Financial Markets

Special Report

Highlights On Black Monday, October 19, 1987, equity bourses around the world plunged amid cascading bouts of selling, recording some of their largest single-day losses of the twentieth century. The plunge, exacerbated by derivatives transactions, and transmitted swiftly around the world, marked the first contemporary global financial crisis. BCA clients were well prepared. The Bank Credit Analyst steadily warned of increasing stock market vulnerabilities across all of 1987 even as it correctly predicted that the S&P 500 would most likely soar before eventually cracking. The Federal Reserve's immediate all-out effort to contain the damage ushered in a new central bank template for responding to quaking markets and helped give rise to the Greenspan put. While we do not fear a repeat of Black Monday, the U.S. equity market's long-term prospects are dramatically less appealing than they were in 1987. Investors should be prepared for an extended stretch of public market returns that pale beside the ones earned over the last 30-plus years. Feature 30 years ago today, Black Monday erupted around the world, reaching its nadir in New York, where relentless waves of selling drove the major indexes down 20%. The contagion had spread in a rapid relay from Hong Kong to Europe and then to New York, before fetching up in Auckland and other Asia-Pacific exchanges as Black Tuesday. The event was the centerpiece of what turned out to be sharp, albeit relatively brief, bear markets around the world (Charts 1 and 2). Confounding nearly every observer, however, the crash did not amount to much in a broader economic context and financial markets quickly regained their footing, with global equities vaulting to new highs in the '90s1 amidst speculative excesses that made the '80s' mania look demure. Chart 1Great Runs... Chart 2...And Sudden Stops Like all serious investors, BCA researchers are students of history. Black Monday was the first modern global financial crisis, and its 30th anniversary affords us the chance to study its run-up and aftermath for insights into future dives. It also gives us the chance to return to BCA's extensive archives and see how our forebears assessed conditions in real time. Their ex-ante analysis and forecasts were stellar, and reinforce the robustness of our approach. Their lagging ex-post performance highlights the need for investors to maintain a flexible mindset that can accommodate all possibilities. From Fear To Greed Black Monday marked the definitive end of a historically potent bull market (Table 1) that began, as the best ones do, in revulsion. Business Week's August 1979 cover story trumpeting the death of equities has become notorious, but the S&P 500 didn't bottom for three more years, during which it lost a quarter of its inflation-adjusted value. All told from the end of September 1968 to the end of July 1982, the S&P tumbled 62.5% in real terms (Chart 3). Inflation took a heavy toll on real growth over the 55 quarters of U.S. stocks' lost decade and a half (Chart 4, top panel), but the economy had expanded nonetheless, and stocks emerged from the ashes of the Volcker double-dip recession with a lot of ground to make up. Table 1A Bull With Speed And Stamina Chart 3A Lost Decade And A Half ... Chart 4...Despite Steady, If Unspectacular, Real Growth The ensuing five-year bull market (Chart 5, top panel) unfolded in two phases: the first, which burst out of the gate on a sudden repricing before taking a full year to catch its breath, had the support of earnings growth (Chart 5, middle panel) and re-rating; the second, which went on without pause for two and a half years, was all about re-rating (Chart 5, bottom panel). It finally ended in late August 1987, when skeptical investors could no longer stomach big gains derived entirely from multiple expansion, and stocks began to retreat in earnest in October, sliding 5% and 9% in the two weeks before Black Monday. Proximate triggers included sickly trade data, a competitive devaluation threat and proposed tax legislation that stood to make corporate takeovers a good deal more costly. The first two factors pushed the dollar down and yields up, as investors fretted that the Fed would be forced to raise rates (Chart 6), and the last pulled the plug on runaway speculation in takeover targets. Chart 5A Two-Act Bull Market Chart 6Be Careful What You Wish For The Echo Chamber, ... There is career safety in numbers, but portfolio danger. As the late Barton Biggs put it, there's no investment so good that it can't be destroyed by too much capital. Portfolio insurance may not have even been a good idea, as it didn't amount to anything more than a portfolio-sized stop-loss order, souped up with computer software and derivatives contracts. But by the fall of 1987, its widespread adoption had turned it into a very bad one. Portfolio insurance was developed in the late '70s by two finance professors who sought a method that would allow investors to participate in equity market gains while limiting their downside exposure. When stocks began to decline in the direction of a set downside limit, the portfolio insurance program would reduce net equity exposure via the sale of index futures. Once the market recovered and the program determined the coast was clear, it would unwind the futures positions. Although the technique had its flaws on a micro scale - futures trading wasn't costless, and there was considerable potential for whipsawing - it was doomed at the aggregate level because the index futures market wasn't deep enough to accommodate all the selling pressure that would be unleashed by a significant correction. ... Or, From Wall Street To LaSalle Street And Back Again There was more to Black Monday than portfolio insurance - the event was global, and the technique was not a factor on other bourses - but it helped to create a self-reinforcing spiral between the cash market in New York and the futures market in Chicago. Heavy selling of stocks in New York triggered heavy selling of index futures in Chicago, as insured portfolios sold futures to mitigate their direct cash exposures. The selling redounded back to New York as the futures buyers on the other side of the trade sold the underlying stocks to balance out their long futures positions2 and opportunistic investors seized the chance to front-run the mechanical portfolio insurers.3 The new sales pushed share prices even lower in New York, triggering more index futures selling in Chicago, and cinching the vicious circle. The View From Peel Street BCA, safely removed from the madding crowd in Montreal, foresaw something quite like the crash. The September 1986 and 1987 editions of our annual New York conferences bore the respective titles, "The Escalation in Debt and Disinflation: Prelude to Financial Mania and Crash?" and "Phase II in the Escalation of Debt, Disinflation and Market Mania: Prelude to Financial Crash?" Throughout all of 1987, the monthly Bank Credit Analyst warned of the U.S. equity market's increasing vulnerability and recommended that investors reduce exposure in a disciplined fashion ahead of the inevitable bust. The investment policy recommendation, issued in accord with prudent money management principles, differed from BCA's market forecast, which was for robust, potentially parabolic, gains before the bull market ended. BCA was not trying to have it both ways: it has long been a central tenet of our work that one's investment strategy can - and regularly should - be distinct from one's market forecast. We do not attempt to squeeze every last drop out of a bull or a bear market. Empirical evidence makes it abundantly clear that no one can consistently call tops or bottoms. In the words of turn-of-the-century trading legend Jesse Livermore: "One of the most helpful things that anybody can learn is to give up trying to catch the last eighth - or the first. These two are the most expensive eighths in the world.4" The opening paragraph of the March 1987 Bank Credit Analyst, published six months before the market peak, summarizes our ongoing advice: [I]nvestors who are overexposed should reduce positions to a level comfortable to ride out what will likely become a much more volatile phase of the secular bull market in stocks. ... At some point, it is likely that the U.S. stock market will experience a 1962-type correction - a sharp decline which comes out of the blue as a result of extreme overvaluation and excessive speculation. As then, it is unlikely to be associated with a credit crunch, as almost all post-war bear markets have been. ... At present, there is nothing in the data, either fundamental or technical, which suggests that such a shakeout is imminent. However, the key for investors in this bull market is to have positions which are sufficiently comfortable so that they can ride out sudden, dramatic corrections and participate in the long upward rise, which we feel has much further to go. (pp. 3-4) Eighteen months before the August 25th peak, the March 1986 Bank Credit Analyst's Section III was titled, "The Coming Financial Mania," and its strategy prescriptions were much more aggressive, even as it acknowledged the risks: Increasing volatility should be expected both because of the still lingering risks prevailing and the dramatic price movements in recent months. Hence, conservative investors should not overtrade. To fully capitalize on the ongoing revaluation of financial assets, it is important not to lose positions as a result of the necessary sharp corrections which will be experienced along the way. The stock and bond market potential over the next 2-3 years remains extraordinary. (p.11) The great dilemma for investors is, of course, how aggressively to play the game during the latter stages. The fascination, excitement and danger is the knowledge that vast fortunes are easily made right up to the end, but there is no reliable method to get out just before the crash. [...] Frequently the bubble goes on much longer and prices go far higher than anyone can imagine [...]. Yet, the vulnerabilities grow proportionately to the power of the manic phase. (p.26) Investment strategy in [a manic] environment must be based on the historically observed phenomenon that price appreciation generally accelerates to a climax or blowoff and that the hidden risks grow exponentially with price rises. Therefore, investors must constantly guard against the natural tendency to become increasingly greedy and careless in valuation standards as prices rise. (p.41) As good as BCA's near- and intermediate-term calls were in the run-up to the '87 crash, our longer-term calls were even better. We repeatedly argued that disinflation would be a secular trend, and that it would power secular bull markets in bonds and equities. Three decades on, with the Barclays Aggregate Index, the Barclays High Yield Index and the S&P 500 having produced real annualized total returns of 5%, 9.3% and 7.6%, respectively, the call has been vindicated (Table 2). As BCA foresaw, the harsh monetary medicine administered by the Volcker Fed to slay the inflation dragon has paid hefty market dividends. Table 2A Great Three Decades For Financial Assets The Trouble With The Austrians For all that BCA achieved ahead of Black Monday, and as correct as our long-term calls from the '80s turned out to be, it must be acknowledged that we missed the boat on getting back into equities after the crash. Part of the miss is understandable: one wouldn't expect the strategist with the most prescient call ahead of a downturn to be the first one to identity the beginning of the subsequent rally. The best investors are the ones with the supplest minds, however, and the BCA archives reveal a bias that may have gotten in the way of embracing more bullish near-term outcomes. To wit, one cannot read the 1988 and 1989 Bank Credit Analysts, and indeed, our original leaders' output, without detecting strong sympathies for the Austrian School of Economics (Box 1). BOX 1 An Austrian's Lonely Lot The Austrian School of Economics most saliently parts company with neoclassical economics in its adamant opposition to government intervention and its fraught relationship with credit. Instead of intervening to counter business cycles, Austrians would prefer to let busts run their course so as to cleanse the economy of the excesses embedded in booms. They occupy the Mellonian, purge-the-rottenness-out-of-the-system end of the continuum in opposition to the Debt Supercycle's unconditional forgiveness. Austrians regard banking and credit with some measure of suspicion, as Austrian Business Cycle Theory holds that artificially low interest rates are the raw material of destabilizing booms. Encouraged by central bankers seeking to steer an economy out of recession with a bare minimum of discomfort, borrowers take on debt to invest in projects that may not be able to pay their own way were it not for intervention. Once rates rise after policy accommodation fades, the economy slows and the extent of the malinvestment is revealed. The Debt Supercycle prescribes more of the hair of the dog to alleviate the suffering from malinvestment. The debt overhang is thereby never eliminated; it instead continues to silt up, requiring larger and larger interventions. Unchecked, the degree of intervention required to keep the plates spinning will eventually exceed capacity. This analysis is logically sound, but it so thoroughly contradicts the reigning orthodoxy that an investor who becomes emotionally invested in it is at risk of serially tilting at windmills. There is nothing wrong with the Austrian School per se. We rather like its outsider status, and actively seek heterodox inputs and perspectives so as to stay out of the ruts of the well-worn consensus path. Even its pessimistic bent has its uses; investors are surely exposed to enough cheerleading. Its prescriptions are so bracing, however, that a little goes a long way and real-world users should handle them with care. A popular pair of You Tube videos of actors portraying Keynes and Hayek issuing dueling raps about their respective ideologies (Keynes: I want to steer markets/Hayek: I want them set free!) provide an entertaining example of the Austrian-inspired investor's dilemma. Keynes, drink after drink in hand, is the exuberant life of the party, while the sallow Hayek stares into the bottom of his glass, unable to capture any other partygoers' attention. The simple conceit animating the video - Keynesianism is fun; Austrians are dour scolds - resonates deeply with elected officials. Voters love free drinks, but hate being told to eat their vegetables. The Austrian School, therefore, is a poor guide to the path that policy is likely to take. It also has the problematic effect of introducing an element of moral judgment into what should be a purely objective sphere. Investors should have a laser-like focus on what is most likely to happen and should strive to suppress extraneous notions about what should happen. The Debt Supercycle is a brilliantly incisive way of viewing the interaction between constituents' desires and officials' incentives, and has predicted the long-run direction of policy to a T. Only someone with a focus on money flows, informed by exposure to Austrian Business Cycle Theory, could have come up with it. In the hands of BCA editors in the late '80s, however, it seemed to feed a desire to see the American economy get its comeuppance. Setting aside that desire for punishment - and value judgments altogether - is the clearest way that we could have done better in the aftermath of the crash 30 years ago, when BCA essentially sat out the December '87 - July '90 equity bull market. We should strive to be dispassionate and unbiased observers of the economy and markets. After all, the process illustrated by the Debt Supercycle concept has surely helped put the wind at equities' back throughout the postwar era (Chart 7). Making sense of it without decrying it could help us to provide even better counsel. Chart 7Equity Investing Is An Optimists' Game Then And Now Does 2017 look like 1987? Is another crash lurking just around the corner? Our answers are "no," and "no." We think the resemblances between then and now are merely superficial. The good news is that the probability of a Black Monday-style crash is remote, and we think that even a run-of-the-mill bear market is not likely until our most reliable recession leading indicators, which are still dormant, begin to flash red.5 While that view may come as a short-term relief, 1987's long-term market outlook was vastly superior. While both today's bull market and the '82-'87 bull market began with forward earnings multiples at multi-year lows, the trough multiple in 1982 was in the low sixes, nearly two standard deviations below the mean (Chart 8). Even though it more than doubled by the August '87 peak, it only just reached what is now the mean level for the entire series. This bull market has seen the S&P 500's forward multiple rise to a full standard deviation above the mean. Valuation is not everything, of course. It is a lousy short-term indicator and only issues a reliable intermediate-term signal at extremes. Long-term returns correlate closely with the cyclically-adjusted P/E ("CAPE"), however, and it is currently at levels only previously reached ahead of the 1929 and 2000 peaks (Chart 9). The frothy CAPE portends a tepid long-run U.S. equity outlook. Chart 8Not A Lot Of Room To Grow Chart 9Not The Stuff Of Secular Rallies Both of the bull markets emerged from the ashes of nasty recessions (Chart 10), but the periods' primary economic threats were polar opposites, as were the policy settings adopted to counteract them. The Volcker Fed tightened monetary conditions to the point of pain in the early '80s, plunging the economy into a double-dip recession for the express purpose of eradicating the scourge of double-digit inflation (Chart 11). After the financial crisis, on the other hand, the clear and present danger was the potential for the credit bust to trigger a deflationary spiral. The Bernanke Fed pursued unprecedentedly accommodative policy in response. Chart 10Similarly Nasty Recessions ... Chart 11... But