Europe

Highlights Mario Draghi will signal the ECB's intention to further taper asset purchases during his Jackson Hole address later today, while cautioning that rate hikes remain a way away. The spread between long-term U.S. and euro area bond yields is not especially wide considering that trend growth is higher in the U.S. and fiscal policy will add 4% of GDP more to U.S. aggregate demand over the next few years than it will in the euro area. The upswing in Japanese growth is unlikely to prompt the BoJ to abandon its yield- curve targeting regime. Japanese stocks are cheap and corporate profits are rebounding smartly. Stay overweight Japanese equities in currency-hedged terms for the next 12 months. As one looks further ahead to the next decade, Japanese inflation will likely break out as labor shortages intensify. This will be part of a broad-based increase in global inflation. Stay long Japanese inflation protection and go short 20-year JGBs relative to their 5-year counterparts. Feature Mario Draghi: Action Jackson, The Sequel? Mario Draghi made shockwaves the last time he spoke at Jackson Hole on August 22, 2014. Draghi used that occasion to lay out the case for additional monetary easing. This paved the way for the ECB's own QE program. From that fateful speech to March 2015, EUR/USD fell from 1.33 to 1.05. Three years later, investors are anxious to hear what Draghi has to say, but this time around the expectation is that he will discuss plans for winding down QE. We agree that Draghi will signal the ECB's intent to further taper asset purchases. Growth is currently strong and the risk of a euro area breakup has all but disappeared. Nevertheless, although he may not publicly admit it, Draghi is cognizant of the fact that euro area financial conditions have tightened on the back of a strong euro, while U.S. financial conditions have continued to ease (Chart 1). Mario Draghi also knows that both inflation and wage growth remain depressed across the euro area, and that labor market slack outside Germany is still 6.7 percentage points higher than in 2008 (Chart 2). In addition, Draghi is undoubtedly aware of the likelihood that the neutral rate of interest is extremely low in the euro area, implying that the ECB would be constrained in raising rates even if the region were close to full employment.1 The spread between the 30-year U.S. Treasury yield and the 30-year GDP-weighted euro area bond yield - a reasonable proxy for the market's estimate of the difference in neutral rates between the two regions - currently stands at 86 basis points in nominal terms and 56 basis points in real terms. This is not especially wide considering that trend growth is higher in the U.S. and fiscal policy will add 4% of GDP more to U.S. aggregate demand over the next few years than it will in the euro area (Chart 3).2 Chart 1Diverging Financial Conditions Favor U.S. Over The Euro Area Chart 2Draghi Is Paying Attention Chart 3The State Of Fiscal Policy In The G4 We expect EUR/USD to pare back its gains, dropping to $1.05 by the end of 2018. However, most of the dollar's rebound is likely to occur next year, when it becomes apparent that the U.S. unemployment rate will fall well below the Fed's 2018 projection of 4.2%. This will force the Fed to step up the pace of rate hikes. For the time being, we see EUR/USD fluctuating within a broad range of $1.10-to-$1.20. BoJ: Time To Remove The Sake Bowl? Could the Bank of Japan follow in the Fed's and ECB's footsteps by signaling the desire to slowly withdraw monetary accommodation? On the surface, there are certainly some reasons to think so. Japanese growth has picked up recently, with real GDP rising at a blistering annualized pace of 4% in the second quarter (Chart 4). The acceleration in growth was driven entirely by stronger domestic demand. Consumer spending increased by 3.7%, while private nonresidential investment jumped by 9.9%. Inflation appears to be bottoming. The national core CPI index, which excludes fresh food prices but includes energy costs, rose for the seventh straight month in June to 0.4% on a year-over-year basis. Corporate goods inflation has reached 2.6%, up from a low of -4.6% in May 2016. Corporate service inflation moved to 0.8% this spring, the highest rate since 1993 (Chart 5). Nominal wage growth has also accelerated. Our Wage Trend Indicator, which uses statistical techniques applied to three separate data series to extract the underlying trend in Japanese wages, is now close to its 2007 highs (Chart 6). Chart 4GDP Growth Has Perked Up In Japan Chart 5Corporate Pricing Power Has Improved Chart 6Japanese Wages Are In An Uptrend The recovery in Japanese wage growth has occurred alongside a tightening of the labor market. The latest Economy Watchers Survey featured a litany of companies complaining of worsening labor shortages (Table 1). This is confirmed by the job openings-to-applicants ratio, which has surged to the highest level since 1974 (Chart 7). Table 1Japan: Evidence Of Shortages Of Workers, Part I Chart 7Japan: Evidence Of Shortages Of Workers, Part II Easy Does It, Kuroda-san Despite the good news on the economy, it is highly unlikely that the Bank of Japan will abandon its ultra-accommodative stance any time soon. There are a number of reasons for this: While inflation is rising, it is coming off a very low base, and is nowhere near the BoJ's 2% target. A deflationary mindset also remains firmly entrenched, as highlighted by both survey data and market expectations (Chart 8). Much of the recent pickup in inflation is attributable to higher energy prices and the lagged effects of a weaker yen. Excluding energy prices, core inflation has barely risen. The increase in corporate goods prices has also closely tracked the price of imports. Considering that the trade-weighted yen has appreciated of late, it is reasonable to assume that import price inflation will dissipate. This spring's annual shunto wage negotiations yielded smaller wage hikes among large companies than in 2016. This suggests that further near-term gains in wages will be hard to come by. Fiscal policy may turn less accommodative. The government passed a supplementary budget last summer (worth 1.5% of GDP according to the IMF). The effects of this package are being felt now. Public fixed investment surged by 21.9% in Q2. Under current law, however, fiscal policy is set to turn contractionary again over the next few years. Leading economic indicators are pointing to a modest slowdown in growth over the coming months (Chart 9). Chart 8Deflationary Mindset Has Been Hard To Shake Off Chart 9LEIs Pointing To Modest Slowdown The BoJ is not the same central bank that it was five years ago. The last two hawkish dissenters, Takehiro Sato and Takehide Kiuchi, both stepped down in July when their terms expired. They were replaced by Goshi Kataoka and Hitoshi Suzuki, neither of whom are expected to oppose Governor Haruhiko Kuroda's dovish approach. As such, it is highly likely that the BoJ will continue to anchor the 10-year yield at close to zero for at least the next 12 months. If bond yields elsewhere rise over this period - as we expect will be the case - the yen will weaken. Good News For Japanese Stocks... For Now A weaker yen is, of course, good news for Japanese stocks. Japanese equities are currently trading at a 16% discount to the MSCI World index based on forward earnings (Chart 10). Moreover, unlike in the past, both earnings and dividend growth have been strong, averaging 19% and 9%, respectively, over the last five years (Chart 11). Corporate governance reform - a key element of Abenomics - can take some credit for this. The share of companies with at least two independent directors rose from 18% in 2013 to 78% in 2016. The number of companies with performance-linked pay increased from 640 to 941, while the number that publish disclosure policies jumped from 679 to 1055. Analysts have been slow to factor in these positive developments. Chart 12 shows that Japan leads all other major stock markets in positive earnings surprises in the second quarter. We remain overweight Japanese equities in currency-hedged terms. Chart 10Good Value In Japanese Stocks Chart 11Solid Earnings And Dividend Growth Chart 12Japan And Positive Earnings Revisions: Follow The Leader . The Longer-Term Outlook: Japan (Eventually) Escapes Deflation As we discussed last week, it is likely that the U.S. will fall into recession in 2019 or 2020, dragging the rest of the world down with it.3 As a risk-off currency, the yen will strengthen, potentially reigniting deflationary forces. This will make it impossible for the BoJ to abandon its yield-curve targeting regime. Does that mean that Japan is condemned to a never-ending cycle of reflation/deflation? Not necessarily. As one looks at a longer-term horizon of 5-to-10 years, it is likely that Japan will finally escape deflation. This is because many of the structural forces that have sustained deflation will have either receded or reversed course by then. The simultaneous bursting of Japan's real estate and stock market bubbles in the early 1990s ushered in a prolonged period of falling property prices and corporate deleveraging. This suppressed both household consumption and business investment, leading to a persistent shortfall in aggregate demand. The latest data suggests that property prices are bottoming and corporate balance sheets have finally improved to the point where further aggressive cost-cutting is no longer necessary (Chart 13). Demographic trends are also likely to fuel higher inflation over the long haul. The deceleration in population growth in the early 1990s reduced the need for everything from new homes to new cars, shopping malls, and factories. This weighed on business capex and consumer durable spending, thereby exacerbating the deflationary forces that were already in place. In addition, a surge in the share of the population in their peak saving years - ages 30 to 50 - led to an increase in desired savings throughout the economy. More savings means less spending, so this also contributed to deflation. Looking out, population growth will remain anemic. However, two important developments will occur. First, the biggest cohort of Japanese baby boomers - those born in 1947-52 - will hit 70, the age at which most Japanese workers retire. Second, the secular rise in female labor force participation will plateau. Chart 14 shows that a larger percentage of Japanese women between the ages of 25 and 54 are employed than in the U.S., a massive shift from 20 years ago. Both these changes will exacerbate labor shortages, while further reducing national savings. Chart 13Deflationary Headwinds Are Abating Chart 14Female Employment In Japan Has Surpassed The U.S. Concluding Thoughts Contrary to popular belief, the Phillips curve remains intact, even in Japan (Chart 15). The market is not at all prepared for the prospect of higher Japanese inflation, as evidenced by the fact that CPI swaps are pricing in inflation of only 0.5% over the next two decades. As inflation picks up in the 2020s, nominal GDP will rise (even if real GDP growth remains anemic due to a shrinking labor force). The Bank of Japan will keep nominal rates low during the first half of the 2020s, ensuring that real rates sink further into negative territory. This will be the way by which Japan reduces its debt burden. Older savers may not like it, but the alternative of pension and health care cuts will be seen as even worse. We are currently long Japanese inflation protection through the CPI swaps market. As of today, we are adding a new long-term trade recommendation: Go short 20-year JGBs relative to their 5-year counterparts. The potential upside from this trade easily compensates for the negative carry of 66 bps. An upswing in Japanese inflation in the 2020s is very much in line with our secular view that global inflation will trend higher over the long haul, as articulated in a recent report.4 This will have a profound impact on fixed-income markets. While Japan's demographic transition has been and will continue to be more extreme than elsewhere, population aging is something that will affect all major economies. Chart 15Japan's Phillips Curve Is Alive And Well Chart 16Demographic Shifts: From Highly Deflationary To Highly Inflationary Chart 16 shows the IMF's estimate of how projected changes in the age structure of the population will affect inflation over the next few decades. The Fund's calculations suggest that demographic shifts will go from being very deflationary to very inflationary in every major economy. This will translate into significantly higher long-term nominal bond yields. Peter Berezin, Global Chief Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "The Future Of The Neutral Rate," dated August 4, 2017. 2 We calculate this number by taking the difference between the structural primary budget balance in the euro area (roughly 1.5% of GDP) and the U.S. (roughly -2.5% of GDP). The claim that this will translate into 4% more in aggregate demand in the U.S. implicitly assumes a fiscal multiplier of one. A larger multiplier would generate an even bigger gap in demand. 3 Please see Global Investment Strategy Weekly Report, "From Slow Burn Recovery To Retro-Recession?" dated August 18, 2017. 4 Please see Global Investment Strategy Weekly Report, "A Secular Bottom In Inflation," dated July 28, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Special Report

Feature Dear client, This week we are publishing a brief Special Report highlighting ten charts that have captured our attention, charts we would like to emphasize before the summer lull ends. We will not be sending a report next week, but we will be resuming our regular publishing schedule on September 8, 2017. Warm regards, Mathieu Savary With both the Manufacturing Council and the Strategy and Policy Forum disbanded, markets have lost faith in the capacity of the Trump administration to pass on any meaningful tax reforms or tax cuts. However, as Chart 1 shows, the imperative for Republicans in Congress to do so before the 2018 mid-term election is in fact growing by the minute: The unpopularity of Donald Trump is becoming a major handicap for the GOP in Congress and the post-Charlottesville debacle is only making matters worse. Legislative action needs to materialize to compensate for this hurdle. The tax cuts or reforms ultimately passed are not likely to be what the administration envisage and are likely to be emanating from Congress itself and not the White House. This situation should also give Republicans an incentive to avoid an unpopular government shutdown around the debt ceiling negotiations, but we expect uncertainty around this question to remain elevated as rhetoric flairs up, which could potentially put our long USD/JPY position at risk. Chart 1If Tax Cuts Don't Pass, Republicans Are Heading For A Huge Defeat In 2018 While automation has received a lot of press, one of the key factors that keeps weighing on inflation on a structural basis is the continuation of a 30-year process: The entry of China and other key emerging markets into the global economy, which has massively expanded global aggregate supply relative to aggregate demand. Through the 1980s and 1990s, this expansion in supply mostly reflected the addition of billions of potential workers to the global labor force. However, as Chart 2 illustrates, since the turn of the millennium, the supply-side expansion has mostly taken the form of a massive increase in the EM and Chinese capital stock, which has lifted the global capital stock. As a result, this has created excess capacity for the world as a whole, which is keeping a lid on prices. As long as China keeps a very high savings rate, global demand is likely to remain inadequate relative to global supply, structurally limiting the upside to global inflation. Chart 2Global Excess Capacity While the structural anchor on inflation remains, this does not mean that cycles in prices are dead. In fact, from a cyclical perspective, U.S. core inflation is likely to bottom and slowly inch higher in the second half of 2017. Inflation remains a lagging indicator of the business cycle. Supported by very easy financial conditions, growth has regained some vigor while the U.S. is now at full employment. Additionally, as Chart 3 illustrates, the U.S. velocity of money has once again picked up, a reliable leading indicator of core inflation over the past 20 years. This supports our thesis that this year's downleg in the dollar is long in the tooth: A stabilization and uptick in inflation could force markets to push up the number of interest rates hikes anticipated from the Federal Reserve. Chart 3Cyclical Inflation Dynamics In 2015, the Chinese economy was losing speed at an accelerating pace. Beijing began to panic and pulled out all the stops to put a floor under growth: Fiscal spending increased at an incredible 25% annual pace by the end of 2015 and credit growth was encouraged. While the fiscal stimulus is long past, the Chinese credit impulse has continued to support economic activity, investment, construction, and imports. However, the People's Bank of China has begun engineering a tightening in monetary conditions and is slowly but surely putting the brakes on the expansion of off-balance sheet instruments in the Chinese financial system. As a result, the amount of financing raised by smaller Chinese financial institutions is decelerating. Historically, without this source of liquidity, total debt growth has tended to slow, adversely impacting the credit impulse (Chart 4). This is likely to weigh on investment and construction, thus negatively affecting the dollar-bloc currencies. Chart 4Key Risk To Chinese Credit Growth The euro has rallied violently this year. Some of this strength has been a reflection of the euro's nature as the anti-dollar. As investors began doubting the capacity of the Fed to stick to its plan of hiking interest rates to 2.9% by the end of 2019, and as political paralysis took over the U.S., the greenback suffered, lifting the euro in the process. In sharp contrast, the European economy and inflation picked up and political risk in continental Europe receded, adding fuel to the fire. Today, buying the euro has become the epitome of the "consensus trade," with investors massively long the common currency. However, while a pickup in U.S. inflation will be required to expect a full reversal of this trade, a correction in the euro is a growing risk: The EUR/USD's fractal dimension - a measure of groupthink - has hit 1.25, a level that in the past has warned of a potential countertrend move (Chart 5). Chart 5Correction In The Euro Betting on the yen remains the FX analogue to betting on bonds. JGB yields display a low beta to global government bond yields; thus, when global rates go up, interest rate differentials move against the yen. The opposite is true when global yields fall. The downside to the yen when global rates rise has now been supercharged by the yield cap implemented by the Bank of Japan, as JGB yields are now prohibited from rising when global bond yields rise. BCA's view is that U.S. bond yields should rise over the next 12 months, which will should prompt a period of pronounced weakness in the JPY. But what if a rise in bond yields causes an EM selloff - wouldn't this help the yen? As Chart 6 illustrates, the correlation between USD/JPY and bond yields is, in fact, stronger than that with stocks. In other words, the pain in EM has to become acute enough to cause bond yields to fall before the yen can rally. This means there is a window of opportunity to short the yen when bond yields rise even if EM assets depreciate. Chart 6The Yen Is A Play On Bonds Dollar-bloc currencies (CAD, AUD and NZD) tend to be prime beneficiaries of expanding global liquidity. This is because in an environment where global liquidity expands, the U.S. dollar weakens and commodity prices strengthen. Moreover, when global liquidity is plentiful, risk-taking and carry trades are emboldened, creating inflows of funds and liquidity into EM nations, which in turn, boosts their economic prospects. This also pushes up the expected returns of assets in the dollar-bloc countries, and thus incentivizes global investors to purchase the AUD, the CAD, and the NZD. This means that historically, the performance of dollar-bloc currencies has been tightly linked to the expansions in global central bank reserves - a good measure of global liquidity growth. This time around, dollar-bloc currencies have massively outperformed the growth in global reserves, leaving them vulnerable to any slowdown in global liquidity (Chart 7). Chart 7Dollar-Bloc Currencies Have Overshot Global Liquidity While commodity currencies are all likely to face headwinds over the course of the next 12 months, all dollar-bloc currencies are not created equal. The AUD looks much more vulnerable than the CAD. First, the AUD is trading at a 10.7% premium vis-à-vis its long-term fair value, while the CAD is only slightly expensive. Second, Canadian terms of trade are governed by dynamics in energy prices, its main commodity export, while Australian export prices are a function of base metal prices. BCA's Commodity And Energy Strategy service is currently more positive on energy prices than it is on industrial metals. The energy market is undergoing an important curtailment of supply that will lead to further drawdowns in oil inventories. Meanwhile, the