Financial Markets

Highlights Key Portfolio Updates Synchronized global economic growth is driving real yields higher and boosting equities (Chart 1). Meantime, core inflation remains muted which will ensure that Fed policy stays sufficiently accommodative (Chart 2). Outside of the U.S., monetary tightening cycles are kicking into high gear, and this will sustain downward pressure on the greenback for now (Chart 3). Easy financial conditions are a boon for S&P 500 profit margins, and a slow moving Fed suggests that investors will extrapolate this goldilocks equity scenario for a while longer (Chart 4). Almost all of the S&P 500's advance year-to-date has been earnings driven (Chart 5). Buoyant EPS breadth bodes well for additional gains, a message in line with our SPX profit model. In terms of how far the broad market can advance from current levels before the next recession hits, we posit three ways to SPX 3,000 (Table 1). The ongoing sector rotation is a healthy development, and is not a precursor to a more viscous and widespread correction (Chart 6). Historically, receding sector correlations represent fertile ground for the overall equity market (Chart 7). Our macro models are signaling that investors should position for a sustained rebound in economic growth. Our interest rate-sensitive models are coming out on top, deep cyclicals are attempting to trough, while defensives took a turn for the worse (Chart 8). Deep cyclical sectors are the most overvalued followed by early cyclicals, while defensives remain in undervalued territory. Interest rate sensitives have recently become overbought, while both deep cyclicals and defensives are in the oversold zone (Charts 9 & 10). The most attractive combination of macro, valuation and technical readings are in the financials and consumer discretionary sectors. The least attractive combinations are in materials, technology and utilities sectors. Prospects for a durable synchronized global economic growth, a coordinated tightening G10 central bank backdrop and cheapened U.S. currency warrant an early cyclical portfolio tilt, with the defensive/deep cyclical stance shifting to a more neutral setting. Chart 1Synchronized Global Growth Chart 2Muted Core Inflation Chart 3G10 Central Banks Map Chart 4Easy Financial Conditions Boost Margins Chart 5Buoyant Breadth Bodes Well Table 1SPX Dividend Discount Model SPX EPS & Multiple Sensitivity ERP Analysis Chart 6Healthy Rotation Chart 7Falling Correlations Boost The S&P 500 Chart 8Interest Rate Sensitives Come Out On Top Chart 9Underowned... Chart 10...And Undervalued Defensives Chart 11Earnings Growth Set To Accelerate Chart 12Consumers Are Feeling Flush Chart 13Improving Fundamentals Signal A Trough Chart 14Staples Remain The Household's Choice Chart 15Weaker Rents And Higher Vacancies Bode Ill Chart 16Profits Look Set To Downshift Chart 17Cyclical Recovery Driving Backlogs Lower Chart 18Margin Recovery Appears Priced In Chart 19Pricing Collapse Driving Earnings Decline Chart 20Productivity Declines Will##br## Keep A Cap On Valuations Chart 21Valuations At Risk##br## When Inflation Returns Feature S&P Financials (Overweight) Our financials cyclical macro indicator (CMI) has climbed to new cyclical highs, supported by broad-based improvement among its components. Firming employment data, historically a precursor to credit growth and capital formation, has been a primary contributor to the lift in the CMI. Importantly, a tight labor market has not yet driven sector costs higher, which bodes well for near term profits (Chart 11 on page 8). A budding revival in loan demand is corroborated by our bank loan growth model, which points to the largest upswing in credit growth of the past 30 years. Soaring consumer and business confidence, rising corporate profits and a potential capital spending revival underpin our loans and leases model (Chart 11 on page 8). Expanding housing prices, increased housing turnover and rebounding mortgage purchase applications support household capital formation (Chart 11 on page 8). A recent lift in share prices partially reflects this much-improved cyclical outlook. Still, the message from our valuation indicator (VI) is that there is significant running room. Our technical indicator (TI) has retreated from overbought levels, but remains solidly in the buy zone, setting the stage for the next leg up in the budding relative bull market. We expect sentiment to steadily improve, buoyed by deregulation moving closer to reality as a partial Dodd-Frank replacement passed the House. Chart 22 S&P Consumer Discretionary (Overweight) Our CMI has snapped back after a tough year, driven by improving real wage growth. Higher home prices, a tighter labor market and increasing disposable income have consumers feeling flush, which should boost discretionary outlays. Importantly, consumer deleveraging is far advanced with the debt service ratio hovering near decade lows (Chart 12 on page 9). Further, our Consumer Drag Indicator remains near its modern high, suggesting EPS gains will prove resilient (Chart 12 on page 9). Although somewhat expensive from a historical perspective, our VI remains close to the neutral zone, underscoring that profits will be the primary sector price driver. Our TI has fully recovered from oversold levels, and is flirting with the buy zone, underscoring additional recovery potential. We continue to recommend an overweight position, favoring the media-oriented sub-indices. Chart 23 S&P Energy (Overweight) Our CMI has recently ticked up from its all-time lows, and is now diverging positively from the share price ratio. Ongoing gains in domestic production, partially offset by a still-high sector wage bill, underlie the recent CMI uptick. The steepest drilling upcycle in recent memory is showing some signs of fatigue. Baker Hughes reported the first weekly decline in 24 weeks in the oil rig count for the week ending June 30th. At least a modest deceleration in shale oil production is likely. Encouragingly, U.S. crude oil inventories are contracting, which could presage a renormalization of domestic inventories, market share gains for domestic production and at least a modest rally in energy shares (Chart 13 on page 9). Our S&P energy sector relative EPS model echoes this cautiously optimistic industry backdrop, indicating a burgeoning recovery in sector earnings (Chart 13 on page 9). The TI has returned to deeply oversold levels, suggesting that an oversold bounce could soon occur at a time when valuations are gravitating back to earth. Chart 24 S&P Consumer Staples (Overweight) The consumer staples CMI has turned lower recently, held back by healthy economic data, particularly among confidence indicators. That should drive a preference for spending over saving after a long period of thrift, although a relative switch from staples into discretionary consumption has not yet taken firm hold. The savings rate has also stayed resilient, despite consumer euphoria (Chart 14 on page 10). The good news is that tamed commodity prices and a soft U.S. dollar should provide bullish offsets for this global-exposed (Chart 14 on page 10) and commodity-input dependent sector. A modestly weaker outlook for staples is more than reflected in our VI, which is still parked in undervalued territory. Technical conditions are completely washed out, signaling widespread bearishness, which is positive from a contrary perspective. Chart 25 S&P Real Estate (Neutral) Ongoing improvements in commercial & residential real estate prices continues to push our real estate CMI higher. However, the outlook for REITs has darkened; rents have crested while the vacancy rate found its nadir in 2016, suggesting further rent weakness on the horizon (Chart 15 on page 10). Further, bankers appear less willing to extend commercial real estate credit; declines in credit availability will directly impact REIT valuations. Our VI is consistent with our Treasury bond indicator, indicating that both are at fair value. Our TI is starting to firm from extremely oversold levels, a positive indication for both 12- and 24-month relative performance. Chart 26 S&P Health Care (Neutral) Our CMI has rolled over, driven by a steep decline in pharma pricing power (Chart 16 on page 11). In fact, the breadth of sector pricing power softness has spread, just as the majority of the industries we cover is enjoying a selling price revival. The divergence between the CMI and recent sector relative performance suggests that the latter has been mostly politically motivated, and may lack staying power. Worrisomely, the sector wage bill has spiked; in combination with a weaker top line, the earnings resilience of the sector could be at risk. Relative valuations remain appealing, but technical conditions are shaky, as our TI has bounced from oversold levels but is still in negative territory. Taken altogether, we would lean against the recent advance in relative performance. Chart 27 S&P Industrials (Neutral) The CMI has recovered smartly in the past couple of quarters, lifted mostly by a weaker U.S. dollar. The sector has moved laterally since the U.S. election. The improved export outlook is a positive, but a lack of response in hard economic data to the surge in confidence is a sizable offset. An inventory imbalance has largely unwound over the past six months, as durable goods orders are easily outpacing inventories, coinciding with a return of some pricing power to the sector (Chart 17 on page 11). Still, years of capacity growth in excess of production and the resulting low utilization rates mean that pricing gains may stay muted unless demand picks up substantially. Our valuation gauge is near the neutral zone, but there is a wide discrepancy beneath the surface, with construction & engineering trading cheaply and railroads and machinery commanding premium valuation multiples. Our TI has returned close to overbought levels, potentially setting the stage for another move higher. Chart 28 S&P Utilities (Neutral) Our CMI for the utilities sector remains in a long-term downtrend, albeit one with periodic countertrend moves. Most of the weakness in the CMI relates to external factors, such as robust leading indicators of global economic growth (Chart 18 on page 12). Encouragingly, the sector's wage bill has slowed from punitively high levels, and combined with improving pricing power should allow for some margin recovery (Chart 18 on page 12). Utilities have outperformed other defensive sectors, likely due to the expectation that the new U.S. administration's long-awaited tax reform will have outsized benefits to this domestic-focused industry. As a result, valuations have been creeping up, though not sufficiently enough to warrant an underweight position. Our TI has reversed its steep fall over the past year, but is unlikely to bounce through neutral levels in the absence of a negative economic shock. Ergo, our preferred strategy is to remain at benchmark, but look for tradable rally opportunities. Chart 29 S&P Telecom Services (Underweight) Our CMI for telecom services has moved laterally, as much-reduced wage inflation is fully offset by the sector's plummeting share of the consumer's wallet and extremely deflationary conditions (Chart 19 on page 12). Our sales model paints a much darker picture, pointing to double-digit topline declines for at least the next few quarters, owing to the plunge in pricing power deep into negative territory (Chart 19 on page 12). The sector remains chronically cheap, and has all the hallmarks of a value trap, as relative forward earnings remain in a relentless secular downtrend. It would take a recession to trigger a valuation re-rating. Our Technical Indicator has nosedived but, like the VI, cycles deep in the sell zone have not proven reliable indicators that a relative bounce is in the offing. Chart 30 S&P Materials (Underweight) Recent Fed rate hikes have driven down the CMI close to all-time lows. The sector has historically performed very poorly in tightening cycles owing to U.S. dollar appreciation and the ensuing strains on the emerging world. Weak signals from China have also helped take the steam out of what looked like a recovery in the CMI last year. Commodity-currencies have rallied, but not by enough to offset a relapse in pricing power and weak sector productivity (Chart 20 on page 13). The heavyweight chemicals group (comprising more than 73% of the index) continues to suffer; earnings growth relies heavily on global reflation, an elusive ingredient in the era of a globally synchronized tightening cycle. Sagging productivity warns that profitability will remain under pressure. Valuations have now spent some time in overvalued territory; without a recovery in earnings growth, a derating is a high probability outcome. Our TI has dipped into the sell zone, indicating a loss of momentum and downside relative performance risks. It would be highly unusual for the sector to stay resilient in the face of a negative TI reading. Chart 31 S&P Technology (Underweight) The technology CMI is in full retreat, driven by ongoing relative pricing power declines and new order weakness. However, the sector had been resilient, until recently, as a mini-mania in a handful of stocks and the previously red-hot semiconductor group have provided resilient support. That reflected persistently low inflation and a belief that interest rates would still low forever. After all, tech stocks thrive in a disinflationary/deflationary environment and suffer during inflationary periods (Chart 21 on page 13). Nevertheless, a recovering economy from the first quarter's lull and tight labor market suggest that an aggressive de-rating in sky-high valuations in previous juggernauts is a serious threat, especially if recent disinflation proves transitory. Our relative EPS model signals a profit slide this year. In the context of analyst estimates of double-digit earnings growth, sector downside risk is elevated. Our VI is not overdone, but that partly reflects the massive overshoot during the bubble years. Our TI is extremely overbought, suggesting that profit-taking is likely to persist. Chart 32 Size Indicator (Overweight Small Vs. Large Caps) Our size CMI has retraced some of its 2016 climb, but remains firmly above the boom/bust line. Keep in mind that this CMI is not designed as a directional trend predictor, but rather as a buy/sell oscillator. Small company business optimism is near modern highs, as pricing and consumption vigor push domestic revenues higher. A smaller government footprint, i.e. fewer regulatory hurdles, and tax relief will disproportionately benefit SMEs. The prospect of trade barriers clearly favors the domestically focused small cap universe and underlie part of the post-election euphoria. Top line growth will need to persist if small businesses are to offset a higher wage bill, as labor looks more difficult to import and the economy pushes against full employment. Valuations have improved and the share price ratio has fully unwound previously overbought conditions. We expect the recent rally to gain steam.\ Chart 33 Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com Chris Bowes, Associate Editor chrisb@bcaresearch.com

Highlights Yellen pointed out that the U.S. R-star is low but that it will rise as temporary depressing factors pass. The Fed is determined to push rates toward 3% over time. The euro area R-star is substantially lower than that of the U.S., limiting the capacity of the ECB to follow the Fed's path and pace. Traders are massively long the euro. Abe's woes do not signal the end of Abenomics, in fact they point toward more stimulus. The BoC has hiked and will keep doing so, continue to favor the CAD. Feature Janet Yellen offered both a fascinating and telling glimpse on the Federal Reserve's thinking this week. She argued that the equilibrium fed funds rate is currently very depressed, which is limiting the pace at which the FOMC can increase interest rates before plunging the economy into recession. However, she also noted that the Fed anticipates equilibrium interest rates will continue to rise over time, which means the actual fed funds rate has more upside on a multi-year horizon, despite what will be a slow pace of increases. With this additional information on the Fed's mindset, investors should be even more comfortable in their assessment that the period of maximum policy divergence between the euro area and the U.S. is behind us, which justified bullish bets on the euro. However, the broader picture is a bit more complex. Different Equilibria The idea that the neutral fed funds rate is still low but rising explains why the Fed is still pegging its terminal rate at 3%. Currently, the Laubach and Williams formulation of the neutral real fed funds rate (also known as R-star) is at 0.4%, while the current real fed funds rate stands at -0.5%, which implies 0.9% upside in real rates over the next two years or so (Chart I-1). Moreover, if as we expect core inflation moves back toward 2% over the Fed's forecast horizon, the upside to rates would be closer to 150 basis points. In the euro area, however, the same long-term R-star stands at -0.1%, depressed by lower population growth, a higher savings rate and lower structural productivity gains. Since the real policy rate is at -0.7%, this signifies that the gap between the actual real policy rate and its equilibrium is a smaller 0.6% (Chart I-2). This means that euro area rates have much less upside than U.S. ones before generating a deleterious impact on growth. Chart I-1U.S. R-Star Vs. Policy Rates Chart I-2Euro Area R-Star Vs. Policy Rates It is easy to argue that R-star differences are nice theoretical concepts, with little practical implications for currency investors. After all, interest rate differentials at the long end of the curve are clearly a function of the relative GDP per capita between the euro area and the U.S. (Chart I-3). These same GDP-dynamics also have an impact - albeit a less tight one - on EUR/USD. Chart I-3Yield Differentials And Relative GDP Chart I-4How R-Star And GDP Tango Yet, R-star spreads do affect growth differentials between the euro area and the U.S. As Chart I-4 illustrates, when the euro area real policy rate crosses above its equilibrium, euro area real GDP per capita growth sags soon after. The same holds true for the U.S. This suggests the capacity of European GDP per capita to outperform that of the U.S. is currently limited, or at the very least needs rates in Europe to remain quite low relative to the U.S., anchored lower by the depressed level of the R-star in Europe vis-a-vis the U.S. Moreover, the recent outperformance of European GDP per capita relative to the U.S. has a lot to do with the poor performance of U.S. GDP in 2016. However, U.S. GDP should firm in the coming quarters, particularly since household income levels are well supported. As Chart I-5 shows, based on an average of the pay-related and hiring-related components of the NFIB small businesses survey, the aggregate wages and salaries received by U.S. households are set to accelerate, both in nominal and real terms. This represents a boost to aggregate income and should support consumption, or almost 70% of the U.S. economy. Additionally, the rebound in U.S. capex should continue. Both the NFIB and the various regional Fed capex intention surveys remain healthy. This, along with labor market tightness, should be accretive to per capita GDP. As Chart I-6 shows, a composite indicator based on the NFIB survey capex and "jobs hard to fill" components is very strong, which historically has led to an acceleration of real-GDP-per capita growth. Chart I-5U.S. Household Income Will Accelerate Chart I-6U.S. Real GDP Per Capita Will Strengthen As a result, we are inclined to bet on a renewal of strength in the U.S. economy, which will support R-star there and help the Fed hike rates by more than the 43 basis points currently anticipated over the next 24 months. Bottom Line: The U.S. long-term equilibrium real fed funds rate is low, but remains substantially higher than the R-star in the euro area. This suggests that U.S. rates have more upside than European ones. Moreover, the outlook for U.S. per capita GDP is healthy, while that of Europe will continue to require low rates to remain on an upward path. Tactical Considerations Around EUR/USD EUR/USD is well bid, and our base case scenario remains that the 1.15 to 1.16 zone will be retested. However, some technical indicators have made us leery to chase this move, and might even prevent this target zone from ever being breached. To begin with, the number of long speculative bets on the euro has hit a record high, while the number of short bets has collapsed (Chart I-7). Net long speculative positions are not at a record high yet, but are in the upper echelons of the distribution of the past 17 years. Interestingly - and some would argue almost mechanically - while speculators' optimist or pessimist extremes can be used as contrarian indicators, commercial traders tend to be disproportionally short or long the euro at the appropriate time - i.e., when the euro is set to plummet or rally, respectively. Theoretically, commercial and non-commercial traders' positions should be in perfect balance as they are counterparties to one another, but in practice this is rarely the case. Because of this observation, we decided to amplify the message of both series by subtracting the net long commercial positions from net long non-commercial ones. This indicator tends to work