Opposite Inflation Backdrops The policy measures of the early '80s were an example of swapping near-term pain for long-term gain, and they set the stage for secular rallies in financial assets that continue to this day. Once inflation was removed from the equation, interest rates had to fall, and they did so for 35 years. The extraordinary accommodation in the wake of the crisis was an attempt to stave off hysteresis, which boils down to mitigating near-term pain as an insurance policy against long-term pain.6 It may well have worked, but there is no such thing as a free lunch, and the Fed's exertions have likely pulled forward much of the bond and stock markets' future returns. Black Monday And The Fed Put Before the October 20th open, the Fed issued the following statement: The Federal Reserve, consistent with its responsibilities as the Nation's central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system. Although it was only 30 words long, the statement packed a punch. It signaled the Fed's willingness to fulfill its function as the lender of last resort and may also have prodded skittish banks into fulfilling their responsibilities as intermediaries. Behind the scenes, the Federal Reserve Banks of New York and Chicago were doing their utmost to keep the system functioning. New York Fed president Corrigan was twisting lenders' arms to keep credit flowing so the crash would not infect the banking system and the real economy.7 Meanwhile, the Chicago Fed wasn't letting the letter of the law keep it from "help[ing to] engineer a solution" when one of the biggest derivatives market participants "ran short of cash.8" The statement, and the vigorous offstage exertions, countered the Fed's determinedly low profile. These were the days, after all, when monetary policy actions were still regarded as something akin to state secrets. Wall Street firms employed "Fed watchers," who were charged with studying the tea leaves to determine if the Fed had adjusted policy. As late as January 1990, the Bank Credit Analyst could devote an entire Section III to the question, "Has the Federal Reserve Eased?" Some of Alan Greenspan's comments in his memoir may reflect after-the-fact boasting or burnishing, but Black Monday can be viewed as a policy watershed. After it, the Fed's conduct of monetary policy has become transparent to the point of oversharing. More meaningfully for investors, it marked the origin of the "Greenspan Put," the widespread notion among market participants that the Fed would do its best to ward off or mitigate financial market downdrafts. Are ETFs The New Portfolio Insurance? Responsibility for the crash cannot be precisely apportioned among factors, but all post-mortem analyses agree that portfolio insurance played a leading role. While it may well have proven harmless if pursued on a modest scale by a limited number of players, it morphed into a destabilizing force once a critical mass of investors embraced it. On Black Monday, it became a paradox of safety akin to the paradox of thrift: prudent and rational when practiced by one individual, but a metastasizing disaster when followed by a crowd. A reasonable roadmap for someone trying to spot parallels between then and now is to identify market products that may have become overly popular. Wall Street's tendency to wring every last drop out of financing innovations, coupled with investors' tendency to move in herds, can lead to excesses. The latest innovation to achieve wild popularity is the ETF. Is it possible that ETFs could exert the same destabilizing influence as portfolio insurance if investors' ardor for them suddenly cools? We think not. As our Global ETF Strategy service has argued, the claims about passive investing's dangers are overheated.9 The notion that index tracking is undermining price discovery disregards the power of incentives. Passive investing strikes us as the best cure for passive investing: if so many people are pursuing it that index-trackers begin to drown out active investors, the prospective returns to active investing will soar and money will rotate out of index-tracking strategies in sufficient quantity to correct the imbalance. Chatter about a passive bubble also fails to consider the source of fund flows into index-tracking ETFs. The oft-repeated statement, "so much money is flowing into ETFs that it's distorting prices across the board," does not hold up to scrutiny. Away from Japan and Switzerland, where QE purchases of ETFs are being funded with new yen and franc notes, ETFs are not being purchased with new investment capital that has materialized out of thin air. They are being purchased with existing investment capital that has merely been reallocated away from actively managed mutual funds (Chart 12). Chart 12Mirror Image Bubbles are always the result of speculative, excess-profit-seeking activity. Index-tracking ETFs are vehicles intended to deliver market returns. They are the opposite of a get-rich-quick scheme; they're the instrument investors turn to when they give up on quick riches. We do not worry that ETFs are the object of a bubble, or that they are in any way analogous to portfolio insurance in the fall of 1987. Investment Implications Black Monday was a one-off event that remained contained within the financial markets despite widespread fears that it would spread to constrict the broader financial system and the real economy. A lot has changed in 30 years, but the collision of algorithms, derivatives and global pressures squarely places it in our time. It is entirely possible that its elements could come together to create another massive single-day drop. A key difference between future single- or intra-day swoons, and the ones that have already occurred since the crisis, is that they will arrive while the Fed is tightening policy at the margin. The future swoons, then, may not be as likely to disappear quickly without leaving much of a mark. It may go too far to say that market infrastructure is vulnerable, but it would be too optimistic to assume that it has kept pace with the advances in rapid-fire trading and the increasing prevalence of algorithms. It may make sense for investors with less tolerance for risk to maintain an extra cash buffer to protect against swoons and to ensure that they have dry powder to exploit them when they materialize. We remain constructive on the global economy, however, and our house view recommends overweighting risk assets while maintaining below-benchmark duration within bond portfolios. We sympathize with investors who lament that nothing in the public markets is cheap, but synchronized global acceleration remains intact. None of our models are warning of imminent danger. We therefore remain fully invested but vigilant, seeking out signs that the long bull market may be running out of steam. After reviewing our shortcomings in the aftermath of Black Monday, however, we will seek with an open mind and will not attenuate our efforts by awaiting the rapture of a final reckoning, when the sheep and the goats will be separated according to their virtue. The whole point of policy makers' efforts to engineer a rising tide is to keep the goats, and the broader economy, from harm. Doug Peta, Senior Vice President Global ETF Strategy dougp@bcaresearch.com 1 Except in New Zealand, where Black Tuesday popped a bubble of such notable excess that the MSCI New Zealand Index today trades at less than two-thirds of its September 1987 high, and Japan, where the mania lasted until December 1989 and the MSCI Japan Index is still nearly 40% below its all-time high. 2 Index arbitrageurs would have followed the same pattern, but they were sidelined by delayed price quotes and the failure of the NYSE's automated order execution system, which kept them from accurately identifying and exploiting true arbitrage opportunities. 3 Portfolio insurance was no secret - it was estimated that $90 billion of assets were following the strategy - and its potential to amplify selling pressures in a vicious circle had been the subject of a widely followed Wall Street Journal column published a week before the crash. 4 Lefevre, Edwin. Reminiscences of a Stock Operator, John Wiley & Sons, Inc.: Hoboken (NJ), pp. 57-8. Until 1997, the prices of NYSE-listed stocks were quoted in eighth-of-a-dollar increments. 5 For details on the interaction between recessions and equity bear markets, please see the August 16, 2017 Global ETF Strategy Special Report, "A Guide to Spotting and Weathering Bear Markets," available at etf.bcaresearch.com. 6 Hysteresis is the process by which a negative cyclical phenomenon, if left unchecked, can evolve into a secular phenomenon. 7 Greenspan, Alan. The Age of Turbulence: Adventures in a New World, Penguin (New York): 2007, p.108. Greenspan disavowed knowledge of the details, but suggested that Corrigan, "the Fed's chief enforcer," "bit off a few earlobes" while encouraging bankers to keep in mind that, "'if you shut off credit to a customer just because you're a little nervous about him, but with no concrete reason, he's going to remember that'." 8 Greenspan, p. 110.

Special Report

Feature It was an honour and privilege to welcome Professor Daniel Kahneman to our New York Conference this year. Professor Kahneman was the 2002 winner of the Nobel Prize in Economics, though the great irony is that he hasn't taken a single economics class in his life! That said, he did have a great informal mentor in the form of Richard Thaler who, coincidentally, has just become the 2017 winner of the Nobel Prize in Economics. Professor Kahneman's lifetime work demonstrates that our economic and financial decisions are often highly irrational - flying in the face of most mainstream economic models which assume fully rational behaviour. His research culminated in a school of thought called Prospect Theory, for which he ultimately won the Nobel Prize. Feature ChartBonds Become Much More Risky At Ultra-Low Yields Over lunch, Professor Kahneman summarised Prospect Theory to us. And as he spoke, the penny suddenly dropped. Prospect Theory's rich findings may have solved some of the most pressing mysteries of finance. Why do equities typically outperform bonds? Why has QE boosted equity prices so much? What happens next to financial markets? Why Do Equities Typically Outperform Bonds? Let's begin by debunking a popular myth. Many people believe that equities typically outperform bonds because equity income streams grow in line with the economy whereas bond income streams are fixed and do not grow. This reasoning is false. Any income stream can be made to generate any return depending on the price you pay for the income stream upfront. A rapidly growing income stream can still generate a deeply negative return if you overpay for it. And a fixed, or shrinking, income stream can still generate a strongly positive return if you underpay for it. It follows that equities generate a higher return than bonds simply because the financial markets typically price them to deliver this higher return. The question is: why? Prospect Theory provides an answer. One of its great insights is that we significantly overestimate the probabilities of rare but sizeable gains and losses. Indeed, this overestimation of rare events provides the entire foundation of the lottery and insurance industries. We overpay for a lottery ticket to buy the tiny possibility of a large gain, which is called positive skew. And we overpay for insurance to remove the tiny possibility of a large loss, which is called negative skew. We do this because creating the tiny possibility of immense wealth lets us dream pleasant thoughts. While removing the tiny possibility of losing our home lets us sleep soundly. The upshot from Prospect Theory is that income streams with positive skew tend to be overvalued, and so generate poor returns - like the lottery ticket. Whereas income streams with negative skew tend to be undervalued, and so generate high returns. This brings us to the first key point. Equity returns possess negative skew (Chart I-2). On rare occasions, they suffer deep losses. Because of this negative skew, it is our contention that the markets price equities to generate an excess return - a risk premium - over investments that do not have a negative skew. Chart I-2Equity Markets Have Negative Skew: "Equity Markets Walk Up The Stairs But Jump Out Of The Window" To illustrate the point, bear with us as we do some simple maths. Say an equity price could end up at 102 with probability 90%, but could plunge to 82 in a rare event with probability 10%. This makes its expected value 100 (because 102*0.9 + 82*0.1 = 100). But if, as Professor Kahneman suggests, the market overestimates the rare event probability to, say, 20%, it will underprice the equity at 98 (because 102*0.8 + 82*0.2 = 98). Clearly, this pricing will generate an excess return - a risk premium of 2% - because the correct expected value is 100. Next consider a bond price which could end up at 101 or 99 with equal probability, giving it an expected value also at 100. As it does not have negative skew, the market will just price it at 100. Observe that the equity price and bond price have exactly the same expected value of 100, but the financial markets have underpriced the equity at 98 to generate an excess return over the bond - because the equity has negative skew while the bond does not. Why Has QE Boosted Equity Prices So Much? When bond yields fall to very low levels, things get more complicated. Bond returns also exhibit extreme negative skew (Chart I-3 and Chart I-4). And the reasons are obvious. At very low bond yields, the prospects for capital appreciation rapidly disappear, while the prospects for large-scale capital losses suddenly increase ( Feature Chart). Chart I-3When Bond Yields Are Ultra-Low Bond Markets Have Negative Skew Too Chart I-4When Bond Yields Are Ultra-Low Bond Markets Have Negative Skew Too One simple way to quantify an investment's negative skew is to pick an extended period of time - say several years - when the price has gone sideways, and then to calculate the worst 3-month loss as a multiple of the best 3-month gain.1 On this metric, equities typically show a negative skew of around 1.5. Meaning that the worst loss is about 1.5 times the size of the best gain. But for bonds, negative skew varies with the bond yield. At yields above 2.5%, bonds show no skew. Worst losses broadly equal best gains. However, when yields drop below 2%, the negative skew approaches the same level as for equities. And at yields around 1%, the negative skew can even exceed that on equities (Table 1 and Chart I-5). Table 1At Low Bond Yields, ##br##Bonds Have Extreme Negative Skew Chart I-5Bonds Become Much More Risky##br## At Ultra-Low Yields This brings us to a crucial conclusion. At very low bond yields, the equity risk premium must compress, and potentially disappear, because both bonds and equities now have the same undesirable negative skew. Is there any empirical evidence for this? The prospective equity risk premium is hard to capture as it requires an accurate forecast of the prospective excess return from equities over bonds. But the realised equity risk premium is easy to measure as it is just the annualised outperformance of equities over bonds. This shows a clear downtrend in Germany, the U.K. and the U.S. Meanwhile, in Japan where bond yields have been near zero for years, the realised equity risk premium is non-existent (Charts I-6, Chart I-7, Chart I-8, Chart I-9). Chart I-6The Equity Risk Premium ##br##Has Trended Lower In Germany... Chart I-7...And In The U.K. Chart I-8The Equity Risk Premium ##br##Has Trended Lower In The U.S. Chart I-9The Equity Risk Premium Is Non-Existent ##br##In Japan One important takeaway is that central banks, perhaps unwittingly, have driven up equity valuations exponentially. This is because QE has simultaneously compressed both the bond yield and the equity risk premium, giving equity valuations a double shot in the arm. Let's reasonably say that central bank policy depressed the 10-year bond yield by 2%. The resulting increased negative skew on bonds might then reasonably depress the 10-year equity risk premium by 2%. In combination, this would reduce the 10-year required return from equities by 4% a year for ten years. Under these assumptions, central bank policy might well have boosted equity valuations by 50%.2 What Happens Next To Financial Markets? The double shot in the arm to developed market equity valuations may have boosted them by 50%, but they are broadly in the right ballpark as long as bond yields remain ultra-low. However, the conditionality on bond yields is crucial. This is because the process that exponentially boosted equity valuations can also work viciously in reverse. To reiterate, the negative skew on bond returns starts to fade when the bond yield is at 2% and completely disappears at 3%, at which point the equity risk premium must fully re-emerge. Given the tendency of equities to exhibit negative skew and to move en masse in the developed markets, we can infer that the current valuation of equities would be in jeopardy if a mainstream bond yield broke well north of 2.5%. Whereupon the reassessment of equity valuations is likely to catalyse a correction, at the very least. Chart I-10Bond Yields Can Rise More In Europe ##br##Than In The U.S. But one important investment implication is that the subsequent flight to investment havens means that no mainstream bond yield can realistically rise beyond 3% in the foreseeable future. We can also infer that European 10-year bond yields have the potential to rise more than their equivalents in the U.S., given that European yields are much further from the 2.5%-3% 'red zone'(Chart I-10). So an excellent structural position is to underweight European government bonds versus U.S. T-bonds. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Using log returns. 2 Because 1.04^10 = 1.48 Fractal Trading Model* This week we observe that Norwegian equities are technically overbought. A market neutral trade is to go short Norway/long Switzerland with a profit target/stop loss of 2%. We now have five open trades. 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-11 Fractal Trading Model 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. 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 - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations

Highlights The uptick in world oil demand in the wake of a strengthening global upturn - the first since the Global Financial Crisis (GFC) - coupled with continued production discipline by OPEC 2.0, will accelerate inventory draws, and lift prices above our previous expectation. Even though we expect - and model for - U.S. shale producers to step up drilling as a result, we are lifting our base case forecast for 2018 Brent and WTI to $65.15/bbl and $62.95/bbl, respectively. These estimates are up $5.51 and $5.98/bbl from our forecast last month.1 Energy: Overweight. Given our view (discussed below), we are taking profits on the long Dec/17 WTI call spread we recommended June 15 - long $50/bbl calls vs. short $55/bbl calls - on the close tonight. This position was up 116% Tuesday. We will replace this spread with long $55/bbl WTI calls vs. short $60/bbl WTI calls in Jul/18 and Dec/18. Base Metals: Neutral. We closed our short Dec 2016 copper trade last week, after our trailing-stop of $3.10/lb was elected, with a 0.75% return. Our trade was up 6% by the end of September, however bullish data in October - including an earthquake in Chile and worries over a potential metal shortage in China - lifted prices back up. Chinese copper import data showed a 26.5% year-on-year (yoy) jump in September. Even so, we expect copper imports to end 2017 with a yoy decline. Precious Metals: Neutral. Palladium continues to trade premium to platinum following its breakout at the end of September. We expect this to continue, given the supply-demand fundamentals we highlighted in June.2 Ags/Softs: Neutral. The USDA's latest World Agricultural Supply and Demand Estimates (WASDE) is supportive of our grains view - projections for 2017/18 wheat ending inventories were revised upward, while corn and soybeans stock estimates were lowered. Our long corn vs. short wheat position recommended October 5 is up 1.5% (please see p. 8 for further discussion.) Feature The global uptick in GDP growth noted this month by the IMF, along with continued production discipline from OPEC 2.0 - the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia - will lift 2018 average Brent and WTI prices to $65.15/bbl and $62.95/bbl, respectively. These estimates are up $5.51 and $5.98/bbl from our forecast last month (Chart of the Week). Chart of the WeekHigher Demand, Lower Supply,##BR##Tighter Inventories Lift Prices We expect the fortuitous combination of fundamentals - for oil producers, that is - to accelerate the drawdown in oil inventories globally, which also will be supportive for prices (Chart 2). This, in turn, will set off a new round of U.S. shale-oil production, which will temper the price rise we expect, but still force inventories to draw harder than expected (Chart 3). Our base case calls for OPEC 2.0 to extend its 1.8mm b/d production cutting deal to end-June 2018, and for compliance within the KSA-Russia-led coalition to remain strong. OPEC 2.0 member states compliance with self-imposed quotas stood at 106% of agreed cuts, according to a state-by-state tally published by S&P's Global Platts earlier this month.3 Iraq continues to flaunt its OPEC 2.0 production quota, at 4.54mm b/d by our estimate, or 153k b/d over its quota. OPEC as a whole is producing 32.74mm b/d of crude oil, by our reckoning, vs. Platts' estimate of 32.66mm b/d. We have Libya and Nigeria, which are not parties to the OPEC 2.0 Agreement, producing 930k b/d and 1.71mm b/d last month, vs. Platts' estimates of 910k b/d and 1.84mm b/d, respectively (Table 1). KSA and Russia continue to lead OPEC 2.0 by example, with the former's crude oil production coming in at 9.97mm b/d in September, vs. 9.95mm b/d in August; the latter's total liquids production was 11.12mm b/d, vs. 11.13mm in August (Chart 4). Chart 2Market Will Get##BR##Tighter Sooner Chart 3BCA Expects Sharper##BR##Inventory Draw Than EIA Chart 4KSA And Russia Continue##BR##Providing Leadership To OPEC 2.0 Global GDP, Oil Demand Growth Strengthens The IMF earlier this month raised its forecast for global GDP growth this year to 3.6% and to 3.7% for next year, up 0.1% for each year vs. previous forecasts. In its analysis, the Fund drew attention to: Notable pickups in investment, trade, and industrial production, coupled with strengthening business and consumer confidence, are supporting the recovery. With growth outcomes in the first half of 2017 generally stronger than expected, upward revisions to growth are broad based, including for the euro area, Japan, China, emerging Europe, and Russia. These more than offset downward revisions for the United States, the United Kingdom, and India.4 On the back of the IMF's revised global growth estimates, we lifted our 2017 and 2018 oil demand expectation to just under 47.5mm b/d on average for the OECD and to just under 52mm b/d for non-OECD economies (Table 1). This translates into global demand growth of 1.65mm b/d in 2017 and 1.69mm b/d in 2018. Notably, we expect global demand to exceed 100mm b/d on average next year in our base case. Table 1BCA Global Oil Supply - Demand Balances (mm b/d) Our estimated demand is driven by global growth projections, particularly for EM economies, which make up the bulk of demand and growth in our balances estimates (Table 1). And, as before, our estimates remain above the EIA's (Chart 5). The indicators we look at to confirm or refute our demand assessment - global trade, particularly EM imports, and manufacturing - remain strong. Global trade continues to expand, particularly in EM ex-Middle East and Africa, as does manufacturing globally, both of which supports the IMF's assessment of growth generally (Charts 6 and 7). Rising incomes lead to rising trade, and also to increased oil and base metals consumption in EM economies. Chart 5We Continue To##BR##Estimate Higher Demand Than The EIA Chart 6Rising Trade Volumes##BR##Support Growth Story ... Chart 7... Expanding Manufacturing##BR##Does, Too Higher Prices, Greater USD Risk Expected In 2018 Given the upward revisions to global growth and our expectation OPEC 2.0 compliance will remain fairly stout, our baseline forecast now calls for WTI prices to average $56.40/bbl in 4Q17 and $62.95/bbl in 2018. Brent is expected to average $58.40/bbl in 4Q17 and $65.15/bbl next year (Chart 1 and Table 2). These estimates are up from last month's averages of $54.89 and $57.44/bbl for 4Q17 and 2018 WTI, and $56.67 and $59.17/bbl for 4Q17 and 2018 Brent.5 Our increasing bullishness is tempered by the risk of a stronger USD, particularly the broad trade-weighted USD index, which captures EM currency weakness. With the Fed set on a course to lift rates - our House view anticipates a Dec/17 rate hike and two or three hikes next year - and the oil market getting fundamentally tighter, we have seen the oil-USD linkage being re-established recently (Chart 8). Table 2Upgrading Our##BR##Price Forecasts Chart 8Expect The USD To Be Less##BR##Determinant For Oil Prices The persistent negative correlation between oil prices and the USD broke down following the global asset sell-off in 1Q16. However, this relationship converged to its long-term equilibrium in recent months. In our view, this reflects market participants' increasing conviction - expressed in market-cleared prices - that OPEC 2.0 will maintain its supply-management accord for an extended period, and that supply is now stabilizing. With demand remaining robust as the global synchronized upturn continues, the fundamental side of price determination has stabilized, and financial variables once again will strongly influence oil prices at the margin. Given our view the USD will trade off interest-rate differentials going forward, and our expectation that U.S. rates are set to increase relative to other systemically important rates, the USD likely will appreciate over the next 12 months. This will be a headwind for oil prices, and may be an additional factor OPEC 2.0 member states have to account for in 2018. Bottom Line: We are raising our price forecast for 4Q17 and 2018 in line with our expectation for stronger global growth and continued strong compliance from OPEC 2.0. With markets getting tighter, we expect the USD to become more important to the evolution of oil prices in 2018. Ag Update: Stay Long Corn, Short Wheat Global grain fundamentals continue to be supportive to our long corn vs. short wheat position, recommended October 5. The USDA's latest WASDE are projecting higher 2017/18 ending wheat inventories, while corn and soybeans stock estimates were lowered (Chart 9).6 Chart 9Fundamentals Support Long Corn##BR##Vs. Short Wheat Trade The USDA lowered its expected global corn stocks-to-use ratio, and increased its wheat stocks-to-use ratio for the current crop year. Revisions to the estimates for the 2016/17 crop year also reflect similar dynamics. We expected this going into the WASDE report at the beginning of the month when we published our Special Report on the Ag markets, and got long corn vs. short wheat. December 2017 corn futures traded on CME are up 0.14% since October 5, while wheat futures are down 1.36%. This brings the return on our long corn/short wheat trade to 1.5%, to date. Highlights from the current WASDE include: Upward revisions to wheat production from India, the EU, Russia, Australia, and Canada more than offset greater projected global demand, most notably from India and the EU. Overall, global ending stocks were revised up by 4.99mm MT, and are projected to stand at 268mm MT by the end of the 2017/18 marketing year. Greater projected corn demand, most notably from the U.S. and China, more than offset the ~ 6mm MT upward revision to global production in the USDA's estimates. Higher projected Chinese demand reflects greater food and seed demand, and higher expected industrial use. Corn stocks are expected to end 2017/18 at 200.96mm MT - 1.51mm MT below September projections. Similarly, in its October Chinese Agricultural Supply and Demand Estimates, China's Agriculture Ministry increased its forecast for the 2017/18 corn deficit to 4.31mm MT from 0.89mm MT projected last month. The Ministry expects lower output and greater consumption on the back of stronger demand from ethanol plants.7 Furthermore, in a move towards market pricing, Heilongjiang - China's top corn province - will be reducing the subsidy it gives corn farmers from 153.92 yuan/mu last year to 133.46 yuan/mu. The province will reorient its subsidies to incentivize more soybean production.8 In soybean markets, USDA projections for ending stocks were reduced by 1.48mm MT to 96.05mm MT by end-2017/18, largely on the back of lower expected U.S. and Brazilian inventories in 2016/17. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com Hugo Bélanger, Research Assistant HugoB@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Report "OPEC 2.0 Will Extend Cuts To June 2018," published September 21, 2017. It is available at ces.bcaresearch.com. 2 Please see "Precious Metals Update," in the June 29, 2017 issue of BCA Research's Commodity & Energy Strategy Weekly Report "EM Trade Volumes Continue Trending Higher, Supporting Metals". It is available at ces.bcaresearch.com. 3 Please see S&P Global Platts OPEC Guide published October 6, 2017. 4 Please see Chapter 1 of the IMF's World Economic Outlook for October 2017, which is available online at https://www.imf.org/en/Publications/WEO/Issues/2017/09/19/world-economic-outlook-october-2017. 5 Our base case continues to call for an end-June 2018 extension of the OPEC 2.0 production deal. Should the deal be extended to end-December 2018, we estimate 2018 WTI prices would average $67.35/bbl, while Brent prices would average just under $70.00/bbl. We are becoming increasingly confident OPEC 2.0 will become a durable production-management coalition, given the increasing cooperation and mutual investment between KSA and Russia. We will be exploring this further in future research. Please see "King Salman Goes To Moscow, Bolsters OPEC 2.0," published October 11, 2017, by BCA Research's Energy Sector Strategy. It is available at nrg.bcaresearch.com. 6 Please see Commodity & Energy Strategy Special Report titled "Ags In 2017/18: Move To Neutral," dated October 5, 2017, available at ces.bcaresearch.com. 7 Please see "China Raises Forecast For 2017/18 Corn Deficit On Lower Output," dated October 12, 2017, available at reuters.com. 8 Please see "Top China Corn Province Cuts Subsidy For Farmers Growing the Grain," dated October 16, 2017, available at reuters.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016

Highlights This week, we are reviewing all our current active trades in our Tactical Overlay. As a reminder, these positions (Table 1) are meant to complement our strategic GFIS Model Fixed Income Portfolio, typically with shorter holding periods and occasionally in smaller or less liquid markets outside our usual core bond market coverage (i.e. U.S. TIPS or Swedish interest rate swaps). This report includes a short summary of the rationale behind each position, as well as a decision on whether to continue holding the trade, close it out or switch to a new position that may more efficiently express our view. The trades are grouped together by the country/region that is most relevant for the performance of each trade. Table 1GFIS Tactical Overlay Trades Feature U.S. Short July 2018 Fed Funds futures (HOLD). Long 5-year U.S. Treasury (UST) bullet vs. 2-year/10-year duration-matched UST barbell (HOLD). Long U.S. TIPS vs. nominal USTs (HOLD). Short 10-year USTs vs. 10-year German Bunds (HOLD). The tactical trades that we have been recommending within U.S. markets all have a common theme - positioning for an expected rebound in U.S. inflation that will push up U.S. bond yields. We are maintaining all of them. The drift lower in realized inflation rates since the spring has been a surprise given the backdrop of above-potential growth, low unemployment and a weakening U.S. dollar. On the back of this, markets have priced out several of the Fed rates hikes that had been expected over the next year, leaving U.S. Treasury yields at overly-depressed levels. Back on July 11th, we initiated a recommendation to short the July 2018 fed funds futures contract (Chart 1). This was a position that would turn a profit if the market moved to once again discount multiple Fed rate hikes by mid-2018. The trade has a modest profit of 9bps, but with scope for additional gains if the market moves to discount 2-3 hikes by the middle of next year. Our base case scenario is that the Fed will lift rates again this December, and deliver additional increases next year amid healthy growth and with inflation likely to grind higher towards the Fed's 2% target. With the market discounting 46bps of rate hikes over the next year, there is scope for additional profits in our fed funds futures trade. Another tactical position that we've been recommending is a butterfly trade within the U.S. Treasury (UST) curve, long a 5-year UST bullet versus a duration-matched 2-year/10-year UST barbell. This is a position that would benefit from a bearish steepening of the UST curve as the market priced in higher longer-term inflation expectations (Chart 2). We have held that trade for a much longer period than a typical tactical trade, going back nearly a full year to December 20th, 2016. Yet while the UST curve has flattened since that date, our trade has delivered a return of +18bps. This outperformance can be attributed to the undervalued level of the 5-year bullet at the initiation of the trade. Chart 1Stay Short July 2018##BR##Fed Funds Futures Chart 2Stay Long The 5yr UST Bullet Vs.##BR##The 2yr/10yr UST Barbell While that valuation cushion no longer exists (bottom panel), longer-term TIPS breakevens are back to the levels seen last December (middle panel), thanks in no small part to much higher energy prices (top panel). This leaves the UST curve at risk of a bearish re-steepening on the back of rising inflation expectations. Add in a U.S. dollar that is -2.5% weaker from year-ago levels (Chart 3, middle panel), and a solid U.S. economic expansion that should eventually translate into rising core inflation momentum (bottom panel), and the case for a steeper UST curve over the next 3-6 months is a strong one. The above logic also supports our trade recommendation to go long U.S. TIPS vs. nominal USTs, which is up +248bps since inception on August 23, 2016. We have been holding this trade for much longer than our usual tactical recommendations, but we will not look to take profits until we see the 10-year breakeven (now at 186bps) return back to levels consistent with the Fed's 2% PCE inflation target (i.e. headline U.S. CPI inflation back to 2.5%). One final tactical trade that will benefit from higher UST yields is our recommendation to position for a wider spread between 10-year USTs and 10-year German Bunds. This trade was initiated on August 9th of this year, and has delivered a profit of +9bps. Yet the UST-Bund spread still looks too low relative to shorter-term interest rate differentials that favor the U.S. (Chart 4, top panel). With U.S. data starting to surprise more on the upside than Euro Area data (middle panel), and with UST positioning still quite long (bottom panel), there is potential for additional near-term UST-Bund spread widening. The upcoming decision by the European Central Bank (ECB) on potential tapering of its asset purchases next year represents a potential risk for the long Bund leg of our recommended trade. Any hawkish surprises on that front would be a likely catalyst for us to close out this position. Chart 3Stay Long U.S. TIPS Vs. Nominal USTs Chart 4Stay Short 10yr USTs Vs. German Bunds Euro Area Long 10yr Euro Area CPI swaps (HOLD). Long 5-year Spain vs. 5-year Italy in government bonds (HOLD). We have two recommended tactical trades that are specifically focused on developments in the Euro Area. We are maintaining both of them. As a way to position for an eventual pickup in European inflation, we entered a long position in 10-year Euro Area CPI swaps back on December 20th, 2016. That trade is now estimated to have a profit of +29bps, as market-based inflation expectations have drifted higher in the Euro Area. The simple reason for that increase is that realized inflation has moved higher on the back of rising energy costs, as there is a very robust correlation between the annual growth rate of oil prices (denominated in euros) and headline Euro Area inflation (Chart 5). More importantly, the booming Euro Area economy, which has eaten up much of the spare capacity in the Europe, has boosted wage growth and core inflation to levels seen prior to the disinflation shock from the 2014/15 collapse in oil prices (bottom panel). With no signs of any imminent slowing of Euro Area growth that could raise unemployment and slow underlying inflation pressures, the trend for inflation expectations in Europe is still upward. The current 10-year Euro Area CPI swap at 1.5% is still well beneath the ECB's inflation target of "just below" 2% on headline CPI, so there is room for inflation expectations to continue drifting higher. ECB tapering of asset purchases is not an immediate threat to this trade, as the central bank is still likely to keep buying bonds next year (at a slower pace), while holding off on any interest rate increases until late 2019. In other words, the ECB will not be looking to act to slow economic growth to bring down Euro Area inflation anytime soon. Our other tactical trade recommendation in Europe is a relative value spread trade, long 5-year Spanish government debt versus 5-year Italian bonds. This trade was initiated on December 13th, 2016 and currently has only a modest gain of +9bps, although the profits were much larger earlier this year. Italian bonds have been outperforming on the back of improving Italian economic growth (Chart 6, top panel) and, recently, a generalized sell-off in Spanish financial assets on the back of the political uncertainty in Catalonia. Chart 5Stay Long 10yr##BR##Euro Area CPI Swaps Chart 6Stay Long 5yr Spanish Government Bonds Vs.