Economy

Highlights Portfolio Strategy The consumer staples recovery is sales-driven, underscoring that additional outperformance lies ahead. The lagging hypermarkets and retail food industries are starting to play catch up, reflecting a shift in consumer spending patterns. Use the drubbing in air freight shares to upgrade to overweight. Recent Changes S&P Air Freight & Logistics - Upgrade to overweight from neutral. Table 1Sector Performance Returns (%) Feature Equities caught a bid last week, after holding at the bottom end of their tactical trading range. The overall consolidation phase likely has further to run, but should ultimately be resolved in a positive fashion. Chart 1Ongoing Margin Expansion Real economic performance continues to lag relative to exuberant 'soft' economic survey data, while the odds of meaningful pro-cyclical U.S. fiscal largesse fade. Inflation expectations are softening as commodity prices dip, while the yield curve is narrowing. These factors are likely to sustain ambiguity about the durability and strength of the expansion. But in the background, the corporate sector continues to heal slowly, aided by the hiatus in the U.S. dollar bull market. The latter is enabling some corporate pricing power revival. Our pricing power diffusion index has surged alongside our pricing power proxy (Chart 1, second panel). The broadening of selling price inflation bodes well for the sustainability of corporate sector pricing power gains. We have updated our industry group pricing power gauges (see Table 2), comprising the respective CPI, PPI, PCE and commodity year-over-year changes for 60 industry groups. The table details the most recent annual and 3-month pricing power trends and each industry's spread to overall inflation in order to identify potential profit winners and losers. Our analysis reveals that ¾ of the industries tracked are experiencing rising selling prices, and half are also besting overall inflation rates. Only 14 of 60 industries are in outright deflation, versus 19 in January and 23 last September. Importantly, 31 of 60 industry groups are enjoying a rising pricing trend, a 50% increase from last quarter, 9 are moving laterally and only 20 are fading. The implication is that upward momentum in pricing power is gathering steam. Importantly, the rate of selling price inflation is outpacing wage bill growth, which heralds some incremental near-term torque for profit margins (Chart 1, bottom panel). Are there any themes of note? Cyclical sectors continue to dominate the table with energy and materials taking the top two spots, although recent corrective action in the commodity pits suggests that these gains may peter out. The technology sector is a notable exception within deep cyclicals, as most tech sub-groups still have to slash prices (Table 2). Early cyclicals (or interest rate-sensitives) also show strength, with banks, insurers, and media-related groups managing to lift selling prices at a decent rate. Select defensives like health care and utilities are expanding pricing power, but the overall consumer staples and telecom services sectors are lagging. Table 2Industry Group Pricing Power Adding it all up, there are tentative signs that the profit advantage may be starting to slowly shift away from defensives. In that light, we are closely monitoring several factors that could expedite a transition to a more balanced portfolio from our current defensive bias. First, the gap between hard and soft data remains unusually wide (Chart 2). The longer hard data takes to play catch up, the less likely the Fed will be re-priced more aggressively. History shows that until this gap narrows, defensive sectors are likely to retain the upper hand in terms of relative performance (Chart 2), while financials could continue to languish owing to uncertainty about the path of future Fed policy. Second, commodity prices and the U.S. dollar - especially versus emerging market (EM) currencies - are still signaling that the cyclical/defensive ratio has more downside (Chart 3). Finally, within the context of the current broad equity market consolidation, it should continue to pay to remain with a defensive over cyclical portfolio tilt for a little while longer (Chart 4, top panel). Chart 2The Gap ##br##Is Closing Chart 3Monitoring The U.S. ##br##Dollar And Commodities1 Chart 4Stick With Defensives##br## For A While Longer Nevertheless, we will likely use this phase to make additional portfolio adjustments. The wide gap between emerging/developing markets performance and the cyclical/defensive share price ratio has narrowed significantly year-to-date, suggesting that defensive outperformance may be in the late stages. In sum, equity markets are in a transition phase and we are further tweaking our intra-industrials positioning after using recent underperformance to upgrade to neutral. We are also updating our high-conviction consumer staples view, and two unloved staples sub-groups. The Consumer Staples Sector Remains Appealing As part of this year's defensive sector leadership, the consumer staples sector has confounded its critics and registered a solid year-to-date relative performance gain. We expect additional near-term upside on the back of both internal and external drivers. Consumer staples companies are enjoying a revenue renaissance. Domestically, non-discretionary retail sales are gaining market share from discretionary outlays (Chart 5), reflecting consumers structurally ingrained propensity to save vs. spend since the financial crisis. Even exports are contributing to rising revenues, despite the U.S. dollar's appreciation (Chart 5). Easing monetary conditions in the emerging markets are underpinning domestic demand, benefiting U.S. staples exporters. Improving demand and cost containment are boosting operating profit margins (Chart 5, fourth panel). This should ensure that the sector continues to register meaningful free cash flow growth, a refreshing difference with the overall corporate sector. Meanwhile, external factors also point to a further relative performance recovery. The bond-to-stock ratio is joined at the hip with relative performance momentum, and a mean reversion phase is unfolding (Chart 6). Geopolitical uncertainty, the risk of a cooling in economic momentum following the downturn in the Economic Surprise Index could fuel flows into this non-cyclical sector. Chart 5Domestic And International##br## Positive Demand Drivers Chart 6Financial Variables ##br##Reinforce Staples Bid There is both valuation and technical motivation for capital inflows. Chart 6 shows that our Technical Indicator has troughed near one standard deviation below the historical mean. Every time this has occurred in the last decade, a sizable relative share price recovery has ensued. There are no valuation roadblocks, countering the assertion that defensive sectors are all overvalued in relative terms (Chart 6). As a result, this sector remains a high-conviction overweight, especially with two previous lagging groups now exhibiting signs of a recovery. Hypermarket Green-Shoots The hypermarkets industry is sprouting a number of green-shoots that should further propel the recent advance in relative share price performance. The industry is enjoying profit margin support on two fronts. Import prices are still deflating (Chart 7), and the nascent rebuilding in Asian manufacturing inventories suggests that pricing pressure will persist. On the revenue front, Wal-Mart recently noted that store traffic continues to improve, albeit aided by discounting. A tight labor market is supporting aggregate wage growth, especially those in lower income brackets, which is supportive of total hypermarkets sales. Importantly, the need to slash prices to attract more customers should abate courtesy of improving demand. The overall retail sales price deflator has climbed into positive territory. Hypermarket sales growth is highly correlated with overall retail selling price inflation (Chart 8). Chart 7Input Costs Will Remain Contained Chart 8Low Profit Hurdle At least some of the improvement in pricing power reflects an easing in food industry deflation, which implies that the intensity of price wars with food retailers will diminish. Total outlays on food and beverages are climbing as a share of total consumer spending after falling for six consecutive years (Chart 8). These elements are captured by our hypermarkets earnings pressure gauge, which is signaling a rosier sales and EPS growth backdrop (Chart 8, fourth panel). If the border adjustment tax continues to lose momentum, the risk premium for this group should narrow. Food Retailers Are Down, But Not Out Elsewhere, the drubbing in food retailers looks overdone. The relative share price ratio is at a multi-decade low. Investor fears have concentrated on industry selling price deflation, which has weighed on already razor thin profit margins. Nevertheless, a turnaround is afoot, and we would lean against extreme bearishness. As noted previously, consumer spending on food and beverages are gaining a foothold relative to overall outlays. That is supporting a reacceleration in grocery store same-store sales. With the unemployment rate this low, wage inflation is expected to sustain recent gains. Rising incomes are synonymous with higher consumer spending power. Thus, the rebound in industry sales has more upside (Chart 9). The upshot of consumers' increased food appetite is that the food CPI is exiting deflation (Chart 10). That should go a long way in allaying investor profit margin concerns. Chart 9Buy The Wash ##br##Out In Food Retailers... Chart 10...Because The Deflation##br## Threat Is Diminishing Previous pricing pressure forced grocers to refocus on productivity. The industry's total wage bill has cooled significantly. Our productivity proxy, defined as sales/employee, is accelerating, hitting growth rates last seen more than five years ago, when share prices were trading at much higher valuations (Chart 10). Bottom Line: We reiterate our overweight stance both in the S&P hypermarkets and the compellingly valued S&P food retail index. The ticker symbols for the stocks in these indexes are: WMT, COST and KR, WFM, respectively. Air Freight Stocks Will Spread Their Wings The sell-off in transportation stocks has progressed to the point where pockets of value are materializing. Specifically, air freight and logistics stocks have been pummeled, trading down to the bottom of their post-GFC trading range (Chart 11). This is a playable opportunity. Relative performance has returned to levels first reached in the depths of the GFC. Bears have pushed valuations and technical conditions to extremely washed out levels. Both the forward P/E and price-to-sales ratios have collapsed, trading significantly below their historical means and at a steep discount to the S&P 500 (Chart 11). To be sure, a number of forces have fueled the selling. Industry activity is running below capacity, as evidenced by weakness in industry average weekly hours worked (Chart 11). The loss of momentum in internet sales compared with bricks and mortar retail sales may be causing some concern about the pace of future land deliveries (Chart 11). Walmart's news that it is offering an in-store pick up option for online orders has also spooled investors. Amazon's push for its own delivery service is a longer-term yellow flag. Nevertheless, deeply discounted valuations and depressed earnings growth expectations imply that these drags are already reflected in prices. In fact, more recently analysts have pushed the net earnings revision ratio back into positive territory. We expect additional upside as global trade improves. While we were concerned about global trade last November when we downgraded to neutral, there is more evidence now that global revenue ton miles will reaccelerate. The surge in BCA's boom/bust indicator and advance in the business sales-to-inventories (S/I) ratio are both signaling that global trade will continue to recover (Chart 12). The sustainability of the S/I improvement looks solid. The global manufacturing PMI has shot higher on the back of a synchronized developed and emerging market final demand improvement, which heralds accelerating global export volumes (Chart 12). hiatus in the U.S. dollar bull market has also provided much needed reflationary relief to the emerging world. We expect these global forces to overwhelm recent domestic freight demand concerns. Importantly, global exports have been positively correlated with air freight pricing power and the current message is to expect price hikes to stick (Chart 13, third and fourth panels). Keep in mind that air freight companies typically command greater pricing power when the supply chain is lean and lead times begin to lengthen, because companies will pay up to ensure product/parts availability. Chart 11Grim News Is Well Discounted Chart 12Recovering Global Trade... Chart 13...Is A Boon To Air Freight Pricing Power In sum, a durable recovery in global trade should ignite an earnings led relative outperformance phase in the S&P air freight & logistics index. Bottom Line: Boost exposure to overweight in the S&P air freight & logistics sub-group. The ticker symbols for the stocks in this index are: BLBG: S5AIRFX - UPS, FDX, CHRW, EXPD. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights Treasury yields have slumped since early March, helping to push down the dollar. Slower U.S. growth in the first quarter of the year, weak inflation readings, uncertainty on tax reform, the prospect of a government shutdown, and rising political risks in Europe have all contributed to the Treasury rally. Looking out, U.S. growth should accelerate while growth abroad will stay reasonably firm. The market is pricing in only 34 basis points in rate hikes over the next 12 months. This seems too low to us. Go short the January 2018 fed funds futures contract. Feature What Explains The Treasury Rally? Global bond yields have swooned since early March. The 10-year Treasury yield fell to as low as 2.18% this week, down from a closing high of 2.62% on March 13th. A number of fundamental factors have contributed to the Treasury rally: Recent "hard data" on the U.S. growth picture has been somewhat disappointing. The Atlanta Fed's model suggests that real GDP expanded by only 0.5% in Q1 (Chart 1). So far this month, hard data on payrolls, housing starts, and auto sales have fallen short of consensus expectations. Credit growth has also decelerated sharply (Chart 2). The prospect of tax cuts this year have faded. Treasury Secretary Steven Mnuchin told the Financial Times on Monday that getting a tax bill through Congress by August was "highly aggressive to not realistic at this point."1 Meanwhile, worries about a government shutdown - possibly coming as early as next week - have escalated. Recent inflation readings have been on the soft side. Core CPI dropped by 0.12% month-over-month in March, the first outright decline since 2010. China's growth outlook remains cloudy. Government officials warned this week that recent measures undertaken to cool the housing sector will begin to bite later this month.2 Concerns that the French election will feature a runoff between the "Alt-Right" candidate, Marine Le Pen, and the "Ctrl-Left" candidate, Jean-Luc Mélenchon, have intensified (Chart 3). Euroskeptic parties also continue to make gains in Italy (Chart 4). Chart 1A Disappointing First Quarter Chart 2Credit Growth Slowdown While none of the things listed above can be easily dismissed, the key question for fixed-income investors is whether bond yields are already adequately discounting these risks. Keep in mind that markets are pricing in only 34 basis points in Fed rate hikes over the next 12 months (Chart 5). This is substantially less than the median "dot" in the Summary of Economic Projections, which implies three more hikes between now and next April. Chart 3French Elections: A Many-Way Race? Chart 4Euroskepticism Is On The Rise In Italy Chart 5Markets Are Too Sanguine About The Fed's Rate Hike Intentions U.S. Economy Still In Reasonably Good Shape Our view on rates for the next year is closer to the Fed's than the market's. Yes, the "hard data" on U.S. growth has been lackluster. However, as we discussed last week, the hard data may be biased down by seasonal adjustment problems.3 Moreover, the hard data tend to lag the soft data, and the latter remain reasonably perky. Reflecting the strength of the soft data, our newly-released Beige Book Monitor points to an improving growth picture across the Fed's 12 districts (Chart 6). Worries about plunging credit growth are also overstated. While the increase in interest rates since last year has likely curbed credit demand, some of the recent deceleration in business lending appears to be due to the improving financial health of energy companies. Higher profits have permitted these firms to pay back old bank loans, while also enabling them to finance new capital expenditures using internally-generated funds. In addition, the rising appetite for corporate debt has also allowed more companies to access the bond market. According to Bloomberg, the U.S. leveraged-loan market saw $434 billion in issuance in Q1, the highest level on record (Chart 7). Chart 6Fed Districts See Things Improving Chart 7More And More Leveraged Loans Looking out, business lending should pick up. The Fed's Senior Loan Officer Survey indicates that banks stopped tightening lending standards to businesses in Q1. This should help boost the supply of credit over the coming months (Chart 8). Meanwhile, the recovery in the manufacturing sector will bolster credit demand. Chart 9 shows that an increase in the ISM manufacturing index leads business lending by 6-to-12 months. Chart 8Bank Lending Standards: Stable For Businesses, Tighter For Consumers Chart 9Manufacturing ISM Points To A Pick Up In Business Lending As far as household credit is concerned, higher interest rates and tighter lending standards for consumer loans (especially auto loans) are both headwinds. Nevertheless, overall household leverage has fallen back to 2003 levels and the household debt-service ratio is at multi-decade lows (Chart 10). And while delinquencies have edged higher, they are still well below their historic average (Chart 11). Chart 10Lower Household Leverage Chart 11Despite Slight Uptick, Delinquency Rates Remain Well Contained A reasonably solid growth picture should help lift inflation over the coming months. Chart 12 shows that inflation tends to accelerate once unemployment falls below its full employment level. The U.S. headline unemployment rate currently stands at 4.5%, below the Fed's estimate of NAIRU. Other measures of labor market slack also point to an economy that is quickly running out of surplus labor (Chart 13). As such, it is not surprising that the Atlanta Fed's wage tracker continues to trend higher, as has the NFIB's labor compensation gauge and most other measures of labor compensation (Chart 14). Chart 12The Phillips Curve Appears To Be Non-Linear Chart 13Disappearing Labor Market Slack Chart 14U.S.: Broad Measures Pointing To Rising Wage Pressures Wage Growth Trending Higher U.S. Political Risks Will Diminish... The political risks which have pushed down Treasury yields since early March should also subside over the coming weeks. Concerns that the Trump administration will be unable to pass tax cuts are overblown. Unlike in the case of health care, there is virtual unanimity among Republicans in favor of cutting taxes.4 Congressional hearings on tax reform are scheduled to begin next week. We expect Trump to move quickly to get a deal done. He needs a political victory and this is his best shot. We are also not especially worried about the prospect of a government shutdown. Congress needs to agree on a bill to extend government funding beyond April 28 when congressional appropriations are set to expire. So far, Republican leaders are pursuing a sensible strategy of keeping controversial items - including funding for a border wall and cuts to Obamacare subsidies - out of the bill in the hopes of attracting enough Democrat support to avoid a filibuster in the Senate. Without the inclusion of these contentious measures, it would be politically difficult for the Democrats to take any action that triggers a government shutdown, as they would be blamed for the outcome. ...As Will Risks In Europe... Chart 15The French Are Not Euroskeptic In the U.K., Prime Minister Theresa May's decision to hold a snap election reduces the risk of a "hard Brexit." The current slim 17-seat majority that the Conservatives hold in Parliament has made May highly dependent on a small band of hardline Tories. These uncompromising MPs would rather see negotiations break down than acquiesce to any of the EU's demands, including that the U.K. pay the remaining £60 billion portion of its contribution to the EU's 2014-20 budget. If the Conservative Party is able to increase its control over Parliament - as current opinion polls suggest is likely - May will have greater flexibility in reaching an agreement with Brussels and will face less of a risk that Parliament shoots down the final deal. Worries about the outcome of French elections should also diminish. Opinion polls continue to signal that Emmanuel Macron will make it to the second round of the presidential contest. If that happens, he would be a shoo-in to win against either Marine Le Pen or the far-left challenger Jean-Luc Mélenchon. Even in the unlikely event that Le Pen or Mélenchon ends up prevailing, their ability to push through their agendas would be severely constrained. Neither candidate is likely to secure a majority in the National Assembly when legislative elections are held in June. French presidents have a lot of leeway over foreign affairs, but need the support of parliament to change taxes, government spending, regulations, or most other aspects of domestic policy.5 Also, keep in mind that France's place in the EU is enshrined in the French constitution. Any modifications to the constitution would require that a referendum be called. Considering that French voters are highly pessimistic of their future outside of the EU, it would require a seismic shift in voter preferences for France to end up following the U.K.'s example (Chart 15). ...And In China Lastly, the risks of a trade war between the U.S. and China have eased following President Trump's summit with President Xi. This should help stem Chinese capital outflows. On the domestic front, the government's efforts to clamp down on property speculation will cool the economy. However, as our China team has pointed out, this may not be such a bad thing, given that recent activity has been strong and parts of the economy are showing signs of overheating. Investment Conclusions Chart 16Bet On The Fed The reflation trade will eventually fizzle out, but our sense is that this will be more of a story for late next year than for 2017. For now, underlying global growth is still strong and the sort of imbalances that usually precipitate recessions are not severe enough. If there is going to be one big surprise in the U.S. fixed-income market this year, it is that the Fed sticks to its guns and keeps raising rates at a pace of roughly once per quarter. With that in mind, we recommend that clients go short the January 2018 fed funds futures contract as a tactical trade (Chart 16). A rebound in U.S. rate expectations will lead to a widening in interest rate differentials between the U.S. and its trading partners. This will produce a stronger dollar. The yen is likely to suffer the most in a rising rate environment, given the Bank of Japan's policy of keeping the 10-year JGB yield pinned close to zero. On the equity side, we continue to recommend a modestly overweight position in global stocks. Investors should favor Japan and the euro area over the U.S. in local-currency terms. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Sam Fleming, Demetri Savastopulo, and Shawn Donnan, "Interview With Steven Mnuchin: Transcript," Financial Times, Monday April 17, 2017. 2 Li Xiang, "Real Estate Investment Likely To Slow Down," Chinadaily.com.cn, April 18, 2017. 3 Please see Global Investment Strategy Weekly Report, "Talk Is Cheap: EUR/USD Is Heading Towards Parity," dated April 14, 2017, available at gis.bcaresearch.com. 4 Please see Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017, available at gps.bcaresearch.com. 5 Please see Geopolitical Strategy Weekly Report, "Five Questions On Europe," dated March 22, 2017, available at gps.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The sequential improvement in global trade is less pronounced than the annual growth rates in the Asian trade data imply. China has been instrumental to the recovery in global trade but mainland's credit and fiscal spending impulse has rolled over decisively pointing to a relapse its growth in general and imports in particular. This will hurt meaningfully countries and sectors selling to China. Commodities prices are set to tumble. In Turkey, reinstate the short TRY versus U.S. dollar and short bank stocks trades. Feature Economic data from China and Asian trade data have been strong of late. However, when one looks ahead, China's growth and imports are set to roll over decisively in the second half of the year, based on the credit and fiscal spending impulse (Chart I-1). This will hurt countries and industries that sell to China. This is why we believe commodities prices are in a broad topping-out phase. Commodities producers and Asian economies will again suffer materially. Any possible strength in U.S. and European growth will not offset the drag on EM growth emanating from China and lower commodities prices. As a result, having priced in a lot of good news, EM risk assets are at major risk of a selloff in absolute terms and are poised to underperform their DM counterparts over the next six months. Beware Of The Low Base Effect Asian trade data have been strong, but the magnitude of recovery has not been as large as implied by annual growth rates: Annual growth rates of export values in U.S. dollar terms have surged everywhere - in Korea, Taiwan, Japan and China (Chart I-2A). Chart I-1China's Growth To Decelerate Again Chart I-2AHigh Annual Growth Rates Are Due To... Chart I-2B...Low Base In Early 2016 Chart I-2B depicts the level of export values in U.S. dollar terms. It is clear that dollar values of shipments remain well below their peak of several years ago. Looking at the annual rate of change is reasonable since it removes seasonality from the series. However, investors should be aware of the low base effect of late 2015 and early 2016 that has made these annual growth rates extraordinarily elevated in recent months. As for export volumes, Chart I-3 illustrates that volumes held up better than U.S. dollar values in late 2015, which is why they are now expanding at a moderate rate (i.e. they are not surging). In short, in the past 12 months there has been a major discrepancy between dollar values and volumes of Asian exports. Indeed, the V-shaped profile of Asian export growth rates has been partially due to price swings in tradable goods. Prices for steel and other metals as well as for petrochemical products and semiconductors dropped substantially in late 2015 and early 2016, and have rebounded materially from that low base since. Correspondingly, Asian export prices have rebounded considerably in percentage terms (Chart I-4). Chart I-3Export Volume Recovery Has Been Moderate Chart I-4Export Values Are Inflated By Rising Prices In the U.S., the low base effect from a year ago is also present in manufacturing and railroad shipments. Both intermodal (container) and carload shipment volumes excluding petroleum and coal plunged in early 2016 and recovered considerably on an annual rate-of-change basis, from a low base (Chart I-5). Chart I-5U.S. Railroad Shipments ##br##Also Had Low Base In Early 2016 All told, the skyrocketing annual rate of change of Asian export values and other global trade series is exaggerated by the fact that global trade volume was sluggish and various tradable goods/commodities prices fell precipitously in the last quarter of 2015 and first quarter of 2016, thereby creating a base effect. We are not implying that there has been no genuine recovery in global trade. Indeed, there has been reasonable sequential recovery in global demand and trade. The point is that the sequential improvement in global trade is less pronounced than the annual growth rates in the trade data imply. Importantly, China has been instrumental to the recovery in global trade and the rebound in commodities prices. Hence, the outlook for China holds the key. Looking Ahead Looking forward, there are few reasons to worry about U.S. growth. Consumer spending is robust and core capital goods orders are recovering following a multi-year slump (Chart I-6). Nevertheless, BCA's Emerging Markets Strategy team's view is that global trade growth will decelerate again because China's one-off stimulus-driven recovery will soon reverse, causing the rest of EM to also suffer: In particular, the credit and fiscal spending impulse has rolled over decisively; the indicator typically leads nominal GDP growth and mainland imports by six months, as exhibited in Chart I-1 on page 1. As Chinese import volume relapses again, economies and sectors selling to China will suffer. Chart I-7 demonstrates China's credit and fiscal spending impulses separately. Chart I-6U.S. Final Demand: No Major Risk Chart I-7China: Fiscal And Credit Impulses The credit impulse is the second derivative of outstanding corporate and household credit.1 It does not take much of a slowdown in credit growth for the second derivative, credit impulse, to roll over and then turn negative. Remarkably, narrow (M1) and broad (M2) money as well as banks' RMB loan growth have all slowed in recent months (Chart I-8). Non-bank (shadow banking) credit growth remains stable (Chart I-8, bottom panel). Yet given that the PBoC's recent tightening has targeted shadow banking activities, it is a matter of time before shadow banking credit also decelerates meaningfully. To assess real-time strength in China's economic activity, we monitor prices of various commodities trading in China. Chart I-9 demonstrates that these commodities prices have lately plunged. Chart I-8China: Money/Credit Growth Is Slowing Chart I-9Plunging Commodities Prices To be sure, commodities prices are influenced not only by final demand but also by other factors such as supply, inventory swings and investor/trader positioning. We use these data as one among many inputs in our analysis. Bottom Line: Money/credit growth has rolled over and will continue to downshift, causing the current recovery underway in China to falter. This will hurt meaningfully countries and sectors selling to China. Commodities prices are set to tumble. Market-Based Indicators Financial asset prices often lead economic data. Therefore, one cannot rely on economic data releases to time turning points in financial markets. We watch and bring to investors' attention price signals from various segments of financial markets to corroborate our investment themes and economic analysis. Presently, there are several indicators flashing warning signals for EM risk assets: The plunge in iron ore prices warrants attention as it has historically correlated with EM equities and industrial metals prices (the LMEX index) (Chart I-10). The commodities currencies index - an equal-weighted average of CAD, AUD and NZD - also points to an end of the rally in EM share prices (Chart I-11). Chart I-10Is Iron Ore A Canary In A Coal Mine? Chart I-11EM Stocks Have Defied ##br##Rollover In Commodities Currencies It appears these long-term correlations have broken down in the past several weeks. We suspect this is due to hefty fund flows into EM. In the short term, the flows could overwhelm fundamentals and prompt financial variables that have historically been correlated to temporarily diverge. However, flows can refute fundamentals for a time, but not forever. It is impossible to time a reversal or magnitude of flows as there is no comprehensive set of data on global investor positioning across various financial markets. The message of a potential relapse in Chinese imports is being reinforced by commodities currencies that lead global export volume growth, and are pointing to weakness in global trade in the second half of this year (Chart I-12). The latest erosion in the commodities currencies has occurred even though the U.S. dollar has been soft and U.S. TIPS yields have not risen at all. This makes this price signal even more important. Oil prices have recovered to their recent highs, but share prices of global oil companies have not confirmed the rebound (Chart I-13). When such a divergence occurs between spot commodities prices and respective equity sectors, the spot prices typically converge toward the equity market. This leads us to argue that oil prices will head south pretty soon. Chart I-12Commodities Currencies ##br##Lead Global Trade Cycles Chart I-13Oil Stocks Have Not Confirmed ##br##The Latest Rebound In Oil Prices The average stock (an equally-weighted equity index) is underperforming the market cap-weighted index in both the EM universe and the U.S. equity market (Chart I-14). Chart I-14Narrowing Breadth Of Equity Rally This usually occurs in two instances: (1) the rally is losing steam and narrowing to large market-cap stocks; and/or (2) the rally is being fueled by flows into ETFs that must allocate money based on market cap. Narrowing breadth of the rally is a warning signal of a top, albeit the precise timing is tricky. Bottom Line: There are several market-based indicators that herald an imminent top in EM share prices, commodities prices and other risk assets. Stay put. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Turkey: Deceitful Stability Turkey held a constitutional referendum that dramatically expands the powers of the presidency on April 16. The proposed 18 amendments passed with a 51.41% majority and a high turnout of 85%. As with all recent Turkish referenda and elections, the results reveal a sharply divided country between the Aegean coastal regions and the Anatolian heartland, the latter being a stronghold of President Recep Tayyip Erdogan. Is Turkey Now A Dictatorship? First, some facts. Turkey has not become a dictatorship, as some Western press alleged. Yes, presidential powers have expanded. In particular, we note that: The president is now both a head of state and government and has the power to appoint government ministers; The president can issue decrees, however, the parliament has the ability to abrogate them through the legislative process; The president can call for new elections, however, they need three-fifths of the parliament to agree to the new election; The president has wide powers to appoint judges. What the media is not reporting is that the parliament can remove or modify any state of emergency enacted by the president. In addition, removing a presidential veto appears to be exceedingly easy, with only an absolute majority (not a super-majority) of votes needed. As such, our review of the constitutional changes is that Turkey is most definitely not a dictatorship. Yes, President Erdogan has bestowed upon the presidency much wider powers than the current ceremonial position possesses. However, the amendments also create a trap for future presidents. If the president should face a parliament ruled by an opposition party, they would lose much of their ability to govern. The changes therefore approximate the current French constitution, which is a semi-presidential system. Under the French system, the president has to cohabitate with the parliament. This appears to be the case with the Turkish constitution as well. Bottom Line: Turkish constitutional referendum has expanded the powers of the presidency, but considerable checks remain. If the ruling Justice and Development Party (AKP) were ever to lose parliamentary control, President Erdogan would become entrapped by the very constitution he just passed. Is Turkey Now Stable? The market reacted to the results of the referendum with a muted cheer. First, we disagree with the market consensus that President Erdogan will feel empowered and confident following the constitutional referendum. This is for several reasons. For one, the referendum passed with a slim majority. Even if we assume (generously) that it was a clean win for the government, the fact remains that the AKP has struggled to win over 50% of the vote in any election it has contested since coming to power in 2002 (Chart II-1). Turkey is a deeply divided country and a narrow win in a constitutional referendum is not going to change this. Chart II-1AKP Versus Other Parties In Turkish Elections Second, Erdogan is making a strategic mistake by giving himself more power. It will also focus the criticism of the public on the presidency and himself if the economy and geopolitical situation surrounding Turkey gets worse. If the buck now stops with Erdogan, it also means that all the blame will go to him as well. We therefore do not expect Erdogan to push away from populist economic and monetary policies. In fact, we could see him double down on unorthodox fiscal and monetary policies as protests mount against his rule. While he has expanded control over the army, judiciary, and police, he has not won over support of the major cities on the Aegean coast, which not only voted against his constitutional referendum but also consistently vote against AKP rule. That said, opposition to AKP remains in disarray. As such, there is no political avenue for opposition to Erdogan. The problem is that such an arrangement raises the probability that the opposition takes the form of a social movement and protest. We would therefore caution investors that a repeat of the Gezi Park protests from 2013 could be likely, especially if the economy takes a stumble. Bottom Line: The referendum has not changed the facts on the ground. Turkey remains a deeply divided country. Erdogan will continue to feel threatened by the general sentiment on the ground and thus continue to avoid taking any painful structural reforms. We believe that economic populism will remain the name of the game. What To Watch? We would first and foremost watch for any sign of protest over the next several weeks. Gezi Park style unrest would hurt Erdogan's credibility. Given his penchant to equate any dissent with terrorism, President Erdogan is very likely to overreact to any sign of a social movement rising in Turkey to oppose him. It is not our baseline case that the constitutional referendum will motivate protests, but it is a risk investors should be concerned with. Next election is set for November 2019 and the constitutional changes will only become effective at that point (save for provisions on the judiciary). Investors should watch for any sign that Erdogan or AKP's popularity is waning in the interim. A failure to secure a majority in parliament could entrap Erdogan in an institutional fight with the legislature that creates a constitutional crisis. Chart II-2Turkey Depends On Europe Turkey ##br##Is Very Reliant On Europe Economically Relations with the EU remain an issue as well. Erdogan will likely further deepen divisions in the country if he goes ahead and makes a formal break with the EU, either by reinstituting the death penalty or holding a referendum on EU accession process. Erdogan's hostile position towards the EU should be seen from the perspective of his own insecurity as a leader: he needs an external enemy in order to rally support around his leadership. We would recommend that clients ignore the rhetoric. Turkey depends on Europe far more than any other trade or investment partner (Chart II-2). If Turkey were to lash out at the EU by encouraging migration into Europe, for example, the subsequent economic sanctions would devastate the Turkish economy and collapse its currency. Nonetheless, Ankara's brinkmanship and anti-EU rhetoric will likely continue. It is further evidence of the regime's insecurity at home. Bottom Line: The more that Erdogan captures power within the institutions he controls, the greater his insecurities will become. This is for two reasons. First, he will increase the risk of a return of social movement protests like the Gezi Park event in 2013. Second, he will become solely responsible for everything that happens in Turkey, closing off the possibility to "pass the buck" to the parliament or the opposition when the economy slows down or a geopolitical crisis emerges. As such, we see no opening for genuine structural reform or orthodox policymaking. Turkey will continue to be run along a populist paradigm. Investment Strategy On January 25th 2017, we recommended that clients take profits on the short positions in Turkish financial assets. Today, we recommend re-instating these short positions, specifically going short TRY versus the U.S. dollar and shorting Turkish bank stocks. The central bank's net liquidity injections into the banking system have recently been expanded again (Chart II-3). As we have argued in past,2 this is a form of quantitative easing and warrants a weaker currency. To be more specific, even though the overnight liquidity injections have tumbled, the use of the late liquidity money market window has gone vertical. This is largely attributed to the fact that the late liquidity window is the only money market facility that has not been capped by the authorities in their attempt to tighten liquidity when the lira was collapsing in January. The fact remains that Turkish commercial banks are requiring continuous liquidity and the Central Bank of Turkey (CBT) is supplying it. Commercial banks demand liquidity because they continue growing their loan books rapidly. Bank loan and money growth remains very strong at 18-20% (Chart II-4). Such extremely strong loan growth means that credit excesses continue to be built. Chart II-3Turkey: Central Bank ##br##Renewed Liquidity Injections Chart II-4Turkey: Money/Credit ##br##Growth Is Too Strong Besides, wages are growing briskly - wages in manufacturing and service sector are rising at 18-20% from a year ago (Chart II-5, top panel). Meanwhile, productivity growth has been very muted. This entails that unit labor costs are mushrooming and inflationary pressures are more entrenched than suggested by headline and core consumer price inflation. It seems Turkey is suffering from outright stagflation: rampant inflationary pressures with a skyrocketing unemployment rate (Chart II-5, bottom panel) The upshot of strong credit/money and wage growth as well as higher inflationary pressures is currency depreciation. Excessive credit and income/wage growth are supporting import demand at a time when the current account deficit is already wide. This will maintain downward pressure on the exchange rate. The currency has been mostly flat year-to-date despite the CBT intervening in the market to support the lira by selling U.S. dollars (Chart II-6). Without this support from the CBT, the lira would be much weaker than it currently is. Chart II-5Turkey: Stagflation? Chart II-6Turkey: Central Bank's Net FX ##br##Reserves Are Being Depleted That said, the CBT's net foreign exchange rates (excluding commercial banks' foreign currency deposits at the CBT) are very low - they stand at US$ 12 billion and are equal to 1 month of imports. Therefore, the central bank has little capacity to defend the lira by selling its own U.S. dollar. Chart II-7Short Turkish Bank Stocks We also believe there is an opportunity to short Turkish banks outright. The currency depreciation will force interbank rates higher (Chart II-7, top panel). Historically, this has always been negative for banks' stock prices as net interest margins will shrink (Chart II-7, bottom panel). Surprisingly, bank share prices in local currency terms have lately rallied despite the headwinds from higher interbank rates and the rollover in net interest rate margin. This creates an attractive opportunity to go short again. Bottom Line: Re-instate a short position in the currency. In addition, short Turkish bank stocks. Dedicated EM equity as well as fixed-income and credit portfolios should continue underweighting Turkish assets within their respective EM universes. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Report titled, "Gauging EM/China Credit Impulses", dated August 30, 2016, link available on page 19. 2 Please refer to the Emerging Markets Strategy Special Report titled, "Turkey's Monetary Demagoguery", dated June 1, 2016, link available on page 19. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Duration: The recent strength in bond markets appears to be a flight to quality driven by heightened political uncertainty. Underlying economic growth remains solid, and investors should fade the recent moves by adding to duration underweights. Quality Spreads: It might be wise to take advantage of current tight quality spreads to hedge the risk of the corporate interest expense tax deduction being repealed. Credit Curve: There is a substantial spread advantage to extending maturity within an allocation to investment grade corporate bonds. Further, this spread advantage should dissipate as Treasury yields move higher. Feature Political risks dominated the headlines last week, sparking what looks like a textbook flight-to-quality in financial markets. The 10-year Treasury yield broke below its long-standing 2.3% floor to end the week at 2.24%, and the S&P 500 declined by just over 1%. Another telltale sign of a flight-to-quality is that the term structure of implied equity volatility inverted (Chart 1). That is, implied volatility on 1-month S&P 500 index options rose above 3-month implied vol. We know the playbook here. Politically driven risk-off episodes that are unlikely to materially impact economic growth should be faded. This means staying at below-benchmark duration and overweight spread product, while favoring curve steepeners and TIPS breakeven wideners. We don't have to look that far back to identify another politically driven risk off episode. The Brexit vote from early last summer also caused the equity volatility term structure to invert, and drove the 10-year Treasury yield down to 1.37%, well below the fair value dictated by global economic fundamentals. Following the Brexit vote the 10-year Treasury yield was 58 bps expensive according to our 2-factor Treasury model.1 Presently, the 10-year yield appears 30 bps expensive (Chart 2), and much like in the aftermath of the Brexit vote, the deviation from fair value looks to be driven by spiking political uncertainty. Chart 1Inverted Vol Term Structure Chart 210-Year Treasury Yield Fair Value Now, the Global Economic Policy Uncertainty Index has been above normal levels since Donald Trump's election last November (Chart 2, bottom panel), and as long as the reading from that index is elevated the risk of another flight-to-quality episode in financial markets will remain high. However, spikes in policy uncertainty that do not coincide with economic deterioration have historically tended to mean-revert in relatively short order. We anticipate that Treasury yields will rise as policy uncertainty eases in the months ahead. Chart 3The Fed Is Being Priced Out Coincident with the drop in long-dated Treasury yields, the overnight index swap curve is now priced for only 39 bps of rate hikes between now and the end of the year (Chart 3). That's barely more than one 25 basis point hike! We previously recommended shorting January 2018 Fed Funds Futures on March 21,2 and would advise investors who have not yet entered this trade to do so now from even more attractive levels. We calculate that a short January 2018 Fed Funds Futures trade will return 20 bps (from current levels) in the event that the Fed hikes twice more this year, and 45 bps in the event of three more hikes. In our view, growth will be strong enough to support at least two more rate hikes this year. Bottom Line: The recent strength in bond markets appears to be a flight to quality driven by heightened political uncertainty. Underlying economic growth remains solid, and investors should fade the recent moves by adding to duration underweights. Are Markets Sniffing Out A Slowdown? Of course, bond markets could just be rallying in response to slowing U.S. economic growth. After all, the Atlanta Fed's GDPNow forecast is calling for a measly 0.5% annualized GDP growth in Q1. In stark contrast, the New York Fed's GDP Nowcast is calling for robust growth of 2.6% in Q1 and 2.1% in Q2 (Chart 4). How do we square the two? The answer relates to the ongoing debate between so-called "soft" and "hard" data. The New York Fed model incorporates a great deal more "soft data" than the Atlanta Fed model. In other words, it incorporates a wider swathe of survey data than the Atlanta Fed model, which relies more heavily on actual production and spending statistics. We think it would be unwise to dismiss the more positive economic message being sent by survey data. First, surveys tend to lead actual spending so we should expect some divergence whenever the economy reaches a turning point. Second, "hard data" are often revised after the fact and there are question marks about whether residual seasonality has biased Q1 growth lower during the past few years. The minutes from the March FOMC meeting showed that participants "noted that residual seasonality might have exaggerated the increase" in the PCE price deflator in January and February. The corollary of an unduly strong PCE price deflator is unusually weak real consumer spending. Real consumer spending was indeed weak in January and February, as was the headline retail sales figure for March. However, the weakness in March retail sales was concentrated in gasoline stations and auto sales. The more stable retail sales control group - a measure that excludes autos, gas stations and building materials - ticked higher in March (Chart 5). While the recent decline in auto sales should not be dismissed, it is too soon to call for a broad slowdown in consumer spending. Finally, as was recently noted by our colleagues at BCA's Global Investment Strategy service,3 even with bad weather having been a large drag on employment growth in March, aggregate hours worked still grew 1.5% in Q1 (Chart 6). This means that productivity growth would need to be negative in order to achieve the Atlanta Fed's 0.5% forecast. Given that aggregate hours worked were biased lower due to weather in the first quarter, and that quarterly productivity growth has averaged approximately +0.7% (annualized) since 2010, overall GDP growth forecasts closer to 2% seem more reasonable going forward. Chart 4Soft Data Versus Hard Data Chart 5Weak Auto Sales Are A Concern Chart 6Aggregate Hours Still Robust No Deflation Here GDP growth in the neighborhood of 2% is sufficient to keep measures of core inflation gradually trending higher. Higher inflation, in turn, will eventually translate into increased inflation expectations and higher long-dated Treasury yields. While last week's release showed that core CPI actually contracted in March, we note that this followed two months of extremely strong inflation (Chart 7). Taking a step back, it still appears as though measures of core inflation put in a cyclical bottom in early 2015 (Chart 8). While our CPI diffusion index is still below zero, signaling that inflation is likely to remain soft during the next couple of months, it would be premature to suggest that the gradual uptrend in core inflation has reversed. Chart 7March CPI Is An Anomaly Chart 8Inflation Still Trending Higher One final point relevant to the inflation outlook is that last week President Trump refused to rule out re-appointing Janet Yellen as Fed Chair when her current term expires early next year. If we can take the President at his word, then this potentially removes what was an important tail risk for the inflation outlook and the reflation trade more generally. If Trump were to appoint a staunch hawk as Fed Chair, then a much tighter Fed policy would likely halt the uptrend in core inflation. This would also cause the Treasury curve to bear-flatten and risk assets to sell off. However, an FOMC hewing closer to the status quo would allow inflation to trend higher, prolonging the reflation trade. Bottom Line: We don't see enough evidence to call for a slowdown in economic growth or inflation. Growth in the neighborhood of 2% going forward will be sufficient to send inflation expectations and long-dated nominal yields higher. Corporate Bond Positioning: Credit Rating & Maturity In last week's report we performed an assessment of the corporate credit cycle and concluded that corporate bonds should perform well relative to Treasuries this year, but are at risk next year once inflationary pressures start to bite and the Fed speeds up the pace of tightening.4 This week, we consider the implications of this outlook for positioning across the corporate bond quality and maturity spectrums. Quality Spreads Chart 9Quality Spreads Are Tight Obviously, lower rated corporate bonds offer a spread advantage relative to more highly rated bonds. This spread advantage is usually worth chasing unless the default outlook is worsening and overall corporate spreads are widening. At the moment, the option-adjusted spread (OAS) advantage in the Barclays High-Yield index relative to the Investment Grade index is 274 bps, about 100 bps below its long-run average. Further, Baa-rated investment grade corporate bonds currently offer a spread advantage of 77 bps over Aa-rated bonds, about 20 bps below the long-run average. Even though these quality spreads are somewhat tight by historical standards, the mere fact that the quality spread is positive means there is an advantage to moving down the quality spectrum as long as default risk is benign. For this reason, it is more relevant to consider the additional compensation for moving down in quality relative to our expectations for default losses during the next 12 months.5 In Chart 9 we see that quality spreads are in fact tighter than average, even after adjusting for default loss expectations, although there have also been extended periods when they were even tighter than current levels. Although the risk/reward trade-off for moving down in quality is not all that attractive by historical standards, given our view that corporate spreads will be well behaved this year, we are fairly agnostic about moving down in quality on a 6-12 month investment horizon. There is, however, one additional factor to consider with regards to positioning across the credit quality spectrum. Corporate tax reform, some form of which our Geopolitical strategists still see as having a high probability of being passed before the end of this year,6 will involve some combination of lower tax rates and the repeal of some deductions. One deduction that is very much at risk is that of corporate interest expense. If implemented, it seems likely that corporate interest deductibility would be phased out over time. That is, the interest on outstanding corporate bonds would remain tax deductible, and only the interest on newly issued debt would be excluded from the deduction. While the gradual phase-out would prevent a wave of defaults related to a sudden surge in tax expense, the provision very clearly favors large highly-rated firms relative to small lower-rated firms, whose interest expense makes up a larger proportion of total expenses. Investors with longer time horizons might be wise to take advantage of current tight quality spreads (i.e. move up in quality) to hedge the risk of the corporate interest expense tax deduction being repealed. Credit Curve Considerations Turning to the corporate bond term structure, we see that the OAS advantage in long-maturity investment grade corporate bonds is extremely high relative to history (Chart 10). As we discussed in a 2013 report,7 the two main drivers of the credit OAS curve are differences in duration and expected default losses. A greater difference in duration between the long-maturity and intermediate-maturity investment grade corporate bond indexes leads to a greater OAS advantage in the long-maturity index. Conversely, an increase in perceived default risk causes the OAS curve to flatten, as short-maturity credits are perceived to be at greater risk of default. We find that the majority of the spread advantage in long-dated corporate bonds represents compensation for duration risk. If we look at OAS per unit of duration rather than outright OAS, the credit curve no longer appears steep (Chart 10, panel 2). Digging a little deeper, we see that the difference in duration between the long-maturity and intermediate-maturity indexes has been steadily increasing since 1990. In the early 1990s the increase was at least partially attributable to actual changes in the maturity structure of the indexes themselves (Chart 10, panel 3). However, in recent years the increased duration spread is entirely the result of lower Treasury yields (Chart 10, bottom panel). It follows that if Treasury yields continue to trend lower, then the corporate OAS curve will remain very steep. Higher Treasury yields would reduce the difference in duration between the intermediate and long maturity indexes, causing the OAS curve to flatten. After adjusting for differences in duration, we also need to consider the default outlook. By performing a regression of the difference in OAS per unit of duration between the long-maturity and intermediate-maturity indexes on our measure of expected default losses, we find that the amount of spread per unit of duration at the long-end of the curve looks somewhat attractive given our outlook for default losses (Chart 11). Chart 10OAS Term Structure Is Steep Chart 11Higher Defaults = Flatter OAS Curve Adding it all up, there is a compelling case to be made for favoring long-maturity investment grade corporate bonds relative to short maturities. Not only is the spread advantage substantial on its face, but the OAS curve should flatten if Treasury yields move higher - as we expect they will. The OAS curve also appears too steep relative to our assessment of default risk. Bottom Line: There is a substantial spread advantage to extending maturity within an allocation to investment grade corporate bonds. Further, this spread advantage should dissipate as Treasury yields move higher. Investors should favor long-maturity issues over short-maturity issues within an overweight allocation to investment grade corporate bonds. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Our 2-factor Treasury model is based on Global Manufacturing PMI and bullish sentiment toward the U.S. dollar. For further details please see U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Model", dated October 11, 2016, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com 3 Please see Global Investment Strategy Weekly Report, "Talk Is Cheap: EUR/USD Is Heading Toward Parity", dated April 14, 2017, available at gis.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "The Payback Period In Corporate Bonds", dated April 11, 2017, available at usbs.bcaresearch.com 5 We calculate expected default losses using the Moody's baseline forecast for the default rate and our own forecast of the recovery rate. 6 Please see Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017", dated April 5, 2017, available at gps.bcaresearch.com 7 Please see U.S. Bond Strategy Special Report, "On The Term Structure Of Credit Spreads", dated July 10, 2013, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

I am honored to join BCA Research as Senior Vice President of the U.S. Investment Strategy service. I have been researching and writing about the economy and financial markets for more than 30 years. I joined BCA Research from LPL Financial in Boston, MA where I served as the firm’s Chief Economic Strategist. At LPL I helped to manage more than $120 billion in client assets and provided more than 14,000 financial advisors and 700+ financial institutions with insights on asset allocation, global financial markets and economics. Prior to LPL, I served in similar functions at PNC Advisors, Stone & McCarthy Research, Prudential Securities, and the Congressional Budget Office in Washington, DC. I look forward to meeting you and providing quality research in the years to come. John Canally, Senior Vice President U.S. Investment Strategy Highlights We are not changing our view on Treasury markets or our stocks over bonds call despite the news that the Fed will begin shrinking its balance sheet later this year. The Fed's action is marginally dollar positive. For the major industrialized economies, the so-called "hard" data are moving in line with the "soft" survey data for the most part. Retail sales and industrial production have accelerated, although "hard" data on business capital spending remains weak. We introduce our Bond Duration checklist this week. These are the key economic and market indicators that we are watching to assess whether we should maintain our current below-benchmark portfolio stance. We continue to favor U.S. equites over bonds in 2017 and recommend keeping duration short of benchmark. Despite outsized performance from high-yield corporate bonds in 2016, investors should favor stocks over high-yield over the coming year. We introduce the BCA Beige Book Monitor this week. This metric provides a quantitative look at the qualitative, or "soft" data in the Fed's Beige Book. The Beige Book is due out Wednesday, April 19. Feature Chart 1Weak Data And More Weighed ##br##On Risk Assets U.S. stocks stumbled and Treasury yields slumped last week with the 10-year Treasury yield hitting a 2017 low. The drop in yields came despite news from the FOMC that the Fed is prepared to shrink its balance sheet later this year, a bit sooner than the market expected. Comments from Fed Chair Yellen - who expressed concern that the Fed's independence is "under threat"- should have jolted the bond market, but didn't. Not yet at least. Geopolitics played a role in the week's market action as well, the main culprits being upcoming French elections, the aftermath of President Trump's missile attack on Syria and ongoing tensions in North Korea. The looming Q1 earnings reporting season weighed on risk assets as well. The dollar ended lower last week. Trump told the Wall Street Journal he prefers a weak dollar. Those comments and the tepid data helped to offset the safe-haven bid generated by the geopolitical events of the week (Chart 1). The "hard" vs "soft" data debate will continue this week and likely for some time thereafter. "Hard" data on housing and manufacturing for March as well as the U.S. leading indicator are due out this week. Of course, the ultimate set of "hard" data is the corporate earnings data. Nearly 70 S&P 500 firms will report Q1 results and provide guidance for Q2 and beyond this week. "Soft" data on the PMI, Philly Fed and Empire State manufacturing sector for April will undoubtedly keep the debate going. Our view is that the hard data will catch up with the upbeat surveys in the U.S. This week we review the key economic indicators for the major advanced economies, which highlight that the global growth acceleration remains on track. We also introduce a Duration Checklist designed to help separate "signal from noise" in the bond market. Most of the items on the Checklist remain bond-bearish. Fed plans to shrink its balance sheet is not particularly negative for bond prices, but it certainly won't be supportive. The main risk to our bond-bearish view remains geopolitics, including the first round voting and results in the French election due on Sunday, April 23. Balance Sheet Bedlam? Maybe Not The release of Minutes from the FOMC's March meeting contained a robust discussion of the Fed's balance sheet. Until recently, most market participants had assumed that the Fed would maintain the size of its balance sheet via reinvesting through at least late 2017/early 2018. The latest FOMC minutes suggest that, assuming the economy continues to track the Fed's forecast, the FOMC will allow its balance sheet to shrink this year. The FOMC will achieve this by ceasing reinvestment of both its MBS and Treasury holdings at the same time. No decision has been made about whether the reinvestments will end all at once or will be phased out over time (tapered). Chart 2 shows that when QE1 ended in 2010 and QE2 ended in 2011, U.S. equities underperformed bonds. It's important to note, however, that underperformance didn't occur in a vacuum. The European debt crisis, the U.S. rating downgrade and debt ceiling debates all weighed on risk assets after QE1 and QE2 ended. Other factors played a role as well, such as weak economic growth and policy uncertainty. Amid QE3, U.S. equities surged in 2013, returning 32.4%, while bonds fell 8.5%. But in late 2013, the Fed announced that purchases would be tapered over the course of 2014. QE3 finally ended in late 2014. Stocks and bonds battled it out over 2014 and 2015, with stocks beating bonds by 3%. Chart 2Reminder What Happened When QE1, QE2 & QE3 Ended Bottom Line: Our view remains that Fed balance sheet run-off won't have a big impact on Treasury yields, although may lead to a widening of MBS spreads. What matters more for Treasury yields than the size of the balance sheet is the expected path of short rates. As for equities, while geopolitical risks are ever-present, the U.S. economy is in far better shape today than it was when QE1, QE2 and QE3 ended. U.S. corporate earnings are pointing higher as well. While we've clearly entered a new part in the Fed cycle, the news on the Fed's balance sheet does not change our view that U.S. stocks will outperform bonds this year. All else equal, the dollar should get a small boost from a shrinking Fed balance sheet, supporting our view that the dollar will rise 10% this year. Overplaying The Soft Data And Underplaying Geopolitics...In 2018 Chart 3Global Pick-Up On Track Traders and investors have been giving up on the global reflation story of late, sending the 10-year Treasury yield down to the bottom end of this year's trading range. Missile strikes, upcoming French elections and U.S. saber rattling regarding North Korea have lifted the allure of safe havens such as government bonds. At the same time, the Fed was unwilling to revise up the 'dot plot', doubts are growing over the ability of the Trump Administration to deliver any stimulus and a few recent U.S. data releases have disappointed. It is difficult to forecast the ebb and flow of safe-haven demand for bonds, especially related to North Korea and Syria. However, our geopolitical team holds a high-conviction view that angst over Eurozone elections this year are overblown. The Italian election in 2018 is more of a threat. While we cannot rule out an even stronger safe-haven bid from developing in the coming weeks, the global cyclical economic backdrop remains negative for government bond markets. For the major industrialized economies, the so-called "hard" data are moving in line with the "soft" survey data for the most part. For example, retail sales growth continues to accelerate, reaching 4.7% in February on a year-over-year basis (Chart 3). This follows the sharp improvement in consumer confidence. Manufacturing production growth is also accelerating to the upside, in line with the PMIs. The global manufacturing sector is rebounding smartly after last year's recession, which was driven by the collapse in oil prices and a global inventory correction. Readers may be excused for jumping to the conclusion that the rebound is largely in the energy space, but this is not true. Production growth in the energy sector is close to zero on a year-over-year basis, and is negative on a 3-month rate of change basis (Chart 4). The growth pickup has been in the other major sectors, including consumer-related goods, capital goods and technology. In the U.S., non-energy production has boomed over the three months, rising 5.2% at annual rates (Chart 5). The weak spot has been in capital goods orders (Chart 3). We only have data for the big three economies - the U.S., Japan and the Eurozone - but growth is near to zero or slightly negative for all three. These data are perplexing because they are at odds with an acceleration in the production of capital goods (noted above) and a pickup in capital goods imports for 20 economies (Chart 3, third panel). Nonetheless, improving CEO sentiment, strengthening profit growth and activity surveys all suggest that capital goods orders will "catch up" in the coming months. Chart 4Manufacturing Rebound Is Not About Energy Chart 5U.S.: Non-Energy Production Surging That said, one risk to our positive capex outlook in the U.S. is that the Republicans could fail to deliver on their promises to cut taxes and boost infrastructure spending. This is not our base case, but current capex plans could be cancelled or put on indefinite hold were there to be no corporate tax cuts or immediate expensing of capital expenditures. Duration Checklist: What We're Watching BCA's Global Fixed Income Strategy service recently introduced a "Duration Checklist" designed to keep us focused on the most relevant factors while trying to sift out the signal from the noise (Table 1).1 These are the key economic and market indicators that we are watching to assess whether we should maintain our current below-benchmark portfolio stance. Naturally, leading and coincident indicators for global growth feature prominently in the top section of the Checklist (Chart 6). All four of these indicators appear to have topped out except the Global Leading Economic Indicator (GLEI), suggesting that the period of maximum growth acceleration has past. Nonetheless, all four are still consistent with robust growth for at least the near term. Table 1Stay Bearish On Treasuries & Bunds Chart 6Some Warning From Leading Indicators The rapid decline in the diffusion index, based on the 22 countries that comprise our GLEI, is concerning. The LEIs for two major economies and two emerging economies dipped slightly in February, such that roughly half of the country LEIs rose and half fell in the month. While it is too early to hit the panic button, the diffusion index is worth watching closely; a decline below 50 for several months would indicate that a peak in the GLEI is approaching. The remainder of the items on the checklist are related to growth, inflation pressure, central bank stance, investor risk-taking behavior and bond market technicals. We are focusing on the U.S. and Eurozone at the moment because we believe these two economies will be the main driver of global yields over the next 12 months. In the U.S., the Fed is tightening and market expectations are overly benign on the pace of rate hikes in the coming years. Upside pressure on global yields should intensify later this year, when the ECB announces the next "tapering" of its asset purchase program. All of the economic growth, inflation pressure and risk-seeking indicators on the Checklist warrant a check mark for the U.S., although this is not the case for the Eurozone inflation indicators. From a technical perspective, the Treasury and bund markets no longer appear as oversold as they did after the rapid run-up in yields following last November's U.S. elections. Large short positions have largely unwound. This removes one of the largest impediments to a renewed decline in global bond prices. For the U.S., we expect that the 10-year yield to rise to the upper end of the recent 2.3%-2.6% trading range in the next couple of months, before eventually breaking out on the way to the 2.8%-3% area by year-end. Bottom Line: A number of political pressure points and some modest U.S. data disappointments have triggered an unwinding of short bond positions. Nonetheless, the global manufacturing revival and growth impulse remain in place, and the majority of items on our Checklist suggest that the recent bond rally represents a consolidation phase rather than a trend reversal. Keep duration short of benchmark within fixed-income portfolios. Favor Stocks Over Junk Bonds Table 2A New Trend In Junk Vs. Stocks? We continue to favor U.S. equities over bonds in 2017 and recommend keeping duration short of benchmark. But what about U.S. equities versus high-yield bonds? As a reminder, favoring corporate bonds over equities was a long-running BCA theme during the early stages of the economic recovery.We noted that corporate bonds were likely to outperform equities in a prescient Special Report published in late-2008,2 and we continued to favor corporate bonds until late-2012 when we shifted towards strong dividend-paying stocks. Table 2 highlights that our corporate bond vs equity recommendations have worked out well over the past several years. The table presents the annual total return for the S&P 500 and high-yield corporate bonds (as well as the difference between the two), and it shows that the former underperformed the latter from 2008 to 2011 (and again in 2012 in risk-adjusted terms). However, stocks materially outperformed high-yield bonds from 2013-2015, which followed our recommendation to favor the S&P Dividend Aristocrats index over corporate bonds in our November 2012 Special Report.3 But Table 2 also shows that the trend of stock outperformance reversed last year, with high-yield bonds having somewhat outpaced the S&P 500 in total return terms. Does this imply that investors are witnessing the beginning of a new uptrend in corporate bond outperformance versus equities? In our view, the answer is 'no'. Chart 7 presents our simple framework for the relative performance of stocks vs high-yield corporate bonds, which suggests that investors should favor the former over the latter. Panel 1 highlights that the trend in stocks vs high-yield is generally the same as that vs 10-year Treasuries, with a few notable exceptions of sustained difference. The first exception was from 2002 to 2004, when stocks significantly outperformed government bonds but were flat vs high-yield. The second exception occurred during the early part of this expansion, which again saw high-yield corporate bonds post equity-like returns. Chart 7Major Valuation Advantage Needed For High-Yield To Outperform Stocks Panel 2 suggests that both of these circumstances were fueled by a substantial high-yield valuation advantage over stocks. The panel illustrates the gap between the speculative-grade corporate bond yield-to-worst and the S&P 500 12-month forward earnings yield, which was elevated and fell materially in both of the cases of sustained divergence shown in panel 1. The key point for investors is that last year's outperformance of junk bonds is unlikely to continue. While the compression of the junk/stock yield gap did lead the former to outperform last year, the gap was not high to begin with and is currently not that far away from its historical lows. This suggests that there is no reason to expect the stock/junk relative performance trend to deviate from the overall stock/government bond trend, which we expect to rise further over the coming 6-12 months. Bottom Line: Despite outsized performance from high-yield corporate bonds in 2016, investors should continue to favor stocks over high-yield over the coming year (but favor both over Treasuries and cash). Introducing The BCA Beige Book Monitor Chart 8BCA Beige Book Monitor: ##br##A "Hard" Look At "Soft" Data The Fed's Beige Book is released eight times a year, two weeks ahead of each FOMC meeting. It was first released in 1983. The Beige Book's predecessor was the Red Book, first produced in 1970. The Beige Book itself got a makeover from the Fed in early 2017. The Fed changed the way the information was presented across the 12 Fed districts, but, according to the Fed, the Beige Book will continue to provide "an up-to-date depiction of regional economic conditions based on anecdotal information gathered from a diverse range of business and community contacts." In addition to the Beige Book, FOMC officials also review what is now known as the "Teal Book" at each meeting. The Teal Book combined the "Green Book" - a review of current economic and financial conditions - and the "Blue Book"- which provided context for FOMC members on monetary policy actions. As noted in the Fed's own description, the Beige Book is "soft data". In discussing the Beige Book, the financial press often notes the number of districts where growth is expanding and contracting or describes the pace of overall activity (modest, moderate etc). The BCA Beige Book Monitor takes a more quantitative approach to all the qualitative data in the Beige Book. We began by searching the document for all the words we could think of that signify strength: Strong, strength, rise, increase, accelerate, fast, expand, advance, positive, robust, optimistic, up, etc. We then counted up all the words that denote weakness: Weak, fell, slow, decelerate, decrease, decline, soft, negative, pessimistic, down, contract, etc. Next, we subtracted the number of weak words from the strong words to calculate the BCA Beige Book Monitor. The Monitor begins in 2005, so it covers the time period from the middle of the 2001-2007 expansion, through the Great Recession (2007-2009) and the recovery since 2009. A more streamlined approach, using the words "strong" and "strength" (and their derivatives like stronger, strengthened, etc) as proxy for all the strong words and the word "weak" as a proxy for all the weak words, showed the same results. We adopted this simpler approach. Chart 8, panels 1 and 2, shows the BCA Beige Book Monitor versus real GDP and CEO Confidence. The BCA Beige Book monitor does a good job explaining GDP, but it is more timely. The Monitor leads CEO confidence, especially around turning points. We intend to do more work with the Beige Book Monitor and present it to you in future editions of this publication. We also track mentions of other key words in the Beige Book. For example changes in mentions of "inflation" words in the Beige book track, and sometimes lead, core inflation (Panel 3). Mentions of the "strong dollar" track the dollar itself, although tends to be lagging (Panel 4). We'll be watching for those inflation words and mentions of the dollar in the Beige Book this week. The Beige Book will also help to shed some qualitative light on the recent weakness in capital spending and C&I loans. Has the uncertainty about the timing, scope and scale of Trump's legislative agenda (taxes, infrastructure and the repeal of Obamacare, etc) had an impact on corporate spending or borrowing? We'll find out this week. Bottom Line: Although technically it is "soft" data, the Beige Book is a major input on monetary policy decision making for the FOMC. As we showed last week, the rise in "inflation" words in the Beige Book has certainly captured the Fed's attention, and confirms the "hard" we've seen on inflation. The next FOMC meeting is on May 2-3, and neither we nor the consensus expects a hike at that meeting. Despite the apparent flare-up in geopolitics last week and the run of disappointing economic data, we continue to expect the Fed to raise rates 2 more times in 2017. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com Jonathan LaBerge Vice President, Special Reports jonathanl@bcaresearch.com 1 Please see Global Fixed Income Strategy Special Report, "A Duration Checklist For U.S. Treasurys And German Bunds," dated February 15, 2017, available at gfis.bcaresearch.com 2 Please see Global Investment Strategy Special Report, "Value And The Cycle Favor Corporate Debt Over Equities," dated November 14, 2008, available at gis.bcaresearch.com 3 Please see U.S. Investment Strategy Special Report, "The Search For Yield Continues: Aristocrats Or High Yield?" dated November 5, 2012, available at usis.bcaresearch.com

Highlights Portfolio Strategy Operating leverage could surprise on the strong side this year, based on the message from our pricing power and wage growth indicators. REITs are experiencing a playable recovery following the Fed-induced sell-off earlier this year, and overweight positions will continue to pay off. Energy services activity is set to steadily accelerate this year, powering an earnings-led share price outperformance phase. Recent Changes There are no changes to our portfolio this week. Table 1 Feature Volatility has climbed to the highest level since the U.S. election, signaling that the broad market is not yet out of the woods. As stocks recalibrate to a cooling in economic growth momentum and an escalation in geopolitical threats, downside risks should be reasonably contained by mounting signs of a healthier corporate sector. Last week we posited that stronger top line revenue growth is necessary to sustain the profit upcycle, and provide justification for historically rich valuations. Chart 1 shows sales and EPS growth over the long-term. Chart 1Joined At The Hip Obviously, the two move closely together, with earnings enjoying more powerful growth phases when revenue accelerates. Since 1960, regression analysis shows that operating leverage for the S&P 500's is 1.4X. In other words, a 5% increase in sales growth typically leads to 7% EPS growth. When sales are initially recovering from a deep slump operating leverage can be even higher, with earnings often rising two to three times as fast as revenue. Clearly, that is not sustainable, but can give the illusion of powerful and sustained growth for brief periods of time. At the current juncture, there are reasons to expect investors to embrace the durability of the profit expansion. Our corporate pricing power proxy has vaulted higher. Importantly, the breadth of this surge has been impressive, which bodes well for its staying power (Chart 2, second panel). On the flip side, rising labor costs look set to take a breather. Compensation growth has crested, and according to our diffusion index, fewer than half of the 18 industries tracked have higher wages than last year. The wage growth diffusion index provides a reliable leading indication for the trend in labor expenses. In other words, pricing power is rising on a broad basis while wage inflation is decelerating on a broad basis. Consequently, there are decent odds that resilient forward operating margin expectations can be matched (Chart 2, bottom panel). Elsewhere, a revival in animal spirits, the potential for easier fiscal policy and prospects for a hiatus in the U.S. dollar bull market bode well for brisk business activity. While the budding recovery in global trade could sputter if protectionism proliferates, our working assumption is that the U.S. Administrations' bark will be worse than its bite. Thus, a self-reinforcing sales and profit upcycle could be materializing. The objective message from our S&P 500 EPS model concurs (Chart 3), underscoring that high single digit/low double digit profit growth could be broadly perceived as attainable this year. Chart 2Profit Margins Can Expand Chart 3Few Sectors Control The Fate Of S&P 500 EPS True, our model has recently shown tentative signs of cresting, but difficult comparisons will only arise later this year. Indeed, Q3 and Q4 2016 were all-time high EPS numbers, implying that 12% estimated growth rates are a tall order (Chart 3, middle panel). Importantly, dissecting the profit growth sectorial contribution is instructive. Calendar 2017 over 2016 S&P 500 earnings growth is concentrated in four sectors: tech, energy, health care and financials comprise over 87% of the incremental profit growth expected (Chart 3, bottom panel). The upshot is that there is a high degree of concentration risk to fulfilling overall profit growth expectations. Energy profits are wholly dependent on the oil price, and financial sector profit optimism appears to have embedded a healthy increase in both interest rates and capital markets activity. In addition, tech sector earnings are heavily influenced by the U.S. dollar. Consequently, it will be critical for monetary conditions to stay loose, otherwise estimates will be at risk of downward revisions. Adding it up, the corporate sector sales pendulum is finally swinging in a positive direction, which should support the cyclical overshoot in stocks for a while longer, notwithstanding our expectation that the current corrective phase has further to run. This week we are updating our high-conviction overweight views on both the lagging energy services index and REIT sector. Revisiting REITs REITs have staged a mini V-shaped rebound after being punished alongside rising bond yields and worries about aggressive Fed rate hikes earlier this year. As outlined in recent Weekly Reports, the reflation theme is likely to lose steam in the second half of the year as economic momentum cools, providing additional impetus for capital inflows into the more stable income profile of REITs. Even if the economy proves more resilient and Treasury yields move higher, there are few barriers to additional outperformance. Our Technical Indicator, a combination of rates of change and moving average divergences, is extremely oversold. Forward intermediate and cyclical relative returns from current readings have been solid, as occurred in 2004, 2008 and 2014 (Chart 4). REIT valuations are more than one standard deviation below normal, according to our gauge. This suggests that poor operating performance and/or higher discount rates are already expected. There may be a limit as to how high bond yields can climb, given that they are already deep in undervalued territory according to the BCA 10-year Treasury Bond Valuation Index (Chart 4). Regardless, history shows that REITs have typically had a more positive than negative correlation with bond yields. The inverse correlation has only been in place since the financial crisis, when zero interest rate policies pushed massive capital flows into all yield generating assets. Chart 5 shows that prior to 2008, REITs outperformed during periods of both rising and falling Treasury yields. Chart 4Unloved And Undervalued Chart 5No Concrete Correlation Pre GFC Similarly, REITs have a solid track record during periods of rising inflation pressures. Since 1975, there have been six periods of rising core PCE inflation: REITs have enjoyed meaningful rallies during five of these phases (Chart 6). Hard assets tend to hold their stock market value well when overall inflation moves higher, with REIT net asset values providing solid support to share price performance. Chart 6Buy REITs In Times Of Inflation Looking ahead, REITs should continue to enjoy success in boosting rental rates. Occupancy rates continue to rise (Chart 7). The unemployment rate is low, consumption is decent and businesses are growing increasingly confident. That is a recipe for higher rental demand. Our Rental Rate Composite has crested on a growth rate basis, but the advance in the CPI for homeowner's equivalent rent, a good proxy for REITs, suggests that the path of least resistance remains higher (Chart 7). REIT supply growth has also leveled off, which provides additional confidence that rental inflation will remain solid. Nevertheless, there are some areas of concern. Banks are tightening lending standards on commercial real estate loans. Some sub-categories are experiencing a mild deterioration in credit quality. For instance, Chart 8 shows that delinquency rates in the retail and office spaces have edged higher. Retail and mall REITs are likely under structural pressure owing to online competition from the likes of Amazon. Chart 7Rental Demand##br## Is Solid Chart 8Watch Delinquencies As ##br##Banks Tighten Credit Standards Overall vacancy rates are still very low (Chart 8), but if credit becomes too tight, then the relentless advance in commercial property prices may cool. For now, our REIT Demand Indicator is not signaling any imminent stress. In fact, the economy is strong enough to expect occupancy rates to keep climbing, to the benefit of underlying property valuations and rental income (Chart 7, bottom panel). In sum, the budding rebound in REIT relative performance should be embraced as the start of a sustained trend. Total return potential is very attractive on a relative basis. Bottom Line: REITs remain a very attractive high-conviction overweight. Energy Servicers Are Cleaning Up Their Act We put the S&P energy services index on our high-conviction overweight list at the start of the year, because three critical factors that typically lead to a playable rally existed, namely; the global rig count had hit an inflection point, oil supplies were easing and global oil production growth had begun to decelerate. While the pullback in oil prices has undermined relative performance for the time being, there is scope for a full recovery, and more. Oil prices have firmed, underpinned by a revival in the geopolitical risk premium following the U.S. bombing campaign in Syria. There is already a wide gap between share prices and oil prices (Chart 9, top panel), and a narrowing is probable, especially as earnings drivers reaccelerate. There are tentative signs that capital spending cuts are finally reversing. The global rig count has rebounded, and is a good leading indicator for investment (Chart 10). This message is corroborated by our Global Capex Indicator, which has recently surged anew (Chart 10). Chart 9Room For ##br##Margin Improvement... Chart 10...As Deflation Eases ##br##And Capex Rebounds The longer that oil prices can stay in their current trading range, or beyond, the more time E&P balance sheets have to heal and the greater the odds that the cost of capital will be reduced. Against this backdrop, there are high odds that previously mothballed exploration projects will be restored. The V-shaped recovery in the global oil rig count, albeit from a very low base, will eventually absorb excess capacity and allow the industry to escape deflation. A major improvement in day rates is unlikely given the scale of the previous capacity boom, but even a modest pricing power improvement should provide a nice boost given high operating leverage. EBITDA margins have considerable room to improve if pricing power grows anew (Chart 9, bottom panel). Importantly, the shifting composition of global production will allow service companies with domestic exposure to shine. Shale oil producers should recapture lost market share, given that the onus to rebalance markets has been taken on by OPEC. OPEC production is contracting, while non-OPEC output is starting to recover (Chart 11, bottom panel), culminating in a widening in the Brent-WTI oil price spread. Production restraint is helping to rebalance physical oil markets. Total OECD inventory growth is reversing, and anecdotal reports are surfacing that floating storage is rapidly being depleted. Oil supply at Cushing is on the cusp of contracting, which is notable given that this has had a high correlation with relative share price performance for the past decade (oil supply shown inverted, Chart 11). On a global basis, global inventory drawdowns have been correlated with a firming industry relative profitability, and vice versa. OECD oil supply growth is rapidly receding, which augurs well for an extension of budding earnings outperformance (Chart 12, middle panel). Chart 11Receding Inventories ##br##Should Boost Performance... Chart 12...EPS And##br## Valuations The rise in clean tanker rates reinforces that oil demand is rising quickly enough to expect additional inventory depletion (Chart 12, bottom panel). Typically, tanker rates and energy service relative valuations are positively correlated. Adding it up, a rising global rig count, decelerating inventories and restrained oil production continue to bode well for a playable rally in the high-beta S&P energy services group. Bottom Line: We reiterate our high-conviction overweight stance in the S&P energy services index. The ticker symbols for the stocks in this index are: BLBG: S5ENRE - SLB, HAL, BHI, NOV, FTI, HP, RIG. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights The level of Fed interest rates, in absolute or relative terms, has been a poor determinant of dollar bull markets. A more useful marker has been the relative performance of U.S. assets as well as relative growth rates. The U.S. economy should continue to outperform the rest of the G10 on a cyclical basis, suggesting that the USD could rise further on a 12-18 months basis. April is seasonally the cruelest month for the USD. Once this hurdle is passed, the likelihood grows that the dollar correction will be over. The conditions are slowly falling into place for the SNB to abandon the floor under EUR/CHF. Bank of Canada: Bye-bye easing bias, hello neutrality. Feature One of the great paradox of modern finance is the relationship between the dollar and the Fed. Contrary to a priories, rising U.S. interest rates are not synonymous with a rising dollar (Chart I-1). In fact, since 1975, out of seven protracted Fed tightening campaigns, the greenback fell four times. Obviously, one could argue that domestic interest rates per say are irrelevant, what matters should be the trend of U.S. interest rates relative to the rest of the world. Here again, the evidence is rather inconclusive. As Chart I-2 illustrates, since 1975, out of the eight episodes where U.S. policy rates rose relative to the rest of the advanced economies, the dollar was down or flat five times. Chart I-1The Fed Is Not An All-Weather Friend Chart I-2Rate Differentials Are Also A Fickle Ally This modern Gordian knot is not as intractable as it seems. In fact, we would argue that focusing on the Fed misses some key drivers of flows inside the U.S. economy. What really matters for the U.S. dollar is not just what the Fed does, but in fact, how U.S. assets are performing relative to the rest of the world. It's Not Just The Fed, It's Everything Simple interest rate differentials have a poor long-term track record explaining the U.S. dollar. However, one factor does seem to work better: the relative performance of a portfolio of U.S. stocks, bonds, and money market securities relative to the rest of the world. This does make sense. Investors who want to buy the USD do so because they expect to receive higher returns on their U.S. assets, independently of whether these assets are cash, stocks or bonds. As Chart I-3 shows, the ups and down of the USD have been contemporaneous with the gyrations of a U.S. portfolio invested 40% in stocks, 30% in bonds, and 30% in cash relative to the same portfolio in the euro area (and its predecessor national markets), Japan, the U.K., and Canada. However, there is a problem with this observation. It is expected returns that should drive the inflows into a currency, not the ex-post returns like the one used in the previous chart. But this forgets a key factor influencing asset returns: the momentum effect. As Chart I-4 illustrates, playing momentum continuation strategies has historically been one of the best performing investment philosophies, a fact not lost on investors.1 As such, there is a very rational reason for previously outperforming markets to attract funds by virtue of their previous outperformance. This would also explain why peaks and troughs in the relative U.S. / global portfolios tend to lead the turning points in the dollar itself. Chart I-3It's All About Returns Chart I-4Don't Get Against The Crowd The same dynamics are prevalent when one looks at bilateral pairs. This is particularly true of the EUR/USD, which has a 58% weight in the dollar index vis-à-vis major currencies. As Chart I-5 illustrates, as was the case with the dollar against the majors, EUR/USD dynamics are a function of the relative performance of a European portfolio of various assets against a similar U.S. portfolio. As an aside, it is true that the secular trend in the dollar is not nearly as well explained by the dynamics in the asset markets. On longer time horizons, other factors dominate currency returns. While the most well know long-term exchange rate determinant has been relative inflation rates (the PPP effect), our research has corroborated well-known academic findings that relative productivity differentials and net international investment positions (NIIP) also play important roles.2 While U.S. productivity growth has been equal or superior to that of the other nations comprised in the dollar index against the majors, the other variables have forced the long-term fair value of the dollar downward. Relative to Europe and Japan (the crucial weights in the dollar index), the U.S. NIIP grows each year more deeply into negative territory, and the U.S. has also experienced structurally more elevated inflation than these currency blocs (Chart I-6). Going back to the cyclical moves in the dollar, another factor has had a very strong explanatory power for the USD: Relative trend growth (Chart I-7). The 5-year moving average of real growth rate differentials - when GDP is measured at PPP, thus eliminating some currency effects - has mimicked the moves in the greenback. In the context of portfolio flows, this also makes sense. Ultimately, a faster growing economy should be able to generate higher rates of returns than slower growing ones, and thus attract more funds. Chart I-5EUR/USD And Asset Returns Chart I-6Secular Drags On The USD Chart I-7Growth Is Paramount What do these observations mean for the future path of the dollar? Despite continued noise by President Trump, we think the outlook for the dollar remains bright. First, the dollar is still not nearly as expensive as it has been at the peak of previous cyclical bull markets, which raises the likelihood that the USD has yet to hit the historical pain thresholds of the U.S. economy (Chart I-8). Further reinforcing this probability, U.S. employment in the manufacturing sector represents 10% of the working population today, versus 15% in 2001 and more than 22% in 1985 (Chart I-9). Not only does this mean that the sector of the U.S. economy most exposed to the pain created by a strong dollar is much smaller than at previous dollar peaks - raising the resilience of the U.S. economy to the tightening created by a strong dollar - the share of employment in that sector today remains much lower in the U.S. than it is in Japan and Europe. Chart I-8Valuations Have Yet To Bite Chart I-9The U.S. Is More Resilient To XR Moves Second, on a multi-year basis, the U.S. economic outlook remains more exciting than what the majority of the rest of the G10 has to offer. Most obviously, even if Trump changes immigration laws, the U.S. demographic outlook still outshines that of other nations (Chart I-10). Also, the U.S. benefits from being much more advanced than the rest of the G10 in its deleveraging cycle. As Chart I-11 illustrates, U.S. non-financial private debt to GDP fell from 170% of GDP to a low of 146% of GDP, while outside of the U.S., the same ratio has plateaued at 175%. This means that debt is likely to represents a greater ceiling on growth outside than inside the United States. Chart I-10A Structural Help To The U.S. Chart I-11Lower Deleveraging Pressures In The U.S. Third, U.S. markets can continue to attract funds. For one, most of the net inflows in the U.S. since 2015 has been driven by a surge in U.S. funds repatriation. Foreign investors remain timid buyers of U.S. assets (Chart I-12). This phenomenon is most pronounced in the equity space, where investors have been net sellers of U.S. equities (Chart I-13). Additionally, if the U.S. continues to grow faster than most other large advanced economies, FDIs inflow into the U.S. are likely to improve further, something that could be reinforced by Trump's hard-nosed trade negotiations with the rest of the world (Chart I-14). Chart I-12Foreigners Still Have Room To Buy Chart I-13Big Deficit In U.S. Stock Purchases Chart I-14FDI Inflows In The U.S. Can Grow More Finally, when it comes to money markets, the U.S. continues to hold the advantage. As we have argued, U.S. rates are likely to remain in the top of the G10 distribution. While the level and direction of rate differentials between the U.S. and the rest of the world has been a poor predictor of the USD's trend, how high U.S. rates rank globally has been a better explanatory variable of the greenback (Chart I-15). This means that money markets in the U.S. are likely to remain more attractive to investors needing to park liquidity than money markets outside the U.S. We are currently still positioned negatively on the U.S. dollar against European currencies and the yen on a tactical basis. We expect this phenomenon to be toward its tail end. First, when it comes to seasonality, April is historically the weakest month for the dollar (Chart I-16). Second, Trump's comments on Wednesday regarding the dollar's strength were enough to prompt a vicious sell-off in the dollar. Yet, this seems overdone. Unlike Reagan in 1985, Trump has little levers to force a strong re-evaluation of the euro and the yen. Moreover, his endorsement of Janet Yellen implies that the Fed is less likely to lose its independence in the near future, suggesting that U.S. rates will continue to be tightened if the economy improves. Thus, a plunge in U.S. real rates relative to the rest of the world prompted by a too easy Fed is less of a risk, reducing the probability of the re-emergence of the 1970s.3 Chart I-15Being The Leader Of The Pack Is What Matters Chart I-16April Is The Cruelest Month Bottom Line: On a cyclical basis, more than simple interest rate differentials between the U.S. and the rest of the world, what matters for the dollar's trend is the return on U.S. assets vis-à-vis the rest of the world as well as the growth rate of the U.S. compared to other nations. On this front, relative growth rate differentials continue to be the best factor pointing toward further USD outperformance. Tactically, the USD is in the midst of its seasonally weakest month, suggesting another down leg in DXY is likely in the coming weeks. However, it may soon be time to start buying the USD once again. EUR/CHF: Getting Closer To The End Recent data in Switzerland have shown great improvement. The PMIs are at their highest levels in six years and CPI has moved back into positive territory. This raises the specter of the end of the Swiss National Bank floor under EUR/CHF (Chart I-17). Chart I-17The SNB Floor Lives On While we think this peg might be in its final innings, its end is not imminent. However, we think that if Swiss data continues to improve, late 2017 will be a more supportive environment for the SNB to bury this strategy. What key signals are we looking for? First, inflation may be in positive territory, but it remains very low by recent standards. Most specifically, core CPI stands at a low 0.1%, well below the 0.8% average experienced from 1999 to 2010, an era when the euro already existed, but when the euro area crisis was still outside of investors' lexicons. As well, wage dynamics continue to underwhelm. Swiss wages are growing at a 2.4% rate compared to 3.3% from 1999 to 2010. Growth conditions also remain weak. Swiss real GDP is growing at 1%, half of the average that existed before the euro area crisis. Nominal GDP growth is undershooting the mark by an even greater margin, standing at 0.7% versus an average of 3%. What does this mean for the SNB? We would expect these datasets to move closer to their historical average before the SNB adjusts its policy stance. The main reason for this is 2015. In late 2014, just before the SNB tentatively let the CHF float, nominal and real GDP growth were outperforming current readings, yet the Swiss economy was not strong enough to handle a stronger franc. While Europe and the global economy are in a better place than in these days, risk management and precaution are likely to dictate a more careful approach by the central bank, especially as the ECB has eased monetary policy since that period, potentially causing another slingshot move in the franc if the SNB lets it float once again. In terms of strategy, we would expect the SNB to manage any appreciation in the franc following a lifting of the floor. We expect a move more akin to that of the PBoC in 2005, when the yuan, after an original 2% move, was allowed to increase progressively to minimize disruptions. We think this type of strategy is also currently being employed by the Czech central bank, and that EUR/CZK will continue to depreciate over time. This means that we would use any rebound in EUR/CHF to 1.08 to begin shorting this cross, knowing that the timing of an SNB policy change will be uncertain, but that the conditions are falling into place. Bottom Line: Even if it is still too early to bet on an imminent fall in EUR/CHF, Swiss data is moving in the right direction to expect a lift of the EUR/CHF floor later this year. As such, with the large amount of uncertainty surrounding such a decision, we would use any rebound in EUR/CHF to 1.08 to implement some short positions on the cross to bet on the eventuality of a policy change in Switzerland. Bank Of Canada: Less Dovish But Far From Hawkish The Bank of Canada this week officially removed its dovish bias. Canadian data has been very strong, with recent housing starts coming in at 254 thousand, a 10-year high. Additionally, recent employment data has been strong and so have purchasing managers index and business surveys. As a result, the BoC used this meeting as an opportunity to increase its growth expectation for the year - albeit a move heavily based on a stronger Q1 - and also brought forward in time its expectation of the closing of the output gap to early 2018. Chart I-18Canadian Surprises: More Likely##br## To Roll-Over Than Not Despite this more upbeat picture, the Bank of Canada also highlighted heavy risks to the Canadian economy. Obviously, the risks from the potential for a U.S. border adjustment tax and renegotiations of NAFTA were seen as crucial. The housing market too continues to be a big worry for the Bank of Canada, with affordability being extremely poor. Moreover, the BoC also decreased its estimate of the neutral rate and observed that monetary conditions are not as accommodative as was believed in January. Going forward, we think that the upside for the CAD remains limited. Canadian economic surprises are stretched and are very likely to rollover in the coming months (Chart I-18). This suggests that further upgrades to the Canadian economic outlook may take some time to emerge. As such, we continue to expect rate differentials between the U.S. and Canada to continue to support a higher USD/CAD, especially as Canadian money markets are already pricing in a full rate hike by Q1 2018. Bottom Line: The Bank Of Canada abandoned it dovish bias, but it is still far away from moving toward a hawkish bias. While a rate hike in 2018 is now much more likely, the market already anticipates this. As such, since the Canadian surprise index is very elevated, the likelihood of a move downward in interest rate expectations grows as surprises are likely to roll over. Stay long USD/CAD. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 For a discussion on why momentum continuation strategies may have worked, see the April 24, 2015 Global Investment Strategy Special Report titled "Investing In Style" available at gis.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report titled "A Guide To Currency Markets (Part I)", dated April 8, 2016, and the Foreign Exchange Strategy Special Report titled "Assessing Fair Value In FX Markets", dated February 26, 2016, both available at fes.bcaresearch.com 3 For a more detailed discussion of the 1970s stagflation, please see Foreign Exchange Strategy Special Report titled "Trump: No Nixon Redux", dated December 2, 2016, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 President Trump, once again, delivered dollar-nuking remarks, after saying it was "getting too strong". The dollar dropped 0.7% on the news, while other currencies appreciated. The dollar has since regained most of its losses, but further upside remains questionable in the coming weeks. The market has already priced-in large amounts of monetary tightening, and recent producer price figures disappointed expectations: PPI increased at a 2.3% annual pace and contracted 0.1% monthly; core PPI increased at a 1.6% annual pace, and did not grow at a monthly pace. Additionally, in the past 5, 10 and 26 years, April has been the weakest month for the dollar. Upside is most likely limited until after the French elections. Report Links: U.S. Households Remain In The Driver's Seat - March 31, 2017 Healthcare Or Not, Risks Remain - March 24, 2017 USD, Oil Divergences Will Continue As Storage Draws - March 17, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent movements in the euro remain largely a function of the dollar. Even after the Trump-induced dollar gyrations, the euro appreciated this week. The ZEW Survey for Economic Sentiment and Current Situation both outperformed expectations, however weak industrial production figures were also evident, which contracted by 0.3% on a monthly basis, and grew at less than expectations at 1.2%. Peripheral economies are also showing strength, with inflation outperforming expectations in Italy and Greece. Nevertheless, the outlook for the euro this month remains decent, as April is notorious for dollar weakness. Moreover, Melanchon's rising popularity is a double-edge sword: while it increases the risk that yet another euro-sceptic becomes the French president, if it grows further it is likely to take away potential voters from Le Pen. In fact, with the chances of Macron winning remaining elevated, this election could ultimately could provide further support to the euro. Report Links: ECB: All About China? - April 7, 2017 Healthcare Or Not, Risks Remain - March 24, 2017 Et Tu, Janet? - March 3, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 USD/JPY continues to fall rapidly, and now stands at 109. However, we believe the yen could still have more upside. Indeed, EM assets continue to struggle with a technical resistance, and a down leg seems imminent, given the tightening in liquidity conditions that China is currently experiencing. As evidenced by the events of early 2016, such as sell off of EM assets could supercharge yen rallies. On the data side the Japanese economy continues to show mixed signs: Labor cash earning underperformed expectations, growing by a paltry 0.4% from a year ago. However domestic corporate goods prices outperformed expectations, growing by 1.4% year on year. Overall Japanese economic activity continues to be too tepid for the BoJ to have a shift from its ultra-dovish policy. This makes us yen bears on a 12 to 18 month basis. Report Links: U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 JPY: Climbing To The Springboard Before The Dive - February 24, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data from the U.K. has been mixed this week: Industrial production growth underperformed coming in at 2.8% The goods trade balance also underperformed coming in at -12.46 billion pounds. However, average hourly earnings including bonus outperformed coming in at 2.3%, while core inflation come in at 1.8%, below expectations. This last point bodes well for consumption as it would limit the downside to real income caused by the inflationary shock resulting from the depreciation of the pound. Moreover, long term inflation expectations remain relatively stable, which means that British households are looking past the temporary nature of the inflation caused by the pound sell-off. Both of these factors should help the British economy outperform expectations, and ultimately help the GBP rally against the EUR. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The ConqueringDollar - October 14, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 An unfortunate tropical storm, Cyclone Debbie, ravaged through the state of Queensland at the end of March. Queensland is known for its agriculture and mining industries, which suffered heavily during the hurricane. March and April export figures are likely to weaken as output was destroyed and reparations may delay production. Exacerbating this weakness is the risk of faltering import demand from China, which is the most likely the reason behind the current weakness in industrial metal prices. As this trend continues, the AUD is likely to suffer for the remainder of the year. On the bright side, the labor market has regained some vigor as full-time employment outperformed part-time employment in two consecutive months, with full-time job growing at a 30-year-high pace. However, a durable trend needs to be apparent for the labor market to fully strengthen. Report Links: U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 2017 Et Tu, Janet? - March 3, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 After positive import and export data out of China, the kiwi rallied strongly. The market interpreted this data as evidence that global growth is on a solid footing and that it will continue to surprise to the upside. Although we agree with the first point we disagree with the second one, as outperformance in global growth amid a sharp tightening in Chinese monetary conditions, a slowdown in Chinese shadow banking credit and a deceleration in Chinese house prices, is highly unlikely. Thus, carry currencies like the NZD are likely to underperform against the dollar. Against other commodity currency the picture is more nuanced, as strong PMI numbers of 57.8 as well as solid credit and employment numbers are evidence that the kiwi economy is better equipped to deal with a Chinese shock than Australia. Report Links: U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The BoC left its overnight rate unchanged at 0.5%, citing recent stronger than expected economic activity and a sooner-than-previously-anticipated closure of the output gap. The gains in the energy sector are unlikely to provide as much of a tailwind as earlier this year as the base effects from rising oil prices prove transitory on inflation and exports. The Bank highlighted labor market slack as a key factor which may contribute to the brevity of this growth impulse, as well as the business sector being hampered by low investment aimed at maintenance rather than expansion. Similarly strong data are needed to keep growth rate high enough for the Bank to become hawkish. For the time being, employment data still remains mixed. Although employment increased by 19,400, the unemployment rate ticked up to 6.7%. With only 38% of firms planning to add jobs over the next 12 months, job gains could be modest and slack could remain. Report Links: AUD And CAD: Risky Business - March 10, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 After a short rally in early March, EUR/CHF cross is once again at 1.066, very close to the SNB's implied floor of 1.065. This sell-off is most likely the result of risk-off flows caused by the French presidential elections. However, we believe these fears are overstated, as Macron seems primed to win the election. Once these political fears dissipate, and economic fundamentals take over, EUR/CHF would likely be at a point where it would become an attractive short, given that there are some early signs that inflation is slowly coming back to the alpine country and that the franc has strong structural forces pushing up its value. While an abandonment of the SNB's floor in unlikely until the end of the year, investors could still begin positioning themselves for this eventuality given that a rally in EUR/CHF beyond the French election should be limited. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The relationship between the NOK and oil prices continues to be a strange one, as the NOK has depreciated this last month even in the face of a strong rally in oil prices. Plummeting inflation and inflation expectations in Norway are probably the main culprit, as it entrenches the Norges Bank dovish bias. All this being said, there are some faint signs that the economy is starting to recover as manufacturing PMI is at 5 year highs while consumer confidence keeps creeping up and is now at its highest point since early 2015. While we are still NOK bears, we will continue to monitor these developments, as the NOK could become an attractive buy against other commodity currencies. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits -December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent inflation numbers corroborate downside risk to the krona. Headline inflation dropped by 0.5% to 1.3% on an annual basis; Core inflation dropped by 0.3% to 1%. This is most likely a follow-through of February's producer prices contraction. This may justify the Riksbank's fear over deflationary risks, as inflation remains tamed despite increased economic activity. However, it is likely that this proves to be a temporary phenomenon, as manufacturing new orders expanded at 12% in February, while industrial production expanded at 4.1%. Given that the next monetary policy meeting is in July, it is too early to tell if the Riksbank will further pursue its dovish stance: inflation will need to be consistently underperform further for that to happen, which is still not our base case. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights This week, we provide one of our occasional updates on Commodities as an Asset class (CAAC), examining the strategic case for getting long commodity index exposure. Commodity index exposure is more highly correlated with inflation than equities or bond exposure, indicating commodities - and real assets generally - provide a better hedge against inflation than financial assets. A pure investment case for getting long broad commodity index exposure can be made if backwardation is expected in one or more of the components of a given index. Given our expectation for higher inflation, and our positioning for backwardation in the oil market, we recommend getting long the energy-heavy S&P GSCI index as a strategic portfolio position. Energy: Overweight. Deeper-than-expected production cuts from OPEC were reported by Reuters Tuesday, suggesting Cartel members are at 104% of pledged output reductions.1 Our $50/bbl vs. $55/bbl WTI calls spreads in Jul-Aug-Sep settled at an average of $3.06/bbl, and we are taking profits of 76.9%, per the upside $3.00/bbl stop we established for these positions on March 23/17. We also are taking profits on our Dec/17 vs. Dec/18 WTI backwardation trade basis tonight's close, after registering a gain of more than 700% when we marked to market earlier this week. We are keeping our long Dec/17 vs. short Dec/18 Brent backwardation spread open; it is up 426.3% since we recommended it on March 23/17. We are recommending a strategic long position in the energy-heavy S&P GSCI basis today's close. Given this commodity index's overweight to oil and refined products, we believe price appreciation will offset negative roll returns until crude markets go into backwardation later this year. We expect WTI and Brent to trade on either side of $60/bbl by year end. Base Metals: Neutral. Workers at Southern Copper's Toquepala and Cuajone mines struck Monday seeking higher wages and improved working conditions, according to Metal Report. Front-line copper on the COMEX has been chopping between ~ $2.50/lb and $2.70/lb since the beginning of the year through multiple strike actions. Precious Metals: Neutral. Gold rallied slightly, but our long volatility play still is down 14.7%. Markets do not appear to be overly concerned with Fed actions over the next couple of months. Feature There's a long-standing argument among equities investors as to whether they trade the stock market or a market of stocks. In the case of the former, getting long index exposure makes sense. In the case of the latter, stock pickers sensitive to the idiosyncratic risk of individual equities outperform the broad-exposure devotees. Sometimes, both are right at the same time. Commodities are no different. There are times when broad exposure to commodities is warranted - e.g., in the early stages of a global industrial rebound or when investors expect higher inflation. However, there are periods in which sensitivity to idiosyncratic risk reflecting different fundamental states for each market works best. And, as is the case with equities, there are times when both points of view can co-exist without contradiction. The relative performance of commodities vs. equities post-Global Financial Crisis (GFC) leaves much to be desired (Chart 1A and Chart 1B). The re-balancing of commodities generally, led by crude oil, but apparent in key base metals like copper, suggests the overall commodity down-cycle - with the exception of ags - has leveled out. Fundamentals - supply, demand and inventories - will be far more important for commodities going forward, particularly as the Fed pursues its rates-normalization policy and markets are slowly weaned off the excessive monetary accommodation they've seen in the post-GFC period. Chart 1ACommodities Were Competitive Pre-GFC, ##br##Post-GFC Underperformance Will Reverse Chart 1BCommodities Were Competitive Pre-GFC, ##br##Post-GFC Underperformance Will Reverse There are two global-macro considerations driving our expectation commodities will outperform the other major asset classes going forward, which we consider below. First, consistent with our House view and recent analysis from our Global Fixed Income Strategy (GFIS) service, we expect higher inflation, which already is being reflected in the forward CPI swaps markets. This could be exacerbated if oil supplies tighten on the back of massive capex cuts following the 2015 - 16 oil-price collapse, and if U.S. fiscal stimulus overheats an economy that already is at or near full capacity and full employment. Second, backwardation in crude oil markets will be a positive development for commodity index products generally, and the energy-heavy S&P GSCI in particular. Together, these fundamentals will provide investors portfolio diversification via non-correlated returns vis-à-vis the other asset classes. Higher Inflation Expectations Support Commodity Index Exposure We have been highlighting the inflationary "tail risks" in commodity markets for a number of months. These include the possibility of 1) higher oil prices after 2018, following the more-than-$1 trillion cuts in oil-and-gas capex in the wake of the 2015 - 16 oil price collapse; and 2) a large injection of fiscal stimulus to the U.S. economy from the Republican-controlled U.S. Congress working with President Trump's White House. The fiscal stimulus could become material next year, revving an economy that is at or near full employment and an output gap at or close to being closed.2 Our colleagues on BCA's GFIS desk note, "underlying U.S. inflation pressures remain strong, particularly given the evidence that conditions in the labor market are getting progressively tighter." While inflationary forces are a bit more subdued in Europe and Japan, our colleagues continue to favor being long CPI swaps in both markets (Chart 2).3 BCA's GFIS expects inflation expectations to rise to a level of ~ 2.5% p.a. on 10-year TIPS breakevens, which are priced off the CPI index. If markets do raise the odds of higher inflation over the medium term, it most likely will continue to show up in the 5-year 5-year (5y5y) CPI Swaps in the U.S. and Europe, which we have found to be cointegrated with 3-year forward WTI futures (Chart 3). The oil market will be especially sensitive to the supply-demand balances after 2018, and will move higher if it senses a supply squeeze from too-little investment in production following the massive cuts to supply-side capex. This will feed into the 5y5y CPI swaps markets, which, in turn, will drive TIPS yields higher. Chart 2Early Days Yet, But ##br##U.S. Inflation Pressures Are Building Chart 3Watch 3-Year Forward WTI Futures ##br##For Early Signs Of Higher Inflation Apart from active commodity positioning, commodity index exposure offers better inflation risk coverage than equities or bonds, as can be seen in Table 1.4 Chart 4 shows the out-performance of the commodity indices, the S&P GSCI in particular, in higher-inflation environments. Table 1Correlations Between Real And Financial Assets Our own modeling supports the academic findings. When we estimated the yoy S&P GSCI returns as a function of U.S. CPI yoy changes and the difference between 1st-nearby WTI futures (CL1) and 12th nearby WTI futures (CL12), we found this specification explained just over 84% of the commodity index's annual returns. Our model indicates the S&P GSCI can be expected to increase in value by close to 15bp for every 1% increase in U.S. CPI (Chart 5). This energy-heavy index - crude oil and refined products comprise more than half of the S&P GSCI - performs much better than the more evenly disbursed Bloomberg Commodity Index (BCI) as an inflation hedge. Chart 4Commodities Outperform In##br## Inflationary Markets Chart 5S&P GSCI Index Exposure ##br##Moves With Inflation Profiting From Backwardation Long-only commodity index products generate returns from three sources: Price appreciation; roll yield - the returns generated by selling and replacing futures contracts approaching their terminal trading date (the expiring contract in the index is sold and replaced by a contract with a deferred delivery); and on the collateral posted to carry positions. An investor with a strong view on prices can express it by getting long or short futures. When an investor wants to express a view on the structure of the market - chiefly the shape of the forward curve and whether it will be backwardated (prompt delivery costs more than deferred delivery), or in contango (prompt delivery costs less than deferred delivery) - they can do so either by trading spreads (buying prompt-delivered contracts vs. selling deferred-delivered contracts, and vice versa) or getting long commodity-index exposure such as the S&P GSCI or Bloomberg Commodity Index (BCI). Typically, long-only commodity-index products largest returns are generated via price appreciation and roll yield, which simply are returns generated by "rolling" the underlying futures contracts in the index as these contracts approach the termination of trading to a deferred month. In a backwardated market, prompt-delivered contracts are sold and replaced with lower-cost contracts. In contango markets the opposite occurs. Indexes with heavy concentrations in futures that are likely to be backwardated for a length of time are preferred to indexes with futures that, on a fundamental basis, are more likely to have a flat or contango term structure. We have been positioning for a backwardation in crude oil later this year for some time. We continue to expect backwardation in crude oil markets, and remain long Dec/17 Brent vs. short Dec/18 Brent to express this view. Given the very high concentration of energy exposure in the S&P GSCI index - more than half of the index is crude oil or refined products, according to S&P - this index is best-suited, in our estimation, to benefit from a backwardated oil market.5 Indeed, our modeling, shown in Chart 5, supports our view that backwardation would significantly boost performance in the S&P GSCI index: A 1% increase in the spread between 1st-nearby WTI vs. 12th-nearby WTI contracts likely would translate into gain in the index of slightly more than 1.14%. Bottom Line: We expect higher inflation and backwardation in the oil market later this year. For this reason, we are recommending a long exposure in the energy-heavy S&P GSCI index. Commodities outperform equities and bonds in inflationary markets. In addition, this index's overweight to crude oil and refined products suggests it will outperform when markets backwardate. Given we expect WTI and Brent prices to trade on either side of $60/bbl later this year, we believe price appreciation will offset minor roll-yield losses until markets backwardate. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see "Exclusive: OPEC futures show oil output cuts exceed pledge in March - sources" published by Reuters.com on April 11, 2017. 2 Please see issue of 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 Please see BCA Research's Global Fixed Income Strategy weekly Report "The Song Remains The Same," dated April 11, 2017, available at gfis.bcaresearch.com. 4 Please see Bhardwaj, Geetesh, Gary Gorton and Geert Rouwenhorst (2015), "Facts and Fantasies about Commodity Futures Ten Years Later*" published by Yale University. This article updates earlier research and notes, "In the original study we found that commodities had historically offered a risk premium similar to equities, and at the same time would provide diversification to a traditional portfolio of stocks and bonds. What set commodities apart from these traditional assets was their positive correlation with inflation. (Emphasis added.) Here we provide 10 years of additional data. Although a decade is sometimes too short to draw firm conclusions, our-of-sample period is rich because it includes a global economic expansion led by the industrialization of China, a housing boom and bust in the United States, the largest financial crisis since the Great Depression, followed by a monetary policy stimulus response which has driven interest rates around the world towards zero. ... Many of the basic conclusions of the original study continue to hold." (p. 22) 5 Please see "WTI Crude Oil Remains On Top As S&P Dow Jones Indices Announces 2017 Weights For The S&P GSCI," at http://ca.spindices.com/indices/commodities/sp-gsci, website for the index. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Summary of Trades Closed In 2016

Highlights The Trump-Xi summit offers hopeful signs that the two sides are mending once-severely tested bilateral relations. The risk of escalation in trade tensions has declined. President Trump and President Xi have different time horizons in setting policy priorities. Trump needs immediate success on trade and job creation to show to his working-class electorates, while Xi's primary objective is to avoid the "Thucydides trap". This offers space for compromises. Unless the Trump administration addresses America's "savings shortage," the country's external deficit will not change materially. Any serious negotiations on bilateral trade imbalances between China and the U.S. must deal with the root causes. Feature The summit between President Donald Trump and President Xi Jinping in Mar-a-Lago last week was hailed by both sides as an "ice breaking" success. Even though no substantive details have been offered, the two countries have formulated a new mechanism for senior-level dialogue, and established a 100-day process for addressing bilateral trade frictions. The risk still exists that Trump could unilaterally impose punitive measures against Chinese goods with his administrative powers, and it is overly simplistic to draw too much information from one particular event. However, the Trump-Xi summit confirms a developing trend: that some of President Trump's highly controversial remarks on his campaign trail are being quickly rolled back. The risk of escalating trade tensions between the world's two largest economies has on margin abated. Trump Goes Mainstream? America's China policy under recent administrations can best be described as "congagement" - an ambiguous mixture of containment and engagement by varying degrees. Trump's remarks on the campaign trail and in his early days in office suggested he was mainly interested in confrontation. But the Trump-Xi summit, along with some recent developments, implies that Trump's China policy is coming back to the middle ground, at least for now. After setting off a fierce firestorm on the Taiwan issue late last year, Trump reaffirmed the "One China" policy in a February phone call with President Xi, re-stating long-standing U.S. policy and easing a key source of diplomatic tensions. Taiwan is still re-emerging as a source of risk.1 But it is unquestionably positive in the short-term that Trump backed away from his initial, highly provocative approach. Treasury Secretary Steven Mnuchin stated in February that the Trump administration will stick to the existing statutory process in judging whether China manipulates its currency, a marked departure from Trump's repeated campaign pledges. It is almost certain that China will not be named a currency manipulator in the U.S. Treasury's upcoming semi-annual assessment due later this week.2 In his visit to Beijing last month, Secretary of State Rex Tillerson used Chinese verbiage to characterize the U.S.-China relationship. This verbiage was not repeated by other officials during Xi's visit to Florida, so it is unclear whether it signals the Trump administration's adoption of China's idea of a "new model of great power relations." Nonetheless, it is a drastic change from Tillerson's aggressive remarks at his congressional confirmation hearings, when he suggested blockading Chinese-built islands in the South China Sea. Separately, Secretary of Defense James Mattis, on his first trip abroad to Japan and South Korea, said he did not anticipate any "dramatic military moves" in the South China Sea. More recently, Steve Bannon, White House Chief Strategist, was removed from the National Security Council. It is futile to try to understand all the internal power struggles within the new administration. Nevertheless, Bannon's departure from the NSC is probably a positive development, viewed through the Chinese lens. Bannon not long ago openly identified China as a major threat to the U.S. and predicted a war in the South China Sea as inevitable. In short, President Trump's summit with President Xi marked continued "mainstreaming" of his China policy. Some strong anti-China rhetoric from him and his inner circle has apparently been sanded off, setting the stage for constructive negotiations with Beijing. Can China Accommodate? The restructuring of the Sino-U.S. comprehensive dialogue and the declaration of a 100-day process for addressing economic frictions are probably the most tangible outcomes from the discussions between the two leaders during the summit. Further detail deserve close attention in order to map out how relations between the world's two largest economies will evolve in the near future. In our view, China is likely to make concessions and avoid confrontations. First, trade appears to be front and center in President Trump's grand dealings with China, an important change compared with previous U.S. administrations that also focused heavily on values and ideological issues, such as democracy, freedom of speech and human rights. From China's perspective, the government has a lot more flexibility in making concessions on trade and economic fronts than in dealing with ideological differences. In the past, China has almost always yielded to U.S. pressure on trade-related issues. For instance, China depegged the RMB from the dollar in 2005 and allowed the RMB to continue to appreciate after the global economic recovery began, all under American political pressure. Chinese senior officials routinely led massive commercial delegations touring the U.S. with big procurement orders for everything from aircraft to agricultural goods in order to address American complaints. Both the U.S. and China understand that bilateral trade imbalances favor the U.S. in the event of an all-out trade war, which China will try its best to avoid. Strategically, President Trump and President Xi have different time horizons in setting policy priorities. Trump needs immediate success on trade and job creation to deliver on promises to his working-class electorate, while Xi is more interested in establishing a cooperative and productive strategic standing with the world's sole superpower. Xi's primary objective is to avoid the "Thucydides trap" - the likelihood of conflict between a rising power and a currently dominant one - by convincing the U.S. to grant China greater global sway. In this vein, Trump's withdrawal from the Trans Pacific Partnership (TPP) has been viewed as an important positive development from Xi's perspective, and it is likely that Beijing will offer incentives to further discourage President Trump to "pivot to Asia". It is already rumored that Beijing has drafted investment plans in the U.S. that could create 700,000 jobs, as well as further opening up agricultural goods imports and financial market access. We suspect these deals will be announced during the 100-day negotiation period, which should give Trump a much-needed boost in his approval ratings. Economically, Trump's resentment of China's trade practices is based on the old growth model that the country no longer adheres to. Trump's version of Chinese manufacturers - "sweat shops" operating in "pollution heaven" heavily dependent on state subsidies and a cheap currency - is increasingly out of touch with today's reality, as discussed in detail in a previous report.3 In a nutshell, Chinese manufacturers have quickly climbed up the value-add ladder due to rapidly rising labor costs, and pollution control has become an urgent social issue. Meanwhile, the RMB has been under constant downward pressure in recent years, and the Chinese authorities may welcome coordinated efforts to weaken the dollar and support the yuan. In short, China will not find it too painful to accept Trump's terms and conditions, as the "sick parts" of the Chinese economy will inevitably be cleansed regardless of pressure from the U.S. The risk to this view is that Trump finds China's progress too slow and grows impatient. Previous American presidents have come to accept China's gradualism and have demurred from punitive measures. Trump, with his populist base and promises, may at some point find it politically expedient to exact a price on China for failing to deliver the desired results on his electoral timeline. Across the board tariffs on Chinese imports are unlikely, but highly symbolic sanctions and anti-dumping measures remain distinct possibility. The End Game Of Sino-U.S. Trade Imbalances However, any immediate concessions from China on trade will do little to fundamentally change the U.S.'s external imbalances. It is well known that a country's current account balance is the residual of its national savings and domestic capital spending. Therefore, it is unrealistic to expect a meaningful reduction in the country's current account deficit without lifting America's domestic savings rate. Chart 1 shows the chronic nature of America's external deficit. It is worth noting that the "Nixon shock" in 1971 - the policy package of closing the gold window and imposing across-the-board tariffs on imports - was triggered when the U.S. was on track to have its first annual trade deficit since the 19th century. Fast forward 46 years later, various attempts by American administrations have failed to rescue the deteriorating trend. Many countries over the years such as Germany, Japan and newly-industrialized economies in Asia were all singled out as conducting unfair trade practices with the U.S., but none of the bilateral and multi-lateral efforts were effective with lasting impact. A fundamental change in global trade over the past four decades has been the rapid industrialization of China. In essence, China has become the final point of an increasingly integrated global assembly line, and therefore America's chronic deficit has been transferred from other countries to China. Chart 2 shows China's surplus with the U.S. has ballooned, while other countries' surpluses have dwindled. This has put China squarely under the spotlight, replacing previous scapegoats. Chart 1America's Secular Deficit... Chart 2... From Changing Sources From China's perspective, the country will continue to run a surplus with the U.S. so long as it remains in the most manufacturing-intensive phase of its development curve, though the product mix will continue to shift from lower-value-added goods to higher-value-added ones. Meanwhile, the Chinese corporate sector will shift production capacity to even lower cost countries, similar to what Japan, Hong Kong and Taiwan have done in relation to China since the early 1980s when China began to open up. Already, China's direct investment to Vietnam has surged in recent years, which partially explains the sharp increase in Vietnam's trade surpluses with the U.S. (Chart 3). In fact, Vietnamese trade surplus with the U.S. account for 15% of the country's GDP, even though its overall trade balance is barely positive. This means that America's demand for cheap consumer goods is the main driving forces for its deficit, rather than any particular country's unfair trade practices. The fact is that the U.S. has moved beyond industrialization and become a post-industrial society, where the service sector generates more wealth than the manufacturing sector. China's shrinking share of imports from the U.S. is the mirror image of America's shrinking share of the manufacturing sector in the overall economy (Chart 4). Furthermore, the self-imposed restrictions on some high-tech goods exports to China further limits American firms growth potential, as this is the most competitive segment of America's manufacturing sector in the global market. Without removing these restrictions, it is unrealistic to expect a material increase in sales to China. Chart 3The "China Factor" In Vietnam's##br## Growing Trade Surpluses Chart 4America's Deindustrialization And ##br##Shrinking Market Share In China For now, the Trump-Xi summit offers hopeful signs that the two sides are mending severely tested bilateral relations and that the risk of escalation in trade tensions has declined. Trump may adopt a "good cop / bad cop" strategy that creates greater volatility. Longer term, unless the Trump administration addresses America's "savings shortage," the country's external deficit will not change materially. Imposing tariffs on Chinese imports only pushes Chinese surpluses to other less-competitive countries; it does not bring jobs back to the U.S. Any serious negotiations on bilateral trade imbalances between China and the U.S. must deal with the root causes. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "The RMB: Back In The Spotlight," dated March 16, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Report, "Dealing With The Trump Wildcard," dated January 26, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Global political risks are understated in 2018; U.S. policy will favor the USD, as will global macro trends; Trump's trade protectionism will re-emerge; China will slow, and may intensify structural reforms; Italian elections will reignite Euro Area breakup risk. Feature In our last report, we detailed why political risks are overstated in 2017.1 First, markets are underestimating President Trump's political capital when it comes to passing his growth agenda. Second, risks of populist revolt remain overstated in Europe. Third, political risks associated with Brexit probably peaked earlier this year. Next year, however, the geopolitical calendar is beset with potential systemic risks. First, we fear that President Trump will elevate trade to the top of his list of priorities, putting fears of protectionism and trade wars back onto the front burner. In turn, this could precipitate a serious crisis in the U.S.-China relationship and potentially inspire Chinese policymakers to redouble their economic reforms - so as not to "let a good crisis go to waste." That, in turn, would create short-term deflationary effects. Meanwhile, we fear that investors will have been lulled to sleep by the pro-market outcomes in Europe this year. The series of elections that go against populists may number seven by January 2018 (two Spanish elections, the Austrian presidential election, the Dutch general election, the French presidential and legislative elections, and the German general election in September). However, the Italian election looms as a risk in early 2018 and investors should not ignore it. Investors should remain overweight risk assets for the next 12 months. Our conviction level, however, declines in 2018 due to mounting geopolitical risks. Mercantilism Makes A Comeback Fears of a trade war appear distant and alarmist following the conclusion of the Mar-a-Lago summit between U.S. President Donald Trump and his Chinese counterpart Xi Jinping. We do not expect the reset in relations to last beyond this year. Trump has issued a "shot across the bow" and now the two sides are settling down to business - but investors should avoid a false sense of complacency.2 Investors should remember that candidate Trump's rhetoric on China and globalization was why he stood out from the crowd of bland, establishment Republican candidates. Despite the establishment's tenacious support for globalization, Americans no longer believe in the benefits of free trade, at least not as defined by the neoliberal "Washington Consensus" of the past two decades (Chart 1). We take Trump's views on trade seriously. They certainly helped him outperform expectations in the manufacturing-heavy Midwest states of Michigan, Pennsylvania, and Wisconsin (Chart 2). And yet, Trump's combined margin of victory in the three states was just 77,744 votes -- less than 0.5% of the electorate of the three states! That should be enough to keep him focused on fulfilling his campaign promises to Midwest voters, at least if he wants to win in 2020.3 Chart 1America Belongs To The Anti-Globalization Bloc Chart 2Protectionism Boosted Trump In The Rust Belt In 2017, Trump's domestic agenda has taken precedent over international trade. The president is dealing with several key pieces of legislation, including the repeal and replacement of the Affordable Care Act, comprehensive tax reform, the repeal of Obama-era regulations, and infrastructure spending. However, there is considerable evidence that trade will eventually come back up: President Trump's appointments have favored proponents of protectionism (Table 1) whose statements have included some true mercantilist gems (Table 2). Table 1Government Appointments Certifying That Trump Is A Protectionist Table 2Protectionist Statements From The Trump Administration Secretary of Treasury Steven Mnuchin, who is not known as a vociferous proponent of protectionism, prevented the G20 communique from reaffirming a commitment to free trade at the March meeting of finance officials in Baden-Baden, Germany.4 Such statements were staples of the summits over the past decade. The Commerce Department - under notable trade hawk Wilbur Ross - looks to be playing a much more active role in setting the trade agenda under President Trump. Ross has already imposed a penalty on Chinese chemical companies in a toughly worded ruling that declares, "this is not the last that bad actors in global trade will hear from us - the games are over." He is overseeing a three-month review of the causes of U.S. deficits, planning to add "national security" considerations to trade and investment assessments, proposing a new means of collecting duties in disputes, and encouraging U.S. firms to bring cases against unfair competition. Ross is likely to be joined by a tougher U.S. Trade Representative (who has historically been the most important driver of trade policy in the executive branch). In addition, we believe that Trump's success on the domestic policy front, in combination with the global macro environment, will lead to higher risk of protectionism in 2018. There are three overarching reasons: Domestic Policy Is Bullish USD: We do not know what path the White House and Congress will take on tax reform. We think tax reform is on the way, but the path of least resistance may be to leave reform for later and focus entirely on tax cuts in 2017. Whatever the outcome, we are almost certain that it will involve greater budget deficits than the current budget law augurs (Chart 3). Even a modest boost to government spending will motivate the Fed to accelerate its tightening cycle at a time when the output gap is nearly closed and unemployment is plumbing decade lows (Chart 4). This will perpetuate the dollar bull market. Chart 3Come What May, Trump Will Increase The Budget Deficit Chart 4A Fiscal Boost Will Accelerate Inflation Chinese Growth Scare Is Bullish USD: At some point later this year, Chinese data is likely to decelerate and induce a growth scare. Our colleague Yan Wang of BCA's China Investment Strategy believes that the Chinese economy is on much better footing than in early 2016, but that the year-on-year macro indicators will begin to moderate.5 This could rekindle investors' fears of another China-led global slowdown. Meanwhile, Chinese policymakers have gone forward with property market curbs and begun to tighten liquidity marginally on the interbank system. The seven-day repo rate, a key benchmark for Chinese lending terms, has surged to its highest level in two years, according to BCA's Foreign Exchange Strategy. It could surge again, dissuading small and medium-sized banks from bond issuance (Chart 5). Falling commodity demand and fear of another slowdown in China will weigh on EM assets and boost the USD. European Political Risks Are Bullish USD: Finally, any rerun of political risks in Europe in 2018 will force the ECB to be a lot more dovish than the market expects. With Italian elections to be held some time in Q1 or Q2 2018 - more on that risk below - we think the market is getting way ahead of itself with expectations of tighter monetary policy in Europe. The expected number of months till an ECB rate hike has collapsed from nearly 60 months in July 2016 to just 20 months in March, before recovering to 28 months as various ECB policymakers sought to dampen expectations of rate hikes (Chart 6).6 In addition, our colleague Mathieu Savary of BCA's Foreign Exchange Strategy has noted that a relationship exists between EM growth and European monetary policy (Chart 7), which suggests that any Chinese growth scares would similarly be euro-bearish and USD-bullish.7 Chart 5Interbank Volatility Will ##br##Dampen Chinese Credit Growth Chart 6Market Is Way Ahead Of ##br## Itself On ECB Hawkishness Chart 7EM Spreads, ECB Months-To-Hike: ##br##Same Battle The combination of Trump's domestic policy agenda and these global macro-economic factors will drive the dollar up. At some point in 2018, we assume that USD strength will begin to irk Donald Trump and his cabinet, particularly as it prevents them from delivering on their promise of shrinking trade deficits. We suspect that President Trump will eventually reach for the "currency manipulation" playbook of the 1970s-80s. There are two parallels that investors should be aware of: 1971 Smithsonian Agreement - President Richard Nixon famously closed the gold window on August 15, 1971 in what came to be known as the "Nixon shock."8 Less understood, but also part of the "shock," was a 10% surcharge on all imported goods, the purpose of which was to force U.S. trade partners to appreciate their currencies against the USD. Much like Trump, Nixon had campaigned on a mercantilist platform in 1968, promising southern voters that he would limit imports of Japanese textiles. As president, he staffed his cabinet with trade hawks, including Treasury Secretary John Connally who was in favor of threatening a reduced U.S. military presence in Europe and Japan to force Berlin and Tokyo to the negotiating table.9 Economists in the cabinet opposed the surcharge, fearing retaliation from trade partners, but policymakers favored brinkmanship.10 The eventual surcharge was said to be "temporary," but there was no explicit end date. The U.S. ultimately got other currencies to appreciate, mostly the deutschmark and yen, but not as much as it wanted. Critics in the administration - particularly the powerful National Security Advisor Henry Kissinger - feared that brinkmanship would hurt Trans-Atlantic relations and thus impede Cold War coordination between allies. As such, the U.S. removed the surcharge by December without meeting most of its other objectives, including increasing allied defense-spending and reducing trade barriers to U.S. exports. Even the exchange-rate outcomes of the deal dissipated within two years. 1985 Plaza Accord - The U.S. reached for the mercantilist playbook again in the early 1980s as the USD rallied on the back of Volcker's dramatic interest rate hikes. The subsequent dollar bull market hurt U.S. exports and widened the current account deficit (Chart 8). U.S. negotiators benefited from the 1971 Nixon surcharge because European and Japanese policymakers knew that Americans were serious about tariffs. The result was coordinated currency manipulation to drive down the dollar and self-imposed export limits by Japan, both of which had an almost instantaneous effect on the Japanese share of American imports (Chart 9). Chart 8Dollar Bull Market And ##br## Current Account Balance Chart 9The U.S. Got What It ##br##Wanted From Plaza Accord The Smithsonian and Plaza examples are important for two reasons. First, they show that Trump's mercantilism is neither novel nor somehow "un-American." It especially is not anti-Republican, with both Nixon and Reagan having used overt protectionism as a negotiating tool in recent history. In fact, Trump's Trade Representative, the yet-to-be-confirmed Robert Lighthizer, is a veteran of the latter agreement, having negotiated it for President Ronald Reagan.11 Second, the experience of both negotiations in bringing about a shift in the U.S. trade imbalance will motivate the Trump administration to reach for the same "coordinated currency manipulation" playbook. The problem is that 2018 is neither 1971 nor 1985. The Trump administration will face three constraints to using currency devaluation to reduce the U.S. trade imbalance: Chart 10Globalization Has Reached Its Apex Chart 11Global Protectionism Has Bottomed Economy: Europe and Japan were booming economies in the early 1970s and mid-1980s and had the luxury of appreciating their currencies at the U.S.'s behest. Today, it is difficult to see how either Europe or China can afford significant monetary policy tightening that engineers structural bull markets in the euro and RMB respectively. For Europe, the risk is that peripheral economies may not survive a back-up in yields. For China, monetary policy tightness would imperil the debt-servicing of its enormous corporate debt horde. Apex of Globalization: U.S. policymakers could negotiate the 1971 and 1985 currency agreements in part because the promise of increased trade remained intact. Europe and Japan agreed to a tactical retreat to get a strategic victory: ongoing trade liberalization. In 2017, however, this promise has been muted. Global trade has peaked as a percent of GDP (Chart 10), average tariffs appear to have bottomed (Chart 11), and the number of preferential trade agreements signed each year has collapsed (Chart 12). Temporary trade barriers have ticked up since 2008 (Chart 13). To be clear, these signs are not necessarily proof that globalization is reversing, but merely that it has reached its apex. Nonetheless, America's trade partners will be far less willing to agree to coordinated currency manipulation in an era where the global trade pie is no longer growing. Geopolitics: During the Cold War, the U.S. had far greater leverage over Europe and Japan than it does today over Europe and China. While the U.S. is still involved in European defense, its geopolitical relationship with China is hostile. What happens when the Smithsonian/Plaza playbook fails? We would expect the Trump administration to switch tactics. Two alternatives come to mind: Protectionism: As the Nixon surcharge demonstrates, the U.S. president has few legal, constitutional constraints to using tariffs against trade partners.12 As the Trump White House grows frustrated in 2018 with the widening trade imbalance, it may reach for the tariff playbook. The risk here is that retaliation from Europe and China would be swift, hurting U.S. exporters in the process. Dovishness: There is a much simpler alternative to a global trade war: inflation. Our theory that the USD will rally amidst domestic fiscal stimulus is predicated on the Fed hiking rates faster as inflation and growth pick up. But what if the Fed decides to respond to higher nominal GDP growth by hiking rates more slowly? This could be the strategy pursued by the next Fed chair, to be in place by February 3, 2018. We do not buy the conventional wisdom that "President Trump will pick hawks because his economic advisors are hawks" for two reasons. First, we do not know that Trump's economic advisors will carry the day. Second, we suspect that President Trump will be far more focused on winning the 2020 election than putting a hawk in charge of the Fed. Chart 12Low-Hanging Fruit Of Globalization Already Picked Chart 13Temporary Trade Barriers Ticking Up Bottom Line: Putting it all together, we expect that U.S. trade imbalances will come to the forefront of the political agenda in 2018. This will especially be the case if the USD continues to rally into next year, contributing to the widening of the trade deficit. We expect any attempt to reenact the Smithsonian/Plaza agreements to flame out quickly. America's trade partners are constrained and unable to appreciate their currencies against the USD. This could rattle the markets in 2018 as investors become aware that Trump's mercantilism is real and that chances of a trade war are high. On the other hand, Trump may take a different tack altogether and instead focus on talking down the USD. This will necessitate a compliant Fed, which will mean higher inflation and a weaker USD. Such a strategy could prolong the reflation trade through 2018 and into 2019, but only if the subsequent bloodbath in the bond market is contained. China Decides To Reform Presidents Trump and Xi launched a new negotiation framework on April 6 that they will personally oversee, as well as a "100 Day Plan" on trade that we expect will result in a flurry of activity over the next three months. One potential outcome of the meeting is a rumored plan for massive Chinese investment into the U.S. that could add a headline 700,000 jobs, complemented with further opening of China's agricultural, automotive, and financial sectors to U.S. investment and exports. Investors may be fêted with more good news, especially with President Trump slated to visit China before long. President Trump, a prominent China-basher, may decide that the deals he brings home from China will be enough to convince the Midwest electorate that he has gotten the U.S. a "better deal" as promised. This would enable him to stabilize China relations in order to focus on other issues, as all presidents since Reagan have done. However, we doubt that the Sino-American relationship can be resolved through short-term trade initiatives alone. There is too much distrust, as we have elucidated before.13 The 100-day plan is a good start but it carries an implicit threat of tariffs from the Trump administration if China fails to follow through; and China is not likely to give Trump everything he wants. Moreover, strategic and security issues are far from settled, despite some positive gestures. As such, we expect both economic and geopolitical tensions to resurface in 2018. Meanwhile Chinese policymakers may decide to use tensions with the U.S. as an opportunity to redouble efforts towards structural reforms at home. Since the Xi Jinping administration pledged sweeping pro-market reforms in 2013, the country has shied away from dealing with its massive corporate debt hoard (Chart 14) and has only trimmed the overcapacity in sectors like steel and coal (Chart 15). It fears incurring short-term pain, albeit for long-term gain. However, if Beijing can blame any reform-induced slowdown on the U.S. and its nationalist administration, it will make it easier to manage the political blowback at home, providing a means of rallying the public around the flag. Chart 14China's Corporate Debt Pile Still A Problem... Chart 15...And So Is Industrial Overcapacity China has, of course, undertaken significant domestic reforms under the current administration. It has re-centralized power in the hands of the Communist Party and made steps to improve quality of life by fighting pollution, expanding health-care access, and loosening the One Child policy. These measures have long-term significance for investors because they imply that the Chinese state is responsive to the secular rise in social unrest over the past decade. The political system is still vulnerable in the event of a major economic crisis, but the party's legitimacy has been reinforced. Nevertheless, what long-term investors fear is China’s simultaneous backsliding on key components of economic liberalization. Since the global financial crisis, the government has adopted a series of laws that impose burdens on firms, especially foreign and private firms, relating to security, intellectual property, technology, legal (and political) compliance, and market access. Moreover, since the market turmoil in 2015-16, the government has moved to micromanage the country’s stock market, capital account, banking and corporate sectors, and Internet and media. The general darkening of the business environment is a major reason why investors have not celebrated notable reform moves like liberalizing deposit interest rates or standardizing the business-service tax. These steps require further reforms to build on them (i.e. to remove lending preferences for SOEs, or to provide local governments with revenues to replace the business tax). But all reforms are now in limbo as the Communist Party approaches its “midterm” party congress this fall. Most importantly for investors, the government has still not shown it can "get off the train" of rapid credit growth that has underpinned China's transition away from foreign demand (Chart 16). The country's relatively robust consumer-oriented and service-sector growth remains to be tested by tighter financial conditions. And the property sector poses an additional, perpetual financial risk, which policymakers have avoided tackling with reforms like the proposed property tax (a key reform item to watch for next year).14 The PBoC's recent tightening efforts come after a period of dramatic liquidity assistance to the banks (Chart 17), and even though interbank rates remain well below their brief double-digit levels during the "Shibor Crisis" in 2013 (see Chart 5 above, page 6), any tightening serves to revive fears that financial instability could re-emerge and translate to the broader economy. Chart 16China's Savings Fueling Debt Buildup Chart 17PBoC Lends A Helping Hand What signposts should investors watch to see whether China re-initiates structural reforms? Already, personnel changes at the finance and commerce ministries, as well as the National Development and Reform Commission and China Banking Regulatory Commission, suggest that the Xi administration may be headed in this direction. Table 3 focuses on the steps that we think would be most important, beginning with the party congress this fall. Given current levels of overcapacity and corporate leverage, we suspect that genuine structural reform will begin with a move toward deleveraging, and involve a mix of bank recapitalization and capacity destruction, as it did in the 1990s and early 2000s. These reforms included the formation of new central financial authorities, like policy banks, regulatory bodies, and asset management companies, to oversee the cleaning up of bank balance sheets and the removal of numerous inefficient players from the financial sector.15 They eventually entailed transfers of funds from the PBoC, from foreign exchange reserves, and from public offerings as major banks were partially privatized. On the corporate side, the reforms witnessed the elimination of a range of SOEs and layoffs numbering around 40% of SOE employees, or 4% of the economically active workforce at the time. Table 3Will China Launch Painful Economic Restructuring Next Year? Chinese President Jiang Zemin launched these reforms after the party congress of 1997, just as his successor, Hu Jintao, attempted to launch similar reforms following the party congress of 2007. The latter got cut short by the Great Recession. The question now for Xi Jinping's administration is whether he will use his own midterm party congress to launch the reforms that he has emphasized: namely, deep overcapacity cuts and financial and property market stabilization through measures to mitigate systemic risks.16 Bottom Line: China may decide to use American antagonism as an "excuse" to launch a serious structural reform push following this fall's National Party Congress. Short-term pain, which is normal under a reform scenario in any country, could then be blamed on an antagonistic U.S. trade and geopolitical policy. While reforms in China are a positive in the long term, we fear that a slowdown in China would export deflation to still fragile EM economies. And given Europe's high-beta economy, it could also be negative for European assets and the euro. Europe's Divine Comedy Investors remain focused on European elections this year. The first round of the French election is just 11 days away and polls are tightening (Chart 18). Although Marine Le Pen is set to lose the second round in a dramatic fashion against the pro-market, centrist Emmanuel Macron (Chart 19), she could be a lot more competitive if either center-right François Fillon or left-wing Jean-Luc Mélenchon squeaks by Macron to get into the second round.17 Chart 18Melenchon's Rise: Comrades Unite! Chart 19Le Pen Cruisin' For A Bruisin' The risk of someone-other-than-Macron getting into the second round is indeed rising. However, Mélenchon's rise thus far appears to be the mirror image of Socialist Party candidate Benoît Hamon's demise. At some point, this move will reach its natural limits: not all Hamon voters are willing to switch to Mélenchon. At that point, the Communist Party-backed Mélenchon will have to start taking voters away from Le Pen. This is definitely possible, but would also create a scenario in which it is Mélenchon, not Le Pen, that faces off against a centrist candidate in the second round. As such, we see Mélenchon's rise primarily as a threat to Le Pen, not Macron.18 While we remain focused on the French election, we think that any market relief from that election - and the subsequent German one - will be temporary. By early next year, investors will have to deal with Italian elections. Unfortunately, there is absolutely no clarity in terms of who will win the Italian election. If elections were held today, the Euroskeptic Five Star Movement (M5S) would gain a narrow victory (Chart 20). However, it is not clear what electoral law will apply in the next election. The current law on the books, which the Democratic Party-led (PD) government is attempting to reform by next February, would give a party reaching 40% of the vote a majority-bonus. As Chart 20 illustrates, however, no party is near that threshold. As such, the next election may produce a hung parliament with no clarity, but with a Euroskeptic plurality. Meanwhile, the ruling center-left Democratic Party is crumbling. Primaries are set for April 30 and will pit former PM Matteo Renzi against left-wing factions that have coalesced into a single alliance called the Progressive and Democratic Movement (DP). For now, DP supports the government of caretaker PM Paolo Gentiloni, but its members have recently embarrassed the government by voting with the opposition in a key April 6 vote in the Senate. If Renzi wins the leadership of the Democratic Party again, DP members could formally split and contest the 2018 election as a separate party. The real problem for investors with Italy is not the next election, whose results are almost certain to be uncertain, but rather the Euroskeptic turn in Italian politics. First, aggregating all Euroskeptic and Europhile parties produces a worrying trend (Chart 21). And we are being generous to the pro-European camp by including the increasingly Euroskeptic Forza Italia of former PM Silvio Berlusconi in its camp. Chart 20Five Star Movement Set For Plurality Win Chart 21Euroskeptics Take The Lead Unlike its Mediterranean peers Spain and Portugal, Italian support for the euro is still plumbing decade lows -- no doubt a reflection of the country's non-existent economic recovery (Chart 22). It is difficult to see how Italians can regain confidence in European integration given that they are unwilling to pursue painful structural reforms. Chart 22Italian Economic Woes Hurt Euro Support The question is not whether Italy will face a Euroskeptic crisis, but rather when. It may avoid one in 2018 as the pro-euro centrists cobble together a weak government or somehow entice the center-right into forming a grand coalition. But even in that rosy scenario, such a government is not going to have a mandate for painful structural reforms that would be required to pull Italy out of its low-growth doldrums. As such, it is unlikely that the next Italian government will last its full five-year term. Bottom Line: Investors should prepare for a re-run of Europe's sovereign debt crisis, with Italy as the main event. We expect this risk to be delayed until after the Italian election in 2018, maybe later. However, it is likely to have global repercussions, given Italy's status as the third-largest sovereign debt market. Will Italy exit the euro? Our view is that Italy needs a crisis in order to stay in the Euro Area, as only the market can bring forward the costs of euro exit for Italian voters by punishing the economy through the bond market. The market, economy, and politics have a dynamic relationship and Italian voters will be able to assess the costs of an exit first hand, as yields approach their highs in 2011 and Italian banks face a potential liquidity crisis. Given that support for the euro remains above 50% today, we would expect that Italians would back off from the abyss after such a shock, but our conviction level is low.19 Housekeeping This week, we are taking profits on our long MXN/RMB trade. We initiated the trade on January 25, 2017 and it has returned 14.2% since then. The trade was a play on our view that Trump's protectionism would hit China harder than Mexico. Given the favorable conclusion to the Mar-a-Lago summit - and the likely easing of risks of a China-U.S. trade war in the near term - it is time to book profits on this trade. We still see short-term upside to MXN and investors may want to pair it by shorting the Turkish lira. We expect more downside to TRY given domestic political instability, which we expect to continue beyond the April 15 constitutional referendum. We see both the yes and no outcomes of the referendum as market negative. In addition, we are closing our short Chinese RMB (via 12-month non-deliverable forwards) trade for a profit of 5.89% and our long USD/SEK trade for a gain of 1.27%. Our short U.K. REITs trade has been stopped out for a loss of 5%. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Matt Gertken, Associate Editor Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017, available at gps.bcaresearch.com. 2 For this negotiating sequence, please see BCA Geopolitical Strategy and The Bank Credit Analyst Special Report, "A Q&A On Political Dynamics In Washington," dated November 24, 2016, available at bca.bcaresearch.com, and Geopolitical Strategy and Global Investment Strategy Special Report, "The Geopolitics Of Trump," dated December 2, 2016, available at gps.bcaresearch.com. 3 Trump loves to win. 4 Please see Federal Ministry of Finance, Germany, "Communique - G20 Finance Ministers and Central Bank Governors Meeting," dated March 18, 2017, available at www.bundesfinanzministerium.de. 5 Please see BCA China Investment Strategy Weekly Report, "Chinese Growth: Testing Time Ahead," dated April 6, 2017, available at cis.bcaresearch.com. 6 The head of the Lithuanian central bank, Vitas Vasiliauskas, was quoted by the Wall Street Journal in early April stating that "it is too early to discuss an exit because still we have a lot of significant uncertainties." This was followed by the executive board member Peter Praet dampening expectations of even a reduction in the bank's bond-buying program and President Mario Draghi stating that the current monetary policy stance remained appropriate. 7 Please see BCA Foreign Exchange Strategy Weekly Report, "ECB: All About China?" dated April 7, 2017, available at fes.bcaresearch.com. 8 Please see Douglas A. Irwin, "The Nixon shock after forty years: the import surcharge revisited," World Trade Review 12:01 (January 2013), pp. 29-56, available at www.nber.org, and Barry Eichengreen, "Before the Plaza: The Exchange Rate Stabilization Attempts of 1925, 1933, 1936 and 1971," Behl Working Paper Series 11 (2015). 9 Treasury Secretary John Connally was particularly protectionist, with two infamous mercantilist quips to his name: "foreigners are out to screw us, our job is to screw them first," and "the dollar may be our currency, but it is your problem." 10 Paul Volcker, then Undersecretary of the Treasury, provided some color on this divide: "As I remember it, the discussion largely was a matter of the economists against the politicians, and the outcome wasn't really close." 11 We highly recommend that our clients peruse Lighthizer's testimony to the U.S.-China Economic and Security Review Commission. Beginning at p. 29, he recommends three key measures: using the 1971 surcharge as a model (p. 31); going beyond "WTO-consistent" policies (p. 33); and imposing tariffs against China explicitly (p. 35). Please see Robert E. Lighthizer, "Testimony Before the U.S.-China Economic and Security Review Commission: Evaluating China's Role in the World Trade Organization Over the Past Decade," dated June 9, 2010, available at www.uscc.gov. 12 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, and Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Reports, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, and "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. See also the recent Geopolitical Strategy and Emerging Market Equity Sector Strategy Special Report, "The South China Sea: Smooth Sailing?" dated March 28, 2017, available at gps.bcaresearch.com. 14 Please see BCA's Commodity & Energy Strategy Special Report, "Chinese Property Market: A Structural Downtrend Just Started," dated June 4, 2015, available at ces.bcaresearch.com. 15 Please see BCA Geopolitical Strategy, "China: Is Beijing About To Blink?" in Monthly Report, "What Geopolitical Risks Keep Our Clients Awake?" dated March 9, 2016, available at gps.bcaresearch.com. 16 At a meeting of the Central Leading Group on Financial and Economic Affairs, which Xi chairs, the decision was made to make some progress on these structural issues this year, but only within the overriding framework of ensuring "stability." The question is whether Xi will grow bolder in 2018. Please see "Xi stresses stability, progress in China's economic work," Xinhua, February 28, 2017, available at news.xinhuanet.com. 17 That said, the most recent poll - conducted between April 9-10 - shows that Mélenchon may be even more likely to defeat Le Pen than Macron. He had a 61% to 39% lead in the second round versus Le Pen. 18 In the second round, Macron is expected to defeat Mélenchon by 55% to 45%, according to the latest poll, conducted April 9-10. 19 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, available at gps.bcaresearch.com.