best at highlighting tops in EUR/USD. The current reading has been indicative of an upcoming period of weakness in this pair (Chart I-8). The only exception was in 2007, a period when unlike today, the Fed was cutting rates while the ECB policy rate was being lifted all the way to July 2008. Chart I-7Record Longs In The Euro Chart I-8Aggregate Positioning Points To A Lower Euro Moreover, the buying pressure on EUR/USD may be exhausting itself. Wednesday, despite a seemingly dovish message from Fed Chair Yellen and despite stronger-than-anticipated industrial production numbers out of the euro area, EUR/USD weakened 0.6% instead of appreciating. In fact, our European Investment Strategy Senior Vice President Dhaval Joshi's Fractal Dimension indicator - a measure of group-think in the market - is now at 1.25, a level that also warns of an imminent trend change (Chart I-9).1 Chart I-9A Risk Of Reversal As a result, we do not yet think it is time to be betting aggressively on a fall in EUR/USD, especially as next week's ECB meeting might give an occasion for President Mario Draghi to re-affirm his optimism, giving the euro its final push toward 1.15-1.16. However, nimble traders should begin building small short positions in the euro on the optic of expanding their bets if the EUR/USD gathers downward momentum. Bottom Line: The euro may well hit the 1.15-1.16 range, but positioning in EUR/USD is currently extremely overstretched, and the euro's trading action suggests that groupthink has become prevalent, confirming the message of positioning. This means the euro is at risk. Nimble traders should begin building small short positions in EUR/USD, but it is not yet time to bet aggressively on this pair. Shinzo's Troubles Are Not The Demise Of Abenomics Japanese Prime Minister Shinzo Abe's popularity has been in freefall in recent weeks, hitting the most dismal levels of his current premiership (Chart I-10). The flogging received by the LDP in the recent Tokyo Metropolitan Assembly election is indeed being perceived as a rejection of the party's policy stance since 2012. Does this represent the coup de grace that will end Abenomics? We doubt it. The key behind the recent dip in Abe's popularity is not his economic policy but his move away from it. Instead, his focus on changing the pacifist constitution of post-war Japan is the source of the LDP's and Abe's woes, as this topic remains anathema with the Japanese public. Moreover, we are not willing to bet on the demise of the LDP. The Tokyo election was a one-off event. The new Tomin First no Kai (Tokyoites First) party that is now the largest force in the regional assembly is led by the very popular Tokyo governor Yuriko Koike, and will rely on the pacifist Komeito to control the Tokyo Metropolitan Assembly. At the national level, the DPJ remains in tatters, and no potential new party is in place to carry the torch of the opposition. Japan is still effectively a one-party democracy. So what are the market implications of these political developments? We expect a doubling down by Abe on economic stimulus. If Abe ever wants a passing chance to have, let alone win, a referendum to increase Japan's militarism, the economy needs to be stronger than it is. Thus, we think this boot of unpopularity will be key to unlocking more fiscal stimulus out of Tokyo. When more fiscal stimulus finally does materialize, if it boosts growth, it will also lift long-term inflation expectations (Chart I-11). Chart I-10Abe's Plummeting##br## Popularity Chart I-11If Fiscal Stimulus Is Implemented ##br##CPI Expectations Will Rise... In this context, we would expect continued pressure on the Bank of Japan to remain one of the two most dovish central banks in the G10, as to not undo the benefits of fiscal stimulus. Moreover, the BoJ cannot remove stimulus, as realized CPI excluding food and energy remains in negative territory. Tokyo's CPI report, which offers a one-month lead on the national release, shows that core inflation is still in negative territory. National summer wage negotiations point to negative wage growth next year, making a revival of domestically generated inflation a remote event without an easing of financial conditions (Chart I-12). Additionally, the recent rollover in the leading diffusion index suggests the economic upswing may already be fading (Chart I-13). Continued BoJ support and higher inflation expectations would hurt Japanese real yields and handicap the yen. Chart I-12...But That Will Also Require Easy Monetary##br## And Financial Conditions Chart I-13A Slowdown ##br##In Japan The recent upswing in global bond yields is thus likely to continue to weigh on the yen, leading to a higher USD/JPY. As this week illustrated, rising global yields are forcing the BoJ to increase its amount of JGB purchases to cap the upside in Japanese 10-year yields. Tactically, USD/JPY has been in an upswing, but has hit an important resistance close to 114.5. A few more days of weakness could ensue, but such weakness should be used by investors to sell the yen. Bottom Line: Abe's political problems do not represent the end of Abenomics. Instead, they illustrate the Japanese public's lack of appetite toward abandoning Japan's post-war pacifism. If Abe is serious about holding a referendum on this topic, he will have to support growth going forward - which implies higher fiscal stimulus and inflation expectations. Meanwhile, the absence of inflation in Japan continues to hamstring the BoJ in keeping policy extremely supportive, limiting the upside to nominal interest rates across the Japanese yield curve. Real rate differentials will continue to support USD/JPY. Use any weakness in this pair to buy the dollar versus the yen. Canada: Poloz Delivers The Bank of Canada on Wednesday increased interest rates by 25 basis points to 0.75%, the first central bank to follow the Fed's lead. Our analysis two weeks ago suggested that the BoC was faced with some of the most supportive conditions in the world to follow the Fed's path.2 More interesting than the decision itself was the accompanying quarterly Monetary Policy Report. In the report, the BoC moved forward its estimation of the closure of the output gap from 2018 to 2017. Additionally, despite expecting a slowdown in household consumption in 2018, the BoC upgraded its GDP forecast by 0.2% in 2017 and 0.1% in 2018, to 2.8% and 2%, respectively. Obviously, the market took note of these views, with USD/CAD falling three big figures on the news. The tone of the report was quite bullish on the Canadian economy, highlighting robust as well as broad-based growth and increasing signs of vanishing slack. In fact, the message reiterated that of the summer Business Outlook Survey, which showed strong growth, growing difficulty meeting demand, and growing and intensifying labor shortages (Chart I-14). As a result, the BoC expects the weak Canadian CPI to rebound, after the transitory effects of low food inflation, automobile rebates, and Ontario's electricity subsidies dissipate. We are inclined to agree with this assessment. At 2% per annum, Canadian employment growth is robust and the unemployment rate has fallen significantly. Now that oil prices have stabilized, employment is improving, suggesting that even the weakest regions of the economy are participating in the party. Additionally, our Canadian economic diffusion index - based on retail trade, manufacturing sales, building permits and employment data in the 10 provinces - has sharply accelerated, pointing to a continued rise in GDP growth (Chart I-15). Chart I-14Canada Is Booming And Slack Is Shrinking Chart I-15Strong Data Across The Board USD/CAD continues to trade at a discount to real interest rate differentials, signaling further upside on the CAD. Also, while investors have begun to curtail their shorts on the loonie, there do remain enough stale shorts for the CAD advance to persevere. We continue to prefer playing the CAD's strength on its crosses such as versus the AUD and the EUR, as the risk profile seems cleaner on these pairs than versus the USD. Short EUR/CAD looks particularly attractive. Our long CAD/NOK trade is near its target, and we are closing this position. Bottom Line: The Bank of Canada has not only hiked rates, but it has also highlighted that the Canadian economy is strong and inching closer to full capacity. The market has taken note, with the loonie rallying violently. The CAD has more upside going forward, especially against the euro and the AUD. We are booking profits on our long CAD/NOK position. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see European Investment Strategy Special Report titled, "Fractals, Liquidity & A Trading Model", dated December 11, 2014, available at eis.bcaresearch.com 2 Please see Foreign Exchange Strategy And Global Alpha Sector Strategy Special Report titled, "Who Hikes Next?", dated June 30, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The greenback has largely been flat this week, despite Yellen's statements regarding rate hikes and balance sheet normalization at her Congressional Testimony, even if, 10-year yields went down. U.S. economic data has a soft tone: NFIB Business Optimism Index came in lower than expected at 103.6, reflecting broad-based softness in the details of the survey; JOLTS job openings also came in lower than expected at 5.666 mn; Initial jobless claims underperformed expectations, coming in at 247,000; Additionally, continuing jobless claims were higher than expected at 1.945 mn. While data remains mixed, the Fed is still intent on tightening policy. The dollar will follow suit, especially if inflation moves as the Fed expects. Report Links: Who Hikes Next? - June 30, 2017 Look Ahead, Not Back - June 9, 2017 Capacity Explosion = Inflation Implosion - June 2, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Data out of Europe this week was reasonably strong: Both exports and imports increased at a 1.4% and 1.2% monthly pace, respectively; The current account beat expectations; Industrial production increased by 4%, more than the expected 3.6%; However, despite this upbeat data, the euro remained largely flat this week. This behavior is justified from a technical perspective: the RSI is close to overbought levels; the MACD line is rolling over and closing the gap with the signal line; the number of speculators with long positions is at its highest level ever. The considerable weakness in EUR/SEK and EUR/NOK on Thursday shows underlying weakness in the euro. This decreases the likelihood that EUR/USD breaches the 1.15-1.16 zone. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Labor cash earnings yearly growth outperformed expectations and grew from last month, coming in at 0.7%. However, machinery orders yearly growth was far below expectations, coming in at 0.6%. In spite of the selloff in the dollar, USD/JPY has rallied by more than 1% since last week, stopping its ascent after hitting a key technical level at 114.5. We continue to be yen bears, even in the face of the declining popularity of Shinzo Abe: the champion for expansionary fiscal policy in Japan. Instead, we are confident that Abe will double down on fiscal spending as his decline in popularity has been precisely because he has strayed away from this key policy pillar which made him so popular. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Updating Our Intermediate Timing Models - April 28, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Halifax House prices grew by only 2.6% YoY, underperforming expectations of 3.1%. Industrial Production contracted by 0.2% year-on-year, also underperforming expectations. While the unemployment rate decreased, coming in at 4.5% and also beating expectations, average earning growth fell to 1.8%. After appreciating by almost 2% this week, and reaching 0.895, EUR/GBP has come down to 0.885, but the pound is likely to have short term downside against the euro. Furthermore, GBP/USD is also likely to have downside, as the pound is not as attractive as it was in the beginning of the year from a valuation standpoint. Indeed, sentiment has turned much more positive on the outcome of Brexit, which means that the significant discount in the pound has disappeared. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The AUD has seen a broad-based increase this week, except for against the CAD. This increase has largely been a factor of Chinese data, although domestic conditions also played a role: Chinese exports and imports both increased at a 11.3% and 17.2% annual pace, respectively; China's trade balance in June was USD 42.77 bn, better than expected; Chinese new loans came in at RMB 1,540 bn; NAB Business Conditions and Confidence both beat expectations; However, investment lending for homes is still contracting at 1.4%, albeit at a lesser than expected pace of 2.3%; Also, home loans are increasing at a lesser than expected pace of 1%. We retain our view of the inherent weakness in the Australian economy, which will restrict the RBA from changing its view. This will weigh on the AUD in the near future. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 AUD/NZD has rallied by almost 1.3% since last week. This in part, was the market reaction to an approved housing infrastructure fund by Prime Minister Bill English worth NZ$1 Billion aimed at increasing the supply of housing in the country. This measure provides the RBNZ with some breathing room, as it is a policy aimed at cooling housing market, which has prices growing at a 14% rate. The increase in housing supply alleviates the pent up demand generated by the dramatic increase in population in New Zealand in recent years. The RBNZ is unlikely to join the BoC and the Fed this year, as they remain cautious, and have opted for macro prudential measures to eliminate any imbalances in the economy. Stay short the NZD against the dollar and the yen. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Canada followed the footsteps of its partner in the south, joining the U.S. as the only two central banks in the G10 space raising interest rates. The Bank of Canada highlighted that "the adjustment to lower oil prices is largely complete" and that "both the goods and services sectors are expanding". Alberta's economy validates this stance as all sectors of the economy are growing at a very brisk pace. The BoC estimates that the output gap will now close at the end of 2017, instead of the previous forecast of the first half of 2018, further escalating their hawkish rhetoric. The press release noted that the recent restrain in inflationary pressures will be transitory, as "excess capacity is absorbed". Recent data corroborates this view with strong employment data and stronger than expected housing starts. USD/CAD declined 1.3% at the end of the day of the hike, and outperformed all other currencies. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Exploring Risks To Our DXY View - May 26, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: Unemployment remains very low, coming in at 3.2% However, producer and import prices contracted by 0.1% year-on-year, coming below expectations and decreasing from the previous month. The low unemployment number is not the only indicator that shows a tight labor market, as employment is also growing at an astonishing 5% yearly rate. However, this tightness in the labor market is not translating to higher wages, as wages are growing at a paltry 0.6%, anchored by strong deflationary forces. Thus, the SNB will continue with their ultra-dovish monetary policy and with their interventions in the currency market. Nevertheless, we will monitor if the recent plunge in the CHF against the euro creates any kind of inflationary dynamics in the economy, and causes the SNB to rethink their stance. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been mixed: Manufacturing output contracted by 0.3%, falling sharply from last month number. Additionally, although both core and headline inflation came above expectations at 1.6% and 1.9% respectively, they still fell from last month reading. The Krone has appreciated sharply the past week, with USD/NOK falling by 1.45% and EUR/NOK falling by 1.15%. This has been a result of the rebound in oil prices caused by the massive draws in inventories the past couple of weeks. Indeed, last week's number, which showed an inventory draw of 7.6 million barrels was the biggest since 2011. Overall, we expect that OPEC should be able to continue managing supply, and therefore, oil should rise until the end of the year. This will be negative for EUR/NOK. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Exploring Risks To Our DXY View - May 26, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The Riksbank's change in rhetoric was perfectly timed, as Sweden's economy is increasingly showing signs of strength. Data has outperformed these past two weeks: Manufacturing PMI came in at 62.4, beating expectations of 59.8; Industrial production increased at a 8% annual pace in May; Inflation in Sweden is firming, coming in at 1.7% in June and beating expectations. The SEK appreciated 0.7% against EUR, and 0.6% against USD. Markets are pricing in stronger growth and a further escalation of hawkish rhetoric from the central bank, especially as Stefan Ingves as tabulated to leave this Riksbank in a few months. Part of the reason for Sweden's strength is also a stronger European economy. With Germany leading the pack, Sweden's largest export partner is also lifting the largest Scandinavian economy. Report Links: Who Hikes Next? - June 30, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The market will not give OPEC 2.0 until March to sort out a durable modus operandi to manage supply and maintain the discipline required to defend crude oil prices. While the odds of Libya and Nigeria being able to keep production at current levels - much less grow output - are less than 50:50 in our estimation, the fact remains the Kingdom of Saudi Arabia (KSA) and Russia need to start communicating post-haste how OPEC 2.0 will manage higher Libyan and Nigerian production. Critically, these leaders will need to follow through on whatever they guide the market to expect. We think OPEC 2.0 will stand by its "whatever it takes" proclamations. Not acting in the face of more than 300k b/d of unexpected supply from a once-moribund Libya placed in the market since October will send a signal, as well: OPEC 2.0 will not defend its Agreement. Should this occur, it likely would result in a breakdown in production discipline within the coalition, sending crude oil prices lower. Energy: Overweight. Crude oil prices remain under pressure as markets price the likelihood of continued increases in production in Libya and the U.S. Spoiler alert: We think OPEC 2.0 will act to accommodate Libya's and Nigeria's return to export markets. Base Metals: Neutral. Workers at the Zaldivar copper mine owned by Antofagasta and Barrick Gold voted to strike earlier this week. If government mediation fails to resolve the issues separating labor and management this week, workers will walk. Precious Metals: Neutral. Gold is recovering from last week's "flash crash" in silver, but markets continue to process recent hawkish guidance from systematically important central banks that could lift real rates and pressure precious metals. Ags/Softs: The USDA's WASDE was published just before our deadline. We will review it in next week's publication. Feature Markets may have tacitly assumed OPEC 2.0 would have until March to figure out how KSA, Russia, and their respective allies would work together to re-gain some control over oil prices. However, given almost-daily reductions in banks' oil-price forecasts in the wake of steadily increasing Libyan and U.S. production, belief in OPEC 2.0's strategy and commitment appears to be all but exhausted. Stronger-than-expected output from Libya and Nigeria - up some 400k b/d vs. the October production levels OPEC 2.0 benchmarks to (Chart of the Week) - is being offset by strong inventory draws in high-frequency data from the U.S. and Europe, as we expected. In addition, a reduction in 2018 U.S. shale-growth forecasts in the EIA's just-released estimates of global supply and demand boosted sentiment some. Even so, markets remain skeptical. Libya's production now is estimated at 850k b/d, and accounts for 300k b/d of newly arrived OPEC supply since October. Nigeria, at close to 1.6mm b/d, accounts for another 90k b/d of the unexpected supply on the market since October. OPEC's total crude output is running at just over 32.6mm b/d, down 470k b/d from October's levels, based on the EIA's tally.1 This was 300k b/d more than May's output. Taking Libyan and Nigerian output out of the tally leaves OPEC crude production at 30.21mm b/d, or 860k b/d below October's level. Close to 26mm b/d of OPEC's output is being exported, according to Thompson Reuters data, surpassing OPEC's 4Q16 export levels when Cartel members' output was surging ahead of the OPEC 2.0 production cuts that took effect in January.2 Although benchmark crude oil prices had recovered from their bear-market lows of late June, the steady increase in Libyan production, in particular, reversed this recovery, taking $2.70 and $2.80/bbl off the interim highs registered by WTI and Brent prompt contracts between July 3 and July 10 (Chart 2). Chart of the WeekLibya, Nigeria Add Close ##br##To 400k b/d To OPEC 2.0 Production Chart 2Libya's Resurgence Clobbers ##br##Benchmark Prices Prices have since moved higher of the