supplies of metal are not as well controlled as those of energy, and China's desire to slow real estate speculation should weigh on construction activity in the Middle Kingdom. Finally, as Chart 8 illustrates, AUD/CAD rarely diverges from AUD/USD, but right now, AUD/CAD is trading at a large premium to AUD/USD. This means shorting AUD/CAD could be a nice way to benefit from a weakening in dollar-bloc currencies while limiting the direct exposure to aggregate commodity-price dynamics. Chart 8AUD/CAD Is A Short The Swedish economy has been strong and the output gap now stands at 1.26% of GDP. Yet, despite this positive backdrop, the Riksbank is keeping in place one of the easiest monetary policies in the world, with nominal policy rates standing at -0.5% and real rates at a stunning -2.6%. It is no wonder that the SEK trades at a 6.4% discount to its PPP fair value against the euro. Now, two developments warrant selling EUR/SEK. First, Stefan Ingves, the extremely dovish president of the Swedish central, is leaving the institution at the end of this year. While his replacement has yet to be announced, it will be difficult to find someone more dovish than him to take the helm of the oldest central bank in the world. Second, not only has Sweden inflation picked up violently, the Riksbank's resource utilization indicator continues to shoot up, pointing to a further acceleration in inflation (Chart 9). As a result, we expect the Swedish central bank to be the next one to join the Fed and the Bank of Canada in tightening policy, which will give additional support for the Swedish krona, especially against the euro. Chart 9The Riksbank Will Hike Soon EUR/NOK has rarely traded above current levels over the course of the last decade. It has only done so when Brent prices have fallen below US$40/bbl (Chart 10). BCA's base case is that oil is more likely to finish the year between US$50 and US$60 than it is to trade below US$40. With EUR/NOK trading 13% over its PPP fair value, and with Norway still sporting a current account surplus of 6% of GDP, even if the Norwegian economy continues to exhibit rather low inflation readings, there is a greater likelihood that EUR/NOK depreciates from current levels than appreciates. We thus recommend investors short this cross over the remainder of 2017. Chart 10If Brent Doesn't Fall Below , EUR/NOK Is A Short Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Your portfolio cash weighting should be at least in the middle of its range, until the observed volatility of risk assets rises meaningfully from its record low. Cyclically add long SEK/USD to long EUR/USD. Within a European equity portfolio, this implies going cyclically underweight Sweden's OMX, given its high exposure to exporters. Go underweight Swedish real estate equities; overweight Spanish real estate equities. Within a global equity portfolio, overweight euro area banks versus U.S. banks. Feature Great expectations for Mario Draghi's appearance at the Jackson Hole Symposium have been dampened, and understandably so. After the last monetary policy meeting, Draghi emphasised that ECB discussions about policy direction would take place in the autumn. It would undermine this decision making process if Draghi's Jackson Hole speech front ran the ECB discussions. Nonetheless, twitchy markets will inevitably read the tone of Draghi's observations on the global and euro area economies. Chart of the WeekSwedish House Prices Are Up 50% In Just Four Years...Thanks To Negative Interest Rates But the more market-relevant presentation might come five hours earlier on Friday at 3pm London time, when Janet Yellen gives a keynote speech on the market's latest meme - financial stability. Three months ago in Madrid, Draghi delivered a keynote speech1 on the very same topic - The interaction between monetary policy and financial stability - available here https://www.ecb.europa.eu/press/key/date/2017/html/ecb.sp170524_1.en.html and well worth reading as a prelude to Yellen's presentation. Draghi explained that ultra-accommodative monetary policy endangers financial stability through three potential channels: Distorting investor behaviour. Generating credit-fuelled bubbles, especially in real estate. Squeezing bank profitability. Do any of these three channels give ground for concern today? Yes. Distorting Investor Behaviour In our view, central banks' distortive impact on investor behaviour is the single biggest source of financial instability today. Yet Draghi devoted only a cursory mention of this danger, noting that investors "could be prone to engage in search-for-yield behaviour and take on excessive risks." The difficulty is that the psychological and behavioural finance biases creating the current distortions lie outside central bankers' natural area of expertise. Nevertheless, we hope that Yellen develops this topic much further at Jackson Hole. Specifically, the behavioural finance distortion known as Mental Accounting Bias describes the irrational distinction between the part of an investment's return that comes from its income, and the part that comes from its capital growth. Rationally, people should not care about this distinction because the money that comes from income and the money that comes from capital growth is perfectly fungible.2 But in practice, many people want a minimum investment income - because they wish to match their known spending outlays with their known income. While they could meet their spending needs by crystalizing capital growth, many people create psychologically separate 'mental accounts': spending from investment income and saving from capital growth. This is especially true for retirees whose main or only income might come from accumulated assets. Traditionally, this psychological mental accounting bias would be unnoticeable because investors could easily match their spending needs with the safe income generated by cash and government bonds. But in recent years, central banks' extended experiments with zero and negative interest rates and QE have forced the 'income mental account' to chase the higher but much more risky income streams from high-yield bonds and equities (Chart I-2 and Chart I-3). To the point where these risk assets no longer offer a sufficient risk premium. Chart I-2A Positive Yield On Equities Can Produce##br## A Negative 5-Year Return... Chart I-3...And Even A Negative##br## 10-Year Return The search-for-yield pushed up the prices of these risk assets. Now add to the mix the phenomenon known as negative skew.3 Risk asset advances tend to be gradual and gentle, and the longer and more established the advance becomes, the lower the observed volatility goes. Some investors then mistakenly interpret lower observed volatility as justification for a lower risk premium, which warrants a further price advance. And so on, in a self-reinforcing feedback. Today, this has left us with a bizarre and unprecedented situation in which the observed volatility of the Eurostoxx50 equity index is a fraction of the observed volatility of the long-dated German bund! (Chart I-4) Chart I-4Unprecedented: The Observed Volatility Of The Eurostoxx50 ##br## Is Now Lower Than That On The German Bund! But given the strong inverse relationship between observed volatility and price, record low observed volatility categorically does not mean that prospective risk of a drawdown is low. Quite the reverse, the lower the observed volatility, the higher the prospective risk. And vice-versa. Investment bottom line: Your portfolio cash weighting should always be inversely proportional to the observed volatility of risk assets. Today, with observed volatility still near a record low, your cash weighting should be at least in the middle of its range. Generating Credit-Fuelled Bubbles... In Sweden Turning to the second channel of financial instability, the ECB sees no evidence of credit-fuelled bubbles. Banks are extending credit, but at a fraction of the rate seen prior to 2007 (Chart I-5). And although house prices are rising, the ECB claims that its ultra-accommodative monetary policy has not created imbalances in real estate markets in the euro area. Taken at face value, this claim might be true. Chart I-5Euro Area Banks Are Extending Credit... But At A Modest Rate But look across the Baltic Sea. Chart I-6Swedish House Prices Accelerated##br## After ZIRP And NIRP Sweden's Riksbank has had to shadow the ECB's ultra-loose policy, to prevent a sharp appreciation of the Swedish krona versus the euro. The trouble is that negative interest rates have been wholly inappropriate for an economy that has recently been growing at 4.5%. One worrying consequence is that Swedish house prices have gone up by 50% in just four years (Chart of the Week), with the bulk of the boom happening after ZIRP and NIRP (Chart I-6). Also, bear in mind that the Swedish real estate market did not suffer a meaningful setback in either 2008 or 2011, meaning the recent boom is not a corrective rebound - like say, in Spain and Ireland. So the ECB's ultra-loose policy may indeed have generated a credit-fuelled bubble... albeit in Sweden! Fortunately, as the ECB ends its ultra-accommodation, it will also liberate the Riksbank to end its incongruous and dangerous NIRP policy. Investment bottom line: Cyclically add long SEK/USD to long EUR/USD. For European equity investors, this implies going cyclically underweight Sweden's OMX, given its high exposure to exporters. Also, go underweight Swedish real estate equities which are now approaching peak price-to-book multiples (Chart I-7). Prefer to overweight Spanish real estate equities which offer much more attractive valuations (Chart I-8). Chart I-7Swedish Real Estate Equities ##br##Are Close To Peak Valuation Chart I-8Spanish Real Estate Equities ##br##Offer Better Value Squeezing Bank Profitability For the third channel of financial instability, the ECB concedes that ultra-loose monetary policy compresses banks' net interest margins and thus exerts pressure on their profitability. "Since banks carry out maturity transformation by borrowing short and lending long-term, both the slope of the yield curve and its level matter for profitability." In turn, lower retained profits means lower accumulation of capital, making banks more fragile. The evidence strongly supports this logic. Since the start of the ECB's asset-purchase program, euro area bank valuations - a good proxy for profitability - have formed a perfect mirror-image of the expected intensity of QE (Chart I-9). Chart I-9Bank Valuations Have Been A Mirror-Image Of QE It follows that as the ECB dials back accommodation, the valuations of euro area banks will continue to recover - at the very least, in relative terms versus banks elsewhere in the world. Investment bottom line: Global equity investors should stay overweight euro area banks versus U.S. banks. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 At the First Conference on Financial Stability, May 24 207. 2 Assuming the tax treatment of income and capital growth is equal. 3 Please see the European Investment Strategy Weekly Report titled 'Negative Skew: A Ticking Time-Bomb' dated July 27, 2017 available at eis.bcaresearch.com Fractal Trading Model* We are monitoring the Italian stock Tenaris which is approaching a point of being technically oversold. We are also monitoring a commodity pair-trade, short nickel / long silver which is also approaching a potential entry point in the coming days. But we have not yet opened either trade. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations

Highlights U.S. Tax Cuts: The ongoing turmoil in the White House, and the negative impact it is having on the popularity ratings of both President Trump and the Republican-led U.S. Congress, will intensify efforts to get a tax cut package done as quickly as possible. Success on this front will help buoy U.S. business confidence and lead to stronger U.S. economic growth, and likely more Fed rate hikes, in 2018. Fed vs. ECB: Economic growth is solid, and inflation expectations remain stable, on both sides of the Atlantic. We expect a December rate hike by the Fed, with more likely in 2018, and a tapering of asset purchases by the ECB beginning in January. Maintain a defensive stance on portfolio duration. U.S. Corporates vs. EM: Emerging market (EM) hard currency debt, both sovereign and corporate looks fully valued, even with a positive global growth backdrop. Reduce EM sovereign and corporate debt in favor of U.S. Investment Grade corporates in global fixed income portfolios. Feature Who's In Charge Here? Table 1A Rough Month For Risk Financial markets are sailing without a rudder at the moment. A clear risk-off flavor has swept over most risk assets, as can be seen in the returns seen so far in August in so many asset classes (Table 1). There have been a number of negative news events for investors to process, from President Trump's Charlottesville controversy to the never-ending staff changes in the White House to the North Korean tensions to last week's terror attack in Spain. On top of that, some of the major central banks have become a bit more wishy-washy in their guidance to the markets, even going as far as questioning their own understanding of the inflation process (does the Philips curve even work anymore?). Investors always prefer a clean narrative when it comes to the "big picture" macro backdrop. Right now, they are not getting that from political leaders and policymakers, especially in the U.S. (Chart of the Week). Trump's popularity rating is steadily declining, even now among Republican voters. This has raised concerns that any of his business-friendly policies tax cuts or initiatives to boost growth like infrastructure spending can be successfully enacted. At the same time, and perhaps for similar reasons, the gap between the market expectation and the Fed's projection for the funds rate is widening with only 24bps of hikes priced over the next year. This is driven largely by investors' persistent lack of belief that U.S. inflation will hit to the Fed's target in the next few years. Simply put, the market is saying that the Fed's current tightening cycle is essentially complete unless there is a turnaround in U.S. inflation and/or a sizeable fiscal stimulus enacted in D.C. On that latter point, we think it is critical to monitor measures of U.S. business confidence. The current cyclical upturn in global growth and corporate profits has certainly lifted optimism among business leaders. Yet it is clear that there was also a boost to business sentiment after the U.S. election (Chart 2) last November as it was believed that Trump's victory, and the likely policies that would follow, would be good for American companies. Right now, business optimism remains at strong levels whether looking at small business measures like the NFIB survey (top panel) or the big business series like the Conference Board CEO confidence index of the Duke University/CFO Magazine indicator for confidence among chief financial officers (middle panel). There has been a slight recent pullback from the post-election peak in all the business sentiment indicators, however, and any sign that Trump will have difficulty pushing his tax cuts through Congress could result in a bigger loss of confidence that could impact future hiring and capital spending activity. Our colleagues at BCA Geopolitical Strategy continue to believe that a tax reform package, including significant tax cuts, is still the most likely outcome. Congressional Republicans will not want to go into the 2018 U.S. mid-term elections "empty-handed". With Congress and the White House on the same page, focused by fears of losing seats next year, even an embattled and unpopular president should be able to get his tax cuts implemented. Any fiscal boost in the U.S. can only help to support the current global cyclical economic upturn. While growth indicators like our global PMI index have come off the highs a bit (Chart 3), the OECD's global leading economic indicator is still rising and pointing to rising real developed market bond yields (middle panel). In addition, the global data surprise index has bottomed out, leaving global bond yields exposed to any improvement in economic momentum (bottom panel). Chart of the WeekLosing Faith In##BR##Trump & The Fed Chart 2U.S. Businesses##BR##Are Still Confident Chart 3Global Bond Yields Are##BR##Vulnerable To Faster Growth The fiscal news flow out of D.C. is likely to remain volatile once Congress returns from its summer recess, particularly with regards to tax cut negotiations and the looming debt ceiling. Yet the big news that investors want to hear, regarding U.S. tax cuts, is more likely to be positive for growth and risk assets and negative for bond yields. Bottom Line: The ongoing turmoil in the White House, and the negative impact it is having on the popularity ratings of both President Trump and the Republican-led U.S. Congress, will intensify efforts to get a tax cut package done as quickly as possible. Success on this front will help buoy U.S. business confidence and lead to stronger U.S. economic growth, and likely more Fed rate hikes, in 2018. The Fed & ECB: Still Sticking To Their Script Chart 4Inflation Expectations Are##BR##Stable In The U.S. & Europe The markets continue to underestimate the likelihood of more Fed rate hikes in the next year. The odds of a hike in December now sit at only 32%, while essentially no hikes in 2018 are currently discounted. This is far too low, given the steady (if unspectacular) growth in the U.S. and tightening labor conditions. The market has clearly responded to the dip in realized U.S. inflation since March as a sign that the real fed funds rate is now close to equilibrium - a point that has also been suggested by some FOMC members - and that the Fed's inflation forecasts are hence unlikely to be realized. Yet measures of U.S. inflation expectations, both survey-based and market-based, have been fairly stable at levels consistent with the Fed's inflation target in recent months, even as headline U.S. inflation has slowed (Chart 4, 2nd panel).1 A similar dynamic is playing out in Europe. Both survey-based and market-based measures of inflation expectations have been stable at levels close to the ECB's inflation target of "just below" 2% on headline inflation (bottom panel), despite the dip in realized inflation. Stable inflation expectations are something that central bankers take very seriously as a sign that their monetary policies are seen as credible. If the recent dip in realized inflation also showed up as an equivalent decline in expected inflation, this would give policymakers in D.C. and Frankfurt second thoughts about making any policy changes in a less dovish/more hawkish direction. The latest readings on realized inflation in both the U.S. and Euro Area suggest some stabilization of the current downturn may be underway. Headline CPI inflation ticked higher from 1.6% to 1.7% in July, ending a streak of four consecutive months of deceleration since March. Core CPI inflation has been stable at 1.7% for three consecutive months up to July, after falling for four consecutive months from January. Data released last week for July inflation in Europe showed a similar dynamic, with core HICP inflation ticking up to 1.2%, the third consecutive month of faster year-over-year inflation. With growth on both sides of the Atlantic maintaining a steady, above-potential pace, amid stable inflation expectations and with realized inflation showing signs of bottoming out, we see both the Fed and the ECB sticking with their current messaging and forward guidance. That means one more rate hike this year by the Fed, most likely in December, following an announcement on beginning the process of reducing the Fed's balance sheet at the September FOMC meeting. After that, at least another 25-50bps of hikes in 2018 will be delivered, which is currently not discounted by the market. As for the ECB, expect a shift to a slower pace of asset purchases for 2018, to be announced at either the September or October monetary policy meetings. Chart 5Has The Euro Already Overshot? The Kansas City Fed's annual Jackson Hole conference, set to take place this weekend, is unlikely to produce any major surprises for investors. Both Fed Chair Janet Yellen and ECB President Mario Draghi will give speeches to an audience of their peers - other global central bankers. Much is being made of Draghi's speech, since he has not spoken at Jackson Hole since 2014 when he gave strong indications of the introduction of the ECB's asset purchase plan in 2015. After his speech at the ECB Forum in Portugal in late June of this year - also to an audience of central bankers - where he mentioned a "reflationary" impulse in Europe that could require some "adjustments" to the ECB's policy settings, investors will be on high alert for any indications that the ECB is about to announce a tapering of its asset purchases. The Account of the July ECB meeting released last week suggested some concern within the ECB Governing Council regarding the potential for an "overshoot" of the euro in response to any policy shift.2 Some are interpreting those comments as a sign that the ECB might be getting cold feet over making any changes to its asset purchase program given the 11% rise in the euro seen this year. However, we think that there was too much attention focused on the fears that a strong euro could derail any plans for an ECB taper, for two reasons: The ECB did note in the July Account that the rise in the euro was a reflection of both the relatively stronger growth seen in the Euro Area this year and the reduction in political risk premia after the French presidential elections in the spring. The Account also noted that the ECB was looking at the totality of its monetary policy measures - policy rates, forward guidance & asset purchases - when assessing its policy stance. This specific quote from the Account, shown with our emphasis on the key passages, highlights that the ECB thinks that a tapering of asset purchases, done on its own with no hikes in short-term interest rates, will still leave monetary policy at very accommodative settings: "...the point was made again that the overall degree of accommodation was determined by the combination of all the monetary policy measures implemented by the ECB, and that the Governing Council's assessment of progress regarding a sustained adjustment in the path of inflation should apply to the overall design and direction of the ECB's monetary policy stance as a whole, and not with reference to any particular instrument in isolation, such as the duration and pace of APP asset purchases." Investors should understandably be worried about the impact of the rising in the euro, which was one of the fastest rates of acceleration seen in the currency's history (Chart 5). Yet given that extreme in price momentum, the lack of support from higher short-term Euro Area interest rates, and with speculative positioning on the euro at very bullish levels, it is unlikely that much further gains in the currency can be expected. This is especially true for the euro versus the U.S. dollar if the Fed delivers additional rate hikes, as we expect. Unless there is decisive evidence that the latest rise in the euro was seriously dampening Euro Area economic growth or inflation, which is not currently visible in the data (bottom panel), then the ECB is still likely to downshift to a slower pace of asset purchases in 2018. Bottom Line: Economic growth is solid, and inflation expectations remain stable, on both sides of the Atlantic. The Fed and ECB remain on course to shift to a less accommodative policy stance towards year-end. That means a December rate hike by the Fed, with more likely in 2018, and a tapering of asset purchases by the ECB beginning in January. Maintain a defensive stance on portfolio duration. Trim EM Debt Exposure Versus U.S. Investment Grade Corporates Emerging market (EM) debt has been one of the strongest performing asset classes so far in 2017. EM USD-denominated sovereign bonds have delivered a total return of 7.5%, while USD-denominated EM corporates have returned 8.7%, according to Bloomberg Barclays index data. These returns have handily surpassed the majority of all other major USD-denominated fixed income sectors. A robust pace of inflows into EM debt, a record $48.6 billion year-to-date to August 9th according to the Wall Street Journal, has helped drive EM debt spreads to tight levels (Chart 6).3 The outperformance of EM debt, both versus its own history and compared with other pro-risk fixed income classes like U.S. corporates, would be justified if EM economic growth was faster than that seen in developed markets. Yet that is not currently the case. An EM (excluding China) PMI Index put together by our colleagues at BCA Emerging Markets Strategy has shown a sharp deceleration of EM growth for most of 2017 (Chart 7, top panel). This stands in sharp contrast to the improving growth seen in both the U.S. and Europe. Chart 6EM Debt Looks##BR##Fully Valued Chart 7Stronger U.S. Growth Favors##BR##U.S. IG Vs EM Sovereigns... The gap between the U.S. and EM (ex China) PMIs has widened to the largest level since 2014. This PMI gap has been a good directional indicator for the spread between U.S. corporate bond spreads (both for Investment Grade and High-Yield) and EM debt spreads (bottom two panels). Right now, it appears that U.S. High-Yield looks fairly valued versus EM USD-denominated sovereign debt but U.S. Investment Grade spreads still look a bit too wide relative to EM sovereigns. A similar story can be told when comparing U.S. corporates to EM USD-denominated corporate debt (Chart 8). Arthur Budaghyan, BCA's Chief Emerging Market strategist, recently made a trade recommendation to go short EM sovereign and corporate debt versus U.S. Investment Grade corporate debt.4 His argument was based on the relatively expensive valuations on EM debt, coming at a time when the outlook for economic growth and corporate profits looks healthier in the U.S. We could not agree more - especially if the Fed begins to hike rates, as we expect, and the U.S. dollar begins to strengthen anew, potentially triggering outflows from EM. Arthur has also pointed out that the gap between the option-adjusted spread (OAS) on EM corporates and U.S. corporates (both Investment Grade and High-Yield) has been an excellent leading indicator of the total return differential between the asset classes (Chart 9). The current relationships show that there is upside potential for U.S. Investment Grade versus EM corporates over the next 12 months, but not for U.S. High-Yield versus EM. Chart 8...And Vs. EM Corporates Chart 9Downgrade EM Debt Vs U.S. IG Corporates Thus, this week, we are cutting our allocations to both EM sovereign and corporate debt in our model bond portfolio, and increasing our allocation to U.S. Investment Grade corporates (see page 12). While this does move us into an asset class with a longer duration, the increase in our overall portfolio duration from this shift is very small given the small weight of EM debt in our custom benchmark. More importantly, U.S. Investment Grade is less risky than EM corporates using the duration-times-spread metric - our preferred measure for spread product risk. Bottom Line: Emerging market (EM) hard currency debt, both sovereign and corporate looks fully valued, even with a positive global growth backdrop. We see better value in U.S. higher-quality corporates vs. EM debt at current spread levels. Reduce EM sovereign and corporate debt in favor of U.S. Investment Grade corporates in global fixed income portfolios. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 The inflation expectations data shown in Chart 4 is based off the U.S. Consumer Price Index (CPI) measure of inflation, while the Fed targets growth in the headline Personal Consumption Expenditure (PCE) deflator of 2%. The spread between the two measures have averaged around 50bps in recent years, which suggests that the current CPI-based inflation expectations around 2.5% are in line with the Fed's 2% PCE inflation target. 2 https://www.ecb.europa.eu/press/accounts/2017/html/ecb.mg170817.en.html 3 https://blogs.wsj.com/moneybeat/2017/08/17/emerging-market-bonds-attract-record-inflows/?mg=prod/accounts-wsj 4 Please see BCA Emerging Markets Strategy Weekly Report, "EM: The Focus Is On Profits", dated August 16th 2017, available at ems.bcaresearch.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns The GFIS Recommended Portfolio Vs. The Custom Benchmark Index

Highlights Mantra 1 - Europe: First Among Equals - instils awareness that the euro area's long-term growth prospects and 'neutral' real interest rate are not meaningfully different to those in other developed economies. Mantra 2 - Mission Impossible: 2% Inflation - instils awareness that central banks are becoming less obsessed with subpar inflation and much more concerned about the danger that ultra-loose policy poses to financial stability. Mantra 3 - Negative Skew: A Ticking Time-Bomb - instils awareness that low observed volatility categorically does not mean that equity market risk has diminished. If anything, it means the exact opposite. Feature The titles of three of our recent reports - Europe: First Among Equals,1 Mission Impossible: 2% Inflation,2 and Negative Skew: A Ticking Time-Bomb3 - can be regarded as mantras instilling awareness of major investment opportunities and threats. This week's report is a recap of the messages encapsulated within these three mantras. Mantra 1 - Europe: First Among Equals Mantra 1 instils awareness that long-term growth in the euro area, adjusted for population, is not meaningfully different to that in other developed economies (Chart of the Week). Through the past 20 years, the euro area has underperformed through multi-year periods encompassing around half the time; but it has outperformed through the multi-year periods encompassing the other half. Chart of the WeekThe Euro Area Is An Economic Equal Seen in this wider context, the euro area's 2008-14 phase of poor economic performance was not structural, it was cyclical - the impact of back to back recessions separated by an unusually short gap. And if the euro area continues its recovery to just the mid-point of its long-term relative cycle, then recent investment trends in the bond and currency markets have much further to run. Bond yield spreads closely follow relative real GDP per head (Chart I-2). As they must, given central banks' self-professed 'data-dependency'. Although nobody expects the ECB to hike interest rates any time soon, expectations for the long-term 'neutral' rate are correctly rising from overly-depressed levels. Hence, the yield spread between long-dated bonds in the euro area4 and the U.S. has compressed from -175 bps last year to -125 bps today. Still, to reach the mid-point of its long-term cycle, this yield spread must ultimately converge to around -40 bps. But why is the mid-cycle yield spread -40 bps? The simple answer is that, over this 20-year period, the euro area versus U.S. inflation differential has averaged -40bps (Chart I-3). In other words, the mid-cycle real yield spread is zero. Chart I-2Bond Yield Spreads Just Follow ##br##Relative GDP Per Head Chart I-3The Euro Area - U.S. Inflation Differential ##br##Has Averaged -40 Bps This leads to a very important empirical observation. The mid-cycle or 'neutral' real interest rates in the euro area and U.S. have been near-identical over the past 20 years. Bear in mind that the past 20 years captures a very wide spectrum of economic and financial backdrops: the launch of the euro, the dotcom bubble and bust, the U.S. subprime credit boom and financial crisis, the euro debt crisis, QE. If this disparate past is a reasonable representation of the disparate future, we should expect the neutral real interest rate in the euro area to remain broadly similar to that in the U.S. The implication is that the yield spread between long-dated bonds in the euro area and the U.S. can compress much more. On a 2-year horizon, stay underweight euro area bonds - especially German bunds - in a European and global bond portfolio. And expect euro/dollar eventually to break through 1.30. Mantra 2 - Mission Impossible: 2% Inflation Mantra 2 instils awareness that central banks are becoming less obsessed with subpar inflation and much more concerned about the danger that ultra-loose policy poses to financial stability. The crux of the matter is that the monetary system and inflation form a classic non-linear system. A defining feature of a non-linear system is that it can be very difficult, even impossible, to achieve an arbitrary point target output like '2%' (Chart I-4). Chart I-4Non-Linear: Inflation Flipped From One Mode To A Completely Different Mode In a linear system, if a small input produces a small output, then double the input will produce double the output and triple the input will produce triple the output. But in a non-linear system, double the input could produce no output, half the output, or ten times the output. To be clear, we have no doubt that a fiat monetary system makes it possible to generate rampant inflation, should policymakers be absolutely determined to create it. But central banks are now starting to ask. At what cost? And for what benefit? Central banks are realising that in the struggle to achieve 2% inflation, persistent ultra-accommodative policy endangers the healthy functioning of markets and poses a risk to financial stability. At the same time, the continued undershoot of 2% inflation is not such a terrible thing when the economy is growing well. Chart I-5Relative Interest Rate Expectations##br## Just Follow Relative GDP Per Head The latest to admit this is Kasumasa Iwata, a leading candidate to become the next governor of the Bank of Japan. With the demerits of extraordinary stimulus becoming clearer, the BoJ should slow purchases of government bonds and ETFs even though inflation is nowhere near its target, he said. This follows hot on the heels of respected and influential ECB Governing Council member, Ewald Nowotny, who recently asked whether there should "be an easing of the 2% inflation goal in the sense of setting a range instead of a clear-cut target." And in Sweden, even though inflation has just hit 2% for the first time in six years, the Riksbank has suggested (re)introducing a variation band of 1% either side of the target5 to acknowledge that persistent 2% inflation is very difficult, or impossible, to achieve. Additionally, Riksbank Governor, Stefan Ingves, proposed that "central banks should also have the explicit responsibility for financial stability." The direction of travel is very clear. The most accommodative central banks are becoming less obsessed with subpar inflation and much more concerned about the danger that ultra-loose policy poses to financial stability. These central banks are set to dial back accommodation. Hence, the multi-year phase of divergent monetary policies across developed economies is over. The new multi-year phase is re-convergence of monetary policy, and specifically the ECB and Riksbank versus the Fed (Chart I-5). Therefore, mantra 2 - Mission Impossible: 2% Inflation - reinforces the investment conclusions that stem from mantra 1 - Europe: First Among Equals. Mantra 3 - Negative Skew: A Ticking Time-Bomb Mantra 3 instils awareness that low observed volatility categorically does not mean that equity market risk has diminished. If anything, it means the exact opposite. When the equity market is advancing, its observed volatility is low. But this is just a property of so-called 'negative skew'. Up weeks tend to generate small and regular positive returns which means that advances tend to be gradual and gentle. And the longer and more established the advance becomes, the lower the observed volatility goes. Unfortunately, some investors and risk-control algorithms mistakenly use the observed volatility of an investment as a gauge of its riskiness. They incorrectly equate low observed volatility with a lower risk premium, which justifies an additional advance in the market. The additional advance then takes observed volatility even lower - which justifies a further market advance. And so on, in a self-reinforcing positive feedback. Eventually, the truth dawns. Equity market risk hasn't actually declined, but the equity risk premium - the excess prospective return that equities offer over bonds - has almost disappeared. And suddenly, the self-reinforcing feedback phase-shifts from positive to negative. The equity risk premium is the excess prospective return that equities offer over bonds, but a good working approximation is the difference between the equity index earnings yield and the bond yield. The concerning thing is that this measure of the equity risk premium is moving exactly in line with the equity market's observed volatility (Chart I-6), when it shouldn't. Admittedly, it is difficult to know when the time-bomb will go off. But the good news is that when observed volatility is very low - as it is now - options become very cheap. And a long index plus at-the-money put option becomes an excellent absolute return strategy.6 Chart I-6The Equity Risk Premium Is Tracking The##br## Equity Market's Observed Volatility Chart I-7Record Low Observed Volatility ##br##Doesn't Last For those that cannot buy options, record low observed volatility tends to signify a good time to raise a little bit of cash. This should be set aside for reinvestment in the equity market when observed volatility spikes (Chart I-7), as it always ultimately does. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Published on August 3 2017 and available at eis.bcaresearch.com 2 Published on July 20 2017 and available at eis.bcaresearch.com 3 Published on July 27 2017 and available at eis.bcaresearch.com 4 Euro area average over 10-year sovereign yield, weighted by sovereign issue size. 5 The Swedish FSA has said that the Riksbank should delay the change until a parliament review of Riksbank policy rules is completed in about 2 years. 6 For more details of the absolute return strategy, please see the European Investment Strategy Special Report titled "Negative Skew: A Ticking Time-Bomb", dated July 27, 2017 and available at eis.bcaresearch.com Fractal Trading Model Long USD/CAD successfully hit its 2.5% profit target and is now closed. This week's new trade is to short MSCI Turkey versus the Eurostoxx600 with a profit target and symmetric stop-loss set at 5%. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-8 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations

Special Report

Feature This is the second of three Special Reports on Electric Vehicles. In the first report published two weeks ago,1 we looked at the current costs of ownership of a typical mass-market EV, including and excluding subsidies, versus a similar Internal Combustion Engine Vehicle (ICEV). Based on current manufacturing costs and battery capabilities, EVs carry a significantly higher total cost per mile, even including current subsidies. In this second report, we determine that EV-specific manufacturers (specifically, TSLA) do not hold any material manufacturing advantage over conventional auto manufacturers, and lack their financial resources and intellectual experiences managing mass production operations. In addition to the risks from increased mass-market competition, the EV market faces risks of today's EV subsidies morphing into tomorrow's EV taxes, retarding the exponential growth of adoption many EV enthusiasts are betting on today. In our forthcoming third report, we will look at the potential regional and global impacts EV adoption will have on energy, power, and commodity markets. Despite the current cost and utility disadvantages of EVs, we expect governments (especially Europe and China) will continue to provide subsidies (carrots) and mandates (sticks) to further the adoption of EVs for the purposes of reducing CO2 emissions and tailpipe particulate pollution. The longer-term hope is that by forcing the EV market to expand, meaningful technological breakthroughs on batteries will eventually enable EVs to exceed ICEVs on a cost and utility basis. In this report, we conclude that: EV-specific manufacturers (TSLA) will face increasingly stiff competition from conventional auto manufacturers, who may enjoy lower manufacturing, distribution, and service costs and have ICEV profits to subsidize near-term EV losses. Access to chargers will be a growing problem for widespread EV adoption, especially for EVs to penetrate apartment-dwellers. Government EV subsidies will become fiscally difficult to continue as adoption increases and gasoline taxes are lost (especially in Europe). The small amount of carbon saved by EVs does not justify the subsidies, further increasing the risk subsidies are reduced or allowed to phase out (especially in the U.S.). EVs: Winners And Losers Investor interest in EVs tends to focus on the only publicly traded play in the space, Tesla Motors (TSLA, Q). Tesla has an enthusiastic fan base, which seems to extend well beyond the rather modest number of people who actually own the vehicles (Chart 1). That enthusiasm is probably somewhat responsible for favorable media coverage and the company's speculatively-high market cap (Chart 2), which is currently on a par with General Motors (GM, N), despite the fact that Tesla has never made a profit. (Chart 3 and Chart 4).When we read media and analyst coverage of Tesla, we often wonder if those writing the articles know anything about automobiles besides how to drive them. An example is this Forbes article regarding Tesla as uniquely visionary, building up a big lead on its sleepy competition. Chart 1Tesla's EV Sales Are Modest Chart 2Tesla's Market Cap Surpasses GM's Chart 3Tesla: Financial Performance Chart 4GM: Financial Performance "[Manufacturer] complacency about electric vehicle (EV) technology is worse than perceived. Despite more talk of developing EVs for mass-market adoption, a lack of real action and strategic commitments betray their underlying conviction, with no clear pathway to high-volume EV production before the mid-2020s"2 Setting aside for a moment the question as to whether Tesla, as a serial destroyer of capital (to date), will have access to the financial resources needed to become itself a "high-volume" producer of EVs, most commentators ignore the fact that building an EV is far less complicated than building an ICEV, and the conventional car companies are likely to have cost advantages (not to mention the benefits of decades of experience with mass production) once they do commit to the EV. What's The Difference Between An EV And An ICEV? In a general sense, an automobile consists of two main components: the drivetrain and the rest of the vehicle. What differentiates an EV from an ICEV is