##BR##5-Year Italian Debt Our colleagues at BCA Geopolitical Strategy have been downplaying the threat to Spanish political stability from the Catalonian independence movement, given that the polling data shows only 35% for outright independence from Spain. At the same time, the poll numbers in Italy for the upcoming parliamentary elections are much closer, with parties favoring less integration with Europe holding a slight lead over more "establishment" parties (bottom two panels). With the bulk of the cyclical convergence between Italian and Spanish growth now largely completed, and with a greater potential for future political instability in Italy compared to Spain, we expect that Spain-Italy spreads will tighten further back to the lows seen at the beginning of 2017 (-64bps on the 5-year spread). That is a level we are targeting on our current tactical trade recommendation. Canada Short 10-year Canadian government bonds vs. 10-year USTs (TAKE PROFITS). Long Canada/U.K. 2-year/10-year government bond yield curve box, positioning for a relatively flatter Canadian curve (TAKE PROFITS). Short 5-year Canada government bond versus a duration-matched 2-year/10-year barbell (TAKE PROFITS). We have three different Canadian fixed income trades in our Tactical Overlay, all of which were biased towards tighter monetary policy in Canada: a Canada-U.S. bond spread widener, a yield curve box trade versus the U.K. and a curve flattener expressed as a barbell trade (Chart 7) All three positions are in the money, but we now recommend taking profits. We had initiated these recommendations in a very timely fashion earlier in the year at a time when the Bank of Canada (BoC) was sending a relative dovish message. In our view, the Canadian economy was building significant upward momentum that would eventually force the central bank to shift its policy bias. This would especially be true with the Fed also in a tightening cycle, given the typical tendency for the BoC to follow the Fed's policy actions. Several members of the BoC monetary policy committee began to sing a more hawkish tune over the summer, particularly after the release of the Q2 BoC Business Outlook Survey. That robust report, which was confirmed by a 2nd quarter GDP growth rate of nearly 4% (Chart 8), led the BoC to deliver not one by two unexpected interest rate hikes in July and September. Markets reacted accordingly, driving Canadian bond yields higher and flattening the yield curve. Chart 7Take Profits On Bearish Canadian Bond Trades Chart 8Canadian Growth Set To Cool Off A Bit Now, we see the market pricing as having gone a bit too far, too quickly. The Q3 Business Outlook Survey, released yesterday, was still positive but with readings softer than the booming Q2 report. Meanwhile, the commentary from the BoC has become more balanced, with BoC Governor (and BCA alumnus) Stephen Poloz describing the central bank as being more "data dependent" after the recent rate hikes. Markets are now pricing in another 72bps of rate hikes over the next year, even with our own BoC Monitor off the peak (Chart 9). Chart 9Our BoC Monitor Is Peaking From a tactical perspective, the repricing of the BoC that we expected earlier this year is now largely complete. Thus, we are taking profits on all three Canadian trades: Canada-U.S. spread trade: initiated on January 17th, profit of +43bps. Canada/U.K. box trade: initiated on May 16th, profit of +67bps. Canada 2yr/5yr/10yr butterfly trade: initiated on December 6th, 2016, profit of +95bps. From a strategic perspective, we still see a case where the BoC can deliver additional rate hikes and keep upward pressure on Canadian bond yields. The output gap in Canada is now closed, according to BoC estimates, and additional strength in the economy now has a greater chance in translating to higher inflation. Strong global growth, especially in the U.S., will also support Canadian export growth and feed into rising capital spending. While the rate hikes have help boost the value of the Canadian dollar (CAD), the exchange rate (on a trade-weighted basis) also largely reflects a rising value of energy prices and is, therefore, should provide an additional boost to growth via stronger terms-of-trade (bottom panel). In other words, the rising CAD will not prevent additional BoC rate hikes if oil prices remain strong. Thus, we are maintaining our underweight recommendation on Canadian government bonds in our strategic model bond portfolio, even as we take profits on our bearish Canadian tactical trades. Australia Long a 2-year/10-year Australia government bond curve flattener (SELL AND SWITCH TO NEW TRADE). On July 25th of this year, we entered into a 2-year/10-year curve flattener trade for Australia. Though employment was improving and house prices were booming in Australia, the wide output gap, high level of consumer indebtedness and lack of real wage growth was keeping the Reserve Bank of Australia (RBA) inactive. In our view, nothing has changed since then; the RBA remains in a very difficult position. While the yield curve flattened substantially following the initiation of our trade, the global rise in long-term yields since mid-September lifted Australian longer-maturity yields, and the yield curve with it (Chart 10). Now, Australian long-term yields are not reflecting domestic fundamentals but are instead driven by improving global growth. As such, we are closing the trade and initiating a new position - long Dec 2018 Australian Bank Bill futures - as a more focused way to express the view that the RBA will stay on hold for longer than markets expect. Markets are currently pricing in 30bps of RBA rate hikes over the next twelve months. We believe this will be unlikely, for several reasons. Macroprudential measures on the Australian housing market will continue to dampen credit growth. Core inflation is slowly rising but still far below the central bank's target. Additionally, there is plenty of slack in the labor market despite the spike in employment growth. This is evidenced in anemic real wage growth, stubbornly high underemployment rate, low hours worked and high percentage of part-time to full-time workers (Chart 11). Chart 10Close Australian Government##BR##Bond 2yr/10yr Flattener Chart 11RBA Unlikely To Deliver##BR##Discounted Rate Hikes The biggest risk to our new trade would if signs of a tighter Australian labor market started to feed through into faster wage growth, which would likely coincide with faster underlying price inflation and a more hawkish turn by the RBA. New Zealand Long 5-year NZ government bonds vs. 5-year USTs (currency hedged). Long 5-year NZ government bonds vs. 5-year Germany (currency unhedged). Chart 12Stay Long 5yr NZ Government Bonds##BR##Vs. U.S, & Germany We entered two New Zealand (NZ) tactical bond trades on May 30th, going long 5-year government bonds vs. U.S. and Germany (Chart 12). We expected NZ spreads to tighten faster than the forwards based on our more hawkish views on the Fed and, to a lesser extent, the ECB relative to the more dovish view on the Reserve Bank of New Zealand (RBNZ). The outright bond spreads have tightened and, on a currency-hedged basis, both trades are in the money. Our dovish view on the RBNZ came from the central bank's own forecasts, which called for slowing headline inflation on the back of softer "tradeables" inflation and a sharp cooling of domestic "non-tradeables" inflation through a slowing housing market (Chart 13, bottom two panels). Our own RBNZ Monitor has been calling for the need for higher interest rates in NZ, mostly from the strength in the labor market. Yet we have been ignoring that signal, as has the market which has priced out one full expected RBNZ rate hike since the beginning of the year. With business confidence rolling over, and with the trade-weighted NZ dollar still staying at stubbornly strong levels, the case for the RBNZ to deliver even a single rate hike is not a strong one - especially given the soft inflation forecasts of the central bank. Thus, we are sticking with our tactical spread trades for NZ versus the U.S. and Germany. We are maintaining the currency hedge on the U.S. version of the trade, as we typically do for the vast majority of our cross-country spread trade recommendations. Occasionally, however, we will make an active decision to do a spread trade UN-hedged if we felt very strongly about a currency move. We did that for our NZ-Germany spread trade and this has cost us in the performance of the trade, which is down -3.4%. This is because of a surprisingly large decline in the New Zealand dollar (NZD) versus the euro since the inception of our trade. Yet a review of the technical indicators on the NZD/EUR currency cross shows that the currency pair is now very stretched versus its medium-term trend (the 40-week moving average), with price momentum also at some of the most negative levels of the past decade (Chart 14). These measures suggest that the worst of the downturn in the currency is likely over. The relative positioning on the two individual currencies is now neutral, as long positions on the NZD have been reduced (bottom panel). Chart 13RBNZ Dovishness Is Justified Chart 14Keep NZ/Germany Position Currency Unhedged Given these technical indicators, and from these current levels, we see greater upside potential for NZD/EUR in the months ahead. This leads us to maintain our unhedged currency position on the NZ-Germany spread trade so as not to realize the current mark-to-market losses on the trade. Sweden Pay 18-month Sweden Overnight Index Swap (OIS) rate (TAKE PROFITS). We entered into a bearish Swedish rates position back on November 22nd, 2016, paying Sweden 18-month Overnight Index swap rates (Chart 15). At the time, we expected the Riksbank to begin hiking interest rates earlier than what was priced in the markets IF inflation reached the central bank target faster due to a weaker Swedish krona. We also believed that the economy would continue to expand at a robust pace when the economy had no spare capacity, creating additional upside inflation surprises. According to the Riksbank's latest Monetary Policy Statement (MPS), the central bank will likely keep the repo rate at -0.5% until mid-2018, while continuing its asset purchase program until the end of this year - even with an overheating economy. This is because realized inflation has remained below the Riksbank target for a long period of time and, although current inflation is above target, it was not necessary to immediately tighten conditions. More likely, the Riskbank is worried about the potential for the krona to appreciate - especially versus the euro - if rate hikes are delivered. It will only be a matter of time before the central bank is forced to tighten policy with the economy likely to strengthen further, led by solid domestic demand, strong productivity growth, and improving exports. Consumption is also expected to increase as households have scope to cut back their high level of savings. Combining the Riksbank's easing policy with the current strength of the economy and the tightness of the labor market, inflation is very likely to return to the 2% target in the next year or two (Chart 16). Chart 15Close Sweden OIS Trade Chart 16Riksbank More Worried About SEK Than Inflation However, if the Riskbank remains too concerned about the currency versus the euro, as we suspect, then this will prevent any shift to a more hawkish stance before any change from the ECB. That is unlikely to happen over the next year, at least, even if the ECB slows the pace of asset purchases as we expect. Thus, we are closing out our Sweden 18-month Overnight Index Swap position at a small profit of 12bps. We have already kept this trade for longer than the typical investment horizon for one of our tactical overlay trades. We will investigate the potential for more profitable trade opportunities in the Swedish fixed income markets in a future report. Korea Long a 2-year/10-year Korean government bond yield curve steepener (HOLD). We recommended entering into a 2-year/10-year steepening trade in the Korean government bond yield curve on May 30th, 2017. Since then, the yield curve has flattened by 7bps, which was mainly caused by an unexpected rise in the 2-year yield, rather than a decline in 10-year yield (Chart 17). Korea is currently enjoying a solid business cycle upturn. Leading economic indicators are rising, the year-over-year growth in exports has risen to a 7-year high and previously sluggish private consumption has also rebounded recently. The Bank of Korea (BoK) is of the view that the recovery will continue and consumer price inflation will stabilize at the target level over the medium-term. This recovery should cause the 2/10 curve to steepen as longer-term inflation expectations rise. Based on South Korean President Moon's aggressive fiscal plans to increase welfare spending and create jobs in the public sector, at a time when the economy is good shape, we still believe that long-end of the curve (10-year) will rise. In addition, as shown in Chart 18, the 26-week rolling beta of changes in the 10-year UST yield and Korean 10-year bond is very high, nearly 1. Given our bearish view on USTs, this implies Korean yields can follow suit. On the other hand, the correlation between the 2-year UST yield and equivalent maturity Korean yields is much lower (4th panel), as Korean rate expectations have not been following those of the U.S. higher - even with a stronger Korean economy. Most likely, this is due to investors downplaying the potential for the BoK to match Fed rate hikes tick-for-tick given the heightened tensions between the U.S. and North Korea. Chart 17Stay In Korea 2yr/10yr##BR##Government Bond Steepener Chart 18Long-Term Korean##BR##Yields Are Too Low We still believe the Korean curve can steepen as longer-term yields rise, although we will be monitoring the behavior of shorter-dated Korean yield as the situation between D.C. and Pyongyang evolves. If investors begin to demand a higher risk premium on Korean assets, particularly the Korean won, then 2-year Korean yields may rise much faster and our curve trade may not go our way. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Patrick Trinh, Associate Editor Patrick@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights High-Yield: High-Yield spreads are 149 bps away from being more expensive than they have ever been. But in the absence of inflation it is difficult to pinpoint a catalyst for sharp spread widening. We expect excess high-yield returns between 2% and 5% (annualized) during the next 6-12 months. EM Sovereigns: There is no compelling valuation argument in favor of hard currency EM Sovereign debt versus U.S. corporate bonds. We will look to shift into EM once the pace of Fed rate hikes starts to slow later in the cycle. Economy & Inflation: Core inflation disappointed expectations in September, but the details of the report showed some silver linings. Inflation looks to be past the worst of its downtrend and should be strong enough during the next two months for the Fed to lift rates in December. Feature Chart 110-Year Treasury Yield Breakdown Just past the three quarter mark of 2017 and stubbornly low inflation remains the story of the year in U.S. bond markets. Quite simply, if inflation rebounds during the next two-and-a-half months, as the Federal Reserve expects, then Treasury yields will move sharply higher and Treasury total returns for 2017 will be close to zero. Otherwise, yields are likely to remain near current levels and 2017 Treasury total returns will approximate carry, in the range of 2.5%. Our valuation framework for the 10-year Treasury yield underscores the importance of inflation for the duration call. The real 10-year Treasury yield (currently 0.43%) is consistent with market expectations for just under two Fed rate hikes during the next 12 months (Chart 1). With the median Fed member calling for 3-4 hikes during that period, the potential remains for somewhat higher real yields in the near-term. But with all but one Fed member forecasting a terminal fed funds rate of 3% or below (1% or below in real terms), the long-run upside in real yields appears limited. On the other hand, the compensation for inflation embedded in 10-year bond yields is still far too low. At 1.85%, the 10-year TIPS breakeven inflation rate is well below the 2.4% to 2.5% range consistent with the Fed hitting its inflation target. This continues to be the case even as our Pipeline Inflation Indicator has accelerated in recent weeks (Chart 1, bottom panel). Bond investors are waiting for inflation to show up in the core CPI and PCE data before liquidating their positions. We retain our below-benchmark duration bias on a 6-12 month horizon on the view that inflation will soon resume its cyclical uptrend. 10-year inflation compensation has 55-65 bps of upside in this scenario, while 10-year real yields will probably stay close to current levels. The outlook for core inflation is discussed in more detail in the Economy & Inflation section below. High-Yield: Just A Carry Trade At this late stage of the credit cycle, low inflation is also the key support for excess returns in both investment grade and high-yield corporate bonds. We see limited scope for further spread tightening but think it's likely that the carry trade will continue until inflation turns the corner and long-maturity TIPS breakevens settle into the 2.4% to 2.5% range consistent with the Fed's target.1 In this week's report we explore what this carry trade means for excess high-yield returns, and put those returns into context with what the asset class has typically delivered for bond investors. Table 1 shows historical annual excess returns for the Bloomberg Barclays High-Yield index since 1995.2 On average High-Yield has returned 3.42% over Treasuries each year, but with significant variation. Most of that variation results from years when the default rate is either rising quickly during a recession or falling fast in the early stages of economic recovery. Since neither of those scenarios is likely during the next 6-12 months we filter out those periods by looking at years when the average index option-adjusted spread (OAS): Widened by more than 100 bps Tightened by more than 100 bps Was range bound between -100 bps and +100 bps The average excess return is 4.9% in years when the spread is confined to a -100 bps to +100 bps range. High-Yield has returned 5.46% in excess of Treasuries so far this year, and the OAS has tightened 61 bps. It is unlikely that junk spreads will tighten by 100 bps or more during the next 12 months. The average index OAS is currently 348 bps, only 115 bps above its all-time low (Chart 2). However, to properly assess current spread levels we also need to consider that the average index duration has declined during the past fifteen years. All else equal, the same spread level is more attractive today because index duration is lower. Table 1Historical Annual High-Yield##br## Excess Returns* (%) Chart 2Junk Spreads Not Far ##br##From All-Time Tights We adjust for index duration by looking at the 12-month breakeven spread.3 At 93 bps, the breakeven spread is currently 40 bps above its all-time low (Chart 2, bottom panel). In other words, at current duration levels, the junk OAS can tighten another 149 bps before the sector is more expensive than it has ever been. Either way, what's clear from Chart 2 is that we should probably not expect much more than 100 bps of further tightening this cycle. Or, put differently, it would definitely make sense to reduce high-yield exposure as we approach all-time expensive valuations. But we can get even more specific about our expectations for high-yield excess returns. Excess junk returns can be approximated using the following formula: Excess return = Starting OAS - Default Losses - Duration*(Change in OAS) The expected return from carry during the next 12 months can be thought of as today's index spread less our expectation for default losses. Capital gains and losses can be approximated using today's index duration and the expected change in spreads. For simplicity we ignore convexity effects. This excess return approximation is shown in the second panel of Chart 3, where the dashed line assumes a base case scenario where default losses fall in line with our expectation and the OAS remains flat. Table 2 shows what 12-month excess returns would be in this base case scenario, as well as in several other scenarios. Chart 3High-Yield ##br##Expected Returns Table 2High-Yield 12-Month Excess ##br##Return* Projections In a base case scenario, where default losses are 1.09% and the OAS is flat, we would expect excess junk returns of 2.39% during the next 12 months. In a more bullish scenario where the OAS tightens by another 100 bps - bringing it to within striking distance of all-time tights - we would expect excess returns of 6.15%. We also consider scenarios where default losses differ from our forecast of 1.09%. For context, that 1.09% forecast is derived from Moody's baseline default rate forecast of 2.26% and our own model-based recovery rate forecast of 51%. For example, in a scenario where default losses are somewhat higher than expected (2%) but where the OAS stays flat, we would expect excess returns of only 1.48%. We should note that 12-month high-yield default losses have never been lower than 0.5%. So we present that optimistic scenario as an upper-bound on potential excess returns to junk. Notice that even in the most optimistic scenario we can envision, default losses reaching all-time lows and spreads contracting to within a hair of all-time tights, expected excess high-yield returns still only reach 6.74%. We would view that as the absolute best case scenario for high-yield. Realistically, default losses will probably fall into a range between 1% and 2% during the next 12 months. Assuming also that spreads come under neither strong upward nor downward pressure, we would expect excess high-yield returns between 2% and 5% (annualized) during the next 6-12 months. Bottom Line: High-Yield spreads are 149 bps away from being more expensive than they have ever been. But in the absence of inflation it is difficult to pinpoint a catalyst for sharp spread widening. We expect excess high-yield returns between 2% and 5% (annualized) during the next 6-12 months. Is Hard Currency EM Debt A Substitute For Junk? Chart 4Favor U.S. Corporates Over EM Sovereigns With relatively feeble expected returns from U.S. high-yield bonds, it's logical to explore whether there are any more attractively valued alternatives in the U.S. bond universe. One potential candidate is the U.S. dollar denominated debt of Emerging Market governments. Unfortunately, valuation in that space does not look much better than in U.S. corporates. In an effort to control for differences in both credit rating and index duration, we compare 12-month breakeven spreads between the Bloomberg Barclays EM USD Sovereign Index and a credit rating matched benchmark consisting of a combination of U.S. investment grade and high-yield corporate bond indexes. We notice that hard currency EM Sovereigns and similarly rated U.S. corporate bonds offer almost exactly the same breakeven spread, and also that EM Sovereigns have been getting comparatively cheaper since early last year (Chart 4). At the moment there is no compelling argument to favor one sector over the other on pure valuation grounds. We therefore also consider the main macro drivers of relative excess returns between EM Sovereigns and U.S. corporates (Chart 4, bottom 2 panels). The last two significant periods of EM outperformance coincided with falling U.S. rate hike expectations - as evidenced by our declining fed funds discounter - and a weaker U.S. dollar. With our 24-month fed funds discounter at only 62 bps - meaning the market expects less than three rate hikes during the next 24 months - we think it is likely to move higher from here. This should lead to one more bout of EM cheapening relative to U.S. corporates. At that point, once we are past peak rate hike expectations for the cycle, we will likely get a more attractive entry point to move into EM. Interestingly, an examination of country level spreads also does not identify any clear pockets of cheapness in EM (Chart 5). Mexico and Turkey both offer similar breakeven spreads to equivalently rated U.S. corporates, but our Emerging Markets Strategy service has a dim view of both the Turkish Lira and Mexican peso versus the U.S. dollar.4 The higher-rated EM countries: Saudi Arabia, UAE and Qatar offer the most attractive relative spreads. But, at least for Qatar, that elevated spread is most likely compensation for a highly volatile currency (Chart 6).5 Chart 5Breakeven Spreads: USD EM Sovereign Vs. U.S. Corporates Chart 6USD EM Sovereign Breakeven Spread Differentials Vs. Exchange Rate Volatility Bottom Line: There is no compelling valuation argument in favor of hard currency EM Sovereign debt versus U.S. corporate bonds. We will look to shift into EM once the pace of Fed rate hikes starts to slow later in the cycle. Economy & Inflation Some Silver Linings In September's CPI The September CPI report was released last week and it disappointed expectations with core CPI rising only 0.13% month-over-month. For context, an environment where inflation is well anchored around the Fed's target would be consistent with core CPI prints of 0.2% every month, roughly 2.4% annualized. However, despite the disappointing month-over-month figure, we continue to see evidence that inflation is past the worst of its recent downtrend. First, while year-over-year core CPI was roughly flat in September, the 3-month rate of change increased for the fourth consecutive month. The year-over-year rate of change tends to converge toward the 3-month rate of change (Chart 7). Second, a look at the underlying components of core CPI shows the following (Chart 8): Chart 7CPI Inflation Chart 8Core CPI Components Shelter inflation fell from 3.30% to 3.24% year-over-year in September. This mild deceleration is consistent with the reading from our model, and will persist going forward (Chart 8, panel 1). Chart 9Wireless No Longer A Drag Core goods inflation also fell in September, but should soon start to rise as the weaker dollar and rising import prices pass through to overall core goods prices (Chart 8, panel 2). Core services inflation, excluding shelter and medical care, increased for the third consecutive month (Chart 8, panel 3). This component of inflation is most sensitive to wage growth, and it is where we would expect most of the inflation to come from going forward. Medical care inflation continues to decelerate sharply (Chart 8, bottom panel), but as we have discussed previously, this mostly reflects a convergence between CPI and PCE inflation.6 The Fed's 2% target refers to PCE inflation. The acceleration in core services inflation (excluding shelter and medical care) is particularly important as it is yet another signal that tight labor markets are starting to pressure wages higher. This is the dynamic that must continue to play out if inflation is to return to the Fed's target, and we would tend to view increases in inflation as more sustainable if they are driven by this component. Additionally, the critical core services inflation (excluding shelter and medical care) component has been depressed in recent months by an incredibly sharp decline in cellular service (aka wireless) inflation (Chart 9). The decline occurred when both Verizon and AT&T unveiled unlimited data plans in the same month, but that drop has since reversed. When we exclude wireless from core services inflation, in addition to shelter and medical care, we see that the resulting series tracks wage growth much more closely in recent months. This underscores our conviction that core services inflation will respond to tightening labor markets and mounting wage pressure going forward. Consumer Sentiment Is Sky High There was one other notable datapoint released last week, and that was the University of Michigan's Consumer Sentiment survey which surged to its highest level since 2004 (Chart 10)! This should lend support to consumer spending (and hence GDP growth) in Q3 and Q4 and is consistent with the message from the New York Fed's GDP tracking estimate which projects GDP growth to average 2.3% in the second half of 2017. This is well above the Fed's 1.8% estimate of trend. Chart 10Consumer Spending & Sentiment With growth coming in solidly above trend, it is unlikely that September's disappointing month-over-month CPI print will be enough to prevent the Fed from lifting rates in December. As long as inflation is flat or higher during the next two months, then another rate hike this year is probably in the cards. Bottom Line: Core inflation disappointed expectations in September, but the details of the report showed some silver linings. Inflation looks to be past the worst of its downtrend and should be strong enough during the next two months for the Fed to lift rates in December. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com 2 Excess returns are calculated relative to a duration-matched position in Treasury securities. 3 The 12-month breakeven spread is the spread widening required on a 12-month investment horizon to deliver zero excess returns. For simplicity we ignore convexity effects and calculate the breakeven spread as OAS divided by duration. 4 For Turkey please see Emerging Markets Strategy Weekly Report, "Is The Dollar Expensive, And Are EM Currencies Cheap?" dated October 11, 2017. For Mexico please see Emerging Markets Strategy Weekly Report, "Questions From The Road", dated September 20, 2017. Both available at ems.bcaresearch.com 5 Both Saudi Arabia and UAE have pegged exchange rates and are not shown in Chart 6. 6 Please see U.S. Bond Strategy Weekly Report, "The Great Unwind", dated September 19, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Revisiting the shadow banking system 10 years later. The September CPI data is unlikely to resolve the inflation debate at the Fed. How to invest in a late cycle environment. Wage Inflation was on the rise even before the hurricanes. Feature Chart 1September CPI And Retail Sales Keep##BR##The Fed On Track To Tighten The state of the U.S. business cycle, and what could end it, were key topics of conversation at BCA's semi-annual Research Advisory Board meeting in early October. Most participants agreed with the BCA view that the economy is in the late stages of the economic cycle, and a few suggested that another bubble in the shadow banking sector may end the expansion. With those discussions in mind, we review the state of the shadow banking in the first section of this report and then examine how key aspects of the economy and U.S. asset classes behave while the U.S. economy is in the final stages of an expansion. In the final section, we take another look at wage inflation signals from the hurricane impacted September jobs report, and conclude that wage growth has accelerated even excluding the effect of the storms. The September CPI and retail sales data were also impacted by the storm, but the message is that the underlying economy is strong enough to generate some inflation (Chart 1), although the September CPI is unlikely to resolve the inflation debate at the Fed. The minutes of last month's FOMC meeting (released last week) indicate that the upcoming inflation data could be pivotal to whether the Fed delivers another rate hike in December. There are two more CPI reports ahead of the December FOMC meeting (with the second release coming on the day of the policy announcement). While the September CPI data was hard to interpret due to the storms, the next few data prints need to affirm the Fed's forecast that core inflation is indeed recovering from the "transitory weakness" seen earlier this year. BCA's U.S. bond strategists believe that inflation will be strong enough for the Fed to justify a hike in December and recommend below-benchmark duration for fixed income portfolios. Shadow Banking Update At current levels, shadow banking activity in the U.S. is not a threat to the economic expansion. The ratio of financial sector debt to non-financial sector debt is a rough proxy of how the system can leverage existing debt into new securities and boost credit creation (Chart 2). As financial innovation and deregulation boosted system liquidity, outstanding financial debt as a percentage of non-financial debt climbed from 10% in the mid-1970s to over 50% in 2008. In Q2 2017, the shadow banking proxy stands at only 33%, because the global financial crisis and subsequent reregulation of the financial sector have reigned in excesses. The last time that the ratio was this low was in the late 1990s. Bank lending standards highlight key differences between the backdrop in the mid-2000s and today (Chart 3). In the mid-2000s, even as the Fed had boosted rates by 425 basis points, lending standards were easy and loosening. In contrast, the 100 bps increase in the Fed funds rate since late 2015 was accompanied by a tightening of lending requirements. Moreover, lending criteria were already tight when the Fed began its latest rate hikes. Chart 2The Shrinking Shadow##BR##Banking Sector Chart 3Bank Lending Standards Tighter##BR##Today Than In Mid '00s The Fed and other regulators are more attuned to financial excesses than they were a decade ago. The central bank under Yellen has raised the profile of financial stability.1 BCA views "financial stability" as a third mandate for the central bank, along with low and stable inflation, and full employment. That said, the Fed did not assess financial stability at the September FOMC meeting and the topic was only briefly mentioned by Fed staff and FOMC participants. At the July 2017 meeting, the central bank's staff characterized the "financial vulnerabilities of the U.S. financial system" as moderate on balance. BCA expects that the Fed will return to the topic at either one or both remaining FOMC meetings in 2017. The October 2017 Bank Credit Analyst Monthly Report2 provided a checklist of liquidity measures to watch as the U.S. economy enters the end of an elongated expansion. In view of these indicators, we would describe liquidity conditions in the U.S. as fairly accommodative, although not nearly as abundant as prior to the Lehman event in 2008. Monetary conditions are super easy, while balance sheet and financial market liquidity are reasonably constructive. In contrast, funding liquidity, while vastly improved since the global financial crisis, is still a long way from the pre-Lehman go-go years (as per indicators such as bank leverage). The Fed is set to begin the process of unwinding the massive amount of monetary liquidity created by its quantitative easing program. This has the potential to undermine other types of liquidity in the financial system, leading to a correction in risk assets. However, the BCA Special Report argues that the reaction of the bond market is more important for risk assets than the balance sheet adjustment itself. If inflation only edges higher and market expectations for the upward path of the Fed funds rate remain gentle, then risk assets should take the balance sheet unwind in stride. An abrupt upward shift in inflation would be an altogether different story. Bottom Line: The U.S. expansion entered a late-cycle environment near the close of 2016 as the unemployment rate dipped below NAIRU. Nonetheless, none of our recession-timing indicators warns that a downtown is imminent3 and the financial excesses in the end stage of the 2001-2007 economic expansion are not present today. If the next recession begins in the second half of 2019, then global equities will probably peak earlier that year or in late 2018. Given the starting point for valuations, U.S. equities may decline by 20% to 30% peak-to-trough. Stay overweight equities for now. The time to trim exposure could come in mid-2018. Late-Cycle Playbook Chart 4Easier Financial Conditions##BR##Will Boost U.S. Growth Easing financial conditions will lead to faster U.S. GDP growth in the next few quarters. Financial conditions have eased sharply this year due to a strengthening stock market, narrower credit spreads and a weaker dollar. Changes in financial conditions lead growth by about 6 to 9 months, implying that U.S. growth could reach 3% early next year (Chart 4). This could drop the unemployment rate to 3.5% by end-2018, more than one point below the Fed's estimate of full employment and even lower than the 2008 low of 3.8%. Rising inflation will compel the Fed to lift rates aggressively next year to cool the economy and push the unemployment rate back above NAIRU. The U.S. has never averted a recession in the post-war era when the unemployment rate has increased by more than one-third of a percentage point. BCA's stance is that the U.S. economy enters the expansion's final stage when the unemployment rate dips below NAIRU. Chart 5 shows that the unemployment rate moved below NAIRU in November 2016. In the past 45 years, the economy has spent an average of 33 months in late-cycle mode ahead of 5 recessions. The exception was 1981-82 when the unemployment rate did not dip below NAIRU ahead of the recession; we treated the separate 1980 and 1981-82 recessions as one episode. Note that several of these late-cycle intervals overlap with recessions (vertical lines on Charts 5, 6 and 7 indicate the start of recessions). Chart 5Late Cycle Performance Of Stocks, Bonds, & Commodities The late-cycle environment favors equities over Treasuries, gold and oil, but other risk assets (small caps, investment-grade and high-yield corporates) underperform (Table 1). The dollar drops by an average of 5% in late cycles and it moved lower in 4 of the 5 previous episodes. Oil is a consistent late-cycle performer, climbing in all the stages in our analysis. The average returns across all assets classes are similar, even excluding the 1973 OPEC oil embargo and the 1987 stock market crash. Nonetheless, asset class returns in the current environment have mostly run counter to history. Table 1Late Cycle Performance Of Stocks, Bonds, & Commodities In typical late-cycle performance, U.S. stocks have outperformed Treasuries since November 2016, the dollar has weakened and oil is up, though by far less than in an average late cycle. However, both investment-grade and high-yield corporate bonds have outpaced Treasuries, and small caps have beaten large caps. Moreover, gold prices have dropped. However, the current late-cycle period has been in place for only 10 months, which is more than two years short of the 33-month average of late cycles since 1972 (Table 1). Furthermore, the level of S&P 500 earnings, both trailing and forward, also rise uniformly in late cycles. That said, earnings growth tends to peak about halfway through each cycle, but we note that we have only forward EPS data for three of the five episodes in our analysis. Profit margins take the same course as earnings and earnings growth (Chart 6). The late-cycle climb in wages and labor compensation impacts margins. Additionally, inflation tends to escalate during late cycles (Chart 7). Chart 6S&P 500 Earnings And Margins In Late Cycle Chart 7Inflation And Interest Rates During Late Cycles Bottom Line: The late-cycle environment may persist for another two years or so, favoring stocks over bonds, a weaker dollar and higher oil prices. Although we are overweight both investment-grade and high-yield corporate bonds, these two asset classes tend to underperform Treasuries as the business cycle fades. We also expect wages and inflation to continue to mount, suggesting that duration should be kept short. The late-cycle pattern is at odds with BCA's view that the dollar will appreciate modestly in the next 12 months. However, the dollar's trajectory depends both on Fed policy and the direction of rates in the economies of the major U.S. trading partners. The Bank of Canada will be lifting rates in the coming quarters, but policy rates will be flat for some time in the Eurozone and Japan, such that interest rate differentials will shift in favor of the dollar on a multi-lateral basis. Another Look At Wage Inflation In last week's report4 we indicated that the September jobs report was difficult to interpret due to the impacts of Hurricanes Harvey and Irma. Specifically, we stated that the unexpected 0.5% month-over-month gain in average hourly earnings should be discounted. Employment in the low-paying leisure and hospitality sector fell by 111,000 in September, helping to boost the aggregate average hourly wage. These wages will correct lower as these workers return to their jobs post-hurricane recovery. A closer look at the wage data, however, suggests that the acceleration in wage growth in September 2017 to 2.9% from 2.7% in August and a recent low of 1.9% in 2014, has been in place for some time. Admittedly, the 2.9% year-over-year reading on wage inflation, may have overstated labor costs in September. That said, at 56% in August, the percentage of U.S. states where the year-over-year percentage change in average hourly earnings is rising has been on the upswing since mid-2014. The August reading was the highest since 2012 (Chart 8). In Chart 9, we created an "equally-weighted" AHE measure to adjust for shifts in the composition of the labor market, but we found that the recent deceleration is not linked to compositional effects. Since wage growth bottomed out in late 2012, the compositional shifts slightly lowered wage inflation on average, but the growth rates today are roughly the same. Chart 10 updates research by the Kansas City Fed5 that found only a few industries (mostly in the goods-producing sector) account for most of the rise in wages, notably manufacturing, construction and wholesale trade. Financial services, retail, professional and business services, and leisure and hospitality - all service sector industries - were the laggards. The report shows that although earnings growth has fallen behind in service-oriented industries since 2015, hours worked have increased faster than in the goods-producing sector. Chart 856% Of States Have Seen##BR##Higher Wage Inflation Chart 9Compositional Effects Do Not##BR##Explain Recent Wage Weakness Chart 10Acceleration In Hours Worked##BR##Should Lead To Faster Wage Growth Moreover, the August JOLTS data also provides evidence that the labor market began to tighten before the effects of Harvey and Irma. The quit rate matched a 15-year high in August, and job openings were at an all-time high. Job openings in the leisure and hospitality sector were at all-time highs in August, and the quit rate in that storm-impacted industry stood at 4.2% (Chart 11). Even excluding the leisure and hospitality industry from the average hourly earnings data, wage growth has unambiguously climbed in the past 1- and 3- months (Chart 12). Chart 11Overall Job Openings And Quit Rates##BR##Vs. Leisure And Hospitality Chart 12Wage Acceleration Evident Even##BR##Excluding Leisure And Hospitality Bottom Line: Wage inflation was on the upswing even before the hurricanes hit in late August and September. Persistent wage inflation will allow the Fed to raise rates again in December and three or four times next year. This supports BCA's underweight stance on duration. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA's U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate," July 24, 2017. Available at usis.bcaresearch.com. 2 Please see The Bank Credit Analyst Monthly Report, "Liquidity And The Great Balance Sheet Unwind," October 2017. Available at bca.bcaresearch.com. 3 Please see BCA's Global Investment Strategy Weekly Report, "Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear," October 4, 2017. Available at gis.bcaresearch.com. 4 Please see BCA's U.S. Investment Strategy Weekly Report, "Small Cap Surge," October 9, 2017. Available at usis.bcaresearch.com. 5 "Wage Leaders and Laggards: Decomposing The Growth In Average Hourly Earnings," Willem Van Zandweghe, Federal Reserve Bank of Kansas City, February 15, 2017.

Special Report

Dear Client, There is no regular report this week. Instead, I am sending you a Special Report written by colleague Mark McClellan, who examines global equity valuations from a bottom-up perspective using our Equity Trading Strategy (ETS) platform. I discussed the intellectual underpinnings for the ETS model in 2015. In addition, if you haven't done so already, please take a moment to listen to our latest webcast, where I survey the global macro landscape, drawing on the material published in our Quarterly Strategy Outlook. Best regards, Peter Berezin, Chief Global Strategist Highlights The performance of Japanese stocks relative to the U.S. has been dismal over the past couple of decades, and the same is true for Europe in the post-Lehman period. However, both the Japanese and European economies are performing impressively this year, profit growth is accelerating and margins are rising. This suggests that there could be some "catch up" for both markets, at least in local-currency terms. Standard valuation measures based on index data also suggest that Eurozone and Japanese stocks are cheap compared to the U.S. Nonetheless, these markets almost always trade at a discount, due to a persistent lackluster profit performance. In this Special Report, we approach the issue from a bottom-up perspective, utilizing the powerful analytics provided by BCA's exciting new Equity Trading Strategy (ETS) platform. The ETS software allows us to compare companies across markets on a head-to-head basis and rank them based on a wide range of characteristics. The bottom-up approach adjusts for structural valuation gaps between these markets and avoids the problems of index construction. Investors can have greater confidence that they will make money on a 12-month horizon by taking a position when the new bottom-up indicators reach +/-1 standard deviations over- or under-valued, although technical information should be taken on board to sharpen the timing. The +/-2 sigma level gives clear buy/sell signals irrespective of fundamental or technical factors. The bottom-up valuation indicators will not replace our top-down versions that are based on index data, but rather will be considered together when evaluating relative value. European stocks are near fair value relative to the U.S. at the moment, while Japan is modestly cheap. We favor the European and, especially, Japanese markets over the U.S., due to policy divergence and the view that EPS has more room to expand in the former two economies. Feature Chart 1European And Japanese Stocks Have Lagged... Japanese equities have been perennial underperformers versus the U.S. for most of the past 2-3 decades in both local- and common-currency terms (Chart 1). The simultaneous bursting of the equity and land bubbles in the 1990s ushered in a prolonged period of deflation in wages and consumer prices. There was a ray of light in the early years of Abenomics, when the aggressive three-arrow approach appeared to be finally lifting the Japanese economy out of a Secular Stagnation. Yen weakness contributed to a surge in earnings-per-share (EPS) in absolute terms and relative to the U.S. Equity multiples rose between 2012 and 2015. Unfortunately, Abe's honeymoon with equity markets faded in 2016 (Chart 2). A bout of yen strength, collapsing inflation expectations, weakening business confidence and a lack of progress on structural reforms caused investors to question the upside potential for Japanese corporate top-line growth. While European indexes have fared better than Japanese stocks relative to the U.S. over the past 25 years as a whole, the post-Lehman period has been particularly tough for European corporate profitability and relative equity market performance. The U.S. total return index has more than doubled its pre-recession peak according to Thomson Reuters/Datastream data, while the Eurozone total return index is only 10% above the previous high-water mark when expressed in U.S. dollars (Chart 2). The yawning return gap between the two equity markets was almost entirely due to earnings as market multiples have moved largely in sync. Earnings-per-share generated by U.S. companies now exceed the pre-recession peak by about 23%. In contrast, earnings produced by their Eurozone peers are a whopping 42% below their peak (common-currency). That said, the earnings backdrop now appears to be shifting. The strengthening global recovery is turbocharging EPS growth in Europe and Japan, where the corporate sector is more leveraged to global growth than is the case in the U.S. Eurozone domestic demand is also hot. Japan is still struggling with deflation, but the economy is performing well and the corporate sector is benefiting from this year's yen pullback. Japanese EPS is surging in both yen and dollar terms. Finally, both Europe and Japan appear cheap versus the U.S. by traditional valuation metrics. Based on index data, these two markets trade at a hefty discount across most of the main valuation measures (Chart 3). This is the case even for normalized measures such as price-to-book. However, these two markets have almost always traded at a discount to the U.S. Chart 2...Due To Depressed Fundamentals Chart 3Europe And Japan Trade At A Discount There are many possible explanations for the persistent valuation gap, including differences in accounting standards, discount rates and sector weights. The wider use of stock buybacks in the U.S. also favors American equity valuations. But most important are historical differences in underlying corporate fundamentals. U.S. companies on the whole have been significantly more profitable over the years based on return on equity and operating margins (Charts 4 and 5). Until recently, U.S. companies have also tended to have lower leverage relative to Europe and Japan, and a higher interest coverage ratio than Europe. Better profitability metrics in the U.S. are not solely an artifact of sector weighting either. Operating margins are lower in Europe and Japan even after applying U.S. sector weights to the other two markets (Chart 6). Chart 4RoE Is Consistently Lower In Japan And Europe Chart 5U.S./Europe/Japan Comparison Chart 6U.S./Europe/Japan Comparison (U.S. Sector Weights) Why the European and Japanese corporate sectors have been profit underachievers is beyond the scope of this paper. U.S. companies reaped most of the benefit from productivity gains over the past 25 years, with the result that the capital share of income soared while the labor share collapsed. European and Japanese companies were less successful in squeezing down labor costs. This raises the question of whether European and Japanese stocks are, in fact, cheap relative to the U.S. Measuring Value Our monthly Bank Credit Analyst publication developed top-down valuation indicators that adjust for different sector weights and persistent differences in the underlying profit fundamentals. These indicators are based on index data, and have a good track record for providing profitable buy/sell signals.1 In this Special Report, we take a bottom-up approach that utilizes the powerful analytics provided by BCA's Equity Trading Strategy (ETS) platform.2 The software allows us to compare companies on a head-to-head basis and rank them based on a wide range of characteristics. The bottom-up approach avoids the problems of index construction when trying to gauge valuation across countries. The web-based platform uses over 27 quantitative factors to rank approximately 10,000 individual stocks in 23 countries, allowing clients to find stocks with winning characteristics at the global level. Users can rank and score individual equities to support a broad set of investment strategies and apply macro and sector views to single-name investments. The ETS approach has an impressive track record.3 Historically, the top-decile of stocks ranked using the "BCA Score" methodology has outperformed stocks in the bottom decile by over 25% a year. The BCA Score includes 27 factors when ranking stocks, including sentiment and momentum. However, since we are interested in developing a valuation metric in this paper, we focus on five valuation measures in the ETS database: trailing P/E, forward P/E, price-to-book, price-to-sales and price-to-cash flow. We combined all of the Eurozone and U.S. companies that have total assets of greater than $1 billion into one dataset. The ETS platform then ranked the stocks from best to worst on a daily basis (i.e., cheapest to most expensive), using an equally-weighted average of the five valuation measures. The average score for U.S. stocks is subtracted from the average score for European stocks, and then divided by the standard deviation of the series. This provides a valuation metric that fluctuates roughly between +/- 2 standard deviations. This approach inherently adjusts for structural valuation gaps. We then used the same methodology to construct bottom-up valuation indicators for Japan relative to the U.S. Chart 7 presents the resulting bottom-up indicators for Europe and Japan, along with our top-down valuation measure. A high reading indicates that European or Japanese stocks are cheap relative to the U.S., while the opposite is true for low readings. Chart 7Top-Down And Bottom-Up Valuation Indicators The underlying bottom-up data extend back to 2000. However, the bursting of the tech bubble in the early 2000's caused major shifts in relative valuation among sectors that skew the indicator when constructed using the entire data set. A cleaner indicator emerges when using only the data from 2005. As with any valuation indicator, it is only useful when it reaches extremes. We calculated the historical track record for a trading rule that is based on critical levels of over- and under-valuation. For example, we calculated the (local-currency basis) excess returns over 3-, 6-, 12- and 24-month horizons generated by (1) overweighting European or Japanese stocks when that market was one and two standard deviations cheap versus the U.S. market, and (2) overweighting the U.S. when the European or Japanese market was one and two standard deviations expensive (Tables 1 and 2). Table 1Eurozone Vs. U.S. Value Indicator: Trading Rule Returns And Batting Average Table 2Japan Vs. U.S. Value Indicator: Trading Rule Returns And Batting Average The trading rule returns are best in the case of Europe when the indicator reached two standard deviations cheap or expensive, providing average returns of almost 11 percent over 12 months. The trading rule returns when the indicator reached +/-1 standard deviation are lower, but still respectable at roughly 3% on 12- and 24-month horizons. The results are even better for the Japan trading rule (Table 2). Excess returns are 14% and 35%, respectively, over 12 and 24-month horizons after the indicator reaches +/-2 standard deviations. The results are very impressive even when using +/-1 standard deviation as the trigger point. Tables 1 and 2 also present the trading rules' batting average. That is, the number of positive excess returns generated by the trading rule as a percent of the total number of signals. For the European indicator, the batting average ranged from 50% on a 3-month horizon to 68% over 12 months when buy/sell signals are triggered at +/- 1 standard deviation. The batting average is much higher (80-100%) using +/- 2 standard deviations as a trigger point, although there were only five months over the entire sample when the indicator reached this level. The batting average is even better for the Japanese indicator. Sharpening The Buy/Sell Signals We then augmented the valuation analysis by adding information on company fundamentals, such as EPS growth and profit margins, among others. The ETS software ranked the companies after equally-weighting the valuation and fundamental factors. However, this approach yielded poor results in terms of the trading rule. This is because, for example, when European stocks reached undervalued levels relative to the U.S., it is usually because the European earnings fundamentals have underperformed those of the U.S. companies. Thus, favorable value is offset by poor fundamentals when scored by the ETS model, muddying the message provided by valuation alone. We also tried including some technical indicators to see if they could add information on timing. Chart 8 compares the valuation indicator discussed above to an enhanced indicator that includes both value and technical factors. Tables 3 and 4 provide the excess returns and batting averages for a trading rule based on the enhanced indicator. Chart 8Bottom-Up Indicators: Value, And Value Plus Technical Table 3Eurozone Vs. U.S. Value And Technical Indicator: Trading Rule Returns And Batting Average Table 4Japan Vs. U.S. Value And Technical Indicator: Trading Rule Returns And Batting Average It turns out that including some technical information does add value, but only in the case of Europe when using +/-1 standard deviation as the trigger point for trades. Both the excess returns and batting average to the trading rule improve. However, this is not the case when using +/-2 sigma. In the case of Japan, including technical information detracts from excess returns for both trigger points. Investment Conclusions Our new ETS platform provides investors with a unique way of picking stocks by combining top-down macro themes with company-specific information. It also allows us to develop valuation tools that avoid some of the pitfalls of index data by comparing stocks on a head-to-head basis. Investors can be fairly confident that they will make money on a 12-month horizon by taking a position when the bottom-up valuation indicators reach +/-1 sigma over- or under-valued. The +/-2 sigma valuation level gives clear buy/sell signals irrespective of fundamental or technical factors for both Europe and Japan. The bottom-up valuation indicators will not replace our top-down versions, but rather will be considered together when evaluating relative value. At the moment, both the top-down and bottom-up versions suggest that European stocks are roughly fairly valued relative to the U.S. market. Japanese stocks are on the cheap side based on both indicators, but neither one exceeds +1 sigma. This means that investors cannot make the allocation decision based on value alone. Valuation indicators need to be at extremes to have any predictive power. Our global equity strategists recommend overweighting Eurozone stocks versus the U.S. on a currency-hedged basis, although not because of valuation. On the plus side, the economy is flying high and there are no warning signs that this is about to end. There is hope for structural reform in France after Macron's election win this year. We give Macron's proposed labor market reforms high marks. Many doubt that these reforms will see the light of day, but our geopolitical team believes that investors are underestimating the chances. The German election in September poured cold water on recent enthusiasm regarding accelerated European integration. This is because Merkel will likely have to deal with a larger contingent of Euroskeptics in the grand coalition that emerges in the coming months. However, we do not expect political developments in Germany to be a headwind for the Eurozone stock market. On the negative side, this year's euro bull phase will take a bite out of earnings. Euro strength so far this year will lop three to four percentage points off of EPS growth by the middle of next year. Our model suggests that this will be overwhelmed by the robust economic expansion at home and abroad, but profit growth will diminish heading into year-end and will likely trail that in the U.S. and Japan over the next six months (local-currency basis). Still, a lot of the negative impact of the currency on profits may already be discounted. The bullish case versus the U.S. is more compelling for the Nikkei, at least in local-currency terms. Valuation is modestly attractive and Japanese earnings are highly geared to economic growth at home and abroad. Japanese EPS is in an uptrend versus the U.S. in both local and common currencies. We do not expect to see a peak in EPS growth until mid-2018, a good six months after the expected top in the U.S. Moreover, an Abe win in the October 22 election would mean that policy will remain highly reflationary in absolute terms and relative to the U.S. However, overweight positions in both the European and Japanese bourses should be currency hedged because the dollar is likely to appreciate over the next 6-12 months due to monetary policy divergences. Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see The Bank Credit Analyst Special Report, "Are Eurozone Stocks Really That Cheap?" dated July 2016. 2 Please see Equity Trading Strategy Special Report, "Introducing ETS: A Top Down Approach To Bottom-Up Stock Picking," dated December 2, 2015. 3 For more information, please see Equity Trading Strategy Special Report, "Making Money with ETS," dated January 20, 2016 Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights It is often argued that the U.S. dollar is expensive, but models do not offer a unanimous picture. The U.S. current account, exports share, and cyclical inflation do not point to an obvious dollar overvaluation either. Without a clear valuation signal, the dollar will continue to trade off rate differentials. An increasing body of evidence points toward a rebound in U.S. inflation. As such, U.S. rates are likely to move up relative to the rest of the world, lifting the USD over the next 12 months. Feature We are sending you a shorter regular bulletin this week as we are also publishing a follow up to our joint Special Report titled, "Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors," released with the Global Asset Allocation team two weeks ago. In this follow-up, my colleague Xiaoli Tang expands on the same methodology, testing various FX-hedging strategies for international investors - but this time looking at portfolios based in the CHF, the SEK, and the NOK. In this week's regular bulletin, we take a closer look at the U.S. dollar's valuations. The consensus view is that the dollar is expensive. We explore how this claim stacks up against the facts. At this juncture, the U.S. economy is not exhibiting some of the key consequences typical of an economy burdened by an expensive currency. Valuation Models The main argument used by some investors to show that the U.S. dollar is expensive is the traditional purchasing power parity model. This indicator does indeed flag a large 17% overvaluation for the greenback (Chart I-1). However, this is only one metric based on producer price indices. We also like to look at measures that focus on the true determinant of competitiveness: the cost of labor. When we deflate the U.S. dollar's exchange rate using unit labor costs, the dollar is neither a screaming sell nor a screaming buy. It is in line with its long-term average (Chart I-2). The same IMF real effective exchange rate model based on unit labor costs also shows the euro as fairly valued. Thus, on this metric, valuations do not seem to provide a compelling argument to go long or short the dollar, which challenges the universally bearish take on the dollar's perceived overvaluation. Chart I-1An Argument For An###br## Expensive USD Chart I-2But Not All Valuation Approaches ##br##Are That Clearcut We can also double-check the result of this metric using our own long-term fair value model, which incorporates long-term relative productivity trends. This model tries to capture the so-called Balassa-Samuelson effect. This effect is an empirical observation that countries with superior long-term labor productivity trends tend to experience a secular upward bias on their real exchange rates. The perceived overvaluation of the U.S. dollar may in fact be an illusion, because when the Balassa-Samuelson effect is taken into account, the dollar currently trades in line with its fair value (Chart I-3). Chart I-3Another Global Approach With USD At Fair Value Bottom Line: Valuing currencies is always an exercise to be approached with plenty of circumspection. It is easy to look at simple PPP models and argue that the dollar looks very expensive. However, when one takes into account labor market costs and productivity trends, the dollar seems fairly valued. A Look At The Symptoms Chart I-4The U.S. Current Account##br## Shows Little Dollar Strain Models are only as good as their inputs. It is important to try to corroborate their insights with economic reality. An expensive currency should produce three major outcomes: the country's current account position should be deteriorating, its market share of global exports should be falling, and it should be experiencing deep deflationary pressures relative to the rest of the world. Let's begin with the current account. Despite a 17% increase in the U.S. dollar since 2014, the U.S. current account has remained stable (Chart I-4). It is undeniable that this reflects an improvement in the energy trade balance of the U.S., itself a byproduct of the shale revolution. Nonetheless, it also highlights that there is little balance-of-payments strains in the U.S. In fact, the move away from energy imports in itself should point to a higher level of equilibrium for the dollar. The export share of the U.S. also does not point to too much stress created by the dollar bull market. As Chart I-5 illustrates, in contrast to the early 1980s or late 1990s-early 2000s, U.S. exports has been faring well when compared to the rest of the world. This exercise needs to be conducted by comparing U.S. exports to the rest of the world excluding China. China has been grabbing global market share from everyone for 30 years. As an aside, the continued rise of China, as well as its still-large current account surplus of more than US$155 billion, supports the idea that the RMB is indeed cheap and remains attractive on a long-term basis - a message also flagged by our long-term fair value model for the CNY (Chart I-6). Chart I-5Growing U.S. Market Share Chart I-6The Yuan Is Clearly Cheap Finally, there is little evidence that the U.S. dollar is depressing U.S. inflation on a cyclical basis. Changes in financial conditions can temporarily redistribute inflationary pressures between the U.S. and the rest of the world, but an expensive dollar should depress U.S. inflation for an extended period of time on a global relative basis. An expensive U.S. dollar makes the U.S. uncompetitive, and should force some degree of internal adjustment on the U.S. economy. So far, the two-year moving average of U.S. core inflation relative to the OECD does not show the same kind of swoon as in the 1980s or late 1990s. In fact, even after this year's inflation slowdown in the U.S., American inflation remains in an uptrend relative to the rest of the OECD (Chart I-7). One source of worry remains the U.S. net international investment position (NIIP). The U.S.'s NIIP currently stands at -41% of GDP, and despite stabilizing for the past two years, has been in a pronounced downtrend over the past 35 years. Historically, countries like Switzerland or Japan with strong NIIPs have tended to experience long-term upward pressure on their exchange rates, while those with poor NIIPs such as South Africa tend to experience negative secular trends, even in real terms. For the time being, what keeps the negative impact of the NIIP on the USD at bay is that the U.S. continues to earn a positive net income - despite negative net assets abroad (Chart I-8). This reflects the willingness of investors to hold the U.S. dollar for its reserve currency status. For the time being, with a lack of alternative to challenge the U.S. dollar's reserve status, the NIIP should not represent a key hurdle for a few more years. Chart I-7The U.S. is Not Experiencing##br## An Internal Devaluation Chart I-8The Exorbitant ##br##Privilege Bottom Line: The U.S. economy is currently exhibiting few of the signals that would be associated with an expensive dollar: the current account remains well behaved, the country is not losing export market shares to its main competitors, and U.S. inflation remains well behaved relative to the rest of the OECD on a cyclical basis. A key risk remains the U.S.'s net international investment position, but so long as the USD can maintain its unchallenged role as the key reserve in the global financial system, the U.S. is likely to continue to run an income surplus vis-à-vis the rest of the world. So What? When it comes to the FX space, long-term valuations only become binding constraints when they are in the extreme. Right now, there is enough conflicting evidence to suggest that if the dollar is indeed expensive, it is not expensive enough to flash a bright sell signal. In this case, the U.S. dollar's dynamics are likely to be dominated by interest rate differentials. Interest rate curves outside of the U.S. seem currently fairly priced, but this is not the case in the U.S. Thus, with only two full hikes priced in over the next 24 months, one needs to see upside for U.S. interest rates if one is to be bullish on the greenback. Despite last month's very poor employment numbers, a consequence of hurricanes Harvey and Irma, the labor market remains strong enough to justify the Federal Reserve's desire to hike rates. The ISM surveys also remains very strong, with the headline numbers and new order components pointing toward robust growth. The only factor that could impede the Fed is inflation. On this front, we remain optimistic that inflation will not deteriorate much further and that, in fact, it is likely to pick up over the next six months, giving the Fed a green light to increase rates in line with its own forecast: First, in the past, we have highlighted that velocity of money - based on the money of zero maturity and nominal GDP - has been a very reliable leading indicator of inflation over the past 20 years, and is pointing toward a rebound in core inflation measures toward year-end.1 Moreover, the easing in U.S. financial conditions over the past 18 months also points toward upside risks to both U.S. growth and inflation. Second, the strength in the Prices-Paid component of both ISM surveys further increases our optimism. Moreover, the recent vigor of the Supplier Delivery subcomponent - a measure of bottlenecks in the system - also points to pipeline inflationary pressures. It is true that some of the recent spike is most likely skewed by the devastating impact of the hurricanes, but this improving trend began much earlier this year. Historically, a combined improvement in both the Prices-Paid and the Supplier Delivery components of the ISM survey tends to provide long leads on core inflation (Chart I-9). Third, the New York Fed has recently started publishing an underlying inflation trend estimate. This measure has also been rebounding sharply, hitting its highest level in 10 years, also pointing toward higher core inflation (Chart I-10). Chart I-9Pipeline Inflationary Pressures##br## Are Growing In The U.S. Chart I-10Underlying Inflationary ##br##Pressures Are Growing Fourth, the behavior of inflation itself is somewhat encouraging. While the recent core PCE year-over-year numbers have been disheartening, the three-month annualized rate of change has picked up robustly. Historically, this has also led to turning points in the year-on-year number (Chart I-11). Finally, there are signs of underlying vigor in wages. Last week's U.S. average hourly earnings number clicked in at 2.9%.It was likely overinflated by the effect of the hurricanes, which have temporarily dropped workers in low-paid industries out of the sample used by the U.S. Bureau of Labor Statistics to compute this data. However, the median average hourly earnings across the key sectors covered by the BLS has been in an uptrend since the beginning of the year (Chart I-12), pointing to some faint but real early signs of rising underlying wage growth. Moreover, while much ink has been spilled regarding whether or not the Philips curve is flat, there remain a well-defined tight relationship between the U.S. employment cost index (ECI) and the level of employment-to-population ratio in the U.S. (Chart I-13). Our view that employment growth will likely continue to tick in north of 120,000 jobs for the next 12 months, implies further improvement in the employment-to-population ratio, and thus a growing ECI. This will both support household income and consumption as well as our inflation view. Chart I-11Sequential Inflation Pointing ##br##To A Turning Point Chart I-12Cross-Sectional Median ##br##Of Wages Improving Chart I-13The Cross-Sectional Median##br## Of Wages Improving Bottom Line: With no clear message from long-term valuation, the key driver of the dollar is likely to remain interest rate differentials. At this point, U.S. interest rates need U.S. inflation to be able to rise by more than what is implied in the OIS curve and lift the dollar. Signs continue to accumulate that U.S. inflation is likely to turn the corner over the next six months, thanks to an easing in U.S. financial conditions and the pick-up in the velocity of money: the Prices-Paid and Supplier Deliveries components of the ISM have hooked up significantly, the NY Fed's underlying inflation measure is strong, the sequential growth rate in core inflation is improving, and there are growing signs that wage growth in the U.S. is picking up. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled "Fade North Korea, And Sell The Yen", dated August 11, 2017, or Foreign Exchange Strategy Weekly Report, titled "Conflicting Forces For The Dollar", dated September 8, 2017, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Closed Trades

Highlights Looking into 2018, the major risk factors driving gold - inflation and inflation expectations; fiscal and monetary policy; and geopolitics - will, on balance, continue to favor gold as a strategic portfolio hedge. We expect gold will provide a good hedge against rising inflation. However, this will be partially mitigated by Fed rate hikes next year. On the back of tighter U.S. monetary policy, our macroeconomists expect a recession by 2H19, possibly earlier in 2019, which likely would be sniffed out by equity markets as early as 2H18. Our analysis indicates gold will provide a good hedge against this expected recession and the associated equity bear market.1 Lastly, geopolitical risks from (1) U.S.-North Korea tensions, (2) trade protectionism of the Trump administration and (3) ongoing conflicts in the Middle East will support gold prices next year, given the metal's safe-haven properties. Energy: Overweight. At the end of 3Q17, our open energy recommendations were up 45%, led by our long Dec/17 WTI $50/bbl vs. $55/bbl Call spread. We closed out our long Brent recommendations in 3Q17 for an average gain of 116%. (Please see p. 13 for a summary of trades closed in 3Q17). Base Metals: Neutral. Our tactical short Dec/17 copper position ended 3Q17 up 6%. We are placing a trailing stop at $3.10/lb. Precious Metals: Neutral. Our long gold portfolio hedge ended 3Q17 up 4.3%. The balance of risks continues to favor this as a strategic position, which we discuss below. Ags/Softs: Neutral. We lifted our weighting on ags - particularly grains - to neutral last week. Our long corn/short wheat position is up 1.2%. Feature Chart of the WeekInflation And U.S. Financial Variables##BR##Explain Gold Prices Inflation and U.S. financial variables - particularly the USD broad trade-weighted index (TWIB), and real rates - are the main factors explaining the evolution of gold prices (Chart of the Week).2 Subdued inflation and low unemployment - a decoupling of the so-called Phillips Curve relationship that drives central-bank models of the macroeconomy - have dominated the macro landscape this year (Chart 2). We expect that current low inflation, positive growth, and low interest rates will remain in place for the next 12 months (Chart 3). Although economies such as the U.S. are growing above trend, inflation has remained weak due to a redistribution of demand through imports from countries with spare capacity, according to BCA's Global Investment Strategy.3 This is expected to continue in the near term to end-2018. However, we expect the USD to gradually strengthen, as the Fed cautiously normalizes policy rates, while other systemically important central banks remain accommodative relative to the U.S. central bank (Chart 4). Further falls in the unemployment rate will push the U.S. economy into the steep end of the Phillips Curve. Weak capex in the post-Global Financial Crisis (GFC) era means demand for labor will increase as low unemployment - and associated higher wages - encourage higher consumer spending. This will cause inflation to lift next year or early 2019. Chart 2A Decoupling Of The Phillips Curve Relationship? In such an environment, any U.S. tax cuts - which we still expect by the end of 1Q18 - will simply add fuel to the inflationary fire, and lift inflation expectations for next year and beyond. As BCA's Geopolitical Strategy team puts it, the tax cuts are a "form of modest stimulus ... (which), this far into the economic cycle, could have a significant effect."4 With unemployment at or below levels consistent with full employment in the U.S. and little slack of any sort, it would not take much in the way of fiscal stimulus to further pressure inflation. Chart 3No Pressure From Inflation Or U.S. Financial##BR##Variables...For Now Chart 4A Strengthening U.S. Dollar Will##BR##Keep The Pressure Off Gold Inflation vs. Fed Hikes In the face of the rising inflation we expect next year, gold's appeal will increase. As our previous research reveals, gold's correlation with inflation is strengthened during periods of low real rates, i.e., the difference between nominal rates and inflation. This is a perfect context for gold. However, gold's ability to hedge inflation risks to portfolios will be partially hampered by a more-hawkish Fed. As inflation finally takes off, the Fed will feel confident to hike rates more aggressively. More than anything, this will put a bid under the USD, as U.S. interest-rate differentials vs. other currencies rise in favor of the dollar. In addition, real rates will rise as the Fed gains confidence it can lift policy rates without doing serious harm to the U.S. economy, and follows thru with its normalization. Thus, the gold market will be facing two opposing forces: On the one hand, gold will be an attractive inflation hedge as inflationary pressures build up. On the other, as the Fed begins to tighten to respond to those inflationary pressures, gold will lose its appeal in the face of rising real rates and a strong dollar. Chart 5Fed Will Ease Pressure Off Gold##BR##If It Gets Ahead Of Inflation The timing of the Fed's rate hikes will be critical to the evolution of gold prices next year and beyond. We previously assumed that rate hikes will remain behind wage growth, which would be supportive of gold prices as inflation picks up. However, if the Fed begins hiking ahead of any realized uptick in inflation, this would create a stronger-than-expected headwind for gold (Chart 5). While we expect inflation to take off in 2H18, our House view calls for 2 to 3 hikes by then. This is a risk to our gold view. Longer term, Fed rate hikes could trigger a feedback loop that will make it difficult for the U.S. central bank policy to support low unemployment rates. As real rates rise, increased unemployment will lead households to spend less. Lower demand will force firms to reduce hiring. The accompanying slowing of U.S. growth will disseminate to the rest of the world, pushing the global economy into a shallow recession as early as 2H19. In all likelihood, this higher-inflation/higher-policy-rate period will be sniffed out by equity markets before the economy actually enters a recession, leading to a bear market. Somewhat counterintuitively, this will favor gold as a portfolio hedge, as we discuss below. Bottom Line: As U.S. unemployment continues falling, inflation will re-emerge, as predicted by the Philips Curve trade-off so important to central-bank policy. Gold then will face two opposing forces. Its inflation hedging properties will be partially hamstrung by rising real U.S. rates and a strengthening USD. Nevertheless, we will turn bullish gold towards the end of next year as signs of an equity bear market emerge. Gold Will Outperform In An Equity Bear Market Our modelling indicates gold is an exceptional safe-haven during downturns in equity markets.5 It is especially attractive in equity bear markets because its returns during such episodes are negatively correlated with the U.S. stock market. This relationship with equities does not hold in bull markets -- gold prices typically rise during such periods, but at a slower rate than equities (Table 1). Table 1Gold's Ability To Hedge U.S. Equities In a Special Report titled "Safe Havens: Where To Hide Next Time?" BCA's Global Asset Allocation Strategy team looked at the performance of nine safe-haven assets and found, on average, they are negatively correlated with equities in every bear market since 1972.6 Although the current equity bull market still has room to run, recessions and bear markets tend to coincide (Chart 6). If the economy goes into recession in 2H19, equities could peak as early as the end of next year.7 Chart 6Bear Markets Usually Precede Recessions Gold's role as a global portfolio hedge during bear markets would thus support the hypothesis that the metal could enter a bull market as soon as end-2018 when equity markets start pricing in a recession (Chart 7). Things could get interesting at this point, since a clear indication the economy is entering into a recession likely will cause "traumatized" central bankers to turn overly dovish. This would add support to the gold market longer term.8 Chart 7Gold Outperforms During Recessions##BR##And Geopolitical Crises Correlations between safe havens decline during bear markets, as our GAA strategists found when they compared correlations by dividing the assets into three "buckets": currencies, inflation hedges, and fixed-income instruments. In this analysis, our GAA team found that gold outperformed TIPS and Farmland in the inflation-hedge bucket.9 Bottom Line: Gold is an exceptional hedge against downturns in equity markets. The bear market preceding the late-2019 recession we expect will put a bid under gold. The eventual turn to the dovish side by central bankers will further support the metal. Gold Will Hedge Geopolitical Risks A confluence of elevated geopolitical risks next year will drive part of gold's performance. BCA's Geopolitical Strategy (GPS) group has highlighted the following three themes investors need to track going into next year: U.S.-China Tensions: Our geopolitical strategists believe that the Korean conflict is a derivative of a more important secular trend of U.S.-China tensions. They estimate the risk of total war on the Korean peninsula at less than 3% and believe that the market impact of North Korea's provocations has peaked in the late summer. Nevertheless, they warn against complacency, as the underlying tensions over Pyongyang's nuclear program remain unresolved and North Korea could break with its past patterns.10 If the North stages attacks against U.S. or Japanese assets, or international shipping or aircraft, for instance, it could cause a larger safe-haven rally than what we witnessed earlier this year. At the very least, geopolitically induced volatility may return as U.S. President Trump tries to convince the world that war is a real option - a critical condition for establishing a "credible threat" of war with which to influence North Korean behavior - and as the U.S. and China spar over other issues. Trump's protectionism: Trump's campaign promised significant trade-protectionism. While he has not yet acted on those promises, the risk is that he returns to them next year.11 These policies could impact the gold market by: a. Feeding fears that the United States is abandoning the global liberal order; b. Intensifying U.S. trade tensions and strategic distrust with China; c. Pressuring U.S. domestic inflation via higher import prices. This risk will become even more elevated if the Trump administration and Congress fail to pass any tax legislation this year. Our geopolitical strategists believe that such a failure, while not their baseline scenario, would drive Trump to focus on his foreign policy and trade agenda more intently, especially ahead of the midterm elections in November next year, which would increase safe-haven flows. 3. Mideast Troubles: While we are not alarmist about the Middle East, the risk of market-relevant conflicts will be higher over the coming 12 months than over the previous year, following the fall of ISIS. The latter gave reason for various regional powers to cooperate, while its absence will revive their grievances with each other. Kurdish assertiveness is a key consequence, highlighted by last month's Kurdish independence referendum.12 Iraqi forces have pushed ISIS out of major Iraqi cities and the slowdown in the fight against ISIS could push Iraqi forces to focus on regaining the province of Kirkuk. Kirkuk, which is home to major oil fields and reserves, has been under Kurdish control since 2014 when the Peshmerga forces there captured it from ISIS. As ISIS ceases to be a threat, Baghdad will try to regain control of these precious oil fields. The Kurdish conflict, as well as Trump's pressure tactics against Iran, will increase geopolitical risks in oil-producing (hence market-relevant) areas. Chart 82017 Risks Were Overstated In a recent study investigating how different "safe-havens" assets react to political and financial events, our GPS colleagues found that gold provides the best average returns following a major geopolitical event (Chart 7).13 Our House geopolitical view has maintained that political risks in 2017 were overstated. This was particularly the case in Europe, where much of the risk was exaggerated and merely the product of linear extrapolation from the outcomes of the U.K. referendum on EU membership and the U.S. presidential election. As such, we do not expect any European break-up risk to support gold prices next year. Although elevated Italian Euroscepticism is one lingering European risk that could impact gold markets, we see this as a long-term risk rather than a market catalyst arising from the Italian general election in May next year. Reflecting our view, the policy uncertainty index has fallen drastically in the last two months (Chart 8). Bottom Line: Elevated political risks in 2018 will further support the gold market. Most notable on our geopolitical strategists' minds are continued U.S.-China tensions (most notably over Korea), Trump's protectionist policies, and potential conflicts in the Middle East. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com Hugo Bélanger, Research Assistant HugoB@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report "Go Long Gold As A Strategic Portfolio Hedge," dated May 4, 2017, available at ces.bcaresearch.com. 2 Our results show 1% increase in U.S. YoY CPI, 5 year real rates, and USD TWI are associated with a 4% increase, 0.18% decline and a 0.21% decline in gold prices, respectively. The adjusted R2 is 0.88. 3 Please see the Global Investment Strategy Outlook "Fourth Quarter 2017: Goldilocks And The Recession Bear," dated October 4, 2017, available at gis.bcaresearch.com. 4 Please see Geopolitical Strategy Weekly Report "Is King Dollar Back," dated October 4, 2017, available at gps.bcaresearch.com. 5 We use the S&P 500 Total Return (TR) index as a proxy for U.S. equities. 6 Please see Global Asset Allocation Special Report "Safe Havens: Where To Hide Next Time?," dated April 21, 2017, available at gaa.bcaresearch.com. 7 Please see Global Asset Allocation Quarterly Portfolio Outlook, dated October 2, 2017, available at gaa.bcaresearch.com. 8 Please see the Global Investment Strategy Outlook "Fourth Quarter 2017: Goldilocks And The Recession Bear," dated October 4, 2017, available at gis.bcaresearch.com. 9 Please see Global Asset Allocation Special Report "Safe Havens: Where To Hide Next Time?," dated April 21, 2017, available at gaa.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Weekly Report, "Insights From The Road - The Rest Of The World," dated September 6, 2017, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 12 Armed conflict in the Middle East usually lead to a sharp rally in gold prices. Please see Table 1 from Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?," dated August 16, 2017, available at gps.bcaresearch.com. 13 Please see Geopolitical Strategy Special Report, "Geopolitics And Safe Havens," dated November 11, 2015, available at gps.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016