back on larger-than-expected draws in crude and products in the OECD, led by the U.S. On Wednesday, the EIA reported U.S. crude inventories declined by a whopping 10.7 million barrels, although product inventories grew by 3.7 million barrels for the week ended July 7. These sharp draws (over 17 million barrels of crude storage reduction in the past two weeks, including SPR withdrawals) are what we have been expecting, so we are not surprised, although this is the second week in a row in which the inventory draws exceeded market expectations for the EIA's reporting week. WTI was trading just above$45/bbl, while Brent was just over $47.60/bbl as we went to press. OPEC 2.0's Problem The problem for OPEC 2.0 is that Libya's unexpectedly strong return will retard the drawdown in OECD inventories around which the reformed Cartel is organized. This is compounded by higher U.S. production, which the EIA's latest estimates put at 9.2mm b/d. U.S. crude production in June was up 410k b/d vs. 4Q16 levels, and 510k b/d yoy, by the EIA's reckoning. The bulk of this increase comes from shale-oil production, which is running at ~ 5.1mm b/d (Chart 3). Lower prices will slow the growth of U.S. shale-oil output, but it won't reverse the absolute increase unless prices once again push below $40/bbl for an extended period. We do not expect such an evolution of prices, and continue to expect Brent will average $55/bbl and will reach $60/bbl by the end of the year, with WTI trading at ~ $58/bbl by then. OPEC 2.0's production is not as sensitive to price as the U.S. shales. The coalition banded together to remove some 1.8mm b/d of oil production from the market, and, based on media reports, continues to maintain production discipline. We reckon actual cuts have been on the order of 1.4 to 1.5mm b/d from OPEC 2.0, favoring the lower end of that range, given the latest estimates of the EIA. Given demand growth of ~ 1.6mm b/d on average this year and next, we are expecting a net physical deficit this year of ~ 900k b/d (Chart 4). This will draw OECD inventories down by March below five-year average levels (Chart 5). Chart 3Higher Prices Lifted U.S. ##br##Shale-Oil Production, But Lower Prices Will Slow The Growth Chart 4Output Declines And Demand ##br##Gains Will Produce A Physical Deficit ... Chart 5OPEC 2.0 Has To Defend Its Strategy, ##br##If OECD Inventories Are To Fall It is worth remembering Libya and Nigeria are not parties to the OPEC 2.0 deal. Nor did the leaders of this coalition anticipate a sustained increase in production by these states when the OPEC 2.0 deal was agreed at the end of last year. This is particularly true for Libya, which is a failed state. The suggestion by Kuwait that Libya and Nigeria be brought into the OPEC 2.0 production-cutting agreement beggars belief: The Arab Spring destroyed Libya as a state, and its oil production. Since March 2011, when the state collapsed, Libya's oil production has averaged 650kb/d, versus 1.65mm b/d in 2010. Even if there were a government in place, it is unlikely it would agree to cap its production. Nigeria's production also has been hampered by civil unrest, particularly in the Niger Delta region, where insurgents periodically sabotage pipelines and loading platforms, which forces oil exports to be suspended until repairs can be made. Nigeria's production averaged over 2mm b/d until 2013, when it fell to 1.83mm b/d. Since then, it has averaged 1.66mm b/d, with 2017 production to June averaging 1.43mm b/d. Any increase in production resulting in export sales is "found money" for these states. And their need for this money is as great, if not greater, than that of the OPEC 2.0 coalition members. Who In OPEC 2.0 Is Likely To Cut Production? KSA, Kuwait and the UAE were producing close to 2.4mm b/d more in June than they were in 2010, the last year Libya was an intact state, even with the cuts agreed under the OPEC 2.0 deal accounted for. Even at its recent high of 850k b/d of production, Libya still is producing 800k b/d less than it did in 2010. We believe an accommodation involving KSA, and possibly Kuwait and the UAE, can and will be reached at the upcoming OPEC 2.0 technical committee meeting in St. Petersburg on July 24. Something on the order of 500k b/d from these Gulf Arab producers will allow Libya and Nigeria to flex into higher production without undermining the OPEC 2.0 production-cutting deal. The stakes are sufficiently high for the OPEC 2.0 members - KSA and Russia in particular - that an accommodation for Libya will be found. Libya's maximum production likely is no more than 1mm b/d, given the damage years of neglect has caused its fields and productive capital. Rebuilding this province will take years, if a way can be found to reconstitute the organs of a functioning state. Absent an accommodation, OPEC 2.0's leaders risk undermining the credibility of the coalition and causing production discipline to collapse as each state in the group rushes to increase output before prices take their inevitable dive. This would severely reduce the proceeds KSA could expect from IPO'ing Aramco, and would again put Russia's revenue under pressure, forcing it to draw down foreign reserves. OPEC 2.0's End Game Hasn't Changed Neither KSA nor Russia wants to re-visit the conditions that prevailed in 1Q16, when markets were pricing a global full-storage event that would require prices to push through $20/bbl to kill off supply so that storage could drain. For this reason, both have shown their commitment to the production-cutting pact they negotiated at the end of last year. Both, we are convinced, are working closely to map a strategy to allow U.S. shale production to co-exist - within limits - with OPEC and Russian production. In earlier research, we laid out a strategy that could work to achieve this result - draw storage down enough to backwardate the WTI forward curve so that deferred prices trade below prompt-delivery prices. This will moderate - but not stop - the rate at which horizontal rigs return to the shale fields.3 OPEC 2.0's leaders will have to find a way to use their production and storage - which is why it is critical to open some space now - to guide markets to expect higher production and crude availability in the future and tighter market conditions in the present. Bottom Line: We expect OPEC 2.0 to accommodate Libya's and Nigeria's increased production with further cuts in their own production, particularly from KSA, Kuwait and the UAE. This will allow Libya and Nigeria to flex into higher output, should they find a way to maintain it going forward. We continue to believe the odds of sustained higher production from these states is less than 50:50, but that does not matter. What matters is that markets see OPEC 2.0 defending their production-cutting strategy so that inventories continue to draw. OPEC 2.0's end-game has not changed. But the leaders of the coalition will have to adapt if they are to succeed in drawing storage to five-year averages or lower. Critically, they must begin to communicate their longer-term strategy to the market, or risk undermining their coalition. 2Q17 Trade Recommendations Re-Cap We closed out 2Q17 with an average loss of 77% on trades recommended and closed during the quarter (Table 1). The primary driver of this underperformance was a return to contango in the WTI and Brent forward curves, as inventories failed to draw as quickly as we expected. Directional trade recommendations anticipating higher prices also performed poorly. Table 1Trade Recommendation Performance In 2Q17 Open trades at the end of 2Q17 were up an average of 26%, led by good performances in option recommendations - i.e., long call spreads in WTI and Brent in Dec/17. Year to date, our trade recommendations are up 72.6%, on the back of strong 1Q17 results. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 This is adjusted for the inclusion of Equatorial Guinea and the recent opting out of Indonesia. We will be updating our global supply-demand balances next week. 2 Please see "Oil slides as OPEC exports rise, prices end 8 days of gains," published by reuters.com July 5, 2017. 3 Please see BCA Research's Commodity & Energy Strategy reports of April 6, 2017, entitled "The Game's Afoot in Oil, But Which One," and March 30, 2017, entitled "KSA's, Russia's End Game: Contain U.S. Shale Oil." Both are available at ces.bcaresearch.com. Investment Views And Themes Recommendations Strategic Recommendations Tactical Trades Trades Open And Closed In 2017 Summary Of Trades Closed In 2016 Trades Closed In 2017 Commodity Prices And Plays Reference Table

Highlights EM growth is set to falter due to budding weakness in Asia's trade, a decline in commodities prices, and the frailty of EM banking systems. U.S./DM bond yields are heading higher for now and China's money/credit growth is set to decelerate. Together, these will trigger a selloff in EM risk assets. The EM equity outperformance versus DM has been extremely narrow and, hence, it is unsustainable. The EM tech sector is unlikely to support the equity rally much further because these stocks are overbought, and the Asian semiconductor cycle is entering a soft patch. Take profits on the yield curve flattening trade in Mexico. Stay long MXN on crosses versus BRL and ZAR and continue overweighting Mexican bonds. Feature Higher bond yields within the advanced economies and policy tightening in China remain the key threats to EM risk assets in the near term (the next three months). In the medium-term (the next three to 12 months or so), the principle risk is weaker growth in EM/China, and hence contracting corporate profits in EM. While this rally has lasted longer and has gone further than we had anticipated, we find the risk-reward for EM risk assets extremely unattractive. In fact, the huge amount of money that has flown into EM equity and debt markets in the past year amid poor fundamentals suggests to us that the next move will not be a simple correction but rather a major bear market. EM Recovery To Falter Although on the surface global growth appears to be on solid footing, there are early signs of a slowdown in Asian exports. Both Taiwanese exports of electronic parts and the country's overall exports to China have rolled over - the latter two lead global export volumes by a few months, as shown in Chart I-1. The reason why Taiwanese exports of electronic parts lead global trade cycles is because these parts are used in the assembly of final products, and producers order and receive these parts before final products are made and shipped. Similarly, a lot of Taiwanese exports to China serve as inputs into final products assembled in China and shipped worldwide. This is why Taiwan's overall shipments to China lead global trade cycles. On top of this, Korea's overall manufacturing and semiconductor shipments-to-inventory ratios have relapsed. Historically, these ratios have correlated with the KOSPI (Chart I-2). Chart I-1Signs Of Slowdown ##br##In Asian Trade Chart I-2Korea's Manufacturing ##br##Growth Has Peaked Outside the manufacturing-based Asian economies, most other EMs are basically commodities plays, except for India and Turkey. The latter two countries are not only relatively small, but Indian stocks are also expensive and overbought while Turkey is sufferings from its own malaise. In short, if the Asian tech cycle rolls over, China slows down and commodities prices relapse, EM growth will falter. That is why the focus of our analysis has been and remains on China's growth, commodities prices and the Asian trade cycle. Meanwhile, many banking systems in the developing world remain frail following the credit excesses of the preceding years. BCA's Emerging Markets Strategy service remains bearish on commodities, and believes the breakdown in the correlation between commodities prices and EM risk assets since the beginning of this year is temporary and unsustainable. As for the increased importance of the technology sector in the EM equity benchmark, we offer further analysis on page 10. Our negative view on EM growth is not contingent on a relapse in U.S. and euro area growth. In fact, our current baseline scenario is that DM growth will remain solid, and government bond yields in these markets will rise further. Although growth in both the U.S. and euro area is robust, their importance for EM has become small. For example, exports to the U.S. and EU altogether account for 35% of total exports in China, 22% in Korea and 20% in Taiwan. All in all, if commodities prices continue to downshift and Asian trade slows, as we expect, EM growth will decelerate. Bottom Line: EM growth is set to falter notably, despite solid demand growth in DM. Liquidity Backdrop To Deteriorate Investors and market commentators often use the term "liquidity" loosely, and denote numerous things by it. We use the term 'liquidity' to signify the level and/or direction of interest rates as well as the level and/or direction of money/credit growth. Below we review some different perspectives of liquidity: EM narrow money (M1) growth points to both lower share prices and a relapse in EPS growth in the months ahead (Chart I-3). Chart I-3EM: Narrow Money (M1) Points To EPS Downturn And Lower Stock Prices This is an equity market cap-weighted aggregate of narrow money growth. M1 growth in China - the largest market cap in the EM equity benchmark - has been essential in driving aggregate EM M1 cycles in recent years. More importantly, China has been tightening liquidity, yet the majority of investors remain complacent about its impact on growth. In this regard, investors should remind themselves that monetary policy works with time lags, and the considerable rise in China's interbank rates and corporate bond yields will produce a growth slowdown in the real economy later this year. Chart I-4 demonstrates that China's broad money growth (M2) - which has in effect dropped to an all-time low - leads bank and non-bank credit origination. This suggests the odds of a slowdown in bank and non-bank credit flows are considerable. There has been no stable correlation between the size of DM central banks' balance sheets and EM stock prices, bond yields and currencies since 2011. Therefore, the Fed's move to reduce its balance sheet by itself should not matter for EM risk assets from a fundamental perspective. Nevertheless, EM risk assets have been negatively correlated with U.S. TIPS yields (Chart I-5), and the potential further rise in U.S./DM real and nominal yields will hurt EM sentiment, with flows to EM drying up. Chart I-4China: M2 Heralds ##br##Slowdown In Credit Growth Chart I-5EM Currencies To Depreciate ##br##As U.S. Real Yields Drift Higher Importantly, traders' bets on U.S. yield curve flattening have risen, as evidenced by large short positions in 2-year U.S. notes and considerable long positions in 10- and 30-year bonds. The unwinding of these positions will drive bond yields higher. Chart I-6Precious Metals Signal ##br##Higher Real Yields Ahead Notably, precious metal prices have failed to break out amid a weak U.S. dollar and have lately relapsed (Chart I-6). Precious metals prices could be sensing a further rise in U.S. real yields and/or an upleg in the U.S. dollar. Both the rise in U.S. yields and a stronger dollar will be negative for EM. Bottom Line: We maintain that U.S./DM bond yields are heading higher in the months ahead and China's money/credit growth is set to decelerate. Altogether these will trigger a selloff in EM risk assets. Underwhelming EM Technicals It is a well-known fact that flows into EM debt funds have been enormous, making EM fixed-income markets vulnerable to a reversal of these flows at the hands of tightening liquidity and EM growth disappointments, as argued above. This section focuses on a number of bearish technical signals for EM share prices. In particular: The EM equity implied volatility curve - 12-month VOL minus 1-month VOL - is at a record steep level, based on available history (Chart I-7). Periods of VOL curve flattening have historically coincided with a selloff in EM share prices, as evidenced by Chart I-7. Given that the VOL curve is record steep, the odds of flattening are substantial. Consistently, the probability of an EM selloff is considerable. Chart I-7A Sign Of Top In EM Share Prices? In absolute terms, EM equity implied 1-month VOL is at an all-time low and reflects enormous complacency about EM. EM equity breadth has also been poor. The MSCI EM equally weighted stock index (where each stock commands an equal weight) has considerably underperformed the EM market cap-weighted index since May 2016 (Chart I-8). This suggests the EM rally has been very narrowly driven. The same measure for DM stocks has done relatively better (Chart I-8). Remarkably, EM has underperformed DM based on equal-weighted equity indexes since July 2016 (Chart I-9). This confirms that EM outperformance against DM since early this year has been largely driven by a few stocks, namely the five companies accounting for the bulk of the EM tech index. Furthermore, EM ex-tech stocks have also failed to establish a bull market, in that the index remains below its prior low (Chart I-10). Chart I-8EM Equity Breadth ##br##Has Been Poor Chart I-9EM Versus DM: Relative ##br##Equity Performance Chart I-10EM Ex-Technology Stocks: ##br##Rebound But No Bull Market Finally, the magnitude of the EM rally this year is somewhat misleading. Only three out of 11 sectors - technology, real estate and consumer discretionary (mainly, autos) - have outperformed the EM benchmark this year. Table I-1 illustrates that these three sectors have been responsible for about 50% of the EM rally year-to-date while their market cap is only 36% of total. Table I-1EM Rally In 2017: Return Decomposition Bottom Line: The EM equity outperformance versus DM has been extremely narrow: it has been due to five tech companies that are currently very overbought (see Chart I-8 on page 7). Valuations EM equity valuations are not cheap, as most of the rally since the early 2016 bottom has been driven by a multiple expansion rather than a rise in corporate earnings (Chart I-11). We are not suggesting EM stocks are expensive, but they do not offer good value either. In fact, good companies/countries/sectors are expensive, while those, that appear "cheap", command low multiples for a reason. As for currencies, they are not cheap either. The real effective exchange rate of EM ex-China is rather elevated after the rally of the past year or so (Chart I-12). Finally, not only are EM sovereign and corporate spreads close to record lows, but also local government bond yield spreads over U.S. Treasurys are at multi-year lows (Chart I-13). Chart I-11Decomposing EM Equity ##br##Return Into P/E And EPS Chart I-12EM Ex-China Currencies ##br##Are Not Cheap And Vulnerable Chart I-13EM Local Bond Yields Spreads ##br##Over U.S. Treasurys Is Low Bottom Line: Adjusted for fundamentals, EM equity, currency and credit market valuations are rather expensive. The odds are that the reality will underwhelm expectations, and that EM risk assets will sell off. A Word On EM Tech: Is This Time Different? During our recent trip to Europe, many clients argued that the increased weight of technology in the EM equity benchmark will cause EM share prices to decouple from the traditional variables they have historically been correlated with, like commodities prices, commodities stocks and others. In brief, the argument is that EM has entered a new paradigm, and past correlations will not work. The last time we at BCA heard similar arguments was back in early 2000 at the peak of the global tech bubble. At the time, the argument was that this time was truly different - that tech stocks could drive the market higher regardless of the old indicators and the performance of other sectors. Chart I-14 portrays that in 2000 the EM equity index, for several months, decoupled from global mining and energy stocks when tech and telecom stocks went ballistic. Chart I-14EM And Commodities Stocks: Can The Recent Decoupling Persist? Back in 2000, the bubble was in tech and telecom stocks. These two sectors together comprised 33% of the EM benchmark as of January 2000 (Chart I-15). This compares with a 27% weighting of technology stocks alone in the EM benchmark now. The combined weight of energy and materials is currently 14% versus 19% in January 2000, as can been seen in Chart I-15. Chart I-15EM Equities Sector Composition Now And In Late 1990s To be sure, we are not suggesting that tech stocks are in a bubble as they were in 2000, and that a bust in share prices is imminent. However, several observations are noteworthy: Chart I-16EM Equities Sector ##br##Composition Now And In Late 1990s Just because EM tech stocks have skyrocketed in the past six months does not mean they will continue to do so. In fact, EM tech is already extremely overbought and likely over-owned (Chart I-16). As global bond yields rise, high-multiples stocks, especially social media/internet companies, could selloff. We, like all macro strategists, can add little value on how to value internet/social media companies and assess their business models. However, we can shed some light on the business cycle in the semiconductor sector that influences performance of heavyweight companies like TSMC and Samsung. As Chart I-1 and I-2 on pages 1 and 3 demonstrate, there are signs that the semi/electronics cycle in Asia has peaked. We do not mean that this sector is headed toward recession. But this is a very cyclical sector, and some slowdown is to be expected following the growth outburst of the past 18 months. This will be enough to cause a correction in semi stocks from extremely overbought levels. The tight correlation between EM share prices and energy and mining stocks has persisted for the past 20 years (Chart I-14 on page 10), and we believe it will re-establish as technology stocks' shine diminishes. Finally, we have been recommending an overweight position in Taiwanese, Korean, and Chinese stocks primarily because of their large tech exposure. For now we maintain this strategy. Bottom Line: While the technology sector could make a difference for EM economies and equity markets in the long run, it is unlikely to support the current rally and outperformance much further. Indeed, tech stocks are heavily overbought, and the Asian semiconductor cycle is entering a soft patch. In brief, the overall EM equity benchmark is at a major risk of relapse and underperformance versus the DM bourses. Stay underweight. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Mexico: Take Profits On Yield Curve Flattener And Stay Long MXN On Crosses Mexico's 10/1-year swap curve has inverted for the first time in history and we are taking a 160 basis points profit on our yield curve flattening trade recommended on June 8, 2016 (Chart II-1). Will the central bank begin cutting interest rates soon? Is it time to get bullish on stocks? We do not think so: Inflation is well above the central bank's target and is broad based (Chart II-2). Notably, wage growth is elevated (Chart II-3). Chart II-1Mexico's Yield Cruve Has Inverted: Take Profits Chart II-2Mexico: Inflation Is Above The Target Chart II-3Mexico: Wage Inflation Is High Provided productivity growth is meager in Mexico, unit labor costs - which are calculated as wage per hour divided by productivity (output per hour) - are rising. This will depress companies' profit margins and make them eager to hike selling prices. This will in turn prevent inflation from falling and, consequently, hamper Banxico's ability to cut rates for now. Meanwhile, the impact of higher interest rates will continue filtering through the economy. High interest rates entail further slowdown in money and credit growth and, hence, in domestic demand. Both consumer spending and capital expenditure by companies are set to weaken a lot (Chart II-4). This will weigh on corporate profits and share prices. Fiscal policy is not going to support growth either because policymakers will opt to consolidate the recent improvement in the fiscal deficit. This is especially true given the latest selloff in oil prices. Notably, oil accounts for about 20% of government revenues. Even though non-oil exports and manufacturing output are accelerating (Chart II-5), non-oil exports - that make about 30% of GDP - are not large enough to offset the deceleration in domestic demand from monetary tightening. Chart II-4Mexico: Domestic Demand To Buckle Chart II-5Mexico: Exports Are Robust Investment Conclusions The outlook for Mexican stocks in absolute terms is poor as domestic demand will slump, further hampering corporate profits. Meanwhile, inflation is still elevated to justify rate cuts by the central bank. Within an EM equity portfolio, we recommend neutral allocation to this bourse mainly due to our expectations of the peso outperforming other EM currencies. The Mexican peso is still cheap (Chart II-6). Therefore, we continue to recommend long positions in MXN versus ZAR and BRL. If EM currencies depreciate and oil prices drop further as we expect, it will be hard for the peso to appreciate versus the U.S. dollar. However, the peso will outperform many other EM currencies. Mexican local currency bonds and sovereign credit offer good value relative to their EM counterparts. (Chart II-7). Fixed income investors should continue to overweight Mexican local currency and sovereign credit within their respective EM benchmarks. Chart II-6Mexico: Peso Is Cheap Chart II-7Continue Overweighting Mexican Bonds Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Coordinated Hawkishness: Central bankers are in the process of taking back the easier monetary policy that followed the deflationary 2014/15 oil shock. Bond yields still have more upside to catch up to the solid pace of global growth and diminishing economic slack. Maintain a below-benchmark stance on overall portfolio duration. ECB Taper Tantrum: The recent European bond sell-off is following a similar pattern to both the 2013 Fed Taper Tantrum and the 2015 Bund Tantrum, suggesting a potential target of 1% on the benchmark 10-year German Bund yield by year-end. Stay underweight Euro Area government bonds. Canada: With the Canadian economy looking very strong, and with the Bank of Canada signaling a desire to begin normalizing monetary policy, the current underperformance of Canadian government bonds will continue. We are maintaining our tactical bearish positions on Canadian bonds, and are also adding a new strategic underweight position (2 out of 5) in our model bond portfolio. Feature A Regime Shift, Not A Regime Change Interest rate risk has returned with a vengeance in global fixed income markets over the past couple of weeks. A string of relatively hawkish policymaker comments has triggered a quick and sharp bond sell-off, as investors reprice the odds of what is looking now like a coordinated recalibration of global monetary policies. Longer-dated bonds have gotten pummeled as yield curves have bear-steepened in most countries, with 30-year government bond prices falling between -5% and -7% in a matter of days (Chart of the Week). With global growth looking very strong at the moment, policymakers are being forced to respond by looking to unwind some of the easing that took place after the crash in oil prices in 2014/15. With that deflation scare now firmly in the rearview mirror, central bankers are having to signal a move away from the emergency stimulus from 2015. The rapid yield responses seen so far suggest that the communication of that subtle policy shift - becoming "less dovish" rather than "more hawkish" - must be handled delicately, or else financial markets may riot and possibly short-circuit the current economic upturn. This yield surge has done very little to dampen investor enthusiasm for risk assets, so far. Equity prices and corporate credit spreads, both in the developed world and emerging markets (EM), have only moved modestly despite the large move in government bond yields (Chart 2). This suggests that the latter was most mispriced compared to the current solid pace of global economic growth. Chart of the WeekA Painful Repricing Chart 2Risk Assets Remain Unfazed With the benefit of hindsight, it now appears that the decline in global bond yields in the spring was an outsized response to a few below-consensus data prints on U.S. economic growth and inflation. Importantly, the numbers in the U.S. are starting to improve again, as indicated by the strong jump in the ISM indices and employment (+220k) in June. Many of our most reliable leading indicators and models are all pointing to further acceleration in U.S. growth in the next few quarters (Chart 3). The U.S. inflation data continues to disappoint, both in terms of price indices and wage growth. Growth in Average Hourly Earnings has drifted lower since the most recent peak, while core PCE inflation is only 1.4%. The latest commentary from the Fed, including the minutes from the June FOMC meeting released last week, suggests that this downdraft in inflation should prove to be temporary and stronger growth should lead to faster inflation. We would agree with that assessment. The U.S. unemployment rate at 4.4% remains below most measures of full employment, while other reliable indicators of labor market tightness, such as the spread between the "jobs plentiful" and "jobs hard to get" components of the U.S. consumer confidence report, are also pointing to an eventual reacceleration of wages (Chart 4, top panel). Meanwhile, the Cleveland Fed Median CPI is hovering around 2.5%, well above the current 5-year/5-year forward cost of inflation compensation embedded in U.S. TIPS prices of 1.83% (middle panel). Furthermore, the Phillips Curve based core PCE inflation model developed by our colleagues at U.S. Bond Strategy is signaling a rebound of core PCE inflation back above 1.9% by year-end, in a scenario of no change in the unemployment rate or U.S. dollar from current levels (bottom panel). Chart 3U.S. Growth Will Rebound Chart 4U.S. Inflation Will Rise Our base case scenario for the Fed is that additional tightening will come in 2017. First through an announcement on starting the process of reducing the Fed's balance sheet, through "tapering" the reinvestment of proceeds from maturing bonds held by the Fed, at the September FOMC meeting. After that, the next rate hike will not be until December. This will allow the Fed to see more inflation prints to confirm its own expectation that inflation will soon rebound before delivering more policy tightening. Of course, if the next couple of inflation releases surprise to the upside, then perhaps a rate hike is possible at the September meeting alongside the announcement on the Fed's balance sheet (which is basically a done deal, at this point). For now, we see the Fed staying cautious, especially given the increasing number of FOMC members who are becoming concerned with the lack of U.S. inflation, according to the June minutes. As for the other major developed economy central banks, this "old-school" cyclical upturn is boosting both capacity utilization and pipeline inflation (Chart 5). Combined with the other measures that have been showing diminished economic slack, like unemployment rates and output gaps, this will give policymakers confidence in their own medium-term growth and inflation forecasts. This will also embolden central bankers to remove some policy accommodation. Our own Central Bank Monitors are indicating a need for tighter monetary policy in every major developed economy except Japan. That is confirmed by Taylor Rule estimates for interest rates. In Chart 6, we present simple Taylor Rule projections for the policy rate in the U.S., Euro Area, U.K., Japan, Canada and Australia. The formula takes potential GDP growth (OECD estimates) and then adds current realized inflation, ½ of the deviation of inflation from the central bank target and ½ of the output gap.1 We also show projections for the Taylor Rule over the next two years, using individual central bank forecasts for inflation and IMF projections for potential growth and the output gap. We then compare those Taylor Rule forecasts with the rate expectations priced into Overnight Index Swap (OIS) curves. Chart 5An "Old-School" Cyclical Upturn Chart 6Rates Too Low, According To The Taylor Rule The first point to note is that policy rates are below the Taylor Rule "equilibrium" level everywhere except Japan, where the 0% interest rate looks appropriate given the lack of actual inflation. Secondly, the Taylor Rule rates are projected to rise in the U.S., Euro Area, Japan and Canada, while remaining around current levels in the U.K. and Australia. Thirdly, the projected rates using Taylor Rule estimates are well above the current path of rates discounted in OIS curves. We do not expect central banks to deliver anywhere near the amount of tightening suggested by these simple Taylor Rules over the next couple of years. Policymakers will likely tolerate some degree of higher realized inflation to ensure that inflation expectations can return to, and sustainably stay at, central bank target levels. This means keeping interest rates below equilibrium levels for as long as possible. However, if central banks believe their own current inflation forecasts (which we have used in our Taylor Rule estimates), then policy rates do have room to move higher without becoming restrictive (i.e. above the Taylor Rule estimates). The markets clearly disagree with these Taylor Rule projections, with much lower OIS rates expected in the next few years. The markets may turn out to be correct. At the moment, however, the gap between the Taylor Rule rate forecasts and market pricing is too large, which suggests there is additional scope for bond yields to rise. Even if central banks ignore their own forecasts of higher inflation and keep rates on hold, this will put upward pressure on bond yields via higher inflation expectations. In other words, the path of least resistance for bond yields is up - at least until there is a major financial market event, like a big pullback in equity prices or widening of corporate bond spreads. Yet until there is evidence that global growth is rolling over and decelerating, a "risk-off" event like that is unlikely. Investors should maintain below-benchmark duration exposure, and overweight allocations of corporate debt to government bonds, in the next 3-6 months. Watch the path of leading economic indicators before looking to reverse those positions. Bottom Line: Central bankers are in the process of taking back the easier monetary policy that followed the deflationary 2014/15 oil shock. Bond yields still have more upside to catch up to the solid pace of global growth and diminishing economic slack. If It Walks Like A Tantrum And Talks Like A Tantrum ... The spike in Euro Area bond yields since June 26th has raised concerns that another bond "tantrum" is unfolding, similar to U.S. Treasury sell-off in 2013 and the German Bund sell-off in 2015. In both cases, bond yields jumped rapidly as investors repriced the outlook for central bank policy. The recent comments from the European Central Bank (ECB) are signaling that a change in its asset purchase program, which is set to end on December 31st, is highly likely and were the trigger for the backup in European yields. We have already shown in previous reports how the benchmark 10-year German Bund yield has been following the same directional path as the 10-year U.S. Treasury yield in the months leading up to the 2013 Taper Tantrum.2 We benchmarked the two markets for the peak in our Months-to-Hike indicator for the timing of the first rate hike priced into OIS curves. In Chart 7, we show the same comparison for the various slopes of yield curves for U.S. Treasuries and German government bonds. Again, the German curve is following the Fed Taper Tantrum experience, which implies more bear-steepening pressure on yields over the rest of 2017. In Chart 8, we show a similar "cycle-on-cycle" comparison of German bonds today compared to the spring of 2015 during the Bund Tantrum episode. That sell-off took place over a much shorter time horizon than the U.S. Taper Tantrum, with the entire sell-off condensed to just over a month. The current backup in German yields looks to be following a similar pattern to the Bund Tantrum, suggesting that this move could take the benchmark 10-year yield back to 1% before it is done. Chart 7Taper Tantrum 2.0?... Chart 8...or Bund Tantrum 2.0? There are major differences between today and the 2015 episode - European economic growth is much faster, the output gap is narrower, and realized inflation is higher than it was two years ago (bottom two panels). The 2015 Tantrum was triggered by two events: a rise in European inflation back above 0% that led to a (misguided) belief among investors that the ECB, which had just started its asset purchase program, would quickly look to exit that program; a massive unwind of long positions in core European bond markets, made worse as speculators who were betting on a reversal of the initial jump in Bund yields got stopped out as yields continued to climb. Roll the tape to 2017, and the growth and inflation backdrop is much different. Now, the ECB is indeed talking openly about exiting/tapering its asset purchase program, supported by a solid European growth backdrop. There is likely less speculative positioning in European markets given the painful experience of the Bund Tantrum. However, with the ECB now owning significant shares of European bonds after two years of steady buying, the potential for a jump in yields driven by less-liquid markets may still be there. Net-net, the current Bund sell-off has additional upside when compared to the previous Tantrums, suggesting the Bund yield could rise to 1% before this move is done. Watch the performance of European equities and the euro for signs that the pain trade in Bunds could stall before 1%. If equities break lower or the Euro breaks higher (or both), the ECB commentary about the timing of a taper could take a more dovish turn. This is not our base case, though. Bottom Line: The recent European bond sell-off is following a similar pattern to both the 2013 Fed Taper Tantrum and the 2015 Bund Tantrum, suggesting a potential target of 1% on the benchmark 10-year German Bund yield by year-end. Stay underweight European government bonds. Move To An Underweight Stance On Canada This week, the Bank of Canada (BoC) meets to determine the next move for Canadian monetary policy. For the first time since 2010, that move will likely be a rate hike. The Canadian economy is booming, and the strength is starting to bump up against capacity constraints. The strong performance of real GDP growth in Q1 (+3%) looks to be followed up by a similar growth rate in Q2. The BoC's latest 2017 Business Outlook Survey made for great summer reading, as expectations for sales, capital spending and employment all remained quite strong (Chart 9). Firms were reporting that an increasing share of capital spending intentions were for the purposes of increasing capacity to accommodate stronger demand, a sign that Canadian businesses are becoming more optimistic that the economic upturn is sustainable. Hiring intentions hit the highest level ever recorded in the Survey, with firms also reporting an increase in employment to meet up with stronger demand. Current Canadian inflation rates remain subdued, but a pickup in output prices is expected over the next 12 months according to the Business Outlook Survey (bottom panel). A net positive number of respondents reported capacity constraints and labor shortages for the first time in the three years that those questions have been asked as part of the Survey. The BoC's growth forecasts are clearly too low and will likely be revised upward at this week's policy meeting, when a new Monetary Policy Report will be presented. This will likely be the reason for a rate hike to either be delivered this week, or strongly hinted at for the next policy meeting. Given the recent comments from BoC Governor Stephen Poloz and other BoC officials discussing the improving health of the economy and the need to "take back" the 50bps of rate cuts in 2015 as oil prices were collapsing, a rate hike is the more likely outcome this week. Already, the markets have moved to price in a more hawkish BoC, with a full 75bps of hikes expected over the next 12 months. This has helped out bearish Canadian rates trades in our Tactical Overlay Portfolio (see Page 15 and Chart 10), which were positions that benefitted from a stronger Canadian economy and more hawkish BoC. With Canadian policy rates still well below equilibrium (see our Taylor Rule estimates shown earlier), and with leading economic indicators still pointing towards accelerating Canadian economic growth in the coming quarters, the case for the BoC to leave rates at these current depressed levels is not a strong one. Chart 9A Robust Canadian##BR##Growth Upturn Chart 10Sticking With Our Winning##BR##Tactical Canadian Trades We see the recent underperformance of Canadian government bonds as the start of a more prolonged trend, thus we are opening up a new strategic position in our model bond portfolio: cutting our Canada country allocation to underweight (2 out of 5). As Canada is only a small part of our benchmark index (only 1%), we are increasing our U.S. exposure as an offset to our lower Canadian weighting. This will not change our below-benchmark allocation to U.S. Treasuries, while making our new position a more explicit bet on additional widening of the Canada-U.S. bond spread. Chart 11Canada Rates Strategy Summary:##BR##Move To Underweight If the economy improves enough to continue absorbing economic slack and put upward pressure on inflation, both realized and expected, then the potential for higher Canadian yields and a flatter Canadian curve - as the BoC becomes even more hawkish - will also increase (Chart 11). One huge caveat to this trade is the state of the Canadian housing market. Even a small move in policy interest rates could have a huge impact on the demand for Canadian housing and the health of Canadian household finances. A recent private-sector survey showed that 70% of Canadian homeowners could not manage even a 10% rise in their interest payments.3 Given the extreme valuations in the Canadian housing market, and some of the recent macro-prudential measures taken to deter speculation in the booming Vancouver and Toronto markets, there is potential for a larger housing downturn after a few BoC rate hikes. This will not prevent the BoC from normalizing rates, but if the housing market responds poorly and there is a spillover into concerns about the state of Canadian banks, then any backup in Canadian bond yields will be short-lived. This is a risk and not our base case over the next year, however. Bottom Line: With the Canadian economy looking very strong, and with the Bank of Canada signaling a desire to begin normalizing monetary policy, the current underperformance of Canadian government bonds will continue. We are maintaining our tactical bearish positions on Canadian bonds, and are also adding a new strategic underweight position (2 out of 5) in our model bond portfolio. Tactical Trade Update We have been recommending a position in our Tactical Overlay Table since March to position for additional Fed rate hikes, shorting the January 2018 fed funds futures contract. That contract is now priced for the fed funds rate to increase 15bps between now and the end of the year. Given that even an optimistic economic scenario would likely only result in one more 25bp increase in the funds rate by year-end, there is no longer much potential for further gains in this trade. We are closing the position this week, taking a tiny profit of +1bp. Chart 12Roll Our Short Fed Funds##BR##Futures Trade To July 2018 Looking further out, we now see an attractive new opportunity to short the July 2018 fed funds futures contract. That contract is currently priced for only 32bps of rate hikes between now and next June (Chart 12), and would therefore turn a profit in the event of two or more rate hikes during that timeframe. We are opening the new trade today, shorting the July 2018 contract. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 We show the inflation gap as the difference between realized inflation and the inflation target, using the actual inflation rate that the central bank is targeting. This could be headline inflation, as in the U.S. and Euro Area, or core inflation, as in Japan. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "Central Banks Are Now Playing Catch-Up", dated July 4 2017, available at gfis.bcaresearch.com. 3 http://www.newswire.ca/news-releases/the-debt-truth-unexpected-expenses-could-spell-big-trouble-for-millennial-homeowners-623825354.html Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns The GFIS Recommended Portfolio Vs. The Custom Benchmark Index

Highlights Duration: Investor optimism about U.S. growth and inflation will return in the coming months. Remain at below-benchmark duration and enter a short position in the July fed funds futures contract. Close short positions in the January contract for a small gain. Credit Spreads: Spreads are at risk of widening as Fed rate hike expectations ramp up in the second half of the year, though we would be inclined to view a Fed-driven back-up in spreads as a buying opportunity. Bank Bonds: Banks continue to shore up their balance sheets and are likely to see rising profits in the coming months. Bank bonds also offer a spread advantage compared to other similarly risky sectors. Feature Chart 1Synchronized Global Selloff The bond selloff is now two weeks old. What began as a reaction to perceived hawkish policy shifts from central banks outside of the U.S. - the European Central Bank in particular - is now morphing into a selloff built on optimism about U.S. growth. Needless to say, we think the recent bearish price action has further to run. Global participation makes it more likely that the weakness in U.S. Treasuries will persist because it prevents the dollar from strengthening as yields move higher (Chart 1). In recent years, most U.S. bond selloffs have been met with an appreciating exchange rate. The stronger dollar then caused investors to lower their U.S. growth expectations, and capped the upside in yields. We view the dollar's current stability as a bearish signal for U.S. bonds. But it has not just been non-U.S. factors driving the uptrend in yields. Last week's positive ISM and employment figures are ushering in renewed optimism about U.S. growth. We also think that U.S. growth is poised to bounce back in the second half of the year, and the Fed is inclined to agree. The Fed's median projection calls for one more 25 basis point rate hike before the end of the year, and we also expect the committee to announce the run-off of the balance sheet in September. With the market still only priced for 15 bps of hikes between now and year-end, there remains scope for further upside surprises. Of course, this forecast for balance sheet run-off in September and another rate hike in December hinges on a second-half snapback in growth, continued strength in labor markets and a rebound in core inflation. Growth Is On The Way Although GDP growth averaged just 1.75% during past two quarters, all signs suggest that the next two quarters will be much stronger. As was mentioned above, both the manufacturing and non-manufacturing ISM surveys delivered strong readings in June. The manufacturing ISM came in at 57.8 and the non-manufacturing survey came in at 57.4, both signal stronger GDP growth in the coming months (Chart 2). The crucial new orders-to-inventories figure calculated from the manufacturing survey is also displaying remarkable strength (Chart 2, bottom panel). We can also infer the current trend in growth from the employment and productivity data. In fact, aggregate hours worked - a combination of total employment and average weekly hours - plus labor productivity growth is more or less equivalent to GDP (Chart 3). After last week's payrolls report, aggregate hours worked are now growing at 1.99% year-over-year. If we combine that growth rate with quarterly productivity growth of 0.7%, the average since 2012, we get a tracking estimate of just below 2.7% for GDP growth. The Atlanta Fed's GDPNow model also currently expects that second quarter growth will be 2.7%. Chart 2PMIs Point To Stronger Growth... Chart 3...As Does The Labor Market Labor Markets: Watching The Participation Rate Last week's jobs report showed that the economy added 222k jobs in June, and that the prior two months were also revised higher. This pushed the 3-month moving average up to +180k jobs per month, right in line with the +187k jobs per month averaged in 2016. However, despite robust payroll gains, the unemployment rate actually ticked higher in June. This is because many previously sidelined workers re-entered the labor force, pushing the labor force participation rate up to 62.8%. Going forward, for the Fed to have confidence that wage growth and inflation will continue to rise, the unemployment rate will have to remain under downward pressure (Chart 4). As long as the labor force participation rate remains flat (or declines) this should be relatively easy to achieve. We calculate that the economy needs to add just above 117k jobs per month for the unemployment rate to continue falling. However, if we assume a higher labor force participation rate of 63.2%, we would need to add 195k jobs per month, a much higher hurdle.1 We detailed the main drivers of the labor force participation rate in a recent report,2 and while we do not see much potential for a significant increase in the participation rate, its trend is critical for the monetary policy outlook and should be monitored closely going forward. Inflation: Is The Fed Too Sanguine? The most important question for policymakers is whether inflation will rebound in the second half of the year. While the Fed will probably start winding down its balance sheet in September no matter what, another rate hike in December is likely contingent on core inflation showing some signs of strength in the next few months. We have previously written3 that if the Fed were to proceed with a December rate hike in the face of low and falling inflation, the market would start to price in a "policy mistake" scenario. The yield curve would flatten, credit spreads would widen, TIPS breakevens would narrow and long-dated Treasury yields could even decline. However, we do expect that core inflation will trend higher in the coming months, mostly driven by strength in the core services (excluding shelter and medical care) component. That component is historically the most sensitive to tight labor markets and rising wage growth (Chart 5). Chart 4Falling Unemployment Rate = ##br##Rising Inflation Chart 5A Boost From Import##br## Prices Is Coming Although it is unlikely to be a long-run driver of inflation, the core goods component also has some upside in the coming months in response to recent dollar weakness and rising non-oil import prices (Chart 5, bottom 2 panels). Investment Strategy Chart 6Too Few Hikes In The Price We think U.S. growth and inflation are poised to snap back during the second half of the year, probably by enough for the Fed to deliver another hike before year-end. We therefore continue to recommend that investors maintain below-benchmark portfolio duration. We have also been advising clients to hold short positions in the January 2018 fed funds futures contract since March 21.4 That contract is now priced for the fed funds rate to increase 15 bps between now and the end of the year. Given that even an optimistic economic scenario would likely only result in a 25 bps increase in the funds rate, there is not much potential for further gains in this trade. We close this position, booking a small profit of +1 bp. Looking further out, we now see an attractive opportunity to short the July 2018 fed funds futures contract. That contract is currently priced for 32 bps of rate hikes between now and next June (Chart 6), and would therefore turn a profit in the event of two or more rate hikes during that timeframe. Bottom Line: Investor optimism about U.S. growth and inflation will return in the coming months. Remain at below-benchmark duration and enter a short position in the July fed funds futures contract. Close short positions in the January contract for a small gain. Credit Spreads: When Good News Is Bad News Chart 7High Risk Of A Near-Term Selloff Renewed optimism on U.S. growth and inflation could ironically pose a problem for credit spreads, at least in the very short term. As we have often discussed in the context of our Fed Policy Loop,5 hawkish shifts in Fed policy tend to result in wider credit spreads and tighter financial conditions more broadly. Fortunately, these periods are usually short lived. Once financial conditions tighten, the Fed backs away from its hawkish stance, allowing financial conditions to ease once again. An extreme example of this dynamic is the 2014/15 selloff in credit markets. Of course, the plunge in oil prices and related stress in the energy sector was the chief catalyst, but what is often overlooked is that Fed rate hike expectations were also quite elevated during that period (Chart 7). It is the combination of stress in the energy sector and unsupportive Fed policy that resulted in the prolonged rise in spreads. A more benign example is the price action from this past March. Junk spreads widened from 344 bps on March 2 to 406 bps on March 22, as rate hike expectations ramped up heading into the March FOMC meeting. Ultimately, this period of spread widening represented a buying opportunity in credit markets. It is a March 2017 style selloff that we see as quite likely in the coming months as growth recovers by just enough to give the Fed cover for another rate increase. Bottom Line: Credit spreads are at risk of widening as Fed rate hike expectations ramp up in the second half of the year. But with inflation and inflation expectations still well below target, the Fed will ultimately be forced to remain supportive. We would therefore view any period of Fed-driven weakness in credit markets as a buying opportunity. Bank Bonds: Still A Strong Buy The Federal Reserve released the results of its annual bank stress tests last month and for once it did not object to the capital plans of any of the 34 participating bank holding companies, a recognition of the fact that banks have dramatically boosted their capital ratios since the first round of stress tests in 2009 (Chart 8). For the most part bank profit growth has also outpaced debt growth during this period, with the exception of last year when profit growth turned negative and debt growth surged (Chart 8, panel 2). A large portion of last year's increase in debt growth was likely a response to the new Total Loss Absorbing Capital (TLAC) regulations which require banks to issue a specified minimum amount of securities that can be easily written off in case of bankruptcy. This includes capital and long-term unsecured debt. Regardless, bank debt growth has already fallen back close to zero and we see upside for bank profits in the next 6-12 months. Meanwhile, non-financial corporate profits have had a much more difficult time outpacing debt growth in recent years (Chart 8, bottom panel). Bank Profits On The Rise A number of forward looking loan growth indicators suggest that credit and capital formation are on an upward trajectory (Chart 9). Our U.S. Equity Strategy service's proprietary Capex Indicator,6 consumer and business confidence, manufacturing new orders and our own C&I loan growth model all point to accelerating loan growth in the coming months. Net interest margins also have scope to widen. A recent blog post from the Federal Reserve Bank of New York7 showed that net interest margins are sensitive to both the level of interest rates and the slope of the yield curve (Chart 10). Lower rates and a flatter curve have both compressed margins in recent years. In addition, net interest margins tend to narrow when banks take less risk on the asset side of their balance sheets, we proxy this by showing banks' risk-weighted assets as a percent of total assets (Chart 10, bottom panel). Chart 8Bank Health Still Improving Chart 9Loan Growth Will Accelerate Chart 10A Higher, Steeper Curve Will Help NIMs Going forward, higher rates and a steeper yield curve8 will apply widening pressure to net interest margins. Similarly, risk-weighted assets have already risen considerably as a fraction of total assets and will increase further as the Fed starts to drain reserves from the banking system. Bank Bonds Are Still Cheap The truly remarkable thing is that even though banks have been raising capital while the non-financial sector has been taking on leverage, bank spreads still look attractive compared to most non-financial sectors after adjusting for credit rating and duration (Chart 11). This is true for both senior and subordinated bank debt. As can be seen in Chart 11, senior bank debt has a low duration-times-spread (DTS) compared to the overall index. This means that it acts as a "low-beta" sector, underperforming the investment grade benchmark during rallies and outperforming during selloffs. Conversely, subordinate bank bonds are a high-DTS sector. They tend to outperform during rallies and underperform during selloffs (Chart 12). Chart 11Corporate Sector Risk Vs. Reward* LegendCorporate Sector Abbreviations Chart 12Add "Beta" With Subordinate Bank Debt While we strongly recommend grabbing the extra spread available in both senior and subordinate bank debt relative to other similarly risky alternatives, subordinate bank bonds look particularly attractive in the current environment. This is because they both add some pro-cyclical risk ("beta") to a corporate bond portfolio and offer a spread advantage compared to other similarly risky bonds. Bottom Line: Banks continue to shore up their balance sheets and are also likely to see rising profits in the coming months. Meanwhile, bank bonds still offer a spread advantage compared to other similarly risky sectors. Remain overweight both senior and subordinate bank debt. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 These calculations assume population growth of 0.08% per month, or 1% per year. 2 Please see U.S. Bond Strategy Weekly Report, "Three Scenarios For Treasury Yields In 2017", dated June 20, 2017, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Three Scenarios For Treasury Yields In 2017", dated June 20, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Equity Strategy Weekly Report, "Unfazed", dated June 12, 2017, available at uses.bcaresearch.com 7 http://libertystreeteconomics.newyorkfed.org/2017/06/low-interest-rates-and-bank-profits.html 8 For further details on the case for a bear-steepening yield curve please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Portfolio Strategy The energy bear market is drawing to a close. Lift exposure to above benchmark. Firming refining operating conditions, at the margin, suggest that it no longer pays to underweight this energy sub-group. Book gains and lift to neutral. Softening profit fundamentals are weighing on the real estate outlook. Trim REITs to neutral. Recent Changes S&P Energy - Lift to overweight. S&P Oil & Gas Refining & Marketing - Upgrade to neutral, lock in profits of 14.3%. S&P Real Estate - Trim to neutral and remove from high-conviction overweight list. Table 1 Feature Equities wrestled to hold on to gains last week, fighting a spike in geopolitical tensions, synchronized global central bank hawkish rhetoric and sector rotation. Investors continued to shed tech stocks in favor of financials, pushing our recently initiated long financials/short tech pair trade return near double digits. Our view remains that a rotational correction is the dominant market theme. Nevertheless, on the eve of earnings season, profits will soon take center stage and serve as a catalyst for the overshoot equity phase to resume. Our sense is that before the end of the business cycle, there are high odds that the S&P 500 will hit the 3,000 mark. That does not mean it will be a straight line advance from here. Garden variety 5-10% corrections are all but inevitable. Rather, our point is that before the next recession hits late in the decade, the SPX can attain 3,000. How did we come up with this figure? We derived the S&P 500's peak cycle value using three different methods: Dividend Discount Model (DDM) Forward P/E and EPS growth sensitivity analysis Equity Risk Premium (ERP) Table 2SPX Dividend Discount Model Table 2 shows our DDM on the S&P 500. It assumes healthy dividend growth in 2017 and 2018. Our expectation of a 2019 recession drives a steep decline in dividends that year, followed by a slow climb in 2020 and 2021, in line with the 2009-2011 experience (Chart 1). 2022 is our terminal year when dividend growth settles at 6.6%, close to the long-term average. Our discount rate assumes a 3.2% 10-year Treasury yield and a 5% equity risk premium (the past decade's average, Chart 2). This discount rate mirrors the historical average corporate junk bond yield. This valuation model delivers an S&P 500 value of 2904. Chart 1Joined At##br## The Hip Chart 2FX10 ERP And The Economy##br## Are Inversely Correlated Alternatively, we examine the S&P 500's sensitivity to EPS growth rates and forward valuation multiples. If we use the street's 160.8 (or 10.6% implied CAGR) S&P 500 2019 EPS estimate and assign the current 12-month forward multiple as a starting point, Table 3 shows an S&P 500 value of just under 3,000. Downside risks look limited. Using this EPS forecast, even a 2-turn multiple contraction results in the S&P 500 appreciating 10% from here. Table 3SPX EPS & Multiple Sensitivity Lastly, a conservative ERP analysis reveals that SPX 3,000 is a realistic peak cycle estimate. Our assumptions include: a 200 bps ERP, a 3.2% 10-year Treasury yield and 160.8 SPX EPS. These assumptions result in an S&P 500 value of slightly over 3,000. How do we justify a decline in the ERP from its current level of 338 bps to our assumed 200 bps? G10 central banks are no longer putting out GFC-related fires; in fact, a slew of them are briskly turning from dovish to hawkish following the Fed's lead (Chart 3). As a result, a sustained decline in the ERP should follow as interest rates rise. Chart 3G10 Central Banks Map Chart 4Negative Correlation Is Re-Established The bottom panel of Chart 2 drives this point home. Since the history of SPX forward EPS data, the year-over-year change in the ERP has been almost perfectly inversely correlated with the ISM manufacturing index, i.e. an improving economy is synonymous with a receding ERP and vice versa. Lastly, keep in mind that a 200 bps ERP is still significantly higher than the 80 bps mean ERP that prevailed in the 1998-2007 decade (middle panel, Chart 2). The depreciating greenback is another source of support for our SPX 3,000 view. The yearlong positive correlation between the U.S. dollar and commodities has likely come to an end and the three plus decade inverse correlation has been re-established (Chart 4). As the cycle matures and enters its late stages, commodities and resource-related equities tend to pick up steam as profits rebound. Even energy stocks may catch a bid. Buy Energy Stocks... Energy equities are down roughly 20% year-to-date versus the broad market. In fact, the energy sector has broken down to a level last seen in 2004, when oil traded near $30/bbl (Chart 5). The three main culprits have been rising U.S. shale oil production, inventory accumulation, and investor doubts about whether all nations will comply with OPEC's mandated production cuts. While going overweight the energy space has been a "widow maker" trade recently, we are now tempted to take a punt on the S&P energy sector from the long side. There are tentative signs that this relative performance bear phase is drawing to a close. Three main drivers support our modestly sanguine view of energy stocks. First, as we mentioned above, the inverse correlation between the U.S. dollar and the commodity complex has been re-established after a one-year hiatus. Synchronized global growth suggests that a corresponding tightening interest rate cycle is brewing (Chart 3). Thus, there are high odds that a