almost entirely the drivetrain and battery pack. Although the shape and weight of the battery pack requires some alteration to the body frame of the vehicle, and many EVs include regenerative brakes, substantially everything else in the rest of the EV is very similar. Drivetrain The drivetrain of an ICEV is where the vast majority of precision parts are located. A typical ICEV has hundreds of precision parts and must be manufactured and assembled to exact tolerances in order to last beyond the typically expected 100,000+ mile trouble-free life. Engines are also subject to extremes in temperatures ranging from -40°C (-40°F) at start up in a cold winter to close to 90°C (190°F) under operation. Transmissions are similarly complicated. In contrast, the drivetrain of an EV is extremely simple, consisting essentially of an electric motor and a transmission, which is also greatly simplified due to the nature of the torque curve of electric motors (Illustration 1). Illustration 1Key Components Of A Bolt EV Drive Unit Unlike an ICEV which has numerous reciprocating parts (which are hard to engineer), all parts of an EV drivetrain rotate (which are much easier to engineer). Similarly, while there are numerous parts on an ICEV which require precision machining, friction bearings, and pressurized lubrication and cooling, analogous parts on an EV drivetrain are much fewer in number, can use ball bearings, and are lubricated for life. The fact that an EV drivetrain does not require pressurized lubrication and has a much simpler cooling system further simplifies the design and reduces the number of parts. It would not be an exaggeration to suggest that the drivetrain of an EV has an order of magnitude fewer parts than an ICEV of similar size. Any automotive company capable of designing and manufacturing an ICEV drivetrain should be capable of producing an EV drivetrain or outsourcing one if necessary. Battery Pack And Electronics Similarly, the battery pack of an EV is a mechanically simple thing to make. Battery cells are assembled into modules and the modules are assembled into the final battery pack (Illustration 2). The major challenge and potential differentiator is in the battery cells, which are effectively commodities (see below), and not in the manufacture or design of the battery pack. EV battery packs can produce a lot of heat when running or charging, and the battery packs tend to have simple cooling systems which vary from manufacturer to manufacturer.3 Illustration 2Battery Packs Are Battery Cells Assembled In Groups An EV requires a significant amount of power electronics for the control of the motor, charging, and so on. Such power systems have been designed and made for decades, and, besides some unusual requirements due to the need to operate at extreme temperatures, there is no great technical challenge inherent in such systems. Indeed, while the operating life of an ICEV is typically on the order of 5,000 to 10,000 hours (100,000-200,000 miles), power electronics are often designed to operate for 100,000 hours or more. The drivetrain will not be the limiting factor on the longevity of an EV. Most likely, the cost of an EV's drivetrain (excluding the battery pack) and typical features such as regenerative brakes, a more robust suspension (due to the greater weight of the EV on account of the heavy battery), and accommodation for the battery pack, is somewhat less than that of an equivalent ICEV. Although the EV drivetrain is simpler to build, high-output electric motors and related control electronics are not cheap to manufacture due to the requirement for materials such as copper and exotic alloys. The reason for the substantially higher cost of EVs is the battery pack. And The Winners Are ... Despite investor enthusiasm for the "technological revolution" EVs represent, it is actually far more complicated and technologically difficult to design and manufacture an ICEV than an EV. The EV has far fewer precision-made parts, and few such components are truly proprietary. Electric motors have been made for over a century, and their design and manufacture are not complicated - at least when compared to the vastly more complicated and precision-made ICEV. Similarly, an EV transmission is significantly simpler than the transmissions found in all ICEVs. We conclude that the design and manufacture of an EV drivetrain should be simple for a company accustomed to making ICEVs. Even the power and charging electronics are similar to the sorts of things electrical engineers have been making for a long time. Similarly, the assembly of a battery pack from commodity cells should be a relatively straightforward process for any company used to volume manufacturing. As we predicted, battery production appears to be scaling up, and sourcing commodity batteries should not be difficult if demand for EVs emerges as some predict. Although we have largely skipped over a discussion of the non-drivetrain components of an automobile, traditional manufacturers have been manufacturing these for a very long time and are capable of producing them at a reasonable cost and in vast numbers. The major difference between the non-drivetrain components of an EV and ICEV is accommodation for the shape and weight of the battery pack, which, again, should not be a substantial engineering challenge for any large auto manufacturer. For many years, auto manufacturers have developed "platforms" that allow them to mass produce standardized components that are used on what are apparently very different vehicles. Most likely, traditional vendors will produce a platform which can be used for both ICEVs and EVs, meaning that they can reuse parts produced for their ICEVs in EVs, saving money in terms of design, tooling, and volume manufacturing. Obviously, an EV-only vendor does not have that option. Finally, large automobile manufacturers have a global distribution channel as well as nearly omnipresent parts and service networks, including parts and service available from an assortment of third party providers. Developing this support system is particularly important for EVs to enter the mainstream: it is false to assume the simpler drivetrain of an EV will mean the vehicles never need repairs, as there are many failure modes. Beyond wealthy early-adopting EV enthusiasts who purchase EVs as a second or third auto, the typical consumer owns only a single vehicle, making prompt and affordable repairs critical to the utility of a mass-market vehicle, regardless of whether that vehicle is an EV or an ICEV. In summary, we conclude that there is no particular engineering challenge for existing large automakers to enter and dominate the EV business (Tables 1 and 2). Most likely, profit margins on EVs will be low or negative for some time (see Part 1), and large vendors will be in a position to use their profitable ICEV sales to subsidize their market share in the EV business. The main competitive uncertainty for EV manufacturing is how much battery performance and price can be improved from current levels. The battery cells themselves are rather commoditized, making it difficult for any single auto company to develop a substantial lead on the field in battery pack performance. Table 1Conventional Auto Manufacturers Are Ramping Up EV Penetration Table 2TSLA Will Lose Market Share As Mass-Market Competition Expands Rate Of Adoption As we showed in Part 1, costs of ownership of EVs are quite high compared to ICEVs over the EV's assumed 100,000 mile life. Although we believe accelerated depreciation of the EV will significantly increase the differential, most consumers are unaware of that likelihood. Governments and EV manufacturers heavily subsidize EVs; without such subsidies, consumers' costs of ownership would be materially higher. If EVs become a significant share of the vehicle market, such subsidies will have to be reduced, and high taxes would have to be applied to either the vehicle or the fuel (electricity) to make up for the loss of massive government revenues from today's gasoline taxes. The most expensive item in an EV is the battery pack (Chart 5). It appears to be an article of faith among EV advocates that existing batteries will somehow see cost reductions to below their current materials costs, and/or that revolutionary battery technology will emerge in (rapid) due course. It is interesting to speculate as to what might occur in the future. However, we prefer to be data driven. After all, why confine speculation on technological advancements only to things battery-related? Rapid technological advancements in oil production have cut gasoline prices dramatically in the past few years, while continued improvements of conventional engines can raise fuel efficiency and dramatically lower pollution/CO2 emissions of ICEVs, stiffening the competition against the rise of EVs. Chart 5As The Battery Pack Increases In Size,##BR##It Commands A Larger Share Of The Total Cost Of The EV Besides cost, there are numerous compromises associated with an EV which may temper adoption. These include the limited range and slow refueling times, which are important if the owner regularly--or even occasionally--makes long trips; degraded performance in temperature extremes, and so on. An important consideration for many buyers is the size of the car: a soccer mom is not likely to find a Bolt a suitable replacement for a minivan. Larger EVs require disproportionally larger batteries: the Tesla Model S 85 has a 40% larger battery but only a 10% greater range compared to the Bolt. EVs More Likely To Be Popular In The EU Than In North America Europeans tend to drive fewer kilometers and take fewer long trips than North Americans. The average distance traveled by car is 14,000 km4 (8,700 miles) in Europe compared to 20,000 km (12,000 miles) in the U.S., so a European would likely get a few more years out an EV - though not many more kilometers. Similarly, most of the population of Europe lives in areas where temperature extremes are less severe than they are in certain areas of the U.S. and Canada, meaning some of the compromises associated with operating an EV would be less significant. Europe has a much higher population density than the U.S., making particulate pollution a larger issue, and Europeans have more concerns regarding climate change. Much higher gasoline taxes and narrow roads in Europe also incentivize drivers to own smaller vehicles, similar to the Bolt. Due to these factors and the "carrot and stick" approach of subsidies and mandates favored by some EU countries, we conclude EVs are likely to be much more popular in the EU than in the U.S. (Chart 6) Chart 6European EV Sales Are Outpacing U.S. Sales Regardless, even EV adoption in the EU is bound to be constrained by: Higher costs of EVs compared to ICEVs; Driving habits which may preclude ownership by some people; Access to both private and public chargers; Long lives of ICEVs; and Availability of EVs for purchase. In Part 1 of our EV analysis, we break down the substantially higher cost of ownership for an EV compared to an ICEV. Driving habits boil down to the question of standard deviation: although the average EU driver may travel about 70 km (43 miles) per work day, a sizeable minority may travel much more than that or regularly make round trips beyond the range of their EVs. Alternatively, some may want to pull a trailer (caravan), etc... These drivers would be less likely to purchase an EV except perhaps as a second vehicle. Access to private chargers depends on the nature of the buyer's housing: somebody living in a house with a driveway can pay to have a slow charger installed, whereby somebody who relies on street parking or a nearby parking lot does not have that option. Due to the far greater population density of Europe, access to public chargers may be more of a constraint in the EU than in the U.S. In Part 1, we explained why we believe that ICEVs will outlast EVs for the foreseeable future due to degradation inherent with all battery technologies. There may be a dramatic breakthrough in battery technology, but batteries have numerous parameters which must be acceptable before they can be used in an EV. Most likely, an EV will be scrapped rather than have its battery replaced after about 160,000 km, whereas many ICEVs are routinely kept on the road for double that range. Consumers will eventually realize this and incorporate accelerated depreciation into their costs of ownership calculation. Not only that, but many will choose to keep their ICEVs on the road as long as possible simply to save the expense of purchasing a new vehicle, especially if the inherent limitations of EVs mean they are not suitable for that particular driver. Despite still-generous government subsidies, GM is believed to lose $9,000 for every Bolt it sells. Similarly, the CEO of Fiat lamented some time ago the company was losing $14,000 for every Fiat 500 EV it sold,5 and Tesla loses money despite selling into a premium segment. There is no reason to believe any EV vendor will actually make money on EVs for many years. After all, they all have the same problems with respect to the cost of batteries. We believe auto vendors are likely to limit sales of EVs through rationing or high prices in order to limit their own losses. EVs Are Unlikely To Replace All ICEVs The compromises/deficiencies associated with EVs mean that they will not be suitable for many consumers unless a massive battery breakthrough is achieved. The limited range is an obvious issue: a consumer might, for example, travel an average of 12,000 miles (20,000 km) per year but may regularly take a drive of a few hundred miles, which would require one or more recharging stops. It is all well and good to speak of rapid charging, but even this would quickly lose its allure after long trips, especially given the issues noted in "EVs Will Require a Sizeable Charging Infrastructure" below. Almost 3 million pickup trucks are sold in the U.S. every year, out of 17.5 million vehicle sales. Light trucks, including SUVs and Crossovers, make up another 10.5 million sales. Whether or not the trucks are actually used for hauling, the battery size, and therefore cost of ownership, would have to be particularly large for a pickup truck. A 120 kWh battery would add about 1,600 pounds (720 kg) to the vehicle, which is about half the cargo capacity of a Ford F-150 full size pickup truck. Many pickup trucks have significantly oversized engines in order to tow heavy loads. It is questionable an EV pickup truck would have the range or towing capacity required by many buyers. EVs Will Require A Sizeable Charging Infrastructure First-time EV owners will either have to invest in a charging station for their homes or somehow get access to one. Charging stations come in different types. In the case of the Bolt, a typical home charger delivers 4 miles (6.5 km) of range/hour of charge or about 32 miles (52 km) of range for 8 hours. What GM calls "Fast Charging" delivers almost a full charge over 8 hours. What GM refers to as "Super Fast Charging", or true fast charging, delivers 90 miles (145 km) of range in 30 minutes or 160 miles (258 km) in 1 hour, but is only available in public locations6 and requires a special option on the vehicle. "Super Fast Charging" means that a customer planning a trip of over 238 miles will have to plan for at least one 30 minute stop for every 90 miles of additional travel. Of course, this is when the vehicle is new and under ideal conditions without any temperature extremes, etc. An older EV may require a 30 minute stop after the first 150 miles and a subsequent 30 minute stop for every hour of travel (60-70 miles) after that. Private Chargers Unless they are satisfied with multi-day charging, new EV buyers have to pay an electrician to install a high current charger outlet which is accessible to the vehicle. Not all homes have ample parking, nor is it easy to install a high current port accessible to a vehicle in all homes. A typical high current charging port required for a "slow charger" requires a 40, 50, or 60 amp outlet. Many homes have only a 100 amp service, which may pose issues if the vehicle is charging and, for example, an air conditioner starts up. Similarly, apartment/condo dwellers with access to parking may have access to EV chargers provided by the building, though the electric service to the building/parking lot may require upgrading in the event a significant number of owners buy EVs. Publicly Available Chargers The largest challenge might be for would-be EV buyers who park on the street, as is fairly common in many urban areas. The cost of installing EV chargers is not trivial, and it is hard to believe cities will accept the costs of installing a large number of chargers to ensure EV owners can charge their vehicles. This doesn't even account for the fact that somebody has to pay for the electricity, and street-side chargers are both expensive and dangerous, require maintenance and snow removal, and may be subject to vandalism. Additionally, some parking lots feature a couple of EV chargers, and most EV vendors provide access to a rather sparse assortment of chargers. On the surface, a 6:1 ratio of global EVs to publicly available chargers may not appear to be as much of a concern, however, the ratio is about 16:1 for slow chargers and 105:1 for fast chargers in the U.S., and 6:1 and 68:1 in the EU, respectively (Charts 7 and 8). Recall that the Bolt's "Fast charger" only supplies about 25 miles of range for every hour of charging, so public units would only be useful as a "top-up". Public chargers will have to become far more common as the number of EVs increases or owners risk planning a trip which assumes access to a charger only to discover the unit is in use and the EV owner who is using it is off shopping. Chart 7Globally, There Is One Public Charger ##br##Per Six EVs Chart 8Fast Chargers Are Much More Scarce ##br##Than Slow Chargers Fast chargers are of particular significance in the event an EV owner wishes to make a trip in excess of the vehicle's fully-charged range. "Fast charge" times - whether with a Bolt or any other EV - assume a charging station is available when the EV arrives. This may be the case on typical days, but less likely during holiday or vacation season: "A video shot yesterday at the Supercharger in Barstow, CA shows a line at the station of Teslas waiting to juice up. The driver who shot the video was number 21 in the queue, and with wait times upwards of two hours just to get to the charger, Tesla's going to have some unhappy customers on its hands."7 One can only imagine how frustrated the owner of an aged Bolt would be if they had to wait 2 hours every 60 miles. Impact Of EV Adoption On Pollution And Greenhouse Gas Emissions The production and operation of any product leaves an environmental impact in terms of pollution and Greenhouse Gas (GHG) emissions. The environmental impact associated with vehicles arises from the production of the commodities used to make the components, the manufacture of the vehicle components, the assembly of the vehicle itself, and the operation of the vehicle. EVs are not "zero emission vehicles" in any meaningful sense. It is true that they do not discharge particulate or CO2 emissions from the tailpipe, but emissions arise from the production of the vehicle platform, the battery pack, and the production of electricity used to charge the battery. The fuel mix of power generation in a particular region has a significant impact on the GHG emissions associated with electric power: countries with significant hydroelectric or nuclear power sources will have lower GHG emissions per kW than those which burn coal, oil, or natural gas. Similarly, the GHG emissions associated with the manufacture of a vehicle and its components depend on the power mix in the country in which those components are manufactured. As previously noted, an EV is very similar to an ICEV except for the drivetrain and battery. The EV's drivetrain is simpler than an ICEV's, but total GHG emissions associated with manufacturing an EV and equivalent ICEV are estimated to be quite similar, excluding the battery pack. GHG emissions associated with the manufacture and recycling of a battery pack are quite hard to pin down. The best and most recent example we found comes from IVL Swedish Environmental Research Institute, and notes: "Based on our review, greenhouse gas emissions of 150-200 kg CO2-eq/kWh battery looks to correspond to the greenhouse gas burden of current battery production."8 To put things in perspective, the GHG burden associated with the lifecycle of a 60 kWh Bolt battery pack is between 9,000 and 12,000 kg, or 9 to 12 metric tons. Because the battery pack is likely larger than advertised to limit degradation, the actual figure is probably at least 20% more, or 10.8 to 14.4 metric tons. At just 9 metric tons, assuming a 160,000 km life, the GHG burden associated manufacture and recycling of a Bolt battery pack is about 56 g CO2/km, and at 14.4 metric tons the burden is about 88 g CO2/km. To be as favorable as possible to the Bolt's potential to reduce GHG emissions, we have used the lower bound of the estimated CO2 burden of the Bolt's 60 kWh battery, 9 metric tons, in our GHG analysis in Table 3. The actual CO2 burden could be as much as 5.4 metric tons more. Note that the above calculations do not include the GHG emissions associated with recharging the battery. Recall that in Part 1, we estimated the power consumption associated with a Bolt operating for 160,000 km would be about 31,250 kWh, or ~0.20 kWh/km (0.3125 kWh/mile). The GHG burden of recharging the battery varies considerably depending on the regional mix of power generation. As shown in Table 3: Table 3EVs Will Reduce Carbon Emissions Only If Power Grid Is Green In France, where power is primarily generated via carbon-free nuclear energy, recharging the Bolt will release just 2 metric tons of CO2 during its 160,000KM life (11g/km). In coal-heavy Germany (40+% coal), recharging the Bolt will generate ~18 metric tons of CO2 (109g/km), slightly more carbon than the fuel-efficient gasoline-powered ICEV Opel Astra (104g/km). In the U.S., with the current diversified mix of power generated by natural gas (34%), coal (30%), nuclear (20%), hydro (7%), wind (6%) and solar (1%), CO2 emissions from recharging the Bolt would be only 13 metric tons (83g/km), 60% lower than the 32 tons of CO2 emitted by the ICEV Chevy Sonic. As shown, despite the higher CO2 footprint associated with manufacturing the EV's battery pack, an EV may indeed lead to an overall reduction in GHG emissions in a region where electricity generation is already low-carbon; however, the EV actually emits more CO2 in Germany, a coal-heavy country (40% coal) with fuel-efficient ICEVs. This implies EVs would create even greater CO2 increases in countries like China or India, which both generate over 70% of power from coal. The carbon intensity of U.S. power generation has been reduced by roughly 23% over the past decade due to the increased displacement of coal with natural gas (~70% of the carbon reduction) and renewables. As the U.S. and other countries continue to de-carbonize their power grids, the emissions to recharge EVs will further decline. However, even where reductions are achieved, the lifecycle emissions of the EV is nothing close to what is implied by the term "Zero Emission Vehicle." Using our generous assumptions for the carbon footprint of the EV's battery, we calculate the approximate lifecycle CO2 reductions for an EV are ~9 metric tons in the U.S., and ~6 metric tons in France. In Germany, the EV actually emits ~10 metric tons more CO2 than a comparable ICEV. EVs in coal-heavy China and India would also be expected to emit more lifecycle CO2 than a fuel-efficient ICEV. Even if power generation were 100% carbon-free in the EU and in the U.S., the CO2 savings would be only 23 tons per vehicle in the U.S and 8 tons per vehicle in the EU (lower savings in the EU due to the higher fuel efficiency of the European ICEV). One area where the EV is bound to come out ahead is in reducing particulates, NOx, and other non-GHG related pollutants, at least in the areas where the vehicles are operated, which provides cleaner air in highly populated areas. EV Subsidies Are Not Justified By Carbon Emissions In order to simplify the cost/benefit debate over legislation and regulation aimed at reducing carbon emissions, the U.S. EPA and other various U.S. agencies have calculated/estimated a "Social Cost of Carbon," i.e., the estimated economic damage created by emitting a ton of CO2 in a given year.9 In the base case, the social cost of carbon was pegged at $36/metric ton in 2015, with expectations that it would rise to $50/metric ton in 2030 and $69/metric ton in 2050 as climate issues became more severe. By comparison, the "market value" for a ton of CO2 on traded exchanges in California and in the E.U. is between $5-$15/ton. Assuming an average value of $50/metric ton, the current CO2 savings of the EV will yield about an economic benefit per vehicle of ~$450 in the U.S, and ~$300 benefit in France. In Germany, where CO2 emissions for the EV are higher than the ICEV, it adds another ~$500 to the economic cost of the EV. At a value of $50/ton, the value of CO2 savings in each region are only ~4-5% of the value of the public subsidies of $7,200-$9,500/vehicle in the U.S. and France, and only 1-2% of the total ~$22,000-$27,000 total extra societal costs of the vehicles (Table 4). In other words, the subsidies alone cost 20x more than the economic benefit of the CO2 reductions, while the total extra costs of the EV are 55-75x higher than the economic value of the CO2 reductions. Germany is offering subsidies for vehicles that increase CO2 emissions. Table 4EV Carbon Reductions Are Way Too Expensive Of course, industry may be able to lower emissions associated with battery manufacturing and recycling, and power generation may continue to be de-carbonized as well, leading to lower GHG emissions associated with EVs in the future. However, the same might be said regarding continuing improvements in ICEVs as well. For example: If U.S. drivers changed preferences to drive European-style cars with smaller engines and greater fuel efficiency (that is, wider adoption of technology that already exists today), that alone could save ~17 tons of carbon per vehicle in the U.S., dwarfing the ~10 tons of carbon savings achieved by owning an EV, at a much lower economic cost. Again, one area where the EV is bound to come out ahead is in reducing particulates, NOx, and other non-GHG related pollutants, at least in the areas where the vehicles are operated, which provides cleaner air in highly populated areas. This reduction/transfer of pollution from the city center to the power generation stations has a real health/quality of life value that we have not included in the above analysis, as the overwhelming amount of EV interest we read and receive is specifically based on EVs' (overestimated) ability to reduce global carbon emissions.10 Bottom Line: TSLA does not have an insurmountable technological lead on conventional car producers in the mass-production EV market, and is likely to lose market share to larger competitors that have better costs, infrastructure, and experience supporting a global fleet of mass-produced vehicles. Near-term adoption of EVs will be forced higher by governmental carrot and stick incentives, but these will become too expensive to continue as EVs' market share increases. Today's EV subsidies will turn into tomorrow's EV taxes as gasoline taxes are diminished, weighing on the longer-term arc of commonly-forecasted EV adoption. Finally, EVs do not necessarily reduce CO2 emissions, and when they do, the value of those CO2 reductions is exceedingly small compared to the added cost of the vehicles to producers, consumers, and government coffers. A modest ICEV only emits ~$2,000 worth of CO2 over 100,000 miles in the first place, elucidating how difficult it will be for an EV to reduce GHG emissions on a cost-competitive basis. For mass-market EVs to successfully displace ICEVs in the eyes of cost-conscious consumers and taxpayers, EV battery technology needs to improve massively, not incrementally. The batteries need to provide multiples of today's energy storage capacity with lower weight, lower cost, faster recharge abilities, and a lower carbon footprint. Furthermore, since an EV's battery recharging is only as green as the power source behind it, continued (expensive) greening and expansion of global power generation would also be necessary for EVs to demonstrate a positive impact on GHG emissions, as will be discussed more in Part 3 of this report series. Brian Piccioni, Vice President Technology Sector Strategy brianp@bcaresearch.com Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Michael Commisso, Research Analyst michaelc@bcaresearch.com Johanna El-Hayek, Research Assistant johannah@bcaresearch.com Hugo Bélanger, Research Assistant HugoB@bcaresearch.com 1 Please see Technology Sector Strategy Special Report, "Electric Vehicles Part 1: Costs of Ownership", dated August 1, 2017, available at tech.bcaresearch.com. 2 https://www.forbes.com/sites/neilwinton/2017/06/29/tesla-focus-means-victory-versus-complacent-mainstream-in-electric-car-market-report/#4d0d4684577e 3 http://www.hybridcars.com/2017-chevy-bolt-battery-cooling-and-gearbox-details/ 4 http://www.acea.be/publications/article/cars-trucks-and-the-environment 5 http://jalopnik.com/sergio-marchionne-doesnt-want-you-to-buy-a-fiat-500e-1579578914 6 https://www.chevyevlife.com/bolt-ev-charging-guide 7 http://bgr.com/2016/12/27/tesla-supercharger-wait-times-lines-california/ 8 http://www.ivl.se/download/18.5922281715bdaebede9559/1496046218976/C243+The+life+cycle+energy+consumption+and+CO2+emissions+from+lithium+ion+batteries+.pdf (page 42) 9 https://www.epa.gov/sites/production/files/2016-12/documents/social_cost_of_carbon_fact_sheet.pdf 10 It is worth pointing out that if the incentive structure is such that entrepreneurs are rewarded for finding ways to economically reduce carbon emissions in ICEVs in a way that is cost-competitive with EVs, the principal advantage of EVs would be challenged. There is no ironclad rule of physics we are aware of that precludes such a development. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016

Highlights Washington must establish a "credible threat" if it is to convince Pyongyang that negotiations offer the superior outcome; The process of establishing such a credible threat is volatile; U.S. Treasurys, along with Swiss and Japanese government bonds have been consistent safe haven assets; The risk of a U.S. attack against North Korea is a red herring, while the crisis itself is not; We suggest that investors hedge the risk with an equally-weighted basket of Swiss bonds and gold. Feature Brinkmanship between Pyongyang and Washington, D.C. has roiled markets over the past week. The uptick in rhetoric has not come as a surprise. Since last year, BCA's Geopolitical Strategy has stressed that souring Sino-American relations were the premier geopolitical risk to investors and that China's periphery, especially the Korean peninsula, would be the "decisive" factor for markets.1 North Korea's nuclear ambitions - which could be snuffed out immediately by a concerted and coordinated effort by China and the U.S. - are a derivative of the broader U.S.-China dynamic. The U.S. is unlikely to use military force to resolve its standoff with North Korea. There are long-standing constraints to war, ones that all of the interested parties know only too well from their experience in the Korean War of 1950-53. The first of these is that war is likely to bring a high death toll: Pyongyang can inflict massive civilian casualties in Seoul with a conventional artillery barrage; U.S. troops and Japanese troops and civilians would also likely suffer. Second, China is unlikely to remain neutral, given its behavior in the 1950s, its persistent strategic interest in the peninsula, and its huge increase in military strength relative to both the past and to the United States. However, the process by which the U.S. establishes a "credible threat" of military action is volatile.2 Such a credible threat is necessary if Washington is to convince Pyongyang that negotiations offer a superior outcome to the belligerent status quo. Viewed from this perspective - which is informed by game theory -President Donald Trump has not committed any grave mistakes so far, but has rather shrewdly manipulated the world's perception that he is mentally unhinged in order to enhance his negotiating leverage. It is unclear how long it will take Trump to convince North Korea that the threat of a U.S. preemptive strike is "credible." As such, it is unclear how long the current standoff will persist. From an investor perspective, it will be difficult to gauge whether the brinkmanship and military posturing are part of this "territorial threat display" or evidence of real preparations for an actual attack. As such, further volatility is likely. The ongoing crisis in North Korea is neither the first nor the last geopolitical crisis the world will face in today's era of paradigm shifts.3 We have long identified East Asia as the cauldron of investment-relevant geopolitical risks.4 This is a dynamic produced by the multipolar global context and the geopolitical disequilibrium in the Sino-American relationship. For now, investors have been able to ignore the rising global tensions (Chart 1) due to the ample liquidity emanating from central banks, but the day of reckoning is nigh (Chart 2). Chart 1Multipolarity Increases Conflict Frequency Chart 2Day Of Reckoning? Q&A On North Korea Back on April 19, we wrote a Special Report, "North Korea: Beyond Satire," which argued that North Korea had at last become a market-relevant geopolitical risk after decades of limited impact (Chart 3).5 Chart 3North Korean Provocations Rarely Affect Markets For Long Looking to the next steps, we introduced the "arc of diplomacy," a framework comparable to the U.S.-Iran nuclear negotiations from 2010-15 (Chart 4). We predicted that the U.S. would ultimately ramp up threats for the purpose of achieving a diplomatic solution. The U.S. was constrained and would only go to war if an act of war were committed, or appeared imminent.6 Chart 4Arc Of Diplomacy: Tensions Ramp Up As Nuclear Negotiations Begin This assessment is now playing out. But not all clients are convinced of our logic, as we have found in our travels throughout Asia Pacific and elsewhere this month. Below we offer a short Q&A based on questions we have received from clients: Q: Diplomacy has already been tried, so why won't the U.S. attack? A: The U.S. public has less appetite for war, especially a preemptive strike, in the wake of the Iraq War, and has not suffered a 9/11 or Pearl Harbor-type catalyst. The U.S. will exhaust diplomatic options before joining a catastrophic second Korean War. And the diplomatic options are far from exhausted. The latest round of sanctions are tighter and more serious than past ones, but still leave categories untouched (like fuel supplies to the North) and are still very hard to enforce (like cutting illegal North Korean labor remittances). Enforcement is always difficult, and the U.S. is currently attempting to ensure that its allies enforce the sanctions strictly, not to mention its rivals (i.e. Russia and China). While we do not think China will ever impose crippling sanctions, we do think it can tighten them up considerably, which could be enough to change the North's behavior. Q: Why doesn't China just take North Korea out? A: China is a formal political, military, and ideological ally of North Korea, and has a strategic interest in maintaining a buffer space on the Korean peninsula - which it defended at enormous human cost in the Korean War. This interest remains in place. China is far more likely to aid and abet a nuclear-armed ally in North Korea than it is to endorse (much less participate in) regime change. The fallout from a new war, such as North Korean refugees flooding into China, is extremely undesirable for China, though it could handle the problem ruthlessly. China would also prefer not to have to occupy a collapsing North, which would be an extensive and dangerous entanglement. Therefore, expect China to twist Pyongyang's arm but not to break its legs. On a more topical note, China is consumed with domestic politics ahead of the nineteenth National Party Congress. It is perhaps more likely to take action after the congress in October-November. Q: Will U.S. allies cooperate with Trump? Why not bandwagon with China to gain economic benefit? A: South Korea is the best litmus test for whether Trump is causing U.S. allies to drift. The new South Korean President Moon Jae-In, who is politically left-of-center, has played his cards very carefully and started out on good footing with President Trump. A disagreement appears to be a likely consequence of Moon's agenda, which calls for extensive engagement with the North and a review of the U.S. THAAD missile defense deployment in Korea. So far, however, Moon is reaffirming the alliance, in his own way, and Trump has not (yet) expressed misgivings about him. If this changes significantly - as in, South Korea joining with China to give North Korea significant economic aid in defiance of U.S. sanctions efforts - then it would be a sign of division among the allies that would benefit North Korea and could even increase the risk of the U.S. taking unilateral action. The odds of that are still low, however. We have been short the Korean won versus the Thai baht since March 1, and the trade is up 6.03%. We also expect greater volatility and higher prices of credit default swaps to plague South Korea while the crisis continues over the coming months. We are closing our long Korean consumer stocks trade versus Taiwanese exporters for a loss of 4.24%. Q: What is Japan's role in the current crisis? What is the impact on Japan? A: Japan is one of the few countries whose relations with the U.S. have benefited under the Trump administration. The Japanese are in lock-step so far in reacting to North Korea. The government has been sounding louder alarms about North Korea for the past year, including by conducting evacuation drills in the case of attack. Japan has long been within range of North Korea's missiles, but its successes in nuclear miniaturization pose a much greater threat. Not only does North Korea pose a legitimate security risk, but Japanese Prime Minister Shinzo Abe also stands to benefit at least marginally in terms of popular support and support for his controversial constitutional revision. This will, in turn, feed into the region's insecurities. Yen strength as a result of the crisis, however, would be a headwind to Japan's economic growth. Thus Abe has a tightrope to walk. We expect him to take actions to ensure the economy continues to reflate. Q: Is Trump rational? How do we know he won't push the nuclear button? A: Ultimately this is unknowable. It also involves one's philosophical outlook. Josef Stalin and Mao Zedong both committed atrocities by the tens of millions but did not use nuclear weapons. Nikita Khrushchev practically wrote the playbook that North Korea's Kim dynasty has used in making its belligerent nuclear threats. Yet Khrushchev ultimately agreed to détente. Kim Jong Un makes Trump look calm. The combination of Kim and Trump is worrisome; but so was the combination of Eisenhower and Khrushchev, one believing nuclear weapons should be used if needed, the other threatening wildly to use them. It may be the case that the threat of an atrocity, or (in Kim's case) of total annihilation, is enough to keep decisions restrained. As we go to press, Kim has ostensibly suspended his plan to fire missiles around Guam and U.S. officials have repeatedly stated that they would not attack unless attacked. Stairway To (Safe) Haven Revisited In expectation of increased frequency of geopolitical risks, BCA's Geopolitical Strategy has produced two quantitative analyses of safe haven assets over the past two years. The first, "Geopolitics And Safe Havens," unequivocally crowned gold as the ultimate safe haven (Table 1), while showing that the USD is not much of a defense against geopolitical events (Chart 5).7 Table 1Safe-Haven Demand Rises During Crises Table 1Safe-Haven Demand Rises During Crises As such, investors should fade the narrative that the failure of the USD to appreciate amidst the latest North Korean imbroglio is a sign of some structural weakness. The greenback continues to underperform due to weak inflation in the U.S., a fleeting condition that our macro-economist colleagues expect to reverse. Mathieu Savary, BCA's currency strategist, believes that more upside exists for the USD regardless of the geopolitical outcome: Chart 5Gold Loves Geopolitical Crises Chart 6DXY Is Cheap... Chart 7...But The Euro Is Not First, the dollar is currently trading at its deepest discount to the BCA Foreign Exchange Service augmented interest rate parity model since 2010 (Chart 6). The euro, which accounts for 58% of the DXY index, is its mirror image, being now overvalued by two sigma, the most since 2010 (Chart 7). Second, bullish euro bets will dissipate as Europe's economic outperformance versus the U.S. fades. Financial conditions have massively eased in the U.S., while they have tightened in Europe, resulting in the biggest upswing on euro area growth relative to the U.S. in over two years (Chart 8). Such an economic outperformance by the U.S. should lead to a strengthening greenback (Chart 9).8 Chart 8Easing Versus Tightening FCI Chart 9PMIs Point To USD Rally Our second attempt to quantify safe-haven assets, "Stairway To (Safe) Haven: Investing In Times Of Crisis," concluded that U.S. Treasurys, Swiss bonds, and Japanese bonds are the best performers in times of crisis.9 We considered 65 assets10 (Table 2) with five different methodologies and back-tested them empirically within the context of 25 financial and geopolitical events since January 1988. Some of these assets have been proven to perform as safe havens by previous academic research, some are commonly utilized in investment strategies, and others could provide alternatives (see Box 1 for further details). Table 2Scrutinizing The World For Safe Havens This report demystifies four key issues related to safe havens: Part I identifies what qualifies as a safe-haven asset. Unsurprisingly, the best performers are U.S. Treasurys along with Swiss and Japanese bonds due to their currency effects. Part II examines if safe havens change over time. We find that gold and Treasurys have changed places as safe havens, and that JGBs and Swiss bonds have a long history as portfolio protectors. Part III breaks down safe havens through an event analysis. We look at the country of origin, the nature of the crisis, and whether the risk is a "black swan" or "red herring" - two classifications of events that BCA's Geopolitical Strategy has established - all of which have an impact on their performance. But red herrings or black swans are only defined after the fact, thus requiring geopolitical analysis or market timing indicators to be able to act on them. Part IV demonstrates that timing plays a crucial part when investing in safe havens as their performance is coincident with that of equities. Box 1 Safe Havens - A Literature Review In a previous Geopolitical Strategy Special Report published in November 2015, it was established that shifts in economic and political regimes alter investors' preferences for safe-haven assets, and that Swiss bonds and U.S. 10-year Treasurys were at the top of that list.11 Also, statistical methods were used to demonstrate that gold had acted as a safe haven from the 1970s to the early 90s, but has since lost its status due in part to a new era of looming deflationary risks. Li and Lucey (2013) have identified a pattern in precious metals, through a series of quarterly rolling regressions testing the significance of the 1st, 5th and 10th percentile movements in U.S. equity movements against safe-haven assets, catching extreme negative events. For instance, the 1st percentile captures the very worst corrections that have occurred, the one that represent the bottom 1% of the equity performances. The 5th and 10th percentiles represent the 5% and 10% lowest returns for equities, respectively. The authors demonstrated that silver, platinum and palladium act as safe havens when gold does not.12 Similarly, Bauer and McDermott (2013) examined the 1st, 5th and 10th percentile movements in U.S. equity movements and proved that both gold and U.S. Treasurys can serve as safe havens, but that gold has the best record in times of extreme financial stress.13 Baele et al. (2015) concentrated on flight-to-safety episodes, which they characterized as events in which the VIX, TED spreads and a basket of CHF, JPY, and USD all increased drastically.14 They found that during flight-to-safety episodes, large cap stocks outperform small caps, precious metal and gold prices (measured in dollars) increase slightly, while bond returns exceed those of the equity market by 2.5-4 percentage points. Baur and Glover (2012) provide further evidence that gold can no longer be utilized as a safe haven due to increased speculation and hedging. Their main finding is that gold cannot be both an investment and a safe-haven asset. That is, gold can only be effective as a safe haven if the periods prior to the event had not generated significant investment demand for gold.15 Using high-frequency exchange rate data, Ranaldo and Soederlind (2010) conclude that the CHF, EUR and JPY have significant safe-haven characteristics, but not the GBP.16 The strongest safe havens are identified as the CHF and JPY, but the returns are partly reversed after a day of safe-haven protection. They also find that the nature of the crisis has a significant effect on safe-haven properties. For instance, a financial crisis and a natural disaster produced drastically different outcomes for the yen. Part I - Safety In Numbers Our first step in identifying safe-haven assets was to review each asset's performance against equities in times of crisis. As such, we conducted a series of threshold regressions to generate a list of true safe-haven assets - assets that have a statistically significant positive performance in times of turmoil. Our method is explained as follows: Step 1 - Percentile Dummies: Following methods from Li and Lucey (2013) and Bauer and McDermott (2013), we created dummy variables for the 1st, 5th and 10th percentile of the S&P 500 daily total returns since 1988. We then multiplied each of these dummies by their corresponding stock returns (see Box 1 for further detail). Step 2 - Regressions: Using the 64 potential safe-haven assets, we ran a series of regressions both in USD and the local currency, testing each asset's returns explained by the three percentile dummies.17 Step 3 - Identifying Safe Havens: We then quantified strong safe-havens as assets having significant coefficients for all three return thresholds (1st, 5th and 10th percentile of the S&P 500 daily total returns). Results - Seek Refuge In Currencies And Government Bonds: Our quantitative results are mainly consistent with what others have found in the past: the Japanese yen and most G10 government bonds are safe havens. Table 3 shows the safe-haven assets that generated negative coefficients versus equities for all three threshold percentiles. Table 3Seeking Protection Against Corrections In our threshold regressions expressed in USD terms, we found that the Japanese yen, Quality Stocks,18 and Japanese, Swiss and U.S. bonds acted as strong safe havens. Currencies play a crucial part in the performance of safe havens. In fact, in local-currency terms, a series of G10 government bonds (U.S., Canada, Belgium, France, Germany, Netherlands, Sweden, Switzerland, and the U.K.) proved to be the most useful safe havens. In sum, true or strong safe havens are government bonds that have currencies that add to positive returns during times of crisis. Unsurprisingly, this select group of strong safe-haven assets is comprised of U.S., Japanese, and Swiss government bonds. Quality Stocks did provide positive and statistically significant results, but the returns were very low - for this reason, we excluded them from our basket of strong safe havens. While gold, the Swiss franc, and the U.S. dollar did generate positive returns during times of crisis, they failed to generate statistically significant results at all three thresholds. Bottom Line: Based on our econometric work, most G10 government bonds can act as safe havens. But due to strong currency effects, our models favor what are already commonly known as safe havens: U.S., Japanese, and Swiss government bonds. Simply put, the difference between this select group and other G10 bonds is that their currencies rise or are stable during turmoil, while the currencies of the other G10 bonds do not. Part II - Are Safe Havens Like Fine Wines? U.S., Japanese, and Swiss government bonds were not always the top assets providing protection against the downside in equities, however. To determine whether safe-haven properties change, we examined the evolution of the relationship between safe havens and U.S. equity markets over time with the following model: Step 1 - Rolling Regressions: Considering the results obtained in Part I, we restricted our sample to G10 governments in USD and local-currency terms, Quality Stocks, gold, JPY, EUR, and USD for this statistical procedure. We put these remaining assets, both in USD and local-currency terms, through a series of 1-year rolling regressions.19 Step 2 - Identifying Trends: Each regression generated a coefficient that explained the relationship between equities and safe havens (B1). We created a new time series by collecting the coefficients for each data point and smoothing them using a five-year moving average, thus depicting a long-term pattern in the evolution of safe havens. Results - A Regime Shift In Gold And Treasurys: Our findings show that safe-haven assets fall in and out of favor through time (Charts 10A, B & C). Most striking are the changes in U.S. Treasurys and gold. Only after 2000 did Treasurys start providing a good hedge for equity corrections. The contrary is true for gold - it acted as one of the most secure investments during corrections until that time, but has since become correlated with S&P 500 total returns. That said, gold's coefficient has been falling closer to zero lately, illustrating that it could soon resurface as a proper safe haven, especially if deflation risks begin to dissipate. Given that this is precisely the conclusion stated by our colleague Peter Berezin - BCA's Chief Global Strategist - and our own political analysis, we suspect that gold may be resurrected as a safe haven very soon.20 Chart 10ASafe Havens Don't Necessarily Age Well Chart 10BSafe Havens Don't Necessarily Age Well Chart 10CSafe Havens Don't Necessarily Age Well Another important finding is that the currency effect plays a key role during recent risk-off periods (Charts 11A & B). The best protector currencies are the ones that are negatively correlated with equity returns. According to our results, the CHF and the JPY have generally been risk-off currencies, while the USD has only been one since 2007, switching places with the euro. This reinforces the case for U.S., Japanese, and Swiss government bonds, which are supported by risk-off currencies. Chart 11ACurrencies Are Difference Makers Chart 11BCurrencies Are Difference Makers Bottom Line: Safe havens change over time. Gold fell out of favor due to global deflationary dynamics. With inflation on the horizon, we will keep monitoring the relationship between gold and equities for a possible return of the yellow metal as a safe haven. Since the July 4 North Korean ICBM test, for example, gold has rallied 4.8%. Part III - Red Herrings And Black Swans Since 1988, we identified 25 economic and (geo)political events that generated instant panic or acute uncertainty in the media and financial markets.21 We analyzed the short-term reactions of the safe-haven assets, both in USD and local-currency terms. This methodology allowed for the deconstruction of the impact of the events by the following factors: Country of origin of the crisis, the nature of the crisis, and whether the event was a "red herring" or a "black swan." Generally speaking, a red herring event is a crisis of some sort with little lasting financial impact. A black swan, on the other hand, is an event that has a very low probability of occurring but has a pronounced market impact if it does. Quantitatively, our definition of a black swan is an event that produces an immediate negative response in the S&P 500 below -1%, while creating a rise in either U.S., Japanese, or Swiss government bonds above 0% (Table 4). Of course, determining which event is a red herring or a black swan is only obvious post-facto and thus requires thorough geopolitical analysis. Table 4Understanding The Crises Results - Red Herrings And Black Swans Matter: Our event analysis solidifies our findings with regards to U.S., Japanese, and Swiss government bonds, but also builds a case for some European bonds as well as gold during black swan events. Our main findings can be summarized as follows. Fade The Red Herrings: Out of the sixteen geopolitical events, ten were identified as red herrings, in which safe havens underperformed the equity market. This, then, suggests that it is not always beneficial to buy safe-haven assets when tensions are rising. What is interpreted as a major geopolitical crisis - say, Ukraine in 2014 or Greece in 2015 - often ends up being a "red herring." Geopolitical Risk = Gold: Geopolitical black swan events, on the other hand, have a significant, negative impact on the market. During these events, gold emerges as the strongest hedge against a downturn in equities. U.S. Treasurys And The Swiss Franc Provide A Baseline: Under all black swan events considered - geopolitical and non-geopolitical - U.S. Treasurys and the Swiss franc had the strongest performance, generating positive returns on the day of the stock market crash in 85% of the cases. G10 Government Bonds Will Also Do: German, Dutch, Swiss and Swedish government bonds also provided protection during black swan events in local and common-currency terms, albeit to a lesser extent. U.S. And Swiss Bonds Outperform During Financial Episodes: During black swan financial crises, Swiss and U.S. government bonds stand out as the best safe havens due to their capacity to generate positive returns both in USD and local-currency terms in eight out of the nine examined crashes. Other findings that are interesting, yet less robust due to a limited sample size, include: When the crisis originated on U.S. soil, U.S. Treasurys and the dollar performed relatively poorly compared to other safe-haven assets. This is a somewhat surprising finding, as most investors believe that U.S. assets rally even at a time of U.S.-based crises, such as the 2011 budget crisis. We show that they may perform well, but in USD, non-U.S. based assets do better. When the crisis originated in Europe, European bonds performed very well both in USD and local-currency terms. When the crisis originated in Europe, Swiss and U.K. government bonds performed poorly in USD terms, but offered strong protection in local-currency terms. When the crisis originated in Russia, precious metals acted as a poor hedge. Bottom Line: It is crucial to gain an understanding of the nature of any potential crisis. Red herrings should always be faded, not hedged against, as they produce poor results in safe-haven assets. U.S. Treasurys, Swiss and Japanese government bonds have been very consistent safe-haven assets during previous periods of acute risk. Part IV: Timing Is Everything As a final step in our quantitative approach, we put our results through numerous timing exercises to test how the assets would perform in real time. Based on our Risk Asset Spectrum (Diagram 1), which summarizes our findings, one could argue that investing in times of crisis simply boils down to buying an equal-weighted basket of U.S. Treasurys, Swiss, and Japanese government bonds. Although this is technically true, such a strategy would require perfect foresight, unparalleled timing, or dumb luck - since black swan events are, by definition, very difficult to predict. Diagram 1Risk Asset Spectrum Proof Of The Ultimate Safe Haven: The first experiment we conducted was to illustrate how powerful safe havens can be when timed perfectly in a trading strategy. We started off by comparing two baskets. The first was a benchmark portfolio comprised of 60% U.S. equities and 40% U.S. bonds. The other contained the same two assets, but with 100% allocated to a basket comprised of U.S. Treasurys, Swiss, and Japanese government bonds during times of negative returns for equities. Of course, this strategy is not realistic and would be impossible to implement, since the trading rule depends on future events. But as Chart 12 shows, if one were able to predict every single period of negative returns for global equities and hold safe-haven assets instead, the trading rule would outperform almost 10-fold. Chart 12Safe Havens Work Wonders With Perfect Information... One-Month Lag Is Already Too Late: Repeating the same exercise, but with a one-month lag in the execution, produces drastically different results. More specifically, whenever the previous month's equity return is negative (t=0), the portfolio allocates 100% to a single safe-haven asset for the current month (t=1), otherwise it keeps the allocation identical to that of the benchmark. The rationale for using such a simple rule is that average investors are generally late in identifying a crisis and only react once they have validation that the market is in a correction. Chart 13 shows that being late by one month changes the performance of the safe haven basket from astronomically outperforming the benchmark to underperforming it. Chart 13... But Timing Is Everything Reaction Is Key: As a final timing exercise, we analyzed the reaction function of our assets to see how quickly they react after the correction in equities begins (Chart 14). Unsurprisingly, the top assets that we identified start appreciating as soon as the crisis hits (t=0). Gold is, on average, the quickest asset to react from investors seeking refuge. Swiss bonds come in as a close second, almost mirroring gold during the first few days of the correction. But both assets start to flatten out and even roll over after a few days. Japanese bonds react slightly later than gold and Swiss bonds, but keep increasing for a longer period of time and start plateauing around the 30th day after the crisis. U.S. Treasurys and Quality Stocks, on the other hand, remain rather flat and constant over the short term. These results attest to the importance of timing the crisis using the best safe-haven assets. Chart 14Safe Havens React Instantly Bottom Line: Timing plays a crucial part in investing in safe-haven assets, as their performance is coincident to that of equities. Investment Implications: Is Pyongyang A Red Herring Or A Black Swan? The results of our quantitative analysis are clear: hedging geopolitical risk depends on whether it is persistent or fleeting. So, is Pyongyang a red herring or a black swan? From our geopolitical analysis we make three key conclusions: The U.S. is not likely to preemptively attack North Korea; However, the U.S. has an interest in signaling that it may conduct precisely such an attack; Brinkmanship could last for a long time. Even if the risk of a U.S. attack against North Korea itself is a red herring, the crisis itself is not. In fact, between now and when a negotiated solution emerges, investors may face several new crises, which may include limited military attacks or skirmishes. While markets have faded such North Korean provocations in the past, the current context is clearly different. As such, we would suggest that investors hedge the risk with an equally-weighted basket of Swiss bonds and gold. Even though a "buy and hold" strategy with such a "Doomsday Basket" will likely underperform the market if tensions with North Korea subside, we are betting that it may take time for the U.S. and North Korea to get to the negotiating table. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com David Boucher, Associate Vice President Quantitative Strategist davidb@bcaresearch.com 1 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "The Geopolitics Of Trump," dated December 6, 2016, available at gis.bcaresearch.com. We upgraded North Korea to the status of a genuine market-relevant risk in "North Korea: A Red Herring No More?" in Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Client Note, "Trump Re-Establishes America's 'Credible Threat'," dated April 7, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2017 available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0," dated September 25, 2012, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. In particular, we argued, "the current saber-rattling is carefully orchestrated. But North Korea can no longer be consigned to the realm of satire. The very fact that the U.S. administration is adopting greater pressure tactics makes this year a heightened risk period. Investors should be especially wary of any missile tests that reveal North Korean long-range capabilities to be substantially better than is known to be the case today." Then, on May 13 and July 4, North Korea conducted its first ICBM launches; the UN Security Council agreed to a new round of even tighter economic sanctions on August 5; and the U.S. and North Korea engaged in an alarming war of words. 6 Specifically, we wrote: "Diplomacy is the only real option. And in fact it is already taking shape. The theatrics of the past few weeks mark the opening gestures. And theatrics are a crucial part of any foreign policy. The international context is looking remarkably similar to the lead-up to the new round of Iranian negotiations in 2012. The United States pounded the war drums and built up the potential for war before coordinating a large, multilateral sanctions-regime and then engaging in talks with real willingness to compromise." 7 Please see BCA Geopolitical Strategy Special Report, "Geopolitics And Safe Havens," dated November 11, 2015, available at gps.bcaresearch.com. 8 Please see BCA Foreign Exchange Strategy Weekly Report, "Fade North Korea, And Sell The Yen," dated August 11, 2017, available at fes.bcaresearch.com. 9 Please see BCA Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com. 10 Forty-one assets were denominated in USD only, while G10 bonds, Credit Suisse Swiss Real Estate Fund, and European 600 real estate were used both in local-currency terms and USD, for a total of 65 assets. 11 Please see Geopolitical Strategy Special Report, "Geopolitics And Safe Havens," dated November 11, 2015, available at gps.bcaresearch.com. 12 Sile Li and Brian M. Lucey, "What precious metals act as safe havens, and when? Some U.S. evidence," Applied Economic Letters, 2013. 13 Dirk G. Bauer and Thomas K.J. McDermott, "Financial Turmoil and Safe Haven Assets," 2013. 14 Lieven Baele, Geer Bekaert, Koen Inghelbrecht and Min Wei, "Flights to Safety," National Bank of Belgium Working Paper No. 230, 2015. 15 Dirk G. Baur and Kristoffer J. Glover, "The Destruction of Safe Haven Asset?,"2012. 16 Angelo Ranaldo and Paul Soederlind, "Safe Haven Currencies," Review of Finance, Vol. 10, pp. 385-407, 2010. 18 Quality stocks are defensive equity plays with high, steady earnings with an elevated return on investments. They are estimated by Deutsche Bank's Factor Index Equity Quality Excess Return in USD. 20 Please see BCA Geopolitical Strategy Monthly Report, "Throwing The Baby (Globalization) Out With The Bath Water (Deflation)," dated July 13, 2016, available at gps.bcaresearch.com, and BCA Global Investment Strategy Weekly Report, "A Secular Bottom In Inflation," dated July 28, 2017, available at gis.bcaresearch.com. 21 Since we were interested in the immediate, often unexpected, response to the event, we did not include economic recessions in our event analysis.

Special Report

Highlights GFIS Portfolio: The GFIS model bond portfolio has lagged its benchmark index since inception last September and since our previous performance update in April. All of that underperformance can be accounted for this month, however, given the risk-off moves seen in global financial markets. As investors begin to shift their attention away from the current geopolitical blustering over North Korea and back towards the solid global economic upturn, our current tilts should begin to outperform again. Risk Management: We have successfully raised the amount of overall portfolio risk (tracking error) since our last portfolio performance update in April. The tracking error remains below our self-imposed limit of 100bps, however, giving us the ability to make further adjustments to our tilts as opportunities arise. Tactical Overlay: Our Tactical Overlay trades have delivered a positive average return over the past year, led by the current open trades that have produced an average gain of +30bps. Feature In this Special Report, we are presenting a performance update for our Global Fixed Income Strategy (GFIS) model bond portfolio. We did the first such update back in mid-April, and we will continue to publish periodic portfolio reviews going forward. As a reminder to our readers, the GFIS model portfolio is intended to be a tool for us to both communicate and evaluate our fixed income investment recommendations. By putting actual weightings to each of our country and sector calls, against a bond benchmark index with an overall portfolio risk limit, we are aiming to express the convictions of our views in a manner more in line with the actual day-to-day portfolio trade-offs faced by bond managers. The model portfolio is a relatively new addition to the GFIS service, starting only in September 2016, thus the return history is still limited. We have built out several pieces of the GFIS model portfolio framework over the past year, and the process is nearing completion. We now have a custom performance benchmark index that reflects the universe of fixed income sectors that we regularly cover in GFIS (essentially, the Bloomberg Barclays Global Aggregate Index plus riskier fixed income classes like High-Yield corporates). We also have performance measurement metrics and a way to regularly present the portfolio returns, while we have also added a risk management (tracking error) element to help size our relative tilts. The final piece will be to incorporate our corporate bond sector recommendations within the model portfolio, both as a source of potential return and a use of our risk budget (tracking error). We intend to add that final element in the coming weeks. Overall Performance Review: Winners & Losers Chart 1GFIS Model Portfolio Performance As of August 11th, the GFIS model portfolio has produced a total return of +0.93% (hedged into U.S. dollars) since inception on September 20, 2016 (Chart 1). This has underperformed our custom benchmark index by -14bps. Since our last performance review on April 18th, the model portfolio has lagged the benchmark by -10bps. The portfolio has suffered in the risk-off environment seen so far in August, with a -14bp underperformance seen month-to-date, equal to the entire underperformance since inception. Our core structural positions of maintaining a below-benchmark duration stance, while staying underweight government bonds versus overweight spread product, have all suffered of late (bottom two panels). Our government bond country allocation has been the biggest overall drag on returns (Table 1) since last September (-26bps versus our benchmark). Japan (+5bps) and Spain (+3bps) have been the biggest positive contributors since inception, while Italy, the U.K. and France have a combined underperformance of -31bps. That more than accounts for the entire underperformance of the government bond sleeve of the model portfolio since inception (Chart 2). Since our last portfolio update in April, our government bond allocations have lagged our benchmark index by -29bps. Small gains in Spain and Germany (+2bps each) have been dwarfed by underperformance in the U.S. (-16bps), Italy (-10bps) and France (-5bps). Across almost every country, our below-benchmark duration positioning has translated into a bear-steepening yield curve bias, as we have been recommending substantially reduced exposure to the 10+ year maturity buckets in the major countries (U.S., Germany, France, Italy, and Japan). The bull-flattening of global yield curves between March and June, led by a downturn in inflation expectations, was more than large enough to offset any of the potential benefits from our country allocation. Yield curves did began to bear-steepen in July after the European Central Bank (ECB) sent signals that a tapering of its asset purchase program next year was increasingly likely. That move has quickly reversed this month, however, as financial markets have shifted to a risk-off stance on the back of rising geopolitical tensions on the Korean Peninsula. Table 1A Detailed Breakdown Of The GFIS Model Portfolio Chart 2GFIS Model Portfolio Government Bond Performance Attribution By Country The news is better with regards to our global spread product allocations. Those have delivered a total return of +1.41% since last September (beating the benchmark by +12bps) and +0.98% since the last performance review in April (+19bps versus the benchmark). Our allocations to U.S. Investment Grade (IG) and High-Yield (HY) have combined for a +30bps outperformance since September and a +23bps outperformance since April (Chart 3). Euro Area corporate debt has been a modest drag, with the combined allocation to IG and HY debt underperforming by -7bps since September and -3bps since April. Emerging Market corporate debt contributed -2bps of underperformance, while U.K. IG corporates added +1bp of excess return. Chart 3GFIS Model Portfolio Spread Product Performance Attribution Among other spread sectors, U.S. Mortgage-Backed Securities (MBS) have generated a -12bps contribution to our excess return, although this entirely came from a period immediately after the inception of our model portfolio (Sept-Nov 2016) where we briefly moved to a tactical overweight stance. We have since maintained a structural underweight posture on U.S. MBS, but this has barely generated any relative performance (-1bp) since our last portfolio review in April. Net-net, the GFIS model portfolio has generally performed in line with where our recommendations are concentrated, both in absolute terms and on a relative basis between sectors. Our below-benchmark stance on overall duration has suffered as the government bond yield curves have exhibited more volatility than trend. At the same time, our structural overweights on global corporate debt, favoring the U.S. over non-U.S. equivalents, have contributed positively to the overall portfolio performance. In Charts 4-7, we show the relative performance of some individual countries and sectors that are part of our GFIS benchmark index. We specifically singled out our major asset allocation calls between sectors made over the past year, with a vertical line drawn at the date when the change was recommended. The data shown in all three charts is the relative performance of each tilt on a duration-adjusted basis and (where applicable) hedged back into U.S. dollars, indexed to 100 at the date of implementation in our model portfolio. Shown this way, we can evaluate the success of the timing of our calls. Our shift to an overweight stance on U.S. corporate debt versus U.S. Treasuries both for IG and HY in the first quarter of this year can be judged a success both in terms of timing and magnitude, with IG outperforming Treasuries by 217bps and HY outperforming by 826bps (Chart 4). Within our HY allocation, we left some performance on the table by concentrating our overweights on the higher-rated credit tiers (bottom panel), but this was a move we felt comfortable with (and still do) as a way of staying a bit up in quality at a time when lower-rated spreads were looking fully valued. In terms of our cross-Atlantic credit allocation, we shifted to an overweight stance on U.S. corporates versus Euro Area equivalents back on January 31st of this year (Chart 5). Since then, U.S. IG has underperformed Euro Area IG by -142bps, but U.S. HY has outperformed by a much larger 581bps. Taken together, these positions have contributed positively to the overall performance of the model portfolio. We continue to like U.S. corporates over Euro Area corporates from a valuation standpoint, thus we are keeping this tilt in the portfolio. Chart 4Our Overweights On##BR##U.S. Corporates Have Done Well Chart 5Our Combined Tilt Towards##BR##U.S. Corporates Has Outperformed With regards to our other major spread sector tilts, our shift to an underweight stance on U.S. MBS versus Treasuries back in November has essentially been a wash (Chart 6). Looking ahead, the combination of unattractive valuations and, more importantly, reduced buying of Agency MBS by the Federal Reserve as it begins to shrink its balance sheet will weigh on MBS performance in the next 6-12 months - we are staying underweight. At the same time, we are maintaining our long-held overweight stance on U.K. IG corporates versus Gilts (bottom panel). The Bank of England will be keeping interest rates unchanged over the next year given mixed readings on U.K. economic growth and the lingering uncertainties over the Brexit negotiations, thus going for the added carry of corporates versus expensive Gilts still makes sense. As for our cross-country government bond allocations, our underweight stance on Italy versus Spain, and our overweight stance on Japan versus Germany, have been volatile while delivering no excess performance (Chart 7). Chart 6Sticking With Our Tilts On##BR##U.S. MBS & U.K. IG Chart 7Our Cross-Country Government Bond##BR##Tilts Have Been Volatile Looking ahead, we continue to expect the global growth backdrop to be supportive of spread product over government debt over the next 6-12 months, particularly with central banks unlikely to shift to a restrictive monetary stance. At the same time, we should soon begin to claw back some of the underperformance of the government bond sleeve of the GFIS model portfolio coming from our below-benchmark duration stance, for several reasons: Our colleagues at BCA's Geopolitical Strategy service do not expect the current standoff between Pyongyang and Washington to devolve into a shooting war, even though the tough talk on both sides will likely continue for some time. As the military tensions begin to subside, this should reverse some of the safe-haven bid for government bonds seen in the past couple of weeks, causing yields to drift higher. The solid global growth backdrop, confirmed by the still-rising trend in leading economic indicators, will continue to force central banks to slowly shift to a less dovish policy stance. U.S. inflation will begin to rebound in the next few months, led by the lagged impact of the U.S. dollar weakness seen in 2017 and continued tightening of the U.S. labor market. This will prompt the Fed to hike rates in December and deliver more hikes in 2018, which is NOT currently priced into U.S. Treasuries. We expect the ECB to soon signal a reduction of the size of its asset purchase program starting in 2018, which will put upward pressure on core Euro Area bond yields, and widen Peripheral European spreads, as the market moves to price in a smaller amount of future bond supply that will be absorbed by the central bank. The combination of modest increases in global inflation, a rebound in investor risk sentiment, and an ECB taper announcement should all place bear-steepening pressures on developed market yield curves (ex-Japan). This will benefit the curve-steepening bias we have in the U.S., Euro Area and U.K., while also supporting our country allocation of a maximum overweight to low-beta Japanese Government Bonds (JGBs). Net-net, we see no reason to alter any of current portfolio tilts at the moment based on any change in our market views. Bottom Line: The GFIS model bond portfolio has lagged its benchmark index since inception last September and since our previous performance update in April. Our overweight credit allocations have performed well but our below-benchmark duration tilts have not. All of that underperformance can be accounted for this month, however, given the risk-off moves seen in global financial markets. As investors begin to shift their attention away from the current geopolitical blustering over North Korea and back towards the solid global economic upturn, our current tilts should begin to outperform again. A Very Brief Comment On Our Risk Management Framework In our prior portfolio update in April, we noted that the initial sizes we placed on the tilts in the GFIS model portfolio proved to be far too small to generate any meaningful outperformance.1 After that, we increased the sizes of our all our existing positions in the portfolio. We later introduced a "risk budget" into our framework that would allow us to measure the tracking error (excess volatility versus the GFIS benchmark index) of our portfolio to ensure that we were taking adequate levels of risk.2 So far, our changes have had the desired effect of raising the tracking error of the portfolio to more realistic levels to try and generate outperformance. The average allocations to our government bond underweights and our spread product overweights have increased since that April portfolio review (Chart 8). This has helped raise the tracking error of the model portfolio to 61bps from 25bps in April (Chart 9). This is still below our risk limit of 100bps of tracking error, giving us room to add positions to the model portfolio if we see opportunities come up. Chart 8We've Increased The Sizes Of##BR##Our Tilts Since April ... Chart 9...Which Has Boosted The Tracking##BR##Error Of The Model Portfolio Bottom Line: We have successfully raised the amount of overall portfolio risk (tracking error) since our last portfolio performance update in April. The tracking error remains below our self-imposed limit of 100bps, however, giving us the ability to make further adjustments to our tilts as opportunities arise. Tactical Overlay Bets Have Been Helpful In addition to our GFIS model bond portfolio, we also are running recommended trades in our Tactical Overlay portfolio. These are positions that typically have a shorter-term investment time horizon (0-6 months) than those in the model portfolio. They can also be in less-liquid markets that are not included in the custom bond benchmark index for the model portfolio, like U.S. TIPS or New Zealand government bonds. The Overlay is intended to produce ideas for more tactical traders than portfolio managers, although the trades can also be viewed as a compliment to the model bond portfolio. The performance of our Tactical Overlay can be seen in Table 2 (for our current open trades) and Table 3 (for our past closed trades). We have shown the trade performance going back to the inception date of our model bond portfolio in September 2016, to facilitate apples-for-apples comparisons. We are currently working on developing a trade sizing and risk management framework along the lines of our model portfolio. For now, we can only present average return numbers and not a meaningful cumulative return measure. Table 2The Current Open GFIS Tactical Overlay Trades Are Performing Well Table 3The Closed GFIS Tactical Overlay Trades Have Been A Mixed Bag Our closed Overlay trades since last September generated only an average total return of a mere +1bp, but this weighed down by a large losing position on shorting Portuguese government bonds versus German Bunds. The average trade return would have been +21bps, on fifteen closed trades, excluding that Portuguese bet. The notable winners were long positions in 10-year French government bonds versus German Bunds (+130bps), a long position on Australian Semi-Government debt versus Federal government debt (+159bps) and a long positon on Korean 5-year government bonds vs. 5-year JGBs on a currency-unhedged basis (+195bps). The other notable loser besides the Portuguese trade was a failed long position on Japanese CPI swaps (-111bps). The current open Overlay trades have performed much better, delivering an average gain of +30bps. 14 of the current 16 open trades have a positive gain, thus the batting average is solid. Notable winners are an overweight on U.S. TIPS versus U.S. Treasuries (+197bps) and our Canada/U.K. 2-year/30-year yield curve box trade (+110bps). The only serious losing trade at the moment is our long position in 5-year New Zealand government bonds versus 5-year German debt (-123bps), although this is the only trade in the table that is currency UN-hedged and is a bet on a stronger New Zealand dollar versus the euro as well as a relative bond spread trade. Net-net, our Tactical Overlay trades have generated a positive average return since last September. In the next few months, we will look to introduce a weighting scheme and risk budget for the Overlay trades to better present these trades as a true complement to our model bond portfolio. Bottom Line: Our Tactical Overlay trades have delivered a positive average return over the past year, led by the current open trades that have produced an average gain of +30bps. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Special Report, "An Initial Look At The Performance Of Our Model Bond Portfolio", dated April 18th 2017, available at gfis.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Special Report, "Adding A Risk Management Framework To Our Model Bond Portfolio", dated June 20th 2017, available at gfis.bcaresearch.com. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Appendix - Selected Sectors From The GFIS Model Portfolio

Highlights Duration: An environment characterized by strong global growth and a weak dollar is very bearish for U.S. bonds. According to our model, fair value for the 10-year Treasury yield is 2.6%. Stay at below-benchmark duration. The Fed & The Dollar: A weak dollar eases financial conditions and supports higher core goods inflation. All else equal, this will strengthen the Fed's hawkish resolve in the near term. However, a rebound in core services (excluding shelter and medical care) inflation will be necessary for core inflation to reach the Fed's target on a sustained basis. USD Sovereigns: USD-denominated sovereigns are not attractive compared to domestic Baa-rated U.S. credit. At the country level, Finland, Mexico and Colombia offer the most attractive spreads and Finnish debt offers the best risk/reward trade-off. Feature Please note there will be no U.S. Bond Strategy report next week. Our regular publishing schedule will resume on August 29, 2017. Chart 1Firm Growth, Despite Weaker $ Escalating tension between the U.S. and North Korea captured the market's attention during the past week, causing investors to ignore what in our view is a more important economic development: Global growth has managed to stay firm even in the face of significant dollar depreciation. Not only does this break the pattern of the past few years when periods of substantial dollar weakness were associated with slowing global growth (Chart 1), but in our view it sends a very bearish signal for U.S. bonds. Above all else, a weak dollar amidst strong global growth suggests that the breadth of the economic recovery is improving. This intuition is confirmed by the fact that our Global Manufacturing PMI Diffusion Index, which measures the net percentage of countries with PMIs above the 50 boom/bust line, is fast approaching 90% (Chart 2). Not only that, but PMIs from the four most important economic blocs are all showing signs of strength. Both the Eurozone and Japanese PMIs are holding firm at high levels, while the U.S. and Chinese PMIs have recently reversed their year-to-date downtrends (Chart 2, bottom two panels). Why is the breadth of the global recovery important? Precisely because a more synchronized recovery prevents the dollar from appreciating too quickly. All else equal, a stronger dollar causes investors to reduce their forecasts for future U.S. growth and inflation. This implies a slower expected pace of rate hikes and lower Treasury yields. Conversely, a weaker dollar causes investors to revise up their growth and inflation forecasts, leading to a quicker expected pace of rate hikes and higher yields. To capture the importance of both global growth and the exchange rate we turn to our 2-factor Treasury model (Chart 3). This is a simple model of the 10-year Treasury yield based on the Global PMI and bullish sentiment toward the dollar. A stronger Global PMI pressures the model's fair value higher, as does increasingly bearish dollar sentiment. Chart 2Synchronized Global Growth Chart 310-Year Treasury Yield Fair Value At present, the model pegs fair value for the 10-year Treasury yield at 2.6%, meaning the current 10-year Treasury yield of 2.22% is 38 bps below fair value. This is the most expensive Treasuries have appeared on our model since the immediate aftermath of last year's Brexit vote. Political Uncertainty & Flights To Quality While our 2-factor model does a good job, there is one important driver of Treasury yields it does not capture. That is the tendency for political events to drive a flight to safety into Treasuries (Chart 4). Typically, if it is possible to identify a purely politically-driven flight to safety - one that is unlikely to exert a meaningful economic impact during the next 6-12 months - then the correct strategy is to heed our model's message and position for higher yields. This strategy worked out perfectly following the Brexit vote, and we anticipate it will work again this time around. Chart 4Policy Uncertainty Is A Driver Of Bond Yields With regards to the catalyst for last week's flight to safety, our Geopolitical Strategy service wrote in a recent Special Report1 that a pre-emptive strike by the U.S. on North Korea is extremely unlikely. The theatrics of the past week demonstrate only that the U.S. needs to establish a "credible threat" if it wants to eventually open a new round of negotiations over North Korea - not unlike the Iranian nuclear negotiations of the past decade. Looking further down the road, if those talks eventually fail then the potential for military conflict is high. We therefore conclude that there is not much potential for U.S. / North Korean tensions to exert a meaningful economic impact during the next 6-12 months, and view the recent bond rally as an opportunity to position for sharply higher yields in the near-term. Bottom Line: An environment characterized by strong global growth and a weak dollar is very bearish for U.S. bonds. According to our model, fair value for the 10-year Treasury yield is 2.6%. Stay at below-benchmark duration. How The Fed Views A Weaker Dollar Financial Conditions Chart 5Weak $ Eases Financial Conditions The Fed views the 7% year-to-date depreciation of the dollar as a significant easing of financial conditions. In fact, most broad indicators of financial conditions have eased this year, even though the Fed has lifted rates by 75 bps since December (Chart 5). In the Fed's framework, this means that the pace of rate hikes might need to increase in order to tighten financial conditions as much as desired. New York Fed President William Dudley summed up this approach in a 2015 speech:2 All else equal, if financial conditions tighten sharply, then we are likely to proceed more slowly. In contrast, if financial conditions were not to tighten at all or only very little, then - assuming the economic outlook hadn't changed significantly - we would likely have to move more quickly. In the end, we will adjust the policy stance to support financial market conditions that we deem are most consistent with our employment and inflation objectives. Of course, all else is not equal. Core inflation has disappointed so far this year and our current assessment of monetary policy is that while the Fed will take action to start shrinking its balance sheet next month, rate hikes are on hold until inflation turns higher. We remain optimistic that inflation will show sufficient strength in time for the Fed to lift rates in December.3 Inflation Chart 6Weak $ = Higher Inflation A weaker dollar also increases the Fed's confidence that inflation will head higher. Although so far we have not seen much evidence that this is occurring. Last Friday's July CPI report showed that core CPI rose only 0.1% month-over-month, while the year-over-year growth rate held flat at 1.7%. However, evidence is mounting that core inflation will soon put in a bottom. Our CPI diffusion index bounced back into positive territory in July (Chart 6) and our PCE diffusion index is at its highest level since last October.4 Both of these measures have excellent track records capturing the near-term swings in core inflation. The year-to-date weakness in the dollar has led to a surge in import prices. Stronger import prices will soon translate into higher core goods inflation (Chart 6, panels 2 and 3). Unfortunately, any increase in core goods inflation is unlikely to be sustained beyond the next 12 months. If the year-to-date dollar weakness starts to reverse, as our currency strategists anticipate,5 then import prices will decline anew. Eventually, this will translate into a deceleration in core goods inflation. For core inflation to sustainably reach the Fed's target, improvement in the lagging core services (excluding shelter and medical care) component will be required. Historically, this component is the most tightly linked to wage growth (Chart 6, bottom panel). A Rising Wage Growth Environment Two related methods do an excellent job predicting the direction of wage growth on a cyclical horizon. First, wages accelerate when the unemployment rate is falling, and second, wages accelerate when the prime-age (25-54) employment-to-population ratio is increasing. The top two panels of Chart 7 show the relationship between wage growth and the unemployment rate. The shaded regions in both panels correspond to periods when the unemployment rate is falling. As can be seen, wage growth always rises during these periods. That being the case, we calculate that non-farm employment needs to grow by more than 125k per month (on average) for the unemployment rate to continue its downtrend, assuming the labor force participation rate remains flat. Chart 7A Rising Wage Environment Of course it is not guaranteed that the labor force participation rate will stay flat. In a recent report we discussed the risk that a large cyclical increase in the participation rate might cause the unemployment rate to rise even as the economy continues to recover.6 This is why we also look at the shaded regions in the bottom two panels of Chart 7 and see that wages always rise during periods when the prime-age employment-to-population ratio is rising. By looking at the employment-to-population ratio instead of the unemployment rate we do not need to make an assumption about the trend in labor force participation. Using this method, we calculate that monthly employment growth must exceed 140k (on average) for the prime-age employment-to-population ratio to keep increasing. Non-farm payroll growth has averaged 184k per month so far in 2017 and averaged 187k per month in 2016. In other words, the U.S. jobs machine is running at a fairly steady pace, well above the thresholds we see as necessary for the recovery in wage growth to continue. Bottom Line: A weak dollar eases financial conditions and supports higher core goods inflation. All else equal, this will strengthen the Fed's hawkish resolve in the near term. However, a rebound in core services (excluding shelter and medical care) inflation will be necessary for core inflation to reach the Fed's target on a sustained basis. Sovereigns Not Buying The Weak Dollar USD-denominated sovereign bonds should benefit from a falling dollar. A weaker U.S. dollar makes the debt obligation cheaper in the issuing nation's local currency. However, the USD Sovereign index has actually underperformed the duration-matched Baa U.S. Credit index during the past six months, despite a depreciating U.S. currency (Chart 8). The duration-matched Baa-rated U.S. Credit index is the closest comparable we can find for the Sovereign index. It matches the Sovereign index in terms of duration and average credit rating, although historically it also delivers less excess return volatility (Chart 8, bottom panel). The two main factors we consider when deciding whether to add USD-denominated sovereigns to our portfolio at the expense of domestic U.S. credit are relative valuation and the outlook for the dollar. Historically, spread differential has been an important driver of relative returns. Attractive starting valuations even allowed sovereigns to outperform credit in 2014 and 2015 despite the dollar's surge. But at the moment, relative value is skewed heavily in favor of domestic U.S. credit (Chart 8, panel 1). Chart 8Sovereigns Too Expensive Added to that, with U.S. growth likely to remain strong and U.S. inflation poised to rebound, we think there is a high likelihood that the Fed will deliver more rate hikes than are currently priced in. This will make it difficult for the dollar to decline further from current levels. Taken together, poor relative valuation and a bullish outlook for the dollar lead us to continue underweighting USD-denominated sovereigns in our portfolio. The Sovereign Index: Country Breakdown Even though the overall index is unappealing, opportunities might still exist at the country level. Chart 9 shows a risk/reward picture for each country in the Bloomberg Barclays Sovereign index. The upper panels show the option-adjusted spread for each country relative to its duration and credit rating. The lower panels show a risk-adjusted spread on the y-axis. This risk-adjusted spread is the excess spread that remains after we adjust for differences in credit rating and duration using a cross-sectional model. What sticks out immediately is that Finland, Colombia and Mexico all offer compelling spreads after adjusting for differences in credit rating and duration. The outlook for each country's currency versus the U.S. dollar is obviously also important. And in fact, the lower-right panel of Chart 9 shows that exchange rate volatility is positively correlated with the risk-adjusted spreads from our cross-sectional model. This implies that the extra compensation available in Mexican and Colombian sovereigns is probably compensation for assuming highly volatile currency risk. By this measure, Finland looks even more attractive given the euro's slightly lower volatility. Chart 9USD Sovereign Index: Country Breakdown Bottom Line: USD-denominated sovereigns are not attractive compared to domestic Baa-rated U.S. credit. Remain underweight. At the country level, Finland, Mexico and Colombia offer the most attractive spreads and Finnish debt offers the best risk/reward trade-off. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see Geopolitical Strategy Special Report, "North Korea: Beyond Satire", dated April 19, 2017, available at gps.bcaresearch.com 2 https://www.newyorkfed.org/newsevents/speeches/2015/dud150605 3 For further details on our outlook for the near-term path of monetary policy please see U.S. Bond Strategy Portfolio Allocation Summary, "On Hold, But Not For Long", dated August 8, 2017, available at usbs.bcaresearch.com 4 For a chart of the PCE diffusion index please see page 11 of U.S. Bond Strategy Portfolio Allocation Summary, "On Hold, But Not For Long", dated August 8, 2017, available at usbs.bcaresearch.com 5 Please see Foreign Exchange Strategy Weekly Report, "Fade North Korea, And Sell The Yen", dated August 11, 2017, available at fes.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Three Scenarios For Treasury Yields In 2017", dated June 20, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Special Report

Feature Visions abound of a dystopia in which Artificial Intelligence (AI) obsoletes all human jobs. In these visions, mankind becomes a subservient sideshow in a world run by robots. But while such dystopian visions make excellent narratives for Hollywood blockbusters, the chance they become a reality is nil. Technological progress is nothing new. Each generation feels it is experiencing unprecedented disruptive changes, but the constant march of technological progress has defined humanity for centuries, or even millennia. In the process, innovation has already obsoleted countless occupations. Where are today's lamplighters, ostlers,1 livery-stable keepers, newspaper criers and boiler firemen? In 1910, one third of the labour force worked on farms,2 with many of these workers tending animals; today, those proportions are near zero. In 1950, one fifth of the workforce was a machine or vehicle operative; today, that proportion is less than a tenth. More recently, in 1970, over 5% of workers were 'stenographers, typists or secretaries'; again today, most of those jobs have vanished. Yet this mass of job obsolescence has not created mass unemployment. The reason is that an advancing economy creates as many new jobs to replace the obsoleted jobs (Feature Chart and Chart I-2). In 1910, less than 5% of workers were in 'professional or technical' jobs; today the category employs over a quarter of workers. In 1950, healthcare employed 2% of workers; today it employs 8%. Moreover, the nature of many of today's jobs might have been unimaginable just a few decades ago. The rapidly growing employment sector 'medical and dental technicians' did not even exist before 1950. In the same way, the precise type of jobs that will see very strong growth in the coming years and decades might be unimaginable today. Feature ChartTechnological Progress In The 20th ##br##Century Destroyed Many Jobs... Feature Chart...But Created As ##br##Many New Jobs Chart I-2Nothing New: Technological Progress Always ##br##Involves Job Destruction And Creation Say's Law Tells Us That Robots Will Not Kill Job Growth Technological progress has not killed job growth. Nor will it. This is because firms choose to replace human workers with machines only if it increases their productivity and profitability (Charts I-3, Chart I-4, Chart I-5). The higher productivity increases the ability to purchase other goods and services - thereby creating jobs elsewhere in the economy (Chart I-6), often in new and surprising industries. Chart I-3Machine And Vehicle Operative ##br##Work Peaked In The 50s Chart I-4Secretarial Work Peaked ##br## In The 70s Chart I-5Clerical Work Peaked##br## In The 80s Chart I-6Healthcare Work Is In##br## A Strong Uptrend This is the idea introduced in 1803 by French economist Jean-Baptiste Say, called Say's Law: The producer of X is able to buy Y, if his products are demanded. Thereby, supply of X creates demand for Y, as long as people wish to buy X. A producer replaces human workers with machines to generate his output at higher profit, enabling him to demand new goods and services that he desires. Crucially, human desires are varied, ever changing and ultimately unlimited. Satisfying those unlimited desires creates new economies and jobs. In this way, technological progress often paves the way for completely new and unrelated goods and services. It creates whole new industries. To give just one example, railways spawned the frozen food industry. The frozen food industry satisfied the human desire to eat fresh food - which railways could now transport (frozen) to cities from distant farms and fisheries. In real time though, it was difficult to connect the advent of railways with the birth of the frozen food industry. Likewise, today it is hard to know precisely which new economies, markets and associated jobs the current new technologies will spawn. Nevertheless, a new technology's disruptive effect on an economy does depend on the broad type of job it destroys versus the broad type of job it creates. Consider a stylized economy with three types of job: a high-income innovator, a middle-income manufacturer, and a low-income animal tender. And imagine two scenarios. Scenario 1: the innovator invents a machine that obsoletes the low-income animal tender. Having replaced the animal tender with a more productive machine, the innovator will use his higher income to satisfy additional desires for manufactured goods. This enables the obsoleted animal tender to retrain and make a better living as a middle-income manufacturer. Scenario 2: the innovator instead invents a machine that obsoletes the middle-income manufacturer. In this case, the innovator will use his higher income to satisfy additional desires for animal tending services. The obsoleted manufacturer must now make a living as a low-income animal tender. So while the innovator sees a rise in his standard of living, the outcome for the unfortunate middle-income manufacturer is a massive deflation in pay. It is our strong contention that whereas previous waves of technological progress looked like scenario 1, the current and forthcoming impact of AI looks more like scenario 2. In other words, robots will kill middle-income jobs rather than low-income jobs. And the reason comes from a discovery called Moravec's Paradox.3 Moravec's Paradox Tells Us That Robots Will Kill Middle Income Jobs Moravec's Paradox is a counterintuitive discovery by robotics researchers that, for AI, the hard problems are easy and the easy problems are hard: High-level reasoning - such as logic and algebra - requires very little computation, but supposedly low-level sensorimotor skills - such as mobility and perception - require vast computational resources. Logic and algebra are considered difficult for humans, a supposed sign of intelligence. Jobs that require them are relatively well paid. Conversely, basic mobility and perception are considered innate. Jobs that rely on them are relatively poorly paid. But from an evolutionary perspective, high-level reasoning is very recent, maybe less than 100 thousand years old. This explains why it seems un-mastered and requires conscious effort. Conversely, evolution has honed and perfected our mobility and perception skills over tens of millions of years. So those low-level skills are subconscious and effortless. As AI is, in effect, just reverse-engineering the brain, the difficulty of any task for AI is roughly proportional to the amount of time it has taken for nature to evolve and encode it in the human brain. Therefore, the 100 thousand year old 'high-level' skills like logic and algebra are relatively easy for AI to replicate and even surpass, whereas the 10 million year old 'low-level' skills like mobility and perception are extremely difficult to replicate. It follows that the jobs that AI can easily replicate and replace are those that require recently evolved skills like logic and algebra. They tend to be middle-income jobs. Conversely, the jobs that AI cannot easily replicate are those that rely on the deeply evolved skills like mobility and perception. They tend to be lower-income jobs. Hence, the current wave of technological progress is following scenario 2. AI is hollowing out middle-income jobs and creating lots of lower-income jobs. Put another way: Say's Law + Moravec's Paradox = Strong Job Creation + Middle Income Wage Depression Is there any evidence of this? Yes, in the United States where the job creation data is a lot more granular than in Europe, the strongest growing employment sub-sector for many years has been 'Food Services And Drinking Places' (Table I-1 and Chart I-7). In other words, bartenders and waiters - classic low-income jobs requiring mobility and perception. Meanwhile, job losses have been concentrated in middle-income occupations. Table I-1Which Sectors Are Seeing ##br##The Job Growth? Chart I-7Bartenders And Waiters Is The Fastest ##br##Growing Employment Sector! Stronger evidence comes from the weakening Phillips curve relationship between unemployment and wage inflation. In many economies, unemployment rates are hitting multi-decade lows, yet wage inflation remains dormant. This has baffled many economists, but it shouldn't. Moravec's Paradox tells us that strong job creation is at the lower-income end of the employment distribution. So a weakening Phillips curve relationship is exactly what we should see. Moreover, as the economic impacts of AI are still in their infancy, the trends we are seeing now have much further to run. The major investment takeaway is that the structural backdrop for bonds is benign. But with the ECB about to end its ultra-accommodation, bond investors should tilt their long-term exposure towards non-euro area government bonds. A New Investment Theme: Animal Care Chart I-8Animal Care: Strong And Steady Growth Despite the on-going disruption to many middle-income jobs, developed economies have grown and will continue to grow. But as we said, economic growth can come through new and surprising industries. The early identification of such industries can create excellent investment opportunities. So we will end this report by introducing an idea. In our stylized scenario 2 we said that the innovator would use his higher income to satisfy additional desires for animal tending services. As it happens, we are witnessing this precise phenomenon today. The demand for animal tending services, such as dog walking, is booming. We fully expect the animal and pet care industry to remain one of the strongest growth sectors in developed economies (Chart I-8). The strong uptrend will be supported by three sub-themes. First, increased pet ownership among wealthy retiring baby boomers. Second, a lower birth rate means that pets are becoming a substitute for a child. Third, the 'humanization of animals': as pets become regarded as equal members of the family, spending on their welfare rises accordingly. We expect to develop this long-term theme in future reports. But today, we are starting our Animal Care basket with 3 initial stocks (Table I-2). Table I-2The Animal Care Basket Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 An ostler was a man employed to look after the horses of people staying at an inn. 2 Based on U.S. data. 3 Named after the robot engineer Hans Moravec. Fractal Trading Model There are no new trades this week. The short CAC40 / long Eurostoxx600 position reached the end of its 65 day term achieving half of its profit target, while the long DM / short EM position hit its stop-loss. This leaves three open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations