more when the VIX is already at a high level. Bottom Line: Markets lack sufficient information to fully price the risks in potential fat-tail events on the down- and up-side of commodity price distributions. We believe gold options - particularly put and call spreads - offer a low-risk way to position for the eventual resolution of this uncertainty. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Assistant hugob@bcaresearch.com 1 For an excellent discussion of the EMH, please see Timmermann, Allan, and Clive W.J. Granger (2004), "Efficient market hypothesis and forecasting," in the International Journal of Forecasting, Vol. 20, pp. 15 - 27. 2 When we regress CBOE gold volatility on first-nearby gold futures volume using daily data over January 2016 to February 2017 using an error-correction model, we find trading volume explains ~ one-third of the CBOE implied gold volatility's level. 3 Many of these risks are geopolitical in nature, which our colleague Marko Papic considers at length in "A Fat-Tails World," published February 22, 2016, in BCA Research's Geopolitical Strategy Weekly Report, available at gps.bcaresearch.com. 4 We mark the post-GFC period as Jan/10 to present. 5 A BAT essentially would tax imports coming in to the U.S. and subsidize exports, using proceeds to reduce corporate taxes. We are not ready to pronounce the BAT dead, as some pundits already have. We think the market's 20% probability that such a tax becomes law is too low: We give it a 50:50 chance of passage, albeit in a watered down form likely calling for a 10% tax on imports, which likely will not include oil or apparel. Base metals and agricultural imports likely would be taxed under this scheme. We analyzed the commodity impacts of this proposed scheme in "Taking a BAT To Commodities," which was published in the January 26, 2017, issue of BCA Research's Commodity & Energy Strategy Weekly Report, available at ces.bcaresearch.com. 6 Please see issue of BCA Research's Commodity & Energy Strategy Weekly Report, "Gold Will Perform...," dated February 2, 2016, available at ces.bcaresearch.com. 7 Call options give the buyer the right to go long an underlying asset at the price at which an option contract is struck - i.e., the option's strike price. Puts give option buyers the right to go short the underlying asset at the price at which the contract is struck. While an option buyer is not required to ever exercise an option, option sellers must take the other side of the deal if the buyer chooses to exercise. Option buyers pay a premium for the put or call they purchase. 8 This probability also can be expressed in terms or price levels, which allows investors to take an explicit view on the likelihood of a particular price being realized during the life of the option being purchased. Please see Ryan, Bob and Tancred Lidderdale (2009), "Energy Price Volatility and Forecast Uncertainty," published by the U.S. Energy Information Administration, for a discussion of options markets and implied volatility. "Appendix II: Derivation of the Cumulative Normal Density for Futures Prices" beginning on p. 22 shows how to transform the returns distribution into a price distribution. It is available at https://www.eia.gov/outlooks/steo/special/pdf/2009_sp_05.pdf. 9 Our results are similar to those reported in "Gold is still a good hedge when volatility rises," by Russ Koesterich, CFA, published by Blackrock on its Blackrock Blog September 9, 2016. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in

Gold mining shares look increasingly attractive, at least as a portfolio hedge. We took profits on our overweight position in the middle of last summer, just prior to the share price crunch, because tactical sentiment and positioning had gotten too stretched. Overzealousness no longer exists, and a revival in market volatility and intensification in policy uncertainty have created an attractive re-entry point in gold shares. The last playable rally began when the yield curve started to flatten, signaling doubts about the longevity of the business cycle. More recently, the yield curve stopped steepening when the Fed raised interest rates last month and may be signaling the start of another move up in gold shares. Importantly, sentiment toward the yellow metal is no longer overheated, as evidenced by both surveys and investor behavior. Flows into gold ETFs have been trending lower, reversing last summer's buying frenzy. Speculative positions have also been unwound. Against a positive structural backdrop for gold, we recommend reestablishing overweight positions in gold mining stocks as a portfolio hedge. Please see yesterday's Weekly Report for more details.

Highlights Portfolio Strategy Food price deflation bodes well for increased volumes, and by extension, packaging stocks. Upgrade to overweight. Prospects for intensifying market and economic volatility argue for reestablishing a portfolio hedge in gold shares. The tech sector underperforms when there is upward pressure on inflation, and the next twelve months is unlikely to prove an exception. Stay clear. Recent Changes S&P Containers & Packaging - Upgrade to overweight from neutral. Gold Mining Shares - Upgrade to overweight from neutral. Table 1 Feature Equity markets finally took a breather last week, as investors digested spotty earnings and began to discount the possible economic downside of U.S. isolationism. While profits should dictate the trend in stocks over the long haul, equity valuations have soared since the election, it is critical to consider the durability of this trend and other influences at this juncture. The recent string of positive economic surprises raises the risk that monetary conditions will tighten further, especially amidst rising inflation pressures and a tight labor market. As such, the broad market remains in a dangerous overshoot phase, predicated on hopes for a sustained non-inflationary global economic mini-boom. The risk is that these hopes are dashed by nationalistic policy blunders (i.e. protectionism and trade barriers) or a more muted and drawn out improvement in global economic growth than double-digit earnings growth forecasts would imply. There appears to be full buy-in to a durable bullish economic/profit outcome. We have constructed a 'Complacency-Anxiety' Indicator (CAI), using a number of variables that gauge investor positioning, sentiment and risk on/off biases (Chart 1). The CAI is at its highest level ever, signaling extreme confidence/conviction in the outlook for equities. While timing market peaks is difficult, because momentum can persist for longer than seems rational, the level of investor complacency is disturbingly high given that policy uncertainty is such a large economic threat. Global economic growth has never accelerated when global economic policy uncertainty has been this high (Chart 2, shown inverted). Chart 1Complacency Reigns Chart 2Uncertainty Is A Growth Impediment If rhetoric about anti-globalization measures turns into reality, that will deal a serious blow to burgeoning economic confidence before it translates into actual economic growth. Thus, the risk of sudden market downdrafts has risen to its highest level of this bull market. Chart 3 shows that positive economic surprises remain primarily sentiment/confidence driven, rather than from upside in hard economic data. To be sure, the stock market trades off of 'soft data' given its leading properties, but the size of the current gap is unusually large and reinforces that a big jump in 'hard data' surprises is already discounted. This gap represents a latent risk, as it did in the spring of 2011 just before the summertime equity market swoon. Chart 3A Big Gap Means Big Shoes To Fill Worryingly, the behavior of corporate insiders suggests that their confidence does not match their share price valuations. According to Barron's1, the insider sell/buy ratio has soared to an extremely bearish level for markets. For context, their gauge is close to 60; anything over 20 is deemed bearish while less than 12 falls into the bullish zone. Chart 4An Increasing Supply Of Stock The spike in secondary issuance corroborates insider selling (Chart 4). Insiders would not be unloading their shares if they felt earnings prospects would outperform what is discounted in current valuations. Even the pace of share buybacks has slowed considerably, to the point where the number of shares outstanding (excluding financials) has moved higher for the first time in 6 years (Chart 4). An increase in the supply of shares, from sources that have incentive to sell when the reward/risk tradeoff is unattractive, is a yellow flag. All of this argues for maintaining a capital preservation mindset rather than chasing market euphoria in the near run. Elevated complacency suggests that the consensus is focused solely on return rather than risk. It will be more constructive to put money to work when anxiety levels are higher than at present. This week we recommend adding a defensive materials sector gem, buying some portfolio insurance and we update our tech sector views. Packaging Stocks Are Gift Wrapped While our materials sector Cyclical Macro Indicator is hitting new lows, this is often a sign that the countercyclical S&P containers & packaging index deserves a second look. We have shown in past research that its strongest relative performance phases often occur when the overall materials sector is struggling. This group offers a more attractively valued alternative to play a transportation recovery than either rails or air freight, as discussed in last week's Report. From a macro perspective, deflation in global export prices should provide a strong tailwind. Why? Low prices spur volume growth. Global export volumes have begun to rebound, consistent with the increase in U.S. port traffic and intermodal (consumer) goods shipments (Chart 5). Any increase in global trade would bolster sentiment toward this high volume industry. Companies in this index are also highly exposed to the food and beverage business since the bulk of consumable non-durable goods products require packaging materials. As such, its fortunes rise and fall with swings in food prices. When food inflation is rising, consumers spend less in real terms, undermining the volume of food packaging demand. The opposite is also true. The current contraction in the food CPI has spawned a boom in food consumption, as measured by the surge in real (volumes) personal outlays on food & beverage products (Chart 6). This phenomenon is also true on a global basis, as food exports are booming (Chart 6, bottom panel), a remarkable development given U.S. dollar appreciation. Chart 5Stealth Play On Volume Growth Chart 6Booming Food Demand... Chart 7... Should Drive Up Multiples If food and beverage consumption stays robust, then the relative valuation expansion in packaging stocks will persist (food demand shown advanced, Chart 7). Increased demand for packaging products has become evident in the budding rebound in pricing power (Chart 8). The producer price index for containers has picked up nicely on a 6-month rate of change basis, albeit it is still low in annual growth terms. Nevertheless, any increase in pricing power would support profit margins if volume expansion persists, given the industry's disciplined productivity focus. Headcount remains in check, likely reflecting automation and investment, and is falling decisively relative to overall employment (Chart 8). The implication is that profit margins have a chance to outperform, particularly if energy prices stay range-bound (Chart 8). U.S. protectionism, and/or a continued rise in bond yields on the back of improving global economic momentum constitute relative performance risks to this position. Chart 9 shows that relative performance is mostly inversely correlated with global bond yields, given that it is a disinflationary winner. Chart 8Productivity Gains Chart 9A Risk Factor However, the global economy has already been through a phase of upside surprises. Moreover, now that China has moved to cool housing, investors should temper expectations for more stimulus to cause Chinese growth to accelerate. Conversely, economic disappointment could materialize before midyear if financial conditions tighten further. In sum, packaging stocks offer attractive exposure within an otherwise unattractive S&P materials sector. Bottom Line: Raise the S&P containers & packaging index to overweight. Gold: Back To Overweight As A Portfolio Hedge Gold mining shares look increasingly attractive, at least as a portfolio hedge. We took profits on our overweight position in the middle of last summer, just prior to the share price crunch, because tactical sentiment and positioning had gotten too stretched. Thereafter, the equity risk premium melted, dimming appetite for portfolio insurance (Chart 10). Moreover, bond yields rose in response to firming economic expectations, increasing the opportunity cost of holding an income-free asset like gold. However, in the absence of a global economic boom, which seems unlikely, and if trade barriers are erected and policy uncertainty continues to escalate, there is a limit to how high real rates can rise. Potential GDP growth remains low throughout the world, weighed down by excessive debt, weak productivity and deflationary demographics (Chart 11, second panel). Chart 10End Of Correction? Chart 11Structurally Bullish A revival in market volatility and an unwinding of previously frothy technical conditions have created an attractive re-entry point in gold shares. The yield curve stopped steepening when the Fed raised interest rates last month (Chart 12). The last playable rally began when the yield curve started to flatten, signaling doubts about the longevity of the business cycle. If the yield curve does not steepen anew, and interest rate expectations move laterally, then the U.S. dollar is less likely to be a barrier to gold price gains. Sentiment toward the yellow metal is no longer overheated, as evidenced by both surveys and investor behavior. Flows into gold ETFs have been trending lower in recent months, reversing last summer's buying frenzy (Chart 12). Speculative positions have also been unwound (Chart 12). Netting it out, the surge in U.S. policy uncertainty, prospects for economic disappointment relative to increasingly elevated expectations and any pause in the U.S. dollar rally support reestablishing overweight positions in gold mining stocks as a portfolio hedge, especially now that overbought conditions have been unwound (Chart 13). Chart 12No Longer Frothy Chart 13Time To Buy Hedges Bottom Line: Return to an overweight position in gold mining shares, using the GDX as a proxy. A Tec(h)tonic Shift Our Special Report published in early-December showed that the tech sector underperforms when inflation pressures accelerate. Companies in the S&P technology sector are typically mature and have shifted from reinvesting for growth to paying dividends and buying back stock. Thus, the rise in bond yields and headline inflation imply higher discount rates and by extension, lower valuations, all other things equal, for the long duration tech sector (Chart 14). Tech companies exist in a deflationary business model mindset. While relative pricing power had been in an uptrend since 2011, it has recently relapsed into the deflationary zone (Chart 15, middle panel). As shown in last Monday's Weekly Report, the tech sector is one of the few suffering from deteriorating pricing power. Chart 14Stiff Headwinds Chart 15Pricing Power Disadvantage Among the broad eleven sectors, tech stocks have the highest international sales exposure, so a higher dollar is also a net negative for exports, revenues and by extension profit growth, relative to the broad market. Industry sales growth is nil, significantly trailing the S&P 500's recent pick up in top line growth rate. History shows that tech relative performance is negatively correlated with the U.S. dollar in the latter stages of a currency bull market. While the temptation to position for an increase in capital spending via the tech sector is high, data do not show any demand improvement. Tech new order growth is decelerating. The tech new orders-to-inventories ratio is on the verge of contracting, and further weakness would herald downward pressure on forward earnings estimates (Chart 16). Net earnings revisions have swung violently downward recently. Any prolonged de-rating would warn of negative share price momentum given the tight correlation between the two (Chart 16). Meanwhile, the loss of tech sector competitiveness and a retreat from globalization via protectionism de-globalization pose serious headwinds to the industry's longer-term prospects. Return on equity is already ebbing, reflecting more intense profit margin pressure from the surge in wage growth and a lack of revenue gains. As a result, EBITDA growth has been non-existent (Chart 17). Chart 16Momentum Is Fading Chart 17Growth Remains Elusive Chart 18Profits Set To Underperform All of these factors are encapsulated in our S&P technology operating profit model, which has an excellent record in forecasting tech earnings. Chart 18 shows that tech profits are likely to contract as the year progresses, a far cry from what is expected for the broad market and the 450bps of profit outperformance embedded in analyst forecasts in the coming 12 months. Bottom Line: Reducing tech exposure on price strength is a prudent strategy. Stay underweight. 1 http://www.barrons.com/public/page/9_0210-instrans.html Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

Highlights In line with our House view, we expect the USD will weaken near term, and are recommending a tactical long gold position if the metal trades to $1,180/oz. Longer term, the Trump administration's presumed fiscal-policy goals - e.g., lighter regulation, lower taxes - will be hitting an economy at or near full employment, and will run smack up against deflationary pressures if a border-adjusted tax (BAT) scheme is implemented. Expect higher volatility. Energy: Overweight. Fundamentals continue to point toward global oil storage drawing by ~ 300mm bbl by 3Q17. Brent was backwardated going to press in the Dec/17 vs. Dec/18 spread, while WTI is in contango.1 Our WTI backwardation trade (long Dec/17 vs. short Dec/18) stopped out at -$0.05/bbl. Markets appear reluctant to take 2018 prices below 2017 levels, but we still like the position and will look to put it on again. Base Metals: Neutral. A weaker USD and marginally softer real rates will support base metals short term. We remain neutral. Precious Metals: Neutral. We are going tactically long gold, and are bracing for more ambiguity in U.S. fiscal-policy. This will keep the Fed on hold till 2H17. Ags/Softs: Underweight. Grains and beans will remain under pressure with Argentine growing conditions improving. High stocks-to-use levels will remain a headwind. Feature Gold prices will get a short-term bounce from financial markets' recalibration of when fiscal stimulus in the U.S. actually will start contributing to growth. With nothing for the Fed to react to in terms of fiscal policy other than sundry indications the Trump administration favors lighter regulation, lower taxes and higher infrastructure spending, we believe the U.S. central bank will remain on the sidelines until mid-year before it starts guiding toward a rate hike. In the meantime, synchronized global growth (Chart of the Week) will continue to fan medium-term inflation expectations (Chart 2). Chart of the WeekSynchronized Global Growth... Chart 2...Is Lifting Inflation Expectations At this point in the cycle, it is unlikely the Fed or other systematically important central banks will tighten policy to arrest the emerging growth. Besides, the U.S. central bank is, for all intents and purposes, on hold until it sees the outlines of the fiscal policy to be proposed by the Trump administration, which has indicated strong preferences for lighter regulation, lower taxes and infrastructure spending. The market is putting the odds of a Fed rate hike by March at just over 20% (Chart 3). The odds of seeing a hike by June, on the other hand, increase to 64%. Chart 3Fed Most Likely On Hold Until June Given the constraints on the Fed for now, and indications of synchronized global growth, we expect some inflation pickup near term. This will lower real rates and weaken the USD over the short term, which will, in turn, support gold prices. Given this expectation, we are recommending a tactical long gold position if the spot contract trades to $1,180/oz. Because this is a tactical position, we will use a 5% stop-loss. Ambiguous Inflation Signals For 1H17, we expect inflation and inflation expectations to remain buoyant, given the synchronized global upturn we are seeing and the prospect - and so far it is only a prospect - for stimulative fiscal policy in the U.S. All else equal, with the U.S. labor market at or close to full employment, and the Trump administration signaling its desire for stimulative fiscal policy, we would be inclined to look for inflation hedges within commodities that are highly sensitive to rising inflation. The top candidates here would be gold and oil (WTI, in particular). But all else is not equal. President Trump and officials within the administration have floated the idea of a border-adjusted tax (BAT) scheme, which would tax imports into the U.S. and subsidize U.S. exports, and replace the existing corporate income tax. Our House view on the BAT is it has a 50% chance of becoming law. Even so, we believe there is a greater-than-50% chance apparel and energy products would be exempt from a BAT, if it became the law of the land, but we obviously cannot be sure this will occur. The first-round effects of a BAT would be felt domestically. U.S. inflation and inflation expectations would increase after it is rolled out, as prices on taxed imports rose by the inverse of (1 - Tax Rate). As an indication, a 10% BAT would lift domestic prices of taxed items by ~ 11%. If the BAT were extended to oil, the domestic price lift there would incentivize higher domestic oil production, which also would find its way to export markets. Taken together, these domestic effects arising from the imposition of a BAT would cause the U.S. trade deficit to contract, which would rally the USD, in addition to lifting domestic inflation. As we noted last week, even under the assumption a somewhat watered down version of a BAT is passed, our colleagues at BCA's Global Investment Strategy service anticipate the USD would rally another 10%.2 The second-round effects on the back of such an increase in the USD would be felt globally, particularly in oil markets and EM economies. In addition to the broad trade-weighted dollar rallying by 10%, we expected a 5% rise in the greenback prior to the discussion of the BAT. So, overall, we'd expect a 15% appreciation in toto following the implementation of a BAT in the U.S. This would stifle EM commodity demand, particularly for oil and base metals, given the stronger USD would make these commodities more expensive in local-currency terms ex U.S. In addition, it would encourage higher commodity production in the U.S. (if a BAT were to be imposed on oil imports) and ex U.S., where local-currency drilling costs once again would fall, leading to increased supplies at the margin. The possibility of deflationary blowback to the U.S. is high in this scenario. Positioning In Ambiguous Markets Investors seeking to profit from rising inflation, which we would expect in the U.S. in the first round of adjustment to a BAT, or to hedge against it often turn to commodities expecting they will rally as inflation increases. They typically do this via index exposure or individual commodity exposure, e.g., going long gold or oil. In the current environment, we believe gold offers the best commodity alternative for participating in a rising inflation environment, or hedging against it, which is why we recommend a tactical long position if the market corrects to $1,180/oz. We compared the one-year return performance of gold and oil as inflation hedges by regressing annual returns of both commodities against annual core PCE and the broad trade-weighted USD returns (Chart 4).3 The R2 goodness-of-fit statistics for both were extremely close - 0.88 (oil) vs. 0.85 (gold), indicating core PCE and USD returns do a good job of explaining oil and gold returns. However, the volatility of the gold regression (its standard error) was half that of the oil regression (0.06 vs. 0.12), indicating gold's relationship is more stable vis-à-vis core PCE inflation and the USD (i.e., subject to less dispersion). This would indicate returns for an inflation hedge using gold would be less volatile than a hedge employing oil futures.4 These tests indicate both gold and oil are well suited to hedging inflation, and that gold hedges will perform as well as an oil hedge with far less volatility in the returns. Longer term, we're concerned with the second-round effects attending a stronger USD on the back of the BAT discussed above - i.e., lower commodity demand and higher commodity supply. Over the medium to longer term, the above dynamic suggests oil and gold volatility will increase (Chart 5). Chart 4Gold Hedges Inflation And USD Risk ##br##As Well As Oil, With Lower Volatility Chart 5Oil And Gold Vol Likely Rise Besides being an inflation hedge, gold, unlike oil, also functions as a store of value. In the event of deflationary blowback arising from the imposition of a BAT, we believe gold also would hedge investor portfolios against the possibility of currency debasement. That is to say, it would hold its value while central banks and governments rolled out fiscal and monetary policy responses to deflation. It is worthwhile recalling nominal gold prices held fairly steady during the Great Depression, while real gold prices appreciated. We believe the optimal vehicle for such a hedge would be call options, but we await clarity the likelihood of a BAT and its provisions before recommending such a position. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Assistant hugob@bcaresearch.com 1 Backwardation and contango are terms describing the shape of commodity forward curves. When a curve is backwardated, prompt-delivery prices (e.g., oil delivered next week) exceed deferred-delivery prices (e.g., oil delivered next year), indicating supplies are tight. A contango curve describes a market in which deferred-delivery prices exceed prompt-delivery prices, which indicates supplies are relatively more abundant. 2 We discussed the implications of a possible border-adjusted tax scheme in last week's Commodity & Energy Strategy Weekly Report, in an article entitled "Taking A Bat To Commodities", dated January 26, 2017, available at ces.bcaresearch.com. See also BCA Research's Global Investment Strategy Special Report entitled "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017" dated January 20, 2017, which examined the BAT in depth, available at gis.bcaresearch.com. 3 We ran a simple regression of the percent returns of gold and oil against core PCE and USD annual returns over the 2001 - 2016 interval to assess the performance of each as inflation hedges. By using one-year returns, we were able to regress stationary variables and use an AR(1) model. 4 Along similar lines, the sum of squared residuals for the oil returns was almost 4x that of the gold returns, indicating far less dispersion in the errors and a tighter fit with gold vs. core PCE once again. The Durbin-Watson statistic measuring the degree of autocorrelation in the errors is was slightly > 2.0 for the gold regression, for the oil regression the DW statistic was < 2.0. This suggests the gold regression is better behaved in that the error terms more closely conform to the assumptions for them in the type of regression we're running. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017

Highlights The tactical environment is dynamic, chaotic and unpredictable. ...Chaos also brings opportunity. We must recognize and exploit opportunities when chance presents them. Look for recurring patterns to exploit.1 Feature Highlights Strategically, major commodity markets are balanced with the exception of ags, where we remain underweight on the back of record grain harvests and high stock-to-use ratios. Otherwise, broad exposure to the asset class is warranted. However, within the larger investment context, we believe tactical positioning once again will produce higher returns than strategic index exposure to commodities. Chart of the WeekTactical Positioning ##br##Rewarded In Oil Markets Supply-driven price volatility and erratic monetary policy presented commodity markets strategic and tactical opportunities in 2016, particularly in oil, where our recommendations returned an average of 95% (Chart of the Week). We remain overweight oil, expecting continued opportunities from volatile markets. Going forward, the contribution of demand-side risk to price volatility will increase. This will be evident in iron ore, steel and base metals, where the opacity of China's fiscal and monetary policy - especially re heavily indebted state-owned enterprises (SOEs) and the banks that support them - in the lead-up to the Communist Party's Congress abounds. Continued adjustments by the U.S. Fed to random-walking data will again contribute to volatility, particularly in oil and gold markets. A stronger dollar resulting from continued Fed tightening will hit U.S. ag exports, and benefit competitors such as Argentina and the EU. However, uncertainty re the Trump administration's fiscal and trade policies could keep the Fed looser for longer, particularly if border-adjusted taxation favoring exports over imports is realized. Geopolitics - particularly vis-à-vis U.S. and China trade and military policy - will become more important if America tilts toward dirigisme, i.e., actively managing its economy by adjusting taxation and policy to support favored industries. Governments typically allocate resources inefficiently, which distorts fundamentals. If border-adjusted taxation becomes law in the U.S. we will look to get long volatility across commodity markets: Such legislation likely would rally the USD, which would lower global demand for commodities generally and lift supply by lowering local costs. This would run smack into higher U.S. inflation arising from the increasing cost of imported goods. This is a recipe for heightened uncertainty and price volatility. Russia lurks in the background: U.S. sanctions in the wake of alleged interference in American presidential elections, and Russia's response, will keep oil markets on edge. 2017 Weightings Energy: Overweight. The OPEC-Russia co-operation pact to limit production could evolve into a durable modus operandi for managing oil supply. Markets will judge the pact effective if tanker chartering out of the Persian Gulf falls, and global inventories draw by mid- to end-February. Base Metals: Neutral. Bulks and base metals prices will remain rangebound, until greater clarity on China's fiscal and monetary policy emerges. Fiscal stimulus in the U.S. will have a marginal effect on demand toward year-end. Precious Metals: Neutral. Gold will remain sensitive to shifts in U.S. fiscal and monetary policy expectations. The possibility of border-adjusted taxes in the U.S. will hang like the proverbial Sword of Damocles over the gold market. Should it pass, the Fed could be forced to keep interest rates lower for longer to offset the massive tightening in financial conditions such a tax would impose. Ags/Softs: Underweight. We see limited downside for grains, despite record harvests. We favor wheat and rice over corn and beans. A stronger USD will be bearish for grain exports. Feature Commodities as an asset class remain attractive. However, constantly changing information flows affecting these markets compel us once again to favor tactical positioning over a broad strategic exposure to the asset class. Fundamentals - supply, demand, inventories - and financial variables remain in a state of flux. In the oil market, the durability of the OPEC-Russia co-operation pact to reduce oil production will be tested, following a year-end surge in global production. Markets will closely follow shipping activity - particularly out of the Persian Gulf - and global oil inventory levels for signs the production cuts engineered late last year by OPEC, led by the Kingdom of Saudi Arabia (KSA), and non-OPEC producers, led by Russia, are taking hold. Uncertainty regarding the incoming Trump administration's tax and trade policies - and responses from states targeted by such policies (e.g., China and Mexico) - will keep decisions affecting supply and demand fluid. The incoming Trump administration's trade policies could alter global oil flows: e.g., a re-working of NAFTA that reduces U.S. refined-product exports to Latin America would result in lower demand for crude at American refineries, and present an opening to Chinese refiners. In addition, as mentioned above, legislation authorizing border-adjusted taxes favoring exports and penalizing imports likely will be taken up this year in the U.S. Congress. If we did see tax policy favouring U.S. exports over imports, we believe it would prompt a USD rally via reducing America's current account deficit. This would, all else equal, send commodity prices sharply lower, as EM commodity demand will contract, owing to higher USD prices for commodities, and production ex U.S. will increase, due to lower local costs. That said, border-adjusted taxation in the U.S. also would increase the price of imports, and lift realized and expected inflation. How this plays out is highly uncertain at present. A border-adjusted tax bill likely will be taken up in the current session. If it passes, it would have major implications for pricing relationships globally - chiefly WTI vs. Brent, and Brent vs. Dubai crudes, along with product differentials that drive shipping economics. If such a bill looks like it will pass, we expect a sharp increase in commodity-price volatility globally. If the odds do favor such a tax regime shift, we would look to get long WTI and short Brent further out the curve, expecting higher U.S. exports and lower imports. In addition, we would look to get long gold volatility - buying puts and calls - as policy uncertainty effects resolve themselves. Heightened Uncertainty Means Tactical Positioning Once Again Trumps Passive Commodities Allocation The primacy of tactical positioning was demonstrated in 2016 in the oil market, when strategic positions quickly became tactical, either because they were stopped out or reached their P&L targets quicker than expected. Supply destruction dominated price formation last year, following OPEC's decision to abandon its strategy to support prices via production management in November 2014. This destruction occurred mostly in non-Gulf OPEC, which was down 7.0% yoy in 2016 (Chart 2), and non-OPEC producers, particularly the U.S. shale-oil fields, where yoy production was down 12.0% by year-end 2016 (Chart 3). Chart 2Low Prices Crushed Non-Gulf Production... Chart 3...And U.S. Production Even in states where production increased - chiefly KSA and Russia (Chart 4) - domestic finances crumbled, leaving them in dire straits. By our estimates, between July 2014, just prior to its decision to launch OPEC's market-share war, and December 2016, KSA had burned through $220 billion of it foreign reserves, equivalent to 30% of its central-bank holdings. Russia had drawn down its official reserves by $77 billion over the same period, or 16% of its holdings; its burn rate was reduced by allowing its currency to depreciate, which lowered the local cost of producing oil and boosted profitability of exports priced in USD. This was the background that forced OPEC, led by KSA, and non-OPEC, led by Russia, to negotiate the year-end pact that resulted in an agreement to cut production by up to 1.8 mm b/d. The stated volumes to be cut are comprised of 1.2 mm from OPEC, 300k b/d from Russia, and another 300 from other non-OPEC producers. The goal of this agreement is to reduce global oil inventories to more normal levels (Chart 5). Chart 4KSA, Russia Production Ramp ##br##Exacerbated Price Weakness Chart 5KSA-Russia Production Pact Aimed ##br##At Lowering Inventories Throughout 2016, as the supply-destruction drama was unfolding, numerous opportunities opened up to investors to fade market overshoots, brought about by over-reactions to fast-moving news flows. Unrestrained output by OPEC and non-OPEC producers strained oil-storage facilities early in the year, taking markets to the brink of breaking down entirely. Unexpected shifts in U.S. monetary policy - driven by random-walking data - also contributed to oil price volatility and opened numerous trading opportunities. Markets essentially ignored the cumulating right-tail price risks last year, following the supply destruction wrought by OPEC's declaration of a market-share war, and Russian overtures to OPEC seeking a production-allocation dialogue, which were very much in evidence in January 2016. The continual OPEC-Russia dialogue, which appeared to be bearing fruit in Doha before it was scuppered by KSA at the last minute in April, was the underlying geopolitical driver last year, and kept the odds of a production deal elevated. Based on our modeling, the supply surge following OPEC's decision made getting long contingent upside price exposure extremely compelling, particularly as it imperiled the finances of all oil producers - rich and poor, but mostly the poorer states like Venezuela and Nigeria. Our reasoning was lower prices would accelerate rebalancing of global markets and raise the odds of a major supply disruption at one of these failing states.2 Our modeling consistently indicated global oil markets would rebalance in 2016H2.3 Ultimately, this is how things played out, aided in no small measure by mid-year wildfires in Canada, which temporarily removed move than 1mm b/d from global markets, and sabotage of pipelines and loading facilities in Nigeria. Even with that, markets remained under pressure as Canadian barrels returned, and foreign reserves in KSA and Russia were rapidly depleted. These fundamentals, along with constantly changing Fed guidance, provided numerous opportunities to exploit recurring patterns thrown up by chance, as is evident in the returns on recommendations we made - averaging 95.1% last year - that naturally followed from our analysis (Table 1). Our favored exposure was getting long contingent exposure (i.e., options), using deferred call spreads in WTI and Brent, given our assessment the odds of higher prices exceeded the market's. Later in the year, following the OPEC-Russia pact, we got long a front-to-back crude oil spread (Dec/17 WTI vs. Dec/18 WTI) expecting the goal of the deal - reducing global inventories - stood a good chance of being realized. We got lucky putting the trade on as the market was correcting, but just ahead of the statement by KSA's oil minister that the Kingdom would do "whatever it takes" to make the deal work. This transformed a strategic position - one we expected to hold for months - into a one-week exposure that returned 493% (Table 1). Table 1Energy Trades Closed In 2016 In order to obtain a more detailed assessment of our energy portfolio's performance, we built an information ratio (IR) to evaluate how our energy recommendations performed compared to a selected benchmark, the S&P GS Commodity Index (GSCI). Essentially, our IR is used to assess whether an active portfolio has outperformed the selected benchmark in a consistent manner during the period of analysis, given the risk it incurred. To that end, our ratio looks at the average excess return of the active portfolio against the benchmark. This average excess return is then divided by its standard deviation (also referred to as the tracking error volatility) in order to get a risk-adjusted metric to evaluate whether the risk we took were compensated by the returns we generated. Our IR thus is calculated as: Formula The higher the IR, the better the risk-adjusted relative performance of the portfolio. Three elements can explain a high IR: high returns in the portfolio, low returns in the benchmark, or low tracking error volatility. Hence, this measure helps analyzing the notion of risk-reward tradeoff; it tells us whether or not the risk assumed in our trades was compensated by larger returns. In our case, to get the risk-adjusted returns of the energy portfolio, we selected the GSCI as a benchmark, as it is heavily skewed towards Energy commodities (around 60% of its composition). We believe this is a plausible benchmark alternative to our energy trade recommendations for an investor, whose choice is passive index exposure with a significant energy weighting. Our portfolio's average return in 2016 was 95%, while the GSCI return was 11%. The tracking error volatility was 56%.4 Using these inputs, we calculated the IR of our recommendations was 1.47. This is an excellent risk-adjusted return, and indicates the high volatility of our returns was more than compensated for by consistent positive excess returns our recommendations generated relative to passive GSCI exposure, which also can be used as a benchmark for energy-heavy commodity index exposure (i.e., "commodity beta"). Remain Overweight Oil We expect the combination of production cuts and natural declines will remove enough production from the market this year to restore global oil stocks to five-year average levels toward the end of 2017Q2 or early Q3 (Chart 5), even with cheating by OPEC and non-OPEC producers capable of increasing production. As a result, in 2017, we expect the OPEC-Russia deal to result in inventory draws of ~ 10% by 2017Q3. On the demand side, we continue to expect global growth of ~ 1.3 to 1.5mm b/d. Given these expectations, we expect U.S. benchmark WTI crude prices to average $55/bbl, up $5 from our 2016 forecast, on the back of the end-year OPEC-Russia pact. We are moving the bottom of the range in which we expect WTI prices to trade most of the time to $45/bbl and keeping the upside at $65/bbl. Markets already are pricing in a normalization of global inventories by year end (Chart 6 and Chart 7). We will look for opportunities to re-establish our long front-to-back positions, expecting the backwardation further out the curve will steepen. Chart 6Backwardation Steepening Near Term... Chart 7...And Further Out the Curve Further out the curve - i.e., mid-2018 and beyond - our conviction is lower: The massive capex cuts seen in the industry for projects expected between 2015 - 2020 will place an enormous burden on shale producers and conventional oil producers, chiefly Gulf Arab producers and Russia. It will be difficult to offset natural decline-curve losses - which will increase as U.S. shales account for a larger share of global supply - and meet increasing demand. As we've often noted, any indication U.S. shales or conventional supplies (Gulf states and Russian production) will not be able to move quickly enough to meet growing demand and replace natural declines could spike prices further out the curve. We expect U.S. oil exports to increase this year, which means the international benchmark, Brent crude oil, will increasingly price to move WTI into global markets. We expect U.S. WTI exports to increase from an average ~ 500k b/d, which should keep the price differential roughly around +$1.50/bbl differential (Brent over) for 2017. If we see border-adjusted taxation laws take effect, we would look to get long WTI vs. short Brent, and long U.S. products (e.g., U.S. Gulf gasoline and distillate exposure) vs. short Brent exposure. Remain Neutral Bulks, Base Metals Over in the bulks and base metals markets, a full-fledged iron-ore market-share war at the beginning of last year threatened to take prices to $30/ton. Then, seemingly out of the blue, an unexpected pivot by Chinese policymakers toward stimulating the "old economy" caught many bulks and base-metals traders and analysts - ourselves included - flat-footed. Powerful rallies in iron ore, steel and base metals early in the year on Chinese exchanges were dismissed as irrational exuberance on the part of retail investors. But, at the end of the day, these market participants were responsible for well-informed price signals that fully reflected low inventories and surging demand.5 The -0.5% average return in our bulks and base metals recommendations last year attests to how difficult we found these markets to read and anticipate (Table 2). Table 2Base Metals Trades Closed In 2016 As always, the evolution of China's economy will, as always, be critical to these markets, given that country's outsized role in iron ore, steel and base metals. We are broadly neutral the complex, and, with the exception of the nickel market, see supply and demand relatively balanced to slightly oversupplied globally and in China. Production globally and in China is growing yoy, while consumption shows signs of slowing. (Chart 8 and Chart 9). Chart 8World Base Metals Consumption Slowing,##br## Relative to Production... Chart 9...As Is ##br##China's Uncertainty re the direction of China's fiscal and monetary policy - chiefly, whether policymakers will, once again, resort to stimulating the "old economy" - will keep us broadly neutral bulks and base metals until we get further clarity on the direction of policy. We expect the monetary and fiscal stimulus that massively boosted China's housing market this year will wind down, bringing an end to the run-up in iron ore, steel and base metals prices. Odds favor "reflationary" policies to continue going into the Communist Party Congress next fall, but we do not expect anything along the lines of the surge in policy stimulus seen earlier this year: Unwinding and controlling property-market excesses and high debt levels will limit policymakers' desire to turbo-charge the housing market again, limiting the boost such policies provide. The fate of border-adjusted taxation in the U.S. Congress is critically important to bulk and base-metals markets, since it would encourage exports and discourage imports (along with raising their prices). Tax policy favouring U.S. exports over imports likely would prompt a USD rally, which would send commodity prices generally sharply lower. It would boost U.S. steel production and base metals exports, while raising the cost of imports. A border-adjusted tax bill likely will be taken up in the current session of Congress. We are downgrading our tactically bullish view on iron ore to neutral. Strategically, we retain a bearish bias, as rising iron ore supply may overwhelm the market again in 2017H2. We remain tactically neutral and strategically bearish steel. Low steel inventories and production disruptions caused by China's recently launched environmental inspection program likely will continue to support steel prices in the near term. However, persistently high steel output and falling demand from the Chinese property sector will eventually knock down prices in 2017H2. Manufacturing will play a larger role in copper markets, and will drive the demand side this year. However, if we see a stronger USD - either as a result of Fed policy or U.S. fiscal policy - price appreciation will be limited. We remain neutral copper, expecting a concerted effort to slow the housing boom in China. Reflationary policies will still support real demand for copper, but will reduce demand from new construction. The supply deficit in nickel will widen on the back of rising stainless steel demand and falling nickel ore supply in 2017, which will support prices. We expect nickel will outperform zinc over a one-year time horizon. For zinc, we remain tactically neutral and strategically bearish. We expect zinc supply to rise considerably in response to current high prices. Aluminum supply - for the moment - will lag demand globally, which keeps us tactically bullish and strategically neutral. Supply shortages will likely persist ex-China over the next three to six months. Stay Neutral Precious Metals Precious metals, gold in particular, staged an impressive rally on the back of unexpected easing by the U.S. Fed in response to weaker-than-expected sub-1% GDP growth in 1Q16 GDP. Markets had been pricing in as many as four interest-rate hikes earlier in the year into short-term expectations, which were quickly dashed. Markets lowered their expectations for multiple rate hikes last year, which weakened the USD and U.S. real rates, setting the stage for the gold rally. Nonetheless, gold proved a difficult commodity to trade last year, as our results indicate - the average return on our precious metals recommendations amounted to a paltry -0.65% (Table 3). For the near term - i.e., until greater clarity on Fed policy and the incoming Trump administration's fiscal policy direction becomes clear - we remain neutral precious metals, and will avoid taking any further exposure other than perhaps getting long gold volatility - i.e., buying puts and calls in the gold market - if the odds of border-adjusted taxation legislation passing increase. Such legislation likely would rally the USD, which would lower global demand and increase supply ex U.S. at the margin for commodities generally, oil and base metals in particular. This would be deflationary, given the high correlations between oil and base metals consumption and U.S. inflation (Chart 10).6 However, such a taxation scheme also would raise U.S. inflation by increasing the cost of imported goods, sending the U.S. core PCE, the Fed's preferred inflation gauge, higher. The global disinflationary impulse from a stronger USD would run headlong into higher U.S. inflation, which would be a recipe for heightened uncertainty and price volatility. Table 3Precious Metals Trades ##br##Closed In 2016 Chart 10Risk of Deflation Will Rise If Border-Adjusted ##br##Taxes Prove Deflationary This will complicate U.S. monetary policy. We believe the Fed also will be waiting on such direction, and that interest-rate policy will, therefore, remain pretty much be on hold, keeping precious metals - gold, in particular - rangebound. For the moment, the possibility of border-adjusted taxes in the U.S. will hang like the proverbial Sword of Damocles over the gold market. We are taking profits on the tactical long gold position we opened December 15, 2016, as of today's close. Remain Underweight AGS Lastly, Ag markets provided us no joy, as the El Nino wreaked havoc on our recommendations. Our average -1.0% return for the year amply demonstrates the difficulty of trading markets so heavily influenced by weather (Table 4). Going into 2017, we believe there is a limited downside for grains. The downtrend since August 2012 like forms a bottom this year, if, as we are modeling, we see a return to normal weather conditions. That said, the principal upside risk remains unfavorable weather in major grain-producing countries, which could send badly battered grain prices surging as they did in 2016H1. Among grains, we favor wheat and rice over corn and soybeans. Global soybean acreage is likely to expand as the crop provides higher returns than other grains. South American corn output will continue rising on favorable policies and weak currencies, adding further pressure to already-high U.S. corn inventories, in particular, and global inventories globally (Chart 11). Table 4AGS Trades Closed In 2016 Chart 11Global Grain Inventories Remain High Softs - cotton and sugar - likely will underperform grains in 2017, reversing their outperformance this year. We are tactically bearish cotton, as U.S. cotton acreage is likely to increase next spring. Strategically, we are neutral cotton. For the global sugar market, barring extremely unfavorable weather, we are tactically and strategically bearish. This year's extreme rally in prices may result in a small supply surplus in 2017. Our Ag strategies will continue to focus on relative-value investments. Robert P. Ryan, Senior Vice President Commodities & Energy Strategy rryan@bcaresearch.com Hugo Belanger, Research Assistant hugob@bcaresearch.com 1 Please see "Tactics Cliff Notes; A Synopsis of MCDP 1-3 Tactics," published by the United States Marine Corps, Marine Corps Warfighting Lab, Marine Corps Combat Development Command, Quantico, Virginia. 10 May 1998 (pp. 2, 3. sf). 2 In our January 7, 2016, publication we noted investors were ignoring growing upside price risk and suggested they get long a Dec/16 $50/$55 WTI call spread to gain exposure to higher volatility. We also recommended remaining long Dec/16 and Dec/17 WTI vs. Brent following passage of legislation to allow U.S. crude exports. We ultimately took profits on these recommendations of 172% on the call spread in June, and 97% on the Dec/16 WTI vs. Brent spread in June, and 88% on the Dec/17 WTI vs. Brent spread in July, respectively (Table 1). Please see "Oil Market Ignores Right-Tail Saudi Risks" in the January 7, 2016, issue of BCA Research's Commodity & Energy Strategy, which is available at ces.bcaresearch.com. 3 In our January 21, 2016, Commodity & Energy Strategy article entitled "Global Oil Sell-off Will Accelerate Rebalancing," we noted, "We expect oil markets to rebalance by late 2016Q3 or early Q4. We remain long Dec/16 $50 calls vs. $55 calls, in anticipation of rebalancing and as a hedge against geopolitical risk." 4 Note: In order to find the standard deviation of the portfolio's excess returns (tracking error volatility), we averaged the daily percentage change in each trade's underlying assets. Any given trade only weighed in the daily average return if it was open during that day of the year. We are not accounting for the type of trades (spreads, pairs or single trades), we only track the underlying asset returns. From these daily average returns we subtracted the daily return of the preferred benchmark to obtain the daily excess return. Using this, we computed an historical standard deviation (based on 20-day periods) for every day during which a trade was open in our portfolio (we had 203 days with at least one energy trade opened). Lastly, we annualized this standard deviation to obtain our tracking error volatility. 5 Please see "Dead-Cat Bounces Notwithstanding, Iron Ore Will Trade Lower" in the January 21, 2016 issue of BCA Research's Commodity & Energy Strategy, and "Fade The Copper Rally" in the February 25, 2016 issue. Both are available at ces.bcaresearch.com. 6 In earlier research, we've shown U.S. core PCE inflation is highly correlated with EM oil and base metals demand. Please see "2017 Commodity Outlook: Precious Metals" published December 15, 2016. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017