number of G10 central banks will hike rates later this summer or early this fall, now that the Fed has paved the path.1 As long as the greenback drifts lower, even energy stocks should catch a bid (Chart 6). Chart 5Crude Oil... Chart 6...And The Dollar Say Buy Energy Stocks Second, on the domestic operating front, the steepest drilling upcycle in recent memory is showing signs of fatigue. Baker Hughes reported the first weekly decline in 24 weeks in the oil rig count for the week ending June 30th. At least a modest deceleration in shale oil production is likely. Encouragingly, Cushing crude oil inventories are contracting on a year-over-year basis and OECD oil stocks appear poised to contract in late autumn/early winter (Chart 7). Predicting OPEC's compliance is tricky. However, BCA's Commodity & Energy Strategy service believes that little to no cheating will occur and in a worst case scenario Saudi Arabia will step in and curtail production were Libya and/or Iraq to pump oil above quota. Finally, our S&P energy sector Valuation Indicator has gravitated back to the neutral zone. Technicals are also washed out with our Technical Indicator breaching one standard deviation below its historical mean, a level that typically heralds a reversal (Chart 8). Recent anecdotes that the sell-side is throwing in the towel on their bullish oil forecasts for the remainder of the year are also contrarily positive. Chart 7Improving Supply Dynamics Chart 8S&P Energy Unloved And Fairly Valued Our newly introduced S&P energy sector relative EPS model encapsulates this cautiously optimistic industry backdrop (Chart 9). Simultaneously, the budding recovery in our S&P energy Cyclical Macro Indicator also signals that profits should best those of the overall market (second panel, Chart 8), giving us comfort to lift the S&P energy sector to a modest overweight position. ... As Refiners Are No Longer Cracking Under Pressure We are executing the upgrade to overweight in the broad energy sector via booking gains of 14.3% since inception in the S&P oil & gas refining & marketing sub-group and lifting exposure to neutral from underweight. It no longer pays to remain bearish on the pure play downstream energy business. Back in late September 2015, when we turned negative on refiners, we were anticipating a cyclical earnings downturn on the back of a refined product glut in this low margin / high volume industry. Fast forward to 2017 and that bearish profit view has materialized as relative EPS have fallen by roughly 60 percentage points from the most recent peak, and have only lately managed to stabilize (Chart 10). Chart 9EPS Model Waves Green Flag Chart 10Refining Profit Contraction Is Over If relative EPS have indeed troughed, then relative performance should soon find a bottom. Relative profit fortunes move with the ebb and flow of gasoline consumption. The latter is on the cusp of expanding for the first time since last November, heralding the same for relative profitability (bottom panel, Chart 10). Industry shipments tell a similar story. After recently bottoming at levels similar to those reached during the GFC, refinery shipments have staged a mini V-shaped recovery (top panel, Chart 11). Crack spreads have not collapsed to razor thin levels as the nearly eliminated Brent/WTI spread would suggest, but have remained resilient in the high-teens per barrel (third panel, Chart 11). Three forces are likely in play. First, not only is domestic gasoline demand underpinning refining margins, but petroleum products are also finding their way into foreign markets with net exports running at over 3 million bbl/day (bottom panel, Chart 11). Second, the U.S. dollar selloff since mid-December is making U.S. refined products more competitive in global markets. Finally, crude oil inventories are nearly 40% higher than gasoline inventories. Lower industry feedstocks represent a boost to refining margins (third, Chart 11). Nevertheless, we refrain from turning outright bullish on refiners. Refinery production hit all-time highs recently, refinery runs are climbing steadily and utilization rates are running hot north of 90%. Tack on, historically high refined products inventories and rising industry capacity growth and the profit backdrop darkens (Chart 12). Chart 11Three Positives... Chart 12...But Do Not Get Carried Away Netting it out, we expect a balanced refining profit outlook in the coming quarters. Bottom Line: Upgrade the S&P oil & gas refining & marketing index (PSX, VLO, TSO, MPC) to neutral and lock in profits of 14.3%. This also pushes the S&P energy index to an above benchmark allocation. Downgrade REITs We are making space for the energy sector upgrade to overweight via trimming the niche S&P real estate sector to neutral and concurrently removing it from the high-conviction overweight list. REITs have marked time year-to-date, but recently operating conditions have downshifted a notch. Three key drivers argue for lightening up exposure on this newly formed S&P GICS1 sector. First, REITs have been unable to materially benefit from the 50bps fall in the 10-year Treasury yield from the mid-December peak to the mid-June trough. As the economy recovers from the first quarter lull, Treasury yields will resume their advance. This is a net negative for the fixed income proxy real estate sector (top panel, Chart 13). Second, real estate occupancy rates have crested and generationally high supply additions in the apartment space are all but certain to push vacancies higher still. The implication is that rental inflation will remain under intense downward pressure (Chart 13). Worrisomely, credit quality in select commercial real estate (CRE) segments is deteriorating at the margin. The bottom panel of Chart 13 shows that retail and office delinquency rates have taken a turn for the worse, and represent a yellow flag. Finally, according to the Fed's latest Senior Loan Officer Survey, bankers are less willing to extend CRE credit. In fact, if one excludes the GFC spike, the tightening in CRE lending standards is near the two previous recessionary highs. If banks continue to close the credit taps, CRE prices will suffer a setback (Chart 14). Chart 13Time To Move To the Sidelines Chart 14Conflicting Signals Chart 15 puts the CRE price appreciation in historical perspective. Currently, CRE prices are on track to climb to two standard deviations above the long-term trend. Such exuberance is a cause for concern as it has historically marked the beginning of a corrective phase in CRE prices. Nevertheless, there are some positive offsets that prevent us from throwing in the towel in the S&P real estate sector. The tight labor market and accelerating industrial production explain the reacceleration in our REITs Demand Indicator, while the recent selloff in the bond market is a modest offset. If CRE appetite remains upbeat, this in turn suggests that CRE prices have a bit more room to run before reaching a cyclical peak (bottom panel, Chart 14). In addition, compelling relative valuations and washed out technicals argue against becoming overly bearish on REITs (Chart 16), as some of the bad news is already reflected in relative share prices. Chart 15An Historical Perspective Chart 16Positive Offsets Bottom Line: Trim the S&P real estate sector to neutral and remove it from the high-conviction overweight list. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see the June 30th, 2017 Foreign Exchange Strategy Service Special Report titled "Who Hikes Next?", available at www.bcaresearch.com Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights Near record high levels for stocks are not an impediment to gains in the stock-to-bond ratio in the next 12 months. Minutes from June's FOMC meeting confirmed that policymakers agree that monetary policy should continue to normalize in the coming quarters. None of the main indicators that have provided some leading information in the past are warning of an equity bear market. Solid ISM and industrial production readings herald bullish profit growth in the second half the year. Treasury yields are headed higher in 2017, supporting our stocks over bond view. Within the U.S. bond market, we prefer short over long duration and investment-grade and high-yield bonds over high-quality debt; MBS will be hurt more than Treasuries as the Fed pares its balance sheet. Feature U.S. stocks will continue to reach all-time highs if inflation remains low, the economic backdrop fosters EPS growth and the Fed only gradually raises rates. We expect these conditions to stay in place in the second half of 2017 and into 2018, allowing stocks to outrun bonds. We note below that neither valuations nor technicals are flashing a red warning sign. Chart 1 shows that most of the time, even when equities are at record highs, valuations are above average (but not extreme) and the Fed is slowly removing accommodation, stocks can still rise. Moreover, none of the indicators that provided leading information in the past now warn of an equity bear market. Chart 1Macro Conditions Favorable For More Gains In Equities Chart 2Labor Market Strong But Wages Still Stagnant The June jobs report suggests that the environment of solid economic growth and still muted wage pressures remains in place, a positive backdrop for equity markets. The report showed that the economy added 222,000 jobs in June, well above the consensus forecast of 178,000. Prior months were also revised higher by 47,000 pushing the 3-month moving average up to 180,000 jobs per month. This is right in line with the 187,000 jobs per month averaged in 2016. Despite robust payroll gains, the unemployment rate actually ticked higher in June, from 4.3% to 4.4%, as previously sidelined workers were drawn back into the labor force. Meanwhile, wage growth continues to underwhelm, rising only 0.2% in June with the year-over-year growth rate holding steady at 2.5%. The deceleration in the 3 month change in average hourly earnings from 2.7% in December 2016 to 1.9% in June challenges the Fed's view on inflation (Chart 2). The recent moderation in wage growth is not yet severe enough to prevent the Fed from delivering one more rate hike before year-end. However, if the labor force participation rate continues to increase, and especially if this increase occurs alongside a rising unemployment rate, then the Fed's forecast of gradually accelerating wages will come into question. Fed Minutes: No Change To Our Base Case Minutes from June's FOMC meeting show that the debate among policymakers over monetary policy centers on the timing and pace of normalization in the coming quarters. The minutes did not provide any new insight about the Fed's plans to shrink its balance sheet. This will be done using caps on the monthly amount of principal repayments from the Fed's security holdings that will not be rolled over. These caps will rise over time on a pre-set path. The FOMC is still debating the timing of the start of this process. The FOMC was reasonably pleased with the tone of recent economic data, which support the view that GDP has bounced back from a soft patch in the first quarter. The June manufacturing and services ISM surveys, released since the FOMC meeting, undoubtedly reinforced policymakers' confidence in the underlying growth trajectory (see below for more details). The FOMC participants discussed at length the recent pullback in core measures of consumer price inflation. Most policymakers are willing for the time being to believe that inflation is driven primarily by temporary one-off factors. Others are worried that it will be more enduring. The moderation in three-month rates of change of prices this year was widespread across sectors of the CPI (i.e. it is not merely the result of one-offs). Inflation according to the Fed's favored measure, the core PCE price index, has also moderated this year although the disinflation has not been as broadly based as in the CPI (Chart 3). Much of the FOMC's debate focused on the relationship between labor market tightness and inflation. The doves want to see inflation rise closer to the 2% target before tightening even more. The hawks worry that the relationship could be non-linear, which means that a further undershoot of unemployment below estimates of full employment could suddenly generate a surge in inflation. At a minimum, an undershoot could boost risks to financial stability by promoting excess risk-taking in the financial markets. The minutes reveal that the worries about the impact of easing financial conditions on financial stability have intensified since the start of the year. Inflation forecasting has been particularly tricky since the Great Recession for both the Fed and other economic prognosticators. Admittedly, it is difficult to explain the sudden and broadly-based inflation deceleration, even in sectors that have nothing to do with oil prices, shifts in the currency or wage growth. That said, the model shown in the top panel of Chart 4 suggests that core CPI inflation will edge higher in the coming months. This reflects the acceleration in ECI wage growth (feeding into higher core services inflation) and in core goods inflation (reflecting rising import prices), which more than offset the slight moderation in our projection for shelter inflation. Chart 3Inflation Readings Must##BR##Improve In Next Few Months Chart 4Core CPI Should Edge Higher##BR##In Coming Months Bottom Line: The minutes did not change our base case outlook; the FOMC will announce in September that it will begin to shrink the Fed's balance sheet shortly thereafter. The next rate hike will occur in December. Nonetheless, this forecast hangs importantly on the assumption that core inflation edges higher in the coming months. We think it will, but uncertainty is high. Monitoring The Bear Market Barometer The FOMC's seeming determination to stick with the current tightening timetable raises question marks over the equity market, especially given elevated valuations. Chart 5Equity Bear Market Indicators BCA's Chief Economist, Martin Barnes, highlighted the best "equity bear market" indicators to watch in a 2014 Special Report1. He noted that no two bear markets are the same and that there are no indicators that have reliably heralded bear phases. Nonetheless, there are some common elements. The safest time to invest in the market is when monetary conditions are favorable, there are no signs of a looming economic downturn, extreme overvaluation is not present and technical indicators are not flashing red. Some indicators related to each of these fundamental factors are shown in Chart 5: Monetary Conditions: The yield curve is flat by historical standards, but it is far from inverted. Moreover, real short-term interest rates are usually substantially higher than today, and above 2%, when bear markets commence. Excess liquidity, which we define as M2 growth less nominal GDP growth, is also well above the zero line, a threshold that in the past has warned of a downturn in stock prices. Valuation: Our composite valuation indicator is still shy of the +1 standard deviation level that defines over-valued. However, this is due to the components that compare equity prices to bond yields. The other three components of the equity indicator, which are unrelated to bond yields, suggest that stock valuation is stretched. Economic Outlook: Economic data, such as the leading economic indicator and ISM, have been unreliable bear market signals. We do not see anything that indicates that a recession is on the horizon. U.S. growth will remain above-trend in the second half of the year based on its relationship with financial conditions. Technical Conditions: Sentiment is elevated, which is bearish from a contrary perspective. However, breadth, the deviation from the 40- week moving average and our composite technical indicator, all are not flashing red. Earnings: Trends in earnings and margins did not provide any additional reliable signals for timing equity market downturns in the past. Still, it is a bad sign when EPS growth tops out. This is often preceded by a peak in industrial production growth. We expect EPS growth to continue to accelerate for at least a few more months, but we are closely watching industrial production. Bottom Line: The equity market is vulnerable to unforeseen shocks given stretched valuation. Nonetheless, none of the indicators that have provided leading information in the past warn of an equity bear market. ISM Above 50 Supports 2H Profit Outlook The elevated level of ISM sets the stage for EPS growth to gather speed in the second half of 2017. Industrial production is a good proxy for sales of S&P 500 companies (Chart 6). A rollover in the 12-month change in IP would challenge our view. However, strong readings on the ISM, which tracks IP, suggest that IP should accelerate in the next six months (Chart 6, panel 1). Chart 6Solid Backdrop For Earnings And Sales At 57.8 in June, the ISM has rebounded from the recent low of 47.9 in 2015. Investors wonder if it will roll over again or simply fluctuate at a high level. The leading components of ISM, including the new orders index and the new orders-to-inventory ratio, indicate that the ISM will remain above 50 in the months ahead (Chart 7). Moreover, the new export orders component of the ISM has also surged. The implication is that foreign demand (rather than domestic consumer or business spending) is leading the U.S. manufacturing sector. In fact, the 3- and 12-month change in the industrial production indices in advanced economies outside the U.S. have outpaced domestic growth (Chart 8). Chart 7IP Poised To Accelerate Chart 8U.S. IP Lagging Other Developed Markets Bottom Line: Firm readings on ISM are an indication that our bullish profit story for 2017 remains intact. Stay overweight stocks versus bonds. Inflection Point The increase in Treasury yields since late June indicates that growth expectations had become overly pessimistic. Our assessment is that U.S. growth will remain above trend for the rest of 2017. The implication for investors is that Treasury bond yields will move higher, the yield curve will bear-steepen, and that credit will outperform Treasuries in the second half of 2017. Moreover, we expect MBSs to underperform. According to our U.S. Bond Strategy service2, Treasury yields are poised to follow the economic surprise index higher in the coming months. Extreme net long positioning in the futures market supports the view. The current reading from our 2-factor Treasury model (which is based on Global PMI and dollar sentiment) places fair value for the 10-year Treasury yield at 2.52%. Our 3-factor version of the model, which also includes the Global Economic Policy Uncertainty Index, places fair value at 2.45% (Chart 9). Investors should continue to position for a steeper curve by favoring the 5-year bullet versus a duration-matched 2/10 barbell. Small positive excess returns, consistent with carry, remain the most likely scenario for investment- grade credit, where we recommend an overweight. We do not see the potential for much spread tightening from current levels. However, a large spread widening would be equally unlikely given the favorable backdrop of steady growth and muted inflation. We recommend an overweight in the high-yield market. We expect the decline in the 12-month trailing speculative default rate to continue for the rest of the year, aided by a moderation in energy sector defaults (Chart 10, bottom panel). This means that the current compensation offered by junk spreads in excess of expected default losses stands at 221 bps, in line with its historical average (Chart 10, panel 3). In last week's Weekly Report3 our U.S. Bond Strategy team showed that a default-adjusted spread of 221 bps is consistent with excess returns close to 150 bps during the next 12 months. Chart 9Treasury Fair Value Models Chart 10High-Yield Market Overview Our Energy Sector Strategy team stated in a Weekly Report4 last week that our base case of $50-$60/bbl WTI crude oil prices by the end of 2017 should keep high-yield energy spreads contained. We remain underweight MBSs. Nominal MBS spreads are already very tight compared with previous levels, and they appear even tighter relative to trends in net issuance. While refinancing activity will remain depressed, we see potential for option-adjusted spreads to follow net issuance higher, even as the compensation for prepayment risk (option cost) remains low. The Fed's exit from the MBS market, which could occur as early as September, represents an additional upside risk for spreads. Bottom Line: Rates have bounced up after undershooting between March and the end of June. Loftier inflation readings are needed to sustain the bounce. Higher rates in the rest of 2017 support our stocks-over-bond stance. Within the U.S. bond market, we favor short duration over long, and credit over high-quality. MBSs will be hurt more than Treasurys as the Fed begins to shrink its balance sheet. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see BCA Special Report "Timing The Next Equity Bear Market, " dated January 24, 2014, available at bca.bcaresearch.com. 2 Please see U.S. Bond Strategy Portfolio Allocation Summary, "Inflection Point", dated July 5, 2017, available at usbs.bcaresearch.com. 3 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com. 4 Please see Energy Sector Strategy Weekly Report, "HY Debt Update: Offshore Drilling & Transportation Getting Left Behind", dated July 5, 2017, available at nrg.bcaresearch.com.

Highlights EM equity breadth has moved into negative territory, DM-based excess liquidity measures are set to roll-over, and China-based liquidity measures are also weak. Individually, each of these factors are not enough to raise alarm bells, but together they point to a period of heightened risks for EM assets and commodity currencies. AUD/CAD and NZD/JPY are set to suffer in this environment. EUR/USD will rise to 1.15-1.16, but unlike in 2015, it should not receive much of a fillip from EM volatility. Feature Chart I-1Technical Risk In EM An interesting development has unfolded in emerging markets. While the pause in the EM rally has hit investors' radar screens, the more puzzling event concerns breadth. Not only has the advanced/decline line rolled over, but more worrisomely, it has recently moved into negative territory. Historically, when more stocks are declining rather than advancing, EM equities tend to experience sharp selloffs (Chart I-1). This development is important when put into a global context. EM stocks and related assets like commodity currencies have been buoyed by plentiful global liquidity conditions. However, global liquidity is set to deteriorate. A rocky second half may emerge in EM assets. Global Liquidity Is Slowing Following in the Federal Reserve's footsteps, DM central banks are moving away from monetary accommodation. Last week, European Central Bank President Mario Draghi made a speech that was interpreted as representing an abandonment of the ECB's dovish bias. With the anticipation that its bond-buying program will be tapered early in 2018 and reports that the ECB is having problems buying its quota of German and Finnish bonds, global bonds suffered, with Bund and T-Note yields moving up 33 and 23 basis points since June 27, respectively. The ECB is not the only central bank to have changed its tack. The Bank of Canada's communications have been crystal clear that it intends to increase rates this summer, or early fall at the latest. Even the perennially dovish Riksbank is moving away from its easy bias, as Sweden's resource utilization points to a continued acceleration in core inflation. But does this even matter? The global economy is strong, and beginning to remove accommodation is not quite the same thing as pushing rates into tight territory. The advanced economies are unlikely to suffer much from this development. However, the picture for EM is more concerning. Some key leading indicators of EM activity have already begun to roll over. For example, Taiwanese IP, a key bellwether of overall EM strength, is now contracting on a year-on-year basis (Chart I-2, top panel). Meanwhile EM PMIs rolled over three months ago and EM narrow money growth, a key forecaster of EM profits, is slowing sharply (Chart I-2, bottom panel). Despite these negative developments, EM stocks have remained resilient. The factor underpinning this impressive performance has been the rise in global liquidity. More technically, the rise in the global Marshallian K - the ratio of money to nominal GDP - over the past six months. Excess money has had to go somewhere. Among the many refuges, EM has been a key pole of attraction, with massive inflows supporting assets prices. The 8% appreciation in EM currencies versus the dollar since their January 2016 trough has been a vivid illustration of this phenomenon. The driver of the rise in excess money has been the ratio's numerator, dollar-based liquidity. The Fed's various QE programs were key determinants of dollar-based liquidity (Chart I-3). However, its tapering in late 2014 was enough to prompt a contraction of the measure. Now that the Fed is intent on decreasing its balance sheet while the ECB tapers and other smaller DM central banks begin increasing rates, the small improvement witnessed in the past three months is likely to end. The recent weakness in gold prices, despite the softness in the dollar, could be a sign that markets are beginning to sniff out the imminent tightening of global liquidity conditions. Chart I-2EM/China Profits Growth To Roll Over (I) EM Growth ##br##Has Deteriorated, Profits Will Suffer Chart I-3The Fed Balance Sheet Runoff ##br##Will Hurt Global Liquidity Additionally, not only are global central banks, led by the Fed, tightening or looking to tighten policy, they are doing so despite an absence of actual inflation. As a result, this means DM real yields are set to rise. As Chart I-4 illustrates, rising real DM yields have historically been a harbinger of poor EM bond performance. In fact, the action in DM real yields since mid-2016 already points to a problematic second half for EM bonds. As a result, EM bond investors are likely to suffer some losses in the coming months. Such losses would not only tighten EM financial conditions, but would also be symptomatic of capital leaving the region. Less money in those markets simply means less liquidity. With EM corporate spreads near historical lows, a repricing of credit risk on the back of softening global and EM liquidity is likely to prompt both a selloff in EM stocks and in EM currencies (Chart I-5). As a result, DM commodity currencies, the NZD and AUD in particular, could suffer. Chart I-4EM Financial Conditions##br## Are Set To Deteriorate Chart I-5If Liquidity Dries, Spreads Widen ##br##And EM Stocks Fall Bottom Line: In November 2016, a new leg of the EM rally began - a move driven by an expansion in global liquidity, even as a key bellwether of EM economic activity rolled over in the interim. Global excess liquidity is set to roll over as DM central banks abandon their dovish biases and the Fed begins to let its balance sheet run off. With EM weaker from a technical perspective, the second half of 2017 could be a tough environment for EM plays. Chinese Liquidity Joins The Fray In May 2015, EM equities in U.S.-dollar terms peaked just before global liquidity began to roll over. Compounding the risks, back then Chinese economic conditions were also problematic. Excess capacity and massive deflationary forces were wearing down on profits and investment. China is thus another key factor to watch. In this optic, beyond DM liquidity, a key driver of the rebound in EM last year was actually Chinese liquidity conditions. In the second half of 2015, China's own Marshallian K - based on M2 relative to nominal GDP growth - was rebounding sharply, as the PBoC was easing policy and the fiscal authorities were pressing on the gas pedal, expanding both public expenditures and pushing credit growth through the economy. However, that was then. Today, China has joined the tightening party. The quarterly moving average of Chinese interbank rates has increased by 100 basis points over the past year. Crackdowns on real estate and excess leverage have also resumed. Most importantly, the issuance of bonds by small and medium banks - a key source of grease to total social financing - has also massively decelerated, which points to a sharp slowdown and even a contraction in the Chinese credit impulse (Chart I-6). Thanks to this development, the Chinese Marshallian K is now in negative territory. The global impact of tighter Chinese monetary conditions is also flashing a red flag. Our indicator is based on the relative performance of Chinese bank stocks and USD/HKD. Underperformance of Chinese banks tends to send warning signs that tightening policy is beginning to negatively affect the outlook for Chinese credit growth. Additionally, USD/HKD is at an 18-month high because Hong Kong interest rates have not been able to follow U.S. ones, as loan demand by mainland-China entities has been poor. Most of the time, this indicator tends to move with EM stock prices, providing very little information. However, as Chart I-7 illustrates, this gauge is at its most useful when it diverges from EM equity prices. In each case, such as in 2007, 2011, and 2014, the divergences between the falling price-based Chinese liquidity indicator and rising EM stock prices was resolved by a correction in the latter. Today, the indicator points to a large amount of downside risk for EM stocks. Chart I-6Chinese Credit Impulse Will Slow Chart I-7A Worrying Divergence Again, it is important to reiterate that in and of itself, such a divergence is not enough to prompt investors to run for the hills and ditch EM stocks and related plays. However, when this happens as DM liquidity is also set to deteriorate, and most crucially, when EM breadth turns negative, decreasing EM exposure makes sense. Bottom Line: Chinese liquidity conditions are also deteriorating. The People's Bank of China may not want to push the economy into another slowdown cycle, which will most likely limit how far the Chinese central bank will tighten policy. However, this tightening has not been priced in by EM equities, and is happening as DM central banks are also reducing accommodation and as EM breadth has greatly deteriorated. A sizeable correction in EM plays is becoming increasingly likely. Investment Implications Chart I-8Global Liquidity Leads EM ##br##By More Than A Year A tightening of dollar-based liquidity and Chinese-based liquidity is a big problem for non-China EM economies. EM economies outside of China and OPEC nations still run an annual current account deficit of more than US$200 billion. They need liquidity. Moreover, they still have at least US$3.6 trillion in foreign-currency debt. With liquidity conditions deteriorating, we should expect a widening of EM spreads, falling EM stock prices and falling commodity currencies. In fact, we are today in the window of maximum risk. Chart I-8 shows the combined G7 and Chinese Marshallian K, standardized. This indicator tends to have long leads over EM equity prices. It turned negative in the summer of 2006, though EM stock prices did not peak until the fourth quarter of 2007. It turned negative again in the early days of 2010, but EM equity prices did not peak until April 2011. The indicator moved below zero in mid-2014, yet EM equities only sold off in the second quarter of 2015. This time around, the combined liquidity indicator became negative in early 2016, suggesting great risks for EM assets and related plays in the second half of 2017. High carry EM currencies like the BRL or the TRY are at risk. The ZAR looks especially poorly positioned as well but the RUB seems better cushioned against these risks. The MXN could suffer too as Mexico has a lot of U.S. dollar-denominated debt. Nonetheless, MXN remains much cheaper than the BRL and could still outperform its Brazilian brethren. The SGD is very sensitive to global liquidity conditions, as Singapore is a key banking center for EM, and could also suffer substantially against the USD. In terms of timing for the G10 currency markets, the deterioration of EM breadth has historically been a dangerous sign for commodity currencies (Chart I-9). This combination of deteriorating liquidity and breadth is often associated with a sharp selloff in NZD/JPY (Chart I-10). Investors should short this cross, and we are re-opening this trade this week. Chart I-9Commodity Currencies##br## Prefer A Fresh Breadth... Chart I-10...So Does ##br##NZD/JPY The dynamics highlighted above also explain why despite our positive stance on Canada and the CAD, we are not willing to chase the selloff in USD/CAD further, and prefer to play the CAD's strength through its crosses. The risk-reward ratio seems better this way, as we are not as negatively exposed to an EM selloff as we would be buying the CAD against the USD. Indeed, a cleaner way to play the BoC's change of tone while gaining exposure to an EM-risk off theme, is to short AUD/CAD, a trade that is already on our book. On the domestic front, this week the Reserve Bank of Australia disappointed markets and did not try to indicate a change in stance away from its dovish bias. Markets have taken notice, with the AUD incapable of rallying against a weak USD, despite very strong trade data yesterday. Meanwhile, the BoC is telegraphing a rate hike in the very near future. Additionally, an abnormal gap has emerged between AUD/CAD and AUD/USD. As Chart I-11 shows, historically, AUD/CAD and AUD/USD have tracked one another. This makes sense. The Australian economy is very levered to Asian growth and liquidity dynamics, while Canada is a crucial link in the North American supply chain. With the U.S. and Canadian business cycles so tightly integrated, the CAD tends to mimic the greenback when compared to non-USD currencies. Chart I-11AUD/CAD Is A Short The points in time when AUD/CAD has been much stronger than the AUD/USD deserve closer attention. They are periods of booms in EM Asia, such as the middle of the 1990s, or 2004 to 2005. Today, AUD/CAD is again out of line with AUD/USD, reflecting the boom in EM assets prices in 2016 and in the first half of 2017. However, if our view is correct that EM is entering a dangerous zone, AUD/CAD should weaken further. Chart I-12When Investors Are Short, ##br##EUR/USD Likes EM Selloffs Last but certainly not least the euro. EUR/USD has much momentum and could continue to rally into the 1.15-1.16 zone. In fact, historically, EM shocks have been able to lift the euro, albeit temporarily. This definitely was the case in 2015 when EM sold off: in April 2015, when EM began to weaken, in August 2015, when a temporary selling climax emerged after the Chinese floated the CNY, and in December 2015, after the Fed hiked. The euro spiked in all three instances. However, investors were very short EUR/USD entering each of these periods, and the ensuing rallies were short-covering rallies (Chart I-12). This time around, investors are very long the euro, suggesting that the euro has not been used as a funding vehicle to the same extent as it was in 2015. Additionally, in all these previous episodes, EUR/USD traded at a small discount to the fair value implied by real rate differentials, today it is trading at a premium. Thus, the same kind of short-covering rally is unlikely. As a result, we do not anticipate EUR/USD to break out of its range on the back of an EM risk-off event. That being said, EUR could outperform GBP in this type of environment. The pound remains very dependent on global liquidity conditions to finance its current account deficit of more than 4% of GDP. With big financial institutions announcing more divesture from the U.K., these hot-money flows could prove even more crucial. As a result, we are removing our call to short EUR/GBP if it moves above 0.88, and expect a move in EUR/GBP toward 0.92-0.93 in the second half of 2017. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The greenback slipped on weak as the ADP employment, the ISM-non manufacturing employment component, and continuing as well as initial jobless claims all underperformed expectations. While the dollar reacted negatively to this news, the Fed's hawkish stance should ultimately help the USD. Supplementing the increases in interest rates, are plans to reverse the multi-year quantitative easing program.The FOMC is also increasingly worried about the "quite high" stock valuations which, could lead to financial instability. U.S. 10-year yields have gone up 4 basis points following the release of the minutes, after the 20 bps spike following initial Fed comments on June 27. Report Links: Who Hikes Next? - June 30, 2017 Look Ahead, Not Back - June 9, 2017 Capacity Explosion = Inflation Implosion - June 2, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The euro's strength extends as the union experienced strong services and composite PMI measures this Wednesday. While it is true that the ECB may be looking to draw back its excessively easy monetary policy, Draghi and Praet have highlighted that accommodative policy is still needed as inflationary pressures are not yet entrenched. The euro's recent appreciation and weak producer price numbers could vindicate this view. The euro's strength has also weighed on manufacturing activity, as PMIs underperformed expectations. This is likely to weigh on EUR/USD going forward, especially as European stocks have been underperofming U.S. ones in recent weeks. EUR/SEK can face considerable pressure ahead due to the Riksbank's change in rhetoric. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Europe's Divine Comedy Part II: Italy In Purgatorio - June 21, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: National inflation came in at 0.4%, while Tokyo ex fresh food and energy inflation contracted by 0.2%. Both of these measures underperformed expectations. On the other hand, Japan's job-to-applicant ratio continues to climb, coming in at 1.49, and outperforming expectations. This last data point is key, as it highlights that the Japanese labor market is very tight, and that the stage is set for inflation to come back to Japan. However, as evidenced by the recent disappointments in data, the currency holds the key to unleash inflation in Japan. Thus, not only is a selloff in the yen needed for inflation to remerge, but this selloff would feed on itself, as a falling currency and a tight labor market would raise inflation (and thus lower real rates, as Japanese 10-year rates are anchored at 0), which would push the yen down further. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Updating Our Intermediate Timing Models - April 28, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Markit manufacturing PMI declined from last month's reading and also came in below expectations at 54.3. Construction PMI also declined and came in below expectations at 53.4 However credit had a strong showing as net lending to individuals, consumer credit and mortgage approvals all came in above expectations at 5.3 billion pounds, 1.73 billion pounds and 65 thousand respectively. Various BoE members have stated that rising interest rates might be necessary to keep a lid on the island's high inflation. Although there are still some voices within the BoE who are more cautious, given the uncertainty that Brexit poses, overall the BoE has shown a much more hawkish tone in recent weeks. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The AUD has experienced considerable weakness this week, following a drawback in inflation estimates for June by the TD Securities measure, of 2.3% from 2.8% and a less hawkish than anticipated RBA. While retail sales beat expectations of 0.2% - coming in at 0.6% - the pace of appreciation in the RBA Commodity Index in SDR terms continues to slow Nevertheless, these factors were not the only contributors to the recent AUD weakness. Australia remains highly levered to emerging markets, and the Fed tightening remains a major risk for the AUD. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been mixed: The annual trade balance underperformed expectations, coming in at a deficit of 3.75 billion U.S. dollars. However the ANZ business confidence index continued climbing, and now stands at the highest level in 8 months Overall the New Zealand economy continues to be one of the best performing in the G10. If one were to be guided merely by domestic factors, the RBNZ should be the next central bank to hike after the Fed. However the picture is slightly more nuanced, as the RBNZ is still worried about foreign developments, particularly EM weakness. This justifies why they continue to state that "monetary policy will remain accommodative for a considerable period". Thus, we continue to be bullish on the NZD against the AUD, while we are shorting it against the JPY, as a mean to benefit from a potential EM dislocation. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 USD/CAD has broken down from a crucial technical level following Poloz's statements about the Canadian economy. He states that the "cuts have done their job". When asked about oil, the reply was reassuring, declaring that the expected level of WTI is at USD 40-50 bbl, which implies that fluctuations within that band should not influence movements the BoC path, helping the CAD in the process. He also suggested that "the adjustment we've been talking about... is largely complete now". While inflation is weak, the BoC governor highlighted that forward looking indicators for inflation should be monitored instead of current inflation. These variables are pointing to stronger growth, and are in line with the bank's expectations of a closing output gap in the first half of 2018. While this may be true, a strengthening CAD will remain a risk for inflation. Report Links: Who Hikes Next? - June 30, 2017 Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: Although real retail sales yearly growth came in negative at -0.3%, it outperformed expectations and was better than last month. Additionally, the SVME PMI came also blew away expectations, increasing from last month's 55.6 reading to 60.1. However Consumer price inflation came in at -0.1%, underperforming expectations. The Swiss economy continues to be haunted by the ghost of deflation. Nonetheless, some economic indicators appear to be ticking up, most likely as a result of the sharp rally in EUR/CHF. We continue to believe that a rally of EUR/CHF beyond 1.1 is unlikely, as most of the good news in the euro area are already priced into the euro. Furthermore, any disappointments, particularly in EM could trigger a selloff in this cross. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The Labor Force survey, which measures the number of unemployed people as a percentage of the total civilian labor force came in at 4.6%, increased since last month. This measure shows that despite the increase in oil prices the Norwegian labour market continues to be tepid. The Norges Bank agrees with our assessment, as it lowered its projected near term policy rate path. Furthermore, they projected that rates in Norway will not rise until the beginning of 2019. The reasons for this are two fold: first, inflation should continue to remain weak, as the pass through from the collapse in the currency has faded. Additionally, bubbly real estate prices, which were the only factor, which could incite the Norges Bank to become more hawkish, have gone down, following reform in lending standards. Thus, despite its good value, the NOK will continue to underperform amongst commodity currencies. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Exploring Risks To Our DXY View - May 26, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 It is true that the Riksbank recently hinted towards a more neutral stance, acknowledging "that inflation has recently been slightly higher than expected", which has made it "less likely than before that the Riksbank will cut the repo rate in the near term". However, the Riksbank also highlighted the fact that the bank is "prepared to implement further monetary policy easing if necessary to stabilize inflation". A very nuanced statement referred to the exchange rate, which "is important that [it] does not appreciate too rapidly", further stating that "this could happen if, for example, the Riksbank's monetary policy deviates clearly from that of other countries." This conclusively highlights that the bank is wary of diverging rates lifting undesirably on the krona, which is a limiting factor for substantial krona strength in the near term. However, the change of guard at the helm of this central bank in early 2018 could change all this caution. Report Links: Who Hikes Next? - June 30, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The rise in global bond yields has been largely "reflective" of stronger global growth rather than "restrictive." Stay cyclically overweight global equities. The Fed has more scope to raise rates than the ECB. Not only is labor market slack much higher in the euro area, but the neutral rate is considerably lower there too. Financial conditions have eased a lot more in the U.S. than in the euro area, which should support relative U.S. growth in the months ahead. U.S. inflation will bounce back in the second half of 2017, removing a key obstacle to further Fed rate hikes. Short-term momentum is working in the euro's favor, but we expect EUR/USD to fall to 1.05 by the end of the year. We are closing our short January 2018 fed funds futures trade for a gain of 11 basis points and rolling it into the June 2018 contract. Oil prices are heading higher. Go long the Russian ruble. Feature Bond Bulls Turned Into Steak Global bond yields continued to move up this week on the back of rising rate expectations (Chart 1). A brighter growth picture helped drive the bond selloff. The ISM manufacturing index jumped to a three-year high in June. The euro area manufacturing PMI clocked in at 57.4, the strongest level since April 2011. That solid PMI report follows on the heels of a record-high German Ifo reading last week. Central bankers are taking note of the better economic data. The FOMC minutes indicated that downside risks to growth have diminished and that the decline in core inflation is likely to be temporary. In fact, the Fed staff upgraded its inflation forecast from the May meeting to show an earlier return to 2%. On the other side of the Atlantic, the ECB minutes expressed confidence about the domestic growth outlook. The release of the minutes followed an upbeat speech by Mario Draghi in late June in which he noted that all signs point to "a strengthening and broadening recovery in the euro area" and that "the past period of low inflation is ... on the whole temporary." We expect ECB asset purchases to be scaled back at the start of next year. However, a full-fledged tightening cycle still looks to be some way off. Labor market slack in the euro area is 3.2 percentage points higher than it was in 2008 and 6.7 points higher outside of Germany (Chart 2). And even when the ECB does start hiking, it is doubtful that it will be able to raise rates all that much. This is because the neutral rate is extremely low in the euro area. Chart 1Rate Expectations Have Adjusted Higher Chart 2Euro Area: Labor Market Slack Still High Outside Of Germany The Importance Of The Neutral Rate Some commentators have alleged that the concept of a neutral rate is of little practical importance. They are wrong. At the start of 2010, 10-year German bund and U.S. Treasury yields stood at 3.4% and 4%, respectively. Much of the rally in bonds since then can be attributed to the slow realization among investors that the equilibrium interest rate in Europe and the U.S. has fallen. Those who understood this point at the outset made a lot of money. Why did the neutral rate decline? Part of the answer has to do with demographics. Slower labor force growth has reduced the incentive for companies to expand capacity. This has weighed on investment spending, leading to lower aggregate demand. Compared to the U.S., the euro area has been more afflicted by deteriorating demographics. For a while, the region was able to make up for the shortfall in population growth by expanding labor participation. But with participation rates in the euro area now higher than in the U.S., that avenue has closed (Chart 3). The end of the debt supercycle also caused the neutral rate to plummet around the world. Here again, Europe was disproportionately affected. Private-sector debt soared across the region in the years leading up to the Great Recession. This was particularly the case in the Mediterranean economies, which benefited from plunging real interest rates and a seemingly insatiable appetite for their debt among banks and foreign investors (Chart 4). When the music stopped, panic ensued. Greece was driven into default. Ireland, Spain, Italy, and Portugal survived by the skin of their teeth. Chart 3Rising Participation Boosted Euro Area Labor Force Growth Chart 4Private Debt Levels Soared In The Run-Up To The Great Recession True, financial stresses have receded since then. But all the spending that rising debt generated has not come back. This is a critical point and one that is often overlooked: If the ratio of private debt-to-GDP simply ends up being flat in the future - rather than rising by an average of 3.9 percentage points per year as it did in the euro area during the 2000s - this will still translate into significantly less demand than what the region was once used to.1 The ECB will need to offset this loss of demand by keeping interest rates lower for longer. Put differently, low rates in the euro area look to be more of a structural phenomenon than a cyclical one. The Shackles Of The Common Currency Chart 5Markets See Only A Small Gap In Neutral Rates Between The U.S. And The Euro Area The now all-too-evident drawbacks of euro area membership only amplify the need to keep rates low. As many European countries have discovered, loosening fiscal policy during a recession is nearly impossible when one loses guaranteed access to a central bank that can serve as a lender of last resort. The inability to devalue one's currency also means that competitive adjustments must occur through weak wage growth or even outright declines in nominal wages. Such outcomes can only occur in the presence of high unemployment. An economy which cannot respond effectively to adverse economic shocks with either fiscal easing or a cheaper currency is one that is likely to experience higher levels of labor market slack over the long haul. This, in turn, implies that interest rates will end up being lower than they would otherwise be. Has the market adequately discounted the fact that the neutral rate is lower in the euro area than in the U.S.? We don't think so. Chart 5 shows market estimates of the neutral real rate based on the difference between 5-year, 5-year forward interest rate index swaps and 5-year, 5-year forward CPI swap rates. The market is currently saying that the neutral rate is 26 basis points higher in the U.S. than in the euro area. We think the true gap is close to 100 basis points. A Higher Hurdle For The Euro Think about what this means for currencies. If interest rates are lower in one country than they are in another, investors will only purchase bonds in the low-yielding economy if they expect that country's currency to appreciate. What will cause them to expect a stronger currency? The answer is that the low-yielding currency has to first depreciate to a level below its long-term fair value. Consider a concrete example: German bunds and U.S. Treasurys. The latter yields 1.82% more than the former for 10-year maturities. This implies that investors expect the euro to appreciate by about 20% over the next decade. As such, whatever one thinks is the true long-term fair value for EUR/USD, the euro currently should trade at a substantial discount to that value. And, of course, the longer one thinks the neutral rate in the U.S. will exceed that of the euro area, the larger that discount should be. Thus, whenever someone tells you that it is "obvious" that the euro will strengthen over the long haul, ask them where they think the euro will be trading against the dollar in ten years' time. If their answer is less than 1.36, they will lose money by being long EUR/USD. Short-Term Momentum Favors The Euro, But The Cyclical Picture Is Still Dollar Bullish Ten years is a long time, of course. Over the next couple of months, we would not be surprised if investors extrapolate the euro area's economic recovery too far into the future, leading to higher bond yields across the region. In fact, BCA's Global Fixed Income Strategy service downgraded core European bonds this week largely for this reason. If that were to happen, EUR/USD could move to as high as 1.18 over the next few weeks. Such euro strength, however, will not last. We are confident that the Fed will deliver more tightening than the ECB over a 12-month horizon compared to what investors are currently anticipating. Despite the decline in the euro area unemployment rate over the past four years, it is still five points higher than in the U.S., greater than at virtually any point during the 2000s! (Chart 6). U.S. financial conditions have eased substantially so far this year - indeed, considerably more so than in the euro area (Chart 7). Our empirical work has shown that financial conditions lead growth by about 6-to-9 months. This suggests that U.S. growth could trump growth in the euro area over the balance of the year, even on a per capita basis. Chart 6There Is More Slack In The Euro Area Chart 7Easier Financial Conditions Will Support U.S. Growth Over The Coming Months U.S. Inflation Will Rise U.S. inflation should also bounce back, removing a key obstacle to further Fed rate hikes. Chart 8 presents a breakdown of U.S. core PCE inflation based on its various components. A few points stand out: About one-third of the decline in core PCE inflation between January and April can be attributed to lower wireless data prices, partly reflecting recent methodological changes undertaken by the Bureau of Labor Statistics to better measure inflation in this segment. We see this largely as statistical noise, which will wash out from the data over the next few quarters. Core goods inflation has been weighed down by the lagged effects of the dollar's appreciation in 2014-15. Given that the broad trade-weighted dollar has weakened by 4.3% this year, goods inflation should begin to move higher, as already foreshadowed by the jump in import prices (Chart 9). Health care inflation rose in the lead-up to the U.S. elections, reportedly because some health care providers feared they would not be able to jack up prices once Hillary Clinton became president. Thus, the ebbing in health care costs over the past few months is not too surprising. Going forward, health care inflation is likely to rise as insurers raise premiums, particularly for policies sold through the exchanges created under the Affordable Care Act. Service inflation has decelerated a notch. We do not expect this to last. Chart 10 shows that underlying wage growth has been accelerating on the back of a tightening labor market. Historically, wage growth has been the dominant driver of service inflation. The deceleration in rent inflation looks more durable, given rising apartment supply (Chart 11). However, one could argue that weaker rent growth could actually make the Fed more hawkish. After all, if builders are now churning out too many new apartments, keeping interest rates low would just encourage overbuilding. Chart 8U.S. Inflation Will Compel The Fed To Hike Rates Chart 9Goods Inflation Will Move Up Chart 10Deceleration In Service Inflation Will Not Last Chart 11Rent Inflation Has Peaked Investment Conclusions The jump in global bond yields in recent weeks raises the odds of a near-term pullback in stocks. Still, history suggests that equities almost always outperform bonds and cash outside of recessions. If global growth remains strong over the next 12 months, as we expect, stocks are likely to climb to new highs. Chart 12Euro Area Business Cycle Follows The U.S. The combination of faster U.S. growth and rising inflation should allow the Fed to raise rates at least three or four more times between now and next June. This is more than the 30 basis points of rate hikes that the market is currently pricing in over this period. We have been positioned for higher rate expectations by being short the January 2018 fed funds futures contract. We are closing this trade today for a gain of 11 basis points and rolling it into the June 2018 contract. While a somewhat more hawkish ECB will blunt the dollar's ascent to some extent, it will not fully counteract it. This is simply because the Fed wants to tighten financial conditions while the ECB does not. The ECB would be happy if the euro were to weaken. In contrast, further dollar weakness would cause the Fed to ramp up its hawkish rhetoric. This asymmetry means that it is the Fed, rather than the ECB, that is in the driver's seat when it comes to the outlook for EUR/USD. We expect the euro to weaken to 1.05 against the dollar by the end of the year, possibly reaching parity in early 2018. When will the dollar peak? The answer is when U.S. growth finally falters and the Fed stops raising rates. As we discussed last week in our Third Quarter Strategy Outlook, this could happen towards the end of 2018.2 Historically, the euro area business cycle has lagged the U.S. cycle by 6-to-12 months (Chart 12). Thus, it is reasonable to assume that euro area growth will remain resilient late next year, even if the U.S. economy begins to slip into recession. That is when the euro will finally take off. New Trade: Go Short EUR/RUB Chart 13Falling Oil Inventories Should Lead To Higher Crude Prices Until then, the euro will remain under pressure. In contrast, the Russian ruble is likely to strengthen over the next 12 months. Russian industrial production surprised to the upside in May, growing at the fastest pace since 2014. Retail sales also accelerated thanks to a pickup in wage growth. The growth revival should reduce the pressure on the Russian central bank to cut rates aggressively. A recovery in oil prices will also help the ruble. Our energy strategists expect global production to increase by only 0.7 MMB/d in 2017, compared to 1.5 MMB/d growth in consumption. While shale output continues to rise, this is largely being offset by falling production from conventional oil fields. Consequently, oil inventories should fall in the remainder of this year. If history is any guide, this will boost oil prices (Chart 13). With this in mind, investors should consider going short EUR/RUB. The ruble has lost 15% against the euro since April, making it ripe for a rebound. The juicy 9.4% in carry that the ruble currently offers over the euro should also benefit this trade. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 In equilibrium, aggregate demand must equal GDP. Since debt is a stock variable while GDP is a flow variable, it is the change in debt that influences GDP. Likewise, it is the change in the change in debt - the so-called "credit impulse" - which influences GDP growth. 2 Please see Global Investment Strategy, "Strategy Outlook Third Quarter 2017: Aging Bull," dated June 30, 2017, available at gis.bcaresearch.com. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades