Developed Countries

Overweight Machinery stocks have been in a V-shaped recovery for the past 18 months retracing all of their relative losses since the 2014 highs. Our machinery EPS model is firing on all cylinders (second panel), underscoring that the earnings-led recovery has more running room, giving us comfort to act on our upgrade alert and lift the S&P construction machinery & heavy truck subindex to overweight. We think a fresh capex upcycle will fuel the next machinery stock outperformance upleg. Not only are expectations for overall capital outlays as good as they get (third panel), but there are also tentative signs that even the previously moribund mining and oil & gas complexes will be capex upcycle participants. A quick channel check also waves the green flag as industrial production remains expansionary and new orders are outpacing inventory accumulation (bottom panel). Bottom Line: We are acting on our upgrade alert and lifting the S&P construction machinery & heavy truck index to overweight. As a result of this change, we have boosted the S&P industrials sector to an above benchmark allocation. Please see yesterday's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, PCAR, CMI.

Highlights Chart 1Tax Reform Is A Bear-Steepener The federal government provided some details about its tax reform proposal last week. Markets reacted immediately, once again starting to price-in the possibility of lower tax rates. A basket of high tax-rate stocks outperformed the S&P 500, although the relative price remains well below the highs reached in the immediate aftermath of the election (Chart 1). Bond markets have also been influenced by the "will they, won't they" tax reform drama. Since tax cuts at this relatively late stage of the economic cycle are widely expected to be inflationary, the slope of the yield curve steepens and long-dated TIPS breakevens widen whenever the passage of a tax bill seems more likely. Our political strategists expect that a tax bill will be passed by the end of Q1 2008, or by early Q2 at the latest.1 All else equal, this will bias TIPS breakevens wider and cause the Treasury curve to steepen. Even in the absence of significant tax legislation we think that TIPS breakevens will widen and the yield curve will steepen as inflation starts to pick up during the next few months. But any fiscal stimulus related to tax reform would certainly expedite the process. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 87 basis points in September, bringing year-to-date excess returns up to 234 bps. The average index option-adjusted spread tightened 9 bps on the month to reach 101 bps. Valuation looks increasingly stretched across much of the corporate bond universe. The 12-month breakeven spread for A-rated corporate bonds has dipped well below its mid-2014 trough and is approaching the minimum value witnessed in the early stages of prior Fed tightening cycles. The same measure for Baa-rated credits fell to 17 bps last month, almost exactly equal to its mid-2014 low. While spreads are somewhat expensive, recent data on profit and debt growth have been positive. We noted in last week's report2 that net leverage declined in the second quarter, breaking a streak of two consecutive increases (Chart 2). In addition, other credit cycle indicators such as the slope of the yield curve and C&I bank lending standards do not yet signal wider spreads. Further declines in leverage will depend on whether profit growth can sustain its recent strength (bottom panel). While some moderation is likely, as of now, our leading profit indicators - particularly the weak dollar and surging manufacturing PMI - suggest that growth will stay firm for the remainder of the year (Table 3). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 143 basis points in September, bringing year-to-date excess returns up to 526 bps. The index option-adjusted spread tightened 31 bps to end the month at 347 bps, 24 bps above the mid-2014 cycle low. After adjusting for expected default losses, we calculate that the junk index currently offers an excess spread of 213 bps. We would expect a default-adjusted spread at this level to translate into low, but positive, excess returns during the next year. A simple linear regression suggests those excess returns will be on the order of 100 to 200 bps (Chart 3), but with a fairly wide margin for error. The default-adjusted spread incorporates our estimate of default losses for the next 12 months. This estimate currently sits at 1.3%. The estimate is derived from the Moody's baseline forecast of a 2.7% default rate and our own estimate of a 51% recovery rate (bottom panel). The relatively benign default outlook is reinforced by the persistent environment of steady growth and low inflation. Last week's third estimate showed that second quarter GDP growth was 3.1%, well above most estimates of trend. Meanwhile, the St. Louis Fed Price Pressures Measure predicts only a 2% chance that inflation will rise above 2.5% during the next year (panel 3). This combo of steady growth and low inflation will ensure that Fed policy remains sufficiently accommodative to support high-yield bond returns. MBS: Upgrade To Neutral Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 35 basis points in September, bringing year-to-date excess returns up to 26 bps. The conventional 30-year MBS yield rose 10 bps in September, driven by a 19 bps increase in the rate component. This was partially offset by an 8 bps tightening of the option-adjusted spread (OAS), while the compensation for prepayment risk (option cost) narrowed 1 bp. OAS have widened considerably during the past few months. In all likelihood this has been in anticipation of the Fed starting to unwind its MBS portfolio. The result is that MBS no longer look expensive compared to Aaa-rated credit (Chart 4). With more attractive valuations and the Fed's schedule for balance sheet runoff now well known, we think the time is right to edge MBS exposure higher. After having sold the rumor of Fed balance sheet runoff, it is time to buy the news. Arbitrage between MBS and credit should limit how much MBS OAS can widen during the next 6-12 months, even in the face of higher MBS supply. Further, recent spread widening has been helped along by falling mortgage rates and rising refinancings. With Treasury yields and mortgage rates now poised to put in a bottom, refis will also roll over and lend support to the MBS trade (bottom panel). Government-Related: Underweight Chart 4MBS Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 26 basis points in September, bringing year-to-date excess returns up to 181 bps. Sovereign bonds outperformed the Treasury benchmark by 93 bps on the month. Foreign Agencies and Local Authority bonds outperformed by 25 bps and 46 bps, respectively. Domestic Agency bonds outperformed by 1 bp and Supranationals outperformed by 3 bps. Year-to-date Sovereign bond outperformance has been spurred by dollar weakness, even though spread differentials are tilted firmly in favor of domestic U.S. credit (Chart 5). But with U.S. economic data just now starting to surprise to the upside, we think the tailwind from a weakening dollar is about to fade. Mexico is the single largest issuer in the Sovereign index, and appreciation in the peso versus the U.S. dollar has been a particularly important driver of Sovereign outperformance this year. However, our Emerging Markets Strategy team now believes that peso appreciation is overdone.3 Mexican growth has been supported by strong exports and a weak currency while domestic demand has been soft. Without a solid foundation from domestic demand, this year's currency appreciation will soon cause inflation to roll over and Mexican interest rates to fall. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 62 basis points in September (before adjusting for the tax advantage). Munis have outperformed the Treasury benchmark by 207 bps, year-to-date. The average Municipal / Treasury (M/T) yield ratio edged up from 84% to 86% in September, but it remains extremely tight relative to its post-crisis trading range (Chart 6). State & local government budgets dodged a bullet when the Graham-Cassidy healthcare reform bill was defeated last month. The bill included a block-grant provision for Medicaid that would have reduced federal government transfer payments, a significant source of state & local government revenue. Last week we also learned more specifics about the federal government's proposed tax reform legislation. While the lower tax rates in the proposal are obviously negative for M/T yield ratios, the impact should be somewhat offset by the elimination of tax deductions, the state & local income tax deduction in particular. Eliminating deductions makes the tax advantage in municipal bonds appear more attractive, irrespective of the tax rate. Most importantly, the municipal bond tax exemption itself appears safe. Of course, it will still be some time before we know the final details of tax reform, which our political strategists expect will be passed by the end of Q1 2018. With the plan still not finalized, M/T yield ratios near post-crisis lows look too complacent. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve shifted higher in September and steepened out to the 5-year maturity point. The 2/10 Treasury slope steepened 7 bps and the 5/30 slope flattened 9 bps. The market brought a December rate hike back into focus last month following a somewhat stronger CPI inflation report and Fed Chair Janet Yellen's insistence that low inflation will prove transitory. Our 12-month fed funds discounter, which shows the market's expected change in the fed funds rate during the next 12 months, moved up to 40 bps from 19 bps. As discussed in last week's report,4 we tend to agree with Chair Yellen that inflation will soon follow growth indicators higher. The market implication of this thesis is that wider TIPS breakevens will lead to one last bout of curve steepening this cycle. We continue to position for curve steepening via a trade long the 5-year bullet and short a duration-matched 2/10 barbell. This trade has returned 16 bps since inception last December. At present, our fair value model shows that the 5-year bullet is slightly expensive on the curve (Chart 7). Or put differently, that the 2/5/10 butterfly spread is fairly priced for 2 bps of 2/10 curve steepening during the next 6 months.5 We think curve steepening will easily surpass this threshold and maintain our long 5-year, short 2/10 position. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 39 basis points in September, bringing year-to-date excess returns up to -131 bps. The 10-year TIPS breakeven inflation rate rose 8 bps on the month but, at 1.84%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. CPI beat expectations in August for the first time in several months and, as was discussed in a recent report,6 the bond market was quick to react to even a tentative sign that inflation might have troughed. The market's sensitivity should not be surprising. Leading pipeline indicators of inflation, such as the prices paid and supplier deliveries components of the ISM manufacturing index, suggest that inflation and TIPS breakevens are biased higher (Chart 8). Counter-acting some of the optimism on inflation was the slightly weaker-than-expected August PCE report. While trimmed mean PCE inflation did perk up on a month-over-month basis, the 6-month and 12-month rates of change continue to fall (bottom panel). The 2% inflation target is of utmost importance to the Fed. In our base case scenario there is sufficient inflationary pressure for this target to be achieved with a pace of rate hikes similar to the Fed's median projection. But if that turns out not to be the case, then the Fed will respond with a slower pace of hikes. Either way, long-maturity TIPS breakevens must move higher before the end of the cycle or the Fed will have failed. ABS: Cut To Neutral Chart 9ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 3 basis points in September, dragging year-to-date excess returns down to 68 bps. Credit card and auto loan ABS both underperformed the duration-equivalent Treasury benchmark by 2 bps in September, pulling year-to-date excess returns down to 67 bps and 69 bps, respectively. The index option-adjusted spread for Aaa-rated ABS widened 3 bps on the month to reach 39 bps. It remains well below its average pre-crisis level (Chart 9). At 39 bps, the Aaa-rated ABS spread is still 11 bps wider than the average option-adjusted spread for conventional 30-year agency MBS. However, as we observed in last week's report,7 delinquency rates for consumer credit (credit cards, auto loans and student loans) are rising, while mortgage delinquency rates continue to fall. This squares with the message from the Fed's Senior Loan Officer Survey which shows that lending standards are tightening for both credit cards and auto loans (bottom panel). While delinquencies appear to have bottomed, the charge-off rate in credit card ABS collateral pools remains near all-time lows. Meanwhile, net losses in auto loan ABS collateral pools are in a clear uptrend. We continue to prefer Aaa-rated credit card ABS over Aaa-rated auto loan ABS, but are wary that credit card charge-offs will also start to increase in the near future, albeit from very low levels. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 6 basis points in September, dragging year-to-date excess returns down to 110 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 1 bp on the month, but it remains well below its average pre-crisis level. Fundamentally, the commercial real estate space continues to be characterized by tightening lending standards and falling demand (Chart 10) and, outside of the multi-family sector, CMBS delinquencies are trending higher (panel 5). Against this back-drop, spreads are not wide enough to entice us. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 18 basis points in September, dragging year-to-date excess returns down to 62 bps. The average index option-adjusted spread for the Agency CMBS index widened 3 bps on the month to reach 51 bps. This compares favorably to the 39 bps offered by Aaa-rated consumer ABS and the 28 bps offered by conventional 30-year Agency MBS. Especially since multi-family delinquency rates remain very low. Treasury Valuation Chart 11Treasury Fair Value Models 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 2.65% (Chart 11). Our 3-factor version of the model (not shown), which also includes the Global Economic Policy Uncertainty Index, places fair value at 2.62%. The Global Manufacturing PMI held flat at 53.2 in September, while bullish sentiment toward the dollar crept higher. This caused our model's fair value to edge lower to 2.65% from 2.67%. The U.S., Eurozone and Japan all saw stronger PMIs in September. While China's PMI dipped slightly (from 51.6 to 51), it remains firmly above the 50 boom/bust line. For further details on our Treasury models please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 11, 2016, available at usbs.bcaresearch.com At the time of publication the 10-year Treasury yield was 2.33%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?", dated September 20, 2017, available at gps.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Won't Back Down", dated September 26, 2017, avail-able at usbs.bcaresearch.com 3 Please see Emerging Markets Strategy Weekly Report, "Questions From The Road", dated September 20, 2017, available at ems.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Won't Back Down", dated September 26, 2017, available at usbs.bcaresearch.com 5 For further details on our fair value model please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "The Great Unwind", dated September 19, 2017, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "Won't Back Down", dated September 26, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of September 29th, 2017. The model sharply reduced its allocation to the U.K. to a bare minimum in response to the tightening in liquidity condition as the Bank of England warned of a rate hike in "coming months." The funds are reallocated to the Spain and Germany. Other smaller changes are the reductions in Italy and Australia in favor of Sweden and Switzerland, as shown in Table 1. As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed its benchmark by 44 bps in September. Both level 1 and level 2 models performed well, with level 2 outperforming its benchmark by 63 bps and level 1 outperforming its benchmark by 9 bps, as the underweight in Australia, U.S. and Japan versus the overweight in Italy, Germany and Netherland worked very well. Since going live in January 2016, the overall model has outperformed the benchmark by 341 bps, largely from the allocation among the 11 non-U.S. countries, which has outperformed its benchmark by 743 bps. Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level1) Chart 3GAA Non U.S. Model (Level 2) Table 1Model Allocation Vs. Benchmark Weights Table 2Performance (Total Returns In USD) Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see the January 29th, 2016 Special Report, "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model." http://gaa.bcaresearch.com/articles/view_report/18850. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of September 30, 2017. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live The model continues to be optimistic on global growth as seen by an increasing allocation to cyclical sectors. Additionally, the model has also reduced its underweight on consumer discretionary stocks, which is currently the only cyclical sector to have a below-benchmark allocation. Finally, the biggest shift was a downgrade in utilities from overweight to underweight. This was primarily driven by momentum. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com

Highlights Oil prices have hit our target, but more upside is likely. President Trump's tax proposal has arrived and the Trump trades have responded. Surging M&A activity is not a sign of a market top. The supports are all in place for a robust period of U.S. capital spending. We expect another solid earnings season in Q3, with little impact from the hurricanes. Feature The S&P 500, Treasury yields and the dollar all rose last week, with the S&P hitting a new all-time high, even as 10-year Treasury yields hit a 2-month high. The sweet spot for risk assets has been extended by the rise in oil prices and rising prospects for tax cuts in the U.S. M&A activity will continue, which is market bullish because it has not yet reached frothy levels. Moreover, capex is blasting off, which will give growth (and EPS) another boost. The downtrends in both Treasury yields and the dollar this year are over, and they both have more upside given that economic growth and underlying inflation are both improving. Moreover, the FOMC is still in a position to deliver on a December rate hike with 2-3 additional hikes in 2018, which will be a wake-up call for bonds and will reverse this year's dollar weakness. More Upside In Oil Prices Last week, both Brent ($57.50/bbl) and WTI ($51.60/bbl) hit the midpoints of the ranges set by our commodity and energy strategists earlier this year. This milestone provides us with an opportunity to revisit BCA's stance on the oil market. OPEC's deal to cut production will be extended to at least June 2018. Based on BCA's latest assessment of the global oil market,1 OPEC 2.0 will fall short of reducing visible inventories to their 5-year average if the coalition's production cut agreement expires which was initially agreed upon in March 2018. Extending OPEC 2.0's cuts through December 2018 would nudge OECD commercial inventories closer to levels originally targeted by OPEC 2.0 at the end of last year (Chart 1). Therefore, in 2018 we expect WTI to average slightly less than $57.50/bbl and Brent to average just under $59/bbl. Accordingly, there is a higher risk that prices will exceed the upper end of our WTI range ($45/bbl to $65/bbl) with greater frequency next year. Furthermore, BCA's Commodity & Energy Strategy team has raised its global oil demand forecasts for both 2017 and 2018; increased demand will support prices in the next 12 months (Chart 2). Chart 1OPEC 2.0 Needs To Extend Cuts,##BR##To Reduce Global Inventories Chart 2Base Case For BCA Oil Supply-Demand Balances##BR##Reflects June 2018 Expiry Of OPEC 2.0 Cuts Geopolitical risks in Iraq and an escalation in supply disruptions add to BCA's bullish view. The Kurd's vote for independence from Iraq last week will elevate tensions in the region and could trigger a civil war. If a war breaks out over Kirkuk, it will lead to production cuts. Furthermore, civil war in Iraq would reduce the flow of FDI into Iraq's oil infrastructure, further crimping output. Moreover, Russia, which supports the Kurd's fight, would also benefit from high oil prices. Oil production wildcards in 2017 mostly favored more oil output. However, in 2018, supply disruptions will curtail global oil output. Bottom Line: Additional supply cuts, higher demand, elevated tensions in Iraq and a normal spate of supply disruptions, all suggest that there is upside risk to our $45-$65 stance on WTI. A risk to this forecast is a sharply higher dollar linked to expansionary fiscal policy. Tax Cuts Imminent Chart 3Trump Trades Making A Comeback As BCA's Geopolitical Strategy service predicted last month, President Trump's long-awaited tax plan will likely be enacted in Q1 2018. Trump and the Republicans in Congress, still desperate for a legislative win after again failing to repeal and replace Obamacare, introduced the proposal last week. However, the plan must clear several hurdles before it becomes law. First, the proposals may run afoul of both deficit hawks and moderates in the Congress' Republican caucus. The initial framework has tax decreases, but no revenue or spending offsets. The implication is that the package would blow out the deficit, alienating the fiscal conservatives. Moderates may not like the lack of cuts for the middle class. Democrats have not yet had their say. The CBO still must score the legislation, and even with dynamic scoring2 which counts on stronger economic growth to boost revenues and reduce outlays for automatic stabilizers and some social programs, it will add to the deficit. This may also cause an uproar in Congress. Nonetheless, on a positive note, Trump has the support of the influential House Ways and Means Committee, as well as the Senate Finance Committee. This was not the case with the Obamacare repeal and replace when the President and his GOP allies were at odds. First and foremost, the GOP-led Congress needs to pass a budget resolution, expected by the end of October. Congress considers the President's request as it formulates a budget resolution, which both houses of Congress must pass. Bottom Line: Investors should watch the response of Congressional Republicans to Trump's tax proposals. A lukewarm reception would indicate that investors' renewed optimism may be premature. The Trump trades have made a comeback in the past two weeks and will continue to be profitable if the current proposal (or something similar) is signed into law in Q1 2018 (Chart 3). If Trump and the GOP could extend the tax cuts into broader tax reform, it would provide a lift to corporate M&A activity. Little Froth From M&A Market U.S. merger and acquisition (M&A) volume peaked along with U.S. equity prices in the late 1990s and mid-2000s, but another top in the current deal market does not signal a top in equity prices. Deal volume (in dollars) and relative to market cap peaked in 1999, again in 2007, and more recently in mid-2015, before a 13% pullback in the S&P 500 in late 2015 and early 2016 (Chart 4). Although not shown on the chart, deal volume surpassed its late 1980s' pinnacle in 1995, five years before equity markets reached record highs in 2000. Through August, corporate takeovers relative to GDP matched those prior heights, but remained below the 1999, 2007 and 2015 tops as a percentage of market cap. Furthermore, global or cross-border M&A, a better indicator of market zest than U.S.-only activity, has not eclipsed the peaks in 2007. Measured against both global GDP and market cap, worldwide corporate combinations are below their 2015 zenith and well below the 2007 peak. At just 7% in 2016, the GDP-based metric was significantly under the mid-2000s pinnacle of 10%. That said, it is difficult to analyze this in context as the time series does not reach back to the late 1990s, which were the boom years for M&A. Bottom Line: Booming M&A activity is not a sign of froth in equity markets but it is a sign that animal spirts are stirring. Overall net equity withdrawal (which includes the net impact of IPOs, share buybacks, and M&A) has not been out of line with previous economic expansions (Chart 5). Stay overweight stocks versus bonds. The uptrend in capital spending is another sign of a shift in animal spirits. Chart 4Roaring M&A Volume Not##BR##A Sign Of A Market Peak Chart 5Comparison Of Corporate Outlays Across Four Economic Expansion Phases Capital Spending Blasting Off The capital spending outlook remains bright despite the recent loss of momentum in industrial production, as indicated by BCA's aggregate for IP in the advanced economies (Chart 6). This is disconcerting because global and regional industrial production are important indicators of both economic growth and corporate earnings. The recent softening is due to a few factors. Much of it is linked to weakness in the U.S. where hurricanes affected the August figures. However, most of our leading indicators remain constructive. Chart 7 presents simple models for real GDP growth for the G4 economies based on our household and capital spending indicators. Real GDP growth will continue to accelerate for the G4 economies, according to the model. BCA's aggregate consumer indicator for the G4 appears to have peaked, but the capex indicator is blasting off. The bullish capital spending reading is unanimous across the major economies. Robust capital goods imports for our 20-country aggregate supports the view that "animal spirits" are stirring in boardrooms in the advanced economies. These imports and BCA's capital spending indicators suggest that the small pullback in advanced-economy industrial production will not last, purchasing managers' indexes will remain elevated, and the acceleration in global export activity is only starting (Chart 7). Despite the lack of progress in Washington on repealing Obamacare and enacting tax cuts, even the U.S. small business sector has shifted into a higher gear in terms of hiring and capital spending, according to the NFIB survey (not shown). Moreover, both BCA's real and nominal U.S. capex models, driven by sturdy capital goods orders, elevated ISM readings and surging sentiment on capex, point to strong business spending in the next few quarters (Chart 8). Chart 6Animal Spirits Are Stirring... Chart 7...Contributing To Stronger G4 Economic Growth Chart 8Prospects For U.S. Capex Are Good Bottom Line: Business capital spending remains sturdy and it will lift overall GDP in 2H despite the recent severe weather. BCA's U.S. Equity Strategy strategists note3 that U.S. industrial machinery manufacturers should be particularly well positioned to see earnings growth outpace the rest of the S&P 500. Stay overweight industrials. Moreover, above-potential GDP growth will keep the Fed on track for gradual tightening this year, and supports BCA's position of stocks over bonds. Stout capital spending will be a theme as the Q3 earnings season unfolds in the next six weeks. Will Hurricanes Impact Q3 Earnings? Chart 9Strong EPS Growth Ahead,##BR##Will Start To Slow Soon The Q3 earnings season will be above average and the BCA Earnings model predicts EPS growth will hit roughly 20% later this year on a 4-quarter moving total basis, before moderating in 2018 (Chart 9). The consensus anticipates a 6% year-over-year increase in EPS in Q3 2017 versus Q3 2016, and 12% for 2017. Energy and technology will likely lead the way in earnings growth in Q3, and utilities and telecom will again be the laggards. The favorable profit picture for Q3 and the rest of the year partly reflects the rebound in oil prices, which are expected to swell the energy sector's EPS by 134%. The positive picture also mirrors the sweet spot of rising top-line growth and still muted labor costs, which are driving a countercyclical rally in profit margins. Investors and corporate executives will focus in Q3 on the improving economic conditions in Europe and the EM, the U.S. dollar, the sustainability of margins, and the impact of Hurricanes Harvey and Irma. President Trump's tax proposal will also be vetted during conference call Q&A's, as investors drill managements on the implications of tax cuts on their operations. Rising interest rates may also demand attention from some analysts because the 10-year Treasury yield in Q3 2017 was 45 bps above Q2 2016 and rose sharply in the final weeks of the third quarter. Guidance from CEOs and CFOs on trends in Q4 2017 and beyond are more important than the actual Q3 results (Chart 10). Investors should guard against managements' over-optimism because earnings growth forecasts almost always move lower over time. Chart 10Unusual Stability In '17 And '18 EPS Estimates In Q3, as in Q2, firms with elevated overseas sales should benefit from the improved growth profile in Europe, Japan and the EM. Global GDP growth projections for this year and next have steadily perked up, in sharp contrast with prior years when forecasters have relentlessly lowered GDP estimates. The U.S. dollar, which has been only a small drag on EPS in recent quarters, should become a modest plus in Q3; the dollar is down by 3% versus a year ago against a broad basket of currencies. Moreover, in the most recent Beige Book (September 6), mentions of a "strong dollar" declined by 4% compared with a year ago, indicating that the stronger currency has faded as a primary concern of managements in recent months. Nonetheless, BCA's view is that the dollar will appreciate by another 10% in the next 12-18 months. The appreciation would trim EPS growth by roughly 2.5 percentage points, although most of this would occur next year due to lagged effects. Another up leg in the dollar, on its own, should not provide a substantial headwind for the stock market. Indeed, the dollar would only climb in the context of robust U.S. economic growth and an expanding corporate top line. The timely enactment of Trump's tax proposal would boost the greenback. Investors are skeptical that margins can advance in Q3 for the fifth consecutive quarter. BCA's view is that we are in a temporary sweet spot for margins, which should continue for the next quarter or two, but the secular "mean reversion" of margins will resume beyond that time. The effect of Harvey and Irma on Q3 results will be muted for the S&P 500 and most sectors, but several weather-sensitive industries (insurance, airlines, chemicals, refining, leisure, etc.) will see significant disruptions. Charts 11A and 11B show that the impact of major hurricanes does not alter the pre-landfall trajectory of S&P 500 earnings forecasts. Earnings estimates for the energy, industrial and utilities sectors (relative to the S&P) tend to move higher after storms, while relative EPS growth in the materials and staples sectors lag behind. Chart 11AImpact Of Major Hurricanes##BR##On Forward EPS Estimates... Chart 11B...Is Muted For S&P 500##BR##And Most Sectors Bottom Line: Look for another solid performance for earnings and margins in Q3 and the rest of 2017, supporting our stocks-over-bonds stance for this year. However, it may be tougher sledding in 2018 when earnings growth begins to moderate and margins begin to "mean revert". Higher inflation, a more active Fed and a stronger dollar will be headwinds for earnings starting in the early part of 2018. FOMC Unified Yet Divided Chart 12Recent Inflation Readings##BR##Challenge The Fed's View U.S. inflation is likely to trend higher over the coming months as a variety of one-off factors that depressed inflation earlier this year fall out of the equation. That said, the August PCE deflator challenges that view (Chart 12). Core PCE inflation slowed further to 1.3%, down from 1.4% last month. In fact, core PCE inflation of 1.3% is at the exact same level as when the Fed delivered its first rate hike in December 2015. Moreover, the diffusion index dipped back to zero, implying the price weakness was widespread. The rollover in the PCE this year is consistent with the soft CPI readings. However, Fed officials highlight the trend in underlying inflation (Chart 12, panel 4) as they make the case for gradual rate hikes. Risk assets are unlikely to suffer if inflation rises towards the Fed's target against the backdrop of stronger growth. However, if inflation moves above the Fed's target due to brewing supply bottlenecks, the Fed will have little choice but to pick up the pace of rate hikes. This could unsettle markets and sow the seeds for the next recession, which we tentatively expect to occur in the second half of 2019. The market is pricing in only 42 basis points of hikes between now and the end of next year. FOMC voting members agree that the path for the normalization of monetary policy should be gradual. However, the path of inflation has provoked squabbling in the past month (Diagram 1) in the Fed and regional branches. Even though the Fed is path-dependent rather than data-dependent, the consensus remains that low inflation is due to temporary factors and higher consumer prices should soon rebound, justifying a December 2017 rate hike. FRBNY President William Dudley remains committed to further gradual rate hikes, although he has been recently surprised by the shortfall of inflation from the FOMC's 2% long-run objective. Fed Chair Janet Yellen confidently backed Dudley's optimism, stating that "low inflation likely reflects factors whose influence should fade over time." But she also struck a cautious tone by highlighting the risks around the uncertainty for the inflation outlook. Yellen even conceded that the Fed would not rule out pausing its gradual rate hike cycle given that they "may have misjudged the strength of the labor market, the degree to which longer-run inflation expectations are consistent with the inflation objective, or even fundamental forces driving inflation". Diagram 1Unified On Gradual Path But Divided On Inflation Path To manage risks, Chair Yellen offered a prescription of scenarios to strengthen the case for a gradual path: "Moving too quickly risks over adjusting policy to head off projected developments that may not come to pass. A gradual approach is particularly appropriate in light of subdued inflation and a low neutral real interest rate, which imply that the FOMC will have only limited scope to cut the federal funds rate should the economy be hit with an adverse shock. But we should also be wary of moving too gradually. Without further modest increases in the federal funds rate over time, there is a risk that the labor market could eventually become overheated, potentially creating an inflationary problem down the road that might be difficult to overcome without triggering a recession." In contrast, dovish FOMC members are apprehensive about the outlook for higher inflation. Governor Lael Brainard, known for her influence on the consensus at the FOMC, needs more confirmation that inflation is moving towards the 2% objective. FRB Chicago President Charles Evans, a dove, but mostly in line with the FOMC consensus, also is skeptical about inflation overshooting its 2% target and is worried about a potential policy mistake. Even FRB Minneapolis President Kashkari, the most dovish and a known dissenter, does not see inflation spiraling out of control given that the economy is unlikely to overheat anytime soon. Not surprising, FOMC hawks Esther George (Kansas City) and Patrick Harker (Philadelphia) noted in speeches late last week that policy was still accommodative and that gradual rate hikes are in order. Ultimately, a pickup in inflation is required to convince the doves at the Fed that even gradual rate hikes are required. BCA's stance is that inflation will pick up over the next year as the unemployment rate falls further and the output gap closes. Bottom Line: The Fed is likely to raise rates in December and three or four more times in 2018. We recommend investors remain underweight duration. Nonetheless, the Treasury market remains unconvinced about the Fed's view on rates and inflation. The implication for investors is that although 10-year Treasury bond yields have risen sharply in recent weeks, we see more upside in yields. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Will Extend Cuts To June 2018," September 21, 2017. Available at ces.bcaresearch.com. 2 Please see BCA Research's Geopolitical Strategy Weekly Report, "Reconciliation And The Markets - Warning: This Report May Put You To Sleep," May 31, 2017. Available at gps.bcaresearch.com. 3 Please see BCA Research's U.S. Equity Strategy Insight "Accelerating Global Manufacturing Means More Machines", dated September 22, 2017. Available at uses.bcaresearch.com.

Highlights Recommendation Allocation The global growth outlook remains strong, with corporate earnings likely to beat expectations for a couple more quarters. Inflation and Fed policy are key to asset allocation. We expect inflation to recover, which will push up interest rates and the dollar. But uncertainty is rising too: for example the composition of the FOMC next year, Chinese policy post the Party Congress, Geopolitics. We keep our pro-risk tilts, particularly overweights in euro area and Japanese equities, U.S. high-yield bonds, private equity, and cyclical sectors. But we reduce portfolio risk by bringing some allocations closer to benchmark, for example downgrading U.S. equities to neutral and reducing the underweight in EM. Feature Overview Growth Is Picking Up - But So Is Uncertainty The outlook for global economic growth remains almost unarguably positive (Chart 1). The key for asset allocation, then, comes down to whether inflation in the U.S. will rebound, and whether therefore the Fed will continue to tighten monetary policy in line with its current projections. This would likely cause long-term interest rates to rise and the dollar to appreciate, which would be positive for developed market equities and credit, but negative for government bonds, emerging market equities and commodities. This scenario has been our expectation - and the basis of our recommendations - for some time, and it remains so. In September, the market started coming around to our view - after months of pricing in that inflation would stay sluggish (which, therefore, had caused the euro and yen, government bonds, EM equities and commodities to perform well). In just a couple of weeks, the futures-market-priced probability of a December Fed hike has moved from 31% to 75%. This was triggered by little more than stabilization of core CPI (Chart 2), due mainly to shelter inflation, which anyway has a low weight in the core PCE inflation data that the Fed most closely watches. To us, this demonstrates just how sensitive the market is to any slight pickup in inflation, due to the fact that its expectations of Fed rate hikes over the next 12 months are so far below what the FOMC is signaling (Chart 3). Chart 1Lead Indicators Looking Good Chart 2Is The Softness In Inflation Over? Chart 3The Market Still Doesn't Believe The Fed However, a risk to BCA's view is that the Fed turns dovish. Even Janet Yellen, in the press conference after the FOMC meeting on 20 September, admitted that the Fed needs "to figure out whether the factors that have lowered inflation are likely to prove persistent". If they do, she said, "it would require an alteration of monetary policy." FOMC member (and notable dove) Lael Brainard, in an important speech earlier in September, laid out the argument that, since inflation has missed the Fed's 2% target for five years, inflation expectations have been damaged (Chart 4) and that only a period during which inflation overshot could repair them. With Yellen's term due to expire next February and four other vacancies on the FOMC, personnel changes could significantly change the Fed's direction. Online prediction sites give a somewhat high probability to President Trump's replacing Yellen, with (the rather more hawkish) Kevin Warsh, a Fed governor in 2006-11 (Chart 5). However, presidents tend to like loose monetary policy - President Trump has said as much himself - which raises the possibility of his trying to steer the Fed in a direction that is more tolerant of rising inflation. A possible scenario, then, is of an accommodative Fed which allows equities markets to have a final meltup for this cycle, similar to 1999. Chart 4Have Inflation Expectations Been Damaged? Chart 5Who Will Trump Choose To Lead The Fed? Another current source of uncertainty is China. Money supply growth there has slowed sharply this year, after being pushed upwards by the government's reflationary policies in late 2015. This historically has been a good lead indicator of growth and, indeed, many cyclical indicators have surprised to the downside recently (Chart 6). It is also hard to predict whether, after October's five-yearly Communist Party congress, newly re-elected President Xi Jinping will move ahead with implementing structural reforms, even at the expense of a short-term slowdown of growth.1 We continue to think that risk assets have further upside for this cycle. Growth is likely to remain strong, the probability of a U.S. tax cut is rising, and corporate earnings should surprise to the upside for another couple of quarters (Q3 S&P500 EPS consensus forecasts remain cautious at 5% YoY, versus our model which suggests double-digit growth). Nonetheless, the cycle is now mature, global equities have already produced a total return of almost 40% since their recent bottom in February last year, and valuations in almost every asset class are stretched (Chart 7). Moreover, geopolitical risks - such as that from North Korean missiles - will not disappear quickly. We continue to pencil in the possibility of a recession in 2019 or 2020, caused by a sharp rise in inflation, especially in the U.S., which the Fed - whoever is running it - would have to stamp on by raising rates above the equilibrium level. Chart 6Is A Downturn Coming In China? Chart 7Nothing Looks Cheap Therefore, on the 12-month horizon we continue to recommend pro-risk and pro-cyclical positioning, for example an overweight in equities versus fixed income. However, given the rising uncertainty, we are reducing the scale of our bets a little and so, for example among our equity country and regional recommendations, move a little closer to benchmark by lowering the U.S. to neutral and reducing the degree of our underweight in EM. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com What Our Clients Are Asking How worried should we be about North Korea? Chart 8Threats - But Eventually A Diplomatic Solution President Obama reportedly warned President Trump just prior to inauguration that North Korea would be his biggest headache. After 15 missile launches and a nuclear test this year (Chart 8, panel 1), investors are beginning to think the same. How big is the risk that the tension turns into warfare? BCA's Geopolitical strategists have written about the subject extensively.2 They conclude that military action is unlikely. An U.S. attack on North Korean missile or nuclear sites would simply provoke an attack with conventional weapons on Seoul, which is only 50 km from the border. Kim Jong-un undoubtedly knows that if he were to attack Guam or Japan, his country would be wiped out. In the end, then, a diplomatic solution is likely - but this will only be achieved after tension has risen sufficiently to force the two sides to the negotiating table. The analogy is Iran in 2012-15, where sanctions finally forced it to agree to a 10-year freeze in its nuclear plans. For the moment, sanctions seem unlikely to bite. North Korea's trade with China is not yet notably slowing (Chart 8, panel 2) and its GDP growth actually accelerated last year, albeit from stagnating levels, according to estimates from the Bank of Korea (Chart 8, panel 3). So the cycle of new threats and tougher sanctions will continue for a while. Historically, North Korean provocations caused related markets (such as South Korea stocks) to fall sharply for a few days, but this always represented a buying opportunity (Chart 8, panel 4). Given the likelihood of a diplomatic outcome, we think this remains a good rule of thumb. What will happen after China's 19th Party Congress, and will there be a slowdown in the economy? China's twice-a-decade National Party Congress will be held October 18-25. The outcome of the meeting could have important economic and market consequences. The key purpose of the Congress is to rotate China's political leaders. The 19th Party Congress is crucial because it marks the passing of a generation: President Xi Jinping will receive a second five-year term, but is predicted to consolidate his power by placing a younger generation of leaders who support his structural reforms into key positions. When Xi came to power, his reform agenda included de-emphasizing GDP targets; injecting private capital, competition and market discipline into the state-owned corporate sector; and fighting pollution. This agenda has since been compromised, with Xi reverting to infrastructure spending and credit growth to avoid painful adjustments. However, recently, there have been signs of a pullback in reflationary policies (Chart 9). Financial tightening is a key to reviving reform. Tighter controls on banks and leverage will translate into greater market discipline, and will put pressure on the sector most in need of change: SOEs. During the twice-a-decade National Financial Work Conference In late July, Yang Weimin, a key economic policymaker who is close to Xi, said, "The nation can't let leverage rise for the purpose of boosting economic expansion," signaling that the administration is willing to tackle difficult reform issues. He also mentioned the potential risks in the economy such as shadow banking, property bubbles, high leverage in SOEs, and local government debt, adding that the nation should set out its priorities and tackle them. Though it is impossible to predict the precise outcome of the Congress, the leadership reshuffle is likely to benefit Xi's reform agenda. The new leadership is likely to work on rebalancing growth toward consumption and services while encouraging private entrepreneurship and cutting back state-owned enterprises and, most importantly, deleveraging corporate debt. If China's credit impulse rolls over, the recent improvement in industrial profits and domestic demand will come under threat (Chart 9). As a result, China's cyclical growth is set to slow in 2018 as Xi reboots reform. Although economic risks will rise as the reform takes place, we still believe China H shares are attractive relative to other EM markets. In the long run, Xi's renewed reform drive should help China to get out of the "middle income trap'', which could help Chinese stocks to outperform EMs such as South Africa, Turkey and Brazil, where reforms are absent.3 Are Indian equities still a buy? In the three years since Prime Minister Narendra Modi's election, Indian stock prices have outperformed their emerging market peers by more than 20%. But the underlying growth dynamics do not justify this performance. We are turning cautious on India and downgrade Indian equities to neutral for the following reasons. India's GDP growth rate fell to a three-year low of 5.7% yoy in the April-June quarter. The administration's "Make In India" campaign is having limited impact, as seen in the near-zero growth of the manufacturing sector. Capital spending by firms has been dismal, further weighing on the outlook for productivity. Increasing layoffs and business shutdowns have produced considerable slack in the economy. Non-performing loans in the banking system have reached 11.8% of assets. As a result, credit growth to business has fallen almost to zero. This has slowed infrastructure development, as seen in the high level of stalled capital projects. The Reserve Bank of India has only just started the process of pushing banks to raise provisioning for distressed assets. The negative impact of last year's demonetization program is finally showing through. Less than 10% of Indians have ever used non-cash payment methods, and so demand for cyclical goods is slowing. Finally, Indian stocks have risen significantly in recent years, making them expensive relative to EM peers. In addition, profit growth has slowed, and return on equity converged with the EM average. Indian equities have been riding on expectations of reforms from the Modi administration. But, with the exception of the Goods & Services Tax (GST), the reform progress has been disappointing. We are turning cautious on Indian equities until we see improvements in the macro backdrop (Chart 10). Chart 9Sign of slowdown in Chinese Economy Chart 10India: Loosing Steam? How should global equity investors hedge foreign currency exposures? Chart 11Dynamic Hedging Outperforms Static Hedging There have been many conflicting views on how to hedge foreign currency exposures in a global equity portfolio. Full hedge,4 no hedge,5 or simply 50% hedge?6 Or should all investors hold the reserve currencies (USD, euro and Swiss Franc), avoid commodities currencies (AUD and CAD) while being neutral on GBP and JPY?7 As published in a Special Report 8 on September 29, 2017, our research has found that not only should investors with different home currencies manage their foreign currency exposures differently, but also a dynamic hedging framework based on the indicators from BCA's Foreign Exchange Strategy service's Intermediate Timing Model (ITTM)9 outperforms all the static hedging strategies for all investors with six different home currencies (USD, EUR, JPY, GBP, AUD and CAD) (Chart 11). A few key observations from Chart 11 Static hedges reduces risk with little impact on returns for the USD and JPY investors only. Unlike the CAD investors, the AUD investors are much better off to hedge than not to, on a risk adjusted basis, even though AUD is also a commodity currencies, like the CAD. The 50% "least regret" hedge ratio has lived up to its reputation as it reduced risk by more than 50% without severely jeopardizing returns. And for the USD based investors, the 50% static hedge has a similar risk/return profile as the dynamic hedge. For all other five home currencies, however, the 50% static hedge underperforms the dynamic hedge. Global Economy Overview: Globally growth has accelerated, with inflation quiescent. We expect growth to continue to be strong, but U.S. inflation will start to normalize, which should trigger further Fed hikes and a rise in long-term rates. Japanese and euro zone growth will be less inflationary, given continued slack in these economies. U.S.: Growth has rebounded sharply after the seasonally weak Q1 and excessive expectations following the presidential election. The Citi Economic Surprise Index (Chart 12, panel 1) shows strong upward surprises. First-half GDP growth came in at 2.2% (above trend, which is estimated at 1.8%), and the manufacturing ISM reached 57.7 in September. The two big hurricanes will probably knock around 0.5 points off Q3 growth but the lesson from previous disasters is that this will be more than made up over the following three quarters. Rebounding capex, and consumption aided by a probable acceleration in wages, should keep GDP growth strong. Euro Area: Due to Europe's greater cyclicality and dependence on the global cycle, growth momentum is unsurprisingly even stronger than in the U.S., with Q2 GDP growth 2.3% YoY and the manufacturing PMI at 57.4. German growth has been particularly robust with the IFO index at 115.9, close to an all-time high, and German manufacturing wages growing by 2.9% YoY. The credit impulse suggests that the strong growth should continue, although the euro appreciation this year (and consequent tightening of financial conditions) might dampen it a little. Japan: Growth continues to be good in the external sector (with exports rising 18% YOY and industrial production 5%), but weak in the domestic economy, where household spending and core inflation continue to flatline. We do, though, see some first tentative signs of inflation: the Bank of Japan's estimate suggests the output gap has now closed, and the tight labor market is showing through in part-time hourly wages, which are rising 2.9%. Emerging Markets: China's PMI has oscillated around 50 all year (Chart 13, panel 3), as the authorities tried to stabilize growth ahead of October's Party Congress. But money supply and credit growth have been slowing all year, and this is now showing through in downside surprises in fixed asset investment and retail sales data. Especially if the congress moves towards structural reform and short-term pain, growth may slow further. This would be negative for other emerging markets, which depend on China for growth. Bank loan growth and domestic consumption generally remain weak throughout EM ex China. Chart 12Global Growth Is Accelerating... Chart 13...Propelling Europe And Japan Interest Rates: Inflation has been soft this year in the U.S. but is likely to pick up in coming months reflecting stronger economic growth and dollar depreciation. We expect the Fed to raise rates in December and confirm its three hikes next year. That should be enough to push the 10-year Treasury yield up to close to 3%. In Japan and the euro area, however, underlying inflationary pressures are much weaker. So we expect the Bank of Japan to stick to its yield curve control policy, and for the ECB to emphasize, when it announces in October next year's (reduced) asset purchase program, that it will be cautious about raising rates. Global Equities Chart 14Earnings Have Been Strong... Q3 2017 was the second quarter in a row when the price appreciation in global equities was driven entirely by earnings growth, since the forward price-to-earnings ratio contracted by 2% compared to Q2 (Chart 14). Chart 15No Compelling Reasons To Make Large Bets The scope of the improvement in earnings so far in 2017 has been wide. Not only are forward earnings being revised up, but 12-month trailing earnings growth has also been very strong, with all 10 top-level sectors registering positive earnings growth. Margins have steadily improved globally from the lows in early 2016. Despite the slight multiple compression in Q3, equity valuations are not cheap by historical standards. As an asset class, however, equities are still attractively valued compared to bonds, especially after the recent safe-haven buying drove global bond yields to very depressed levels. We remain overweight equities versus bonds on the 9-12 month horizon. Within equities, however, we think it's prudent to reduce portfolio risk by bringing allocations closer to benchmark weighting because 1) equities are not cheap, 2) volatility is low, 3) geopolitical tension is rising, and 4) year-on-year earnings growth over coming quarters may not be as strong as it has been so far this year because earnings in the first half of the 2016 were very depressed. As such, we downgrade the U.S. to neutral from overweight (+3 percentage points), and reduce the underweight in EM (to -2 from -5). We remain overweight the euro area and Japan (but hedge the yen exposure). Within EM, we have been more positive on China and remain so on a 6-9 month horizon. Sector-wise, we maintain our pro-cyclical tilt. Country Allocations: Downgrade U.S. To Neutral We started the year being "cautiously optimistic" with a maximum overweight (+6 ppts) in U.S. equities.10 We added risk at the end of the first quarter by reducing by half the U.S. overweight in order to upgrade the higher-beta euro area to overweight (+3) from neutral.11 The change has worked well, as the euro area outperformed the U.S. by 542 basis points (bps) in Q2 and then by 370 bps in Q3 in unhedged USD terms. Our DM-only quant model also started the year with a maximum overweight in the U.S., but the overweight was gradually reduced each month until July when the model indicated a benchmark weight for the U.S. The model continued its shift away from the U.S. in August and September, and now the U.S. is the largest underweight in the model. As we have previously stated, we use the quant model as one key input into our decision-making process, but we do not follow it slavishly because 1) no model can capture all the ever-changing driving forces in the market, and 2) the model moves more often than we prefer. In light of the rising geopolitical risks and low levels of volatility in all asset classes, we conclude that there are no longer compelling reasons to make large bets among the countries (Chart 15). Valuation in the U.S. is stretched, but neither is it cheap in EM anymore; both trailing and forward earnings growth in the U.S. are below the global average. Forward earnings in the EM look likely to outpace the global average, but EM trailing earnings growth seems to be losing steam. As such, we recommend investors to be neutral in the U.S. and use the funds to reduce the underweight in EM. Sector Allocation: Stay Underweight Global Utilities Overall, our sector positioning retains its tilt towards cyclicals and against defensives (see Table 1). Our global sector quant model, however, in September reduced its underweight in defensives by upgrading utilities to overweight from underweight, mainly due to the momentum factor. We have decided to overwrite the model result and maintain our underweight recommendation for the following reasons. In October, the model again downgraded utilities to underweight. In the most recent cycle post the Global Financial Crisis (GFC), the relative performance of utilities has been closely correlated with the performance of bonds vs. equities (Chart 16, top panel). This is not surprising given the bond-like nature of the sector. The sector enjoys a higher dividend yield than the global average: other than during the GFC, the excess yield has been in the range of 1-2%. In a low bond-yield environment, this yield pick-up is no doubt attractive. However, our house view is for global bond yields to rise over the next 9-12 months and we maintain our overweight on equities vs. bonds. As such, underweight utilities is in line with our overall risk/return assessment. In addition, even though the utilities sector has a higher dividend yield, the current reading is not particularly attractive compared to the five-year average (panel 4); valuation measures such as price to book (panel 3) show a neutral reading as well. The other sector where we override our quant model is Healthcare, which we favor as a long-term play because of favorable demographic trends, while the quant model points to an underweight due to short-term factors such as momentum and valuation. Smart Beta Update Year-to-date, the equal-weighted multi-factor portfolio has outperformed the global benchmark by 54 basis point (bps). (Table 1 and Chart 17) Among the five most enduring factors - size, value, quality, minimum volatility, and momentum - momentum is the only factor that has prevailed in both DM and EM universes, while quality has outperformed in the DM, but underperformed in EM. (Table 1) Chart 16Maintain Underweight Utilities Chart 17MSCI ACW: Factor Relative Performance Value has underperformed growth across the board (Table 1). The size performance, however, has large regional divergences in both value and growth spaces. Small cap has outperformed large cap consistently in both the value and growth spaces in the higher-beta euro area, Japan and U.K., while underperforming in the lower-beta U.S. (Table 2) We maintain our neutral view on styles and prefer to use sector positioning to implement the underlying factors given the historically close correlation between styles and cyclicals versus defensives (Chart 17, bottom two panels). Year-to-date cyclicals have outperformed defensives (Table 1). Table 1YTD Relative Performance* Table 2YTD Total Returns* (%) Small Cap - Large Cap Government Bonds Maintain Slight Underweight Duration. U.S. bond yields declined significantly in Q3 to below fair-value levels in response to heightened geopolitical risks and hurricanes (Chart 18, top panel). This safe-haven buying spread globally, despite ample evidence of faster global growth (middle panel) and less accommodative monetary policies from the major central banks. There is now considerable upside risk for global bond yields from these current low levels. Maintain Overweight TIPS Vs. Treasuries. The fall in nominal U.S. Treasury yields, however, was concentrated in the real yields, as 10-year break-even inflation widened in Q3 (Chart 18, panel 3). In terms of relative value, TIPS are now fairly valued vs. nominal bonds. However, our U.S. Bond Strategy's core PCE model, which closely tracks the 10-year TIPS breakeven rate (Chart 18, panel 3), is sending the message that inflationary pressures are building in the economy and that core PCE should reach the Fed's 2% target by the end of this year. This suggests that the bond markets are not providing adequate compensation for the inflationary economic backdrop. Underweight Canadian Government Bonds. The Bank of Canada (BOC) delivered another surprise 25 bps rate hike in September, due to "the impressive strength of the Canadian economy" and "the more synchronized global expansion that was supporting higher industrial commodity prices." BCA's Global Fixed Income Strategy has been underweight Canada in its hedged global portfolio and recommends investors not to fight the BOC despite little inflation pressure in the Canadian economy (Chart 19). Chart 18Poor Value in Nominal Government Bonds Chart 19Bank of Canada: Shock Hawks Corporate Bonds As inflation recovers and the Fed moves ahead with rate hikes, we expect long-term risk-free rates to rise moderately. Fair value for the 10-year U.S. Treasury yield is currently close to 2.7%. In the context of rising rates and continued economic expansion, we continue to prefer spread product over government bonds. Investment grade bonds in the U.S. trade at an average option-adjusted spread over Treasuries of 110 bps. While Aaa corporate spreads are expensive, other investment grade credit tiers appear fairly valued. Given the deterioration in our U.S. Corporate Health Monitor (Chart 20), amid a rise in leverage, over the past two years (Chart 21) we do not expect the spread to contract further or fall back close to historic lows. However, investors should still be moderately attracted by the carry in a low interest rate environment. Our preference is for U.S. investment-grade corporate bonds over European ones, since the latter could be negatively impacted when the ECB announces its tapering of asset purchases in October. High-yield bonds look attractive after a small rise in spreads and an improvement in the cyclical outlook over the past quarter. The current spread of U.S. high-yield, 360 bps, translates into a default-adjusted yield (assuming a 2.6% default rate and 49% recovery rate over the next 12 months) of 250 bps - close to the long-run average (Chart 22). European junk debt looks less attractive from a valuation perspective. Chart 20Corporate Health Is A Worry In The U.S. Chart 21IG Spreads Unlikely To Contract Further Chart 22High-Yield Debt Valuations Look Attractive Commodities Chart 23Mixed View Towards Commodities Secular perspective: Bearish We hold a bearish secular outlook for commodities, mainly due to our view on China's slowing economic growth and the increasing shift from traditional energy sources to alternatives. Cyclical perspective: Neutral Our short-term commodities view remains neutral since oil inventory drawdowns will push up the crude oil price further, and because low real interest rates will keep gold from falling this year. But industrial metals are likely to react negatively to the winding down of China's reflation after the Party Congress in mid-October. Precious metal: Short-term bullish, long-term bearish. We expect the Fed to tighten rates only slowly which, over time, will mean the central bank finds itself behind the curve on inflation. Real rates are expected to remain relatively low for the foreseeable future, which will be supportive of gold. Rising tension between North Korea and the U.S. could also give gold a lift. Industrial metals: Bearish The copper price has rallied by 10% during Q3 2017, thanks to supply-side disruptions at some of the world's largest copper mines, along with better-than-expected performance of the Chinese economy. However, mine interruptions will be transitory, and the world copper market is already back in balance (Chart 23, panel 3). Although the rebound in the Chinese PMI is keeping metal prices up, we believe China after the Party Congress will try to reengineer its economy towards being more consumption and services-led, which will temper demand for industrial metals. Energy: Bullish We believe that market has been overly pessimistic on oil, and that this will change due to declining inventories and better demand and supply dynamics. (Chart 23) The U.S. Energy Information Administration revised down its shale production forecast for 2H 2017 by 200,000 barrels/day, which should lower investors' concerns over shale overproduction. Libyan oil production, the biggest threat to our bullish oil view, faltered by 300,000/day in August, keeping OPEC in compliance with its promised cuts. Currencies U.S. Dollar: Year to date, the dollar is down by 8% on a trade-weighted basis (Chart 24). However, after a period of underperformance, the U.S. economy is improving relative to its G10 peers, as seen by the strong rebound in the U.S. ISM manufacturing index. Additionally, the pick-up in money velocity points to a recovery in core inflation. As inflation starts to pick up again, markets will discount additional Fed rate hikes. Stay bullish U.S. dollar over the next 12 months. Chart 24U.S. Dollar Recovery? Pound: After a weak start to the year, sterling has recovered all its losses. Strong net FDI inflows have pushed the basic balance back into positive territory. However, Brexit negotiations will impact the financial sector, the largest target for FDI. Additionally, the recent sharp increase in inflation came from the pass-through effect of the weaker currency, and is not reflective of domestic economic activity. We expect increased political uncertainty to weigh down on future growth, forcing the Bank of England to maintain a dovish stance. Stay bearish over the next 12 months. Dollar: On a trade-weighted basis the currency is up 4% year to date, primarily driven by the rally in select metal prices. OECD's measure of output gap still points to substantial slack in the domestic economy, as seen in the downtrend in core inflation and nominal retail sales. However, despite improvements in global trade and domestic real estate activity, the Reserve Bank of Australia will keep policy easy in response to volatile commodity markets. Stay bearish over the next 12 months. Canadian Dollar: Driven by net portfolio inflows near record highs, the currency is up 6% on a trade-weighted basis so far this year. With improving economic activity, as seen in strong retail sales, the Bank of Canada expects the output gap to close in 2018. However, going forward, oil prices are unlikely to double again, and the combination of elevated indebtedness, bubby house prices and rising rates will create headwinds for the household sector. Stay bearish over the next 12 months. Alternatives Chart 25Favor PE, Real Assets Return Enhancers: Favor private equity vs. hedge funds In 2017 so far, private equity has returned 9%, whereas hedge funds have managed only a 3.5% return (Chart 25). Given their strong performance, private equity firms are raising near-record amounts of capital from investors starved for yield. By contrast, hedge funds continue to underperform both global equities and private equity, as is typical outside of recessions or bear markets. However, increasing concerns about valuations in private markets have pushed private equity dry powder to new highs of $963 billion. We continue to favor private equity over hedge funds, albeit with a more cautious outlook. Within the hedge fund space, we favor event-driven funds over the cycle, and macro funds heading into a recession. Inflation Hedges: Favor direct real estate vs. commodity futures In 2017 to date, direct real estate has returned 3.3%, whereas commodity futures are down over 10%. With energy markets likely to continue to recover lost ground over the coming months, we stress the structural nature of our negative recommendation on commodities. Depressed interest rates will keep financing cheap, making the spread between real estate and fixed income yields attractive. However, the slowdown in commercial real estate has made us more cautious on the overall real estate space. With regards to the commodity complex, the long term transition of China to a service-based economy will continue the structural decline in commodity demand. Continue to favor direct real estate vs. commodity futures. Volatility Dampeners: Favor farmland & timberland vs. structured products In 2017 to date, farmland and timberland have returned 2.2% and 1.5% respectively, whereas structured products have returned 1.4%. Farmland continues to outperform timberland given the latter's lower correlation with growth. Timberland returns have also lagged farmland given the weak recovery in the U.S. housing market. Investors can reduce the volatility of a multi-asset portfolio with the inclusion of farmland and timberland. With regards to structured products, rising rates and deteriorating credit quality in the auto loan market will weigh on returns. Given the Fed's plans to start unwinding its balance sheet this year, increased supply will put upward pressure on spreads. Risks To Our View Our pro-risk positioning would be incorrect if global growth were to slow sharply. But we see little sign that this is a significant risk over the next six to 12 months. Of our three favorite indicators of recession risk, global PMIs remain strong, and the U.S. 10-minus-2 year yield curve is still solidly positive at around 80 BP. Only a small blip up in junk bond spreads in August (Chart 26) is of any concern, and it was probably caused just by geopolitical tensions. With U.S. and European consumption and capex looking strong, probably the biggest risk to global growth would come from China, similar to 2015, if October's Party Congress signals a shift to short-term pain to achieve structural reforms. Perhaps more likely is an upside surprise to growth, with BCA's models - based on consumer and business sentiment - pointing to around 3% real GDP growth in the U.S. and 2½% in the euro area over the coming couple of quarters (Chart 27). Such an acceleration of growth would raise the risk of upside surprises to inflation, which could cause a bigger sell off in bond markets than we currently anticipate. Chart 26Any Need To Worry About Credit Spreads? Chart 27Could Growth Surprise On The Upside? Chart 28Suppose Inflation Stays Stubbornly Low Our positioning is not based on inflation remaining chronically low. But structural changes in the economy could cause this. While the Philips curve has not broken down completely, wage growth in the U.S. is 1-1½% lower than in previous expansions when the unemployment gap was at its current level (Chart 28). Could the Nairu be lower than the Fed's estimate of 4.6%? Has the gig economy somehow changed worker and employer behavior? 1 Please see What Our Clients Are Asking: "What Will Happen After China's 19th Party Congress, And Will There Be A Slowdown In The Economy?" of this report. 2 For their most comprehensive analysis, please see Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 3 Please see Geopolitical Strategy Special Report "China: Looking Beyond The Party Congress'' dated July 19, 2017. available at gps.bcaresearch.com). 4 Perold, A and E. Schulman, 1988, "The free lunch in currency hedging: Implications for investment policy and performance standards," Financial Analyst Journal 44, 45-50. 5 Froot K., 1993, "Currency hedging over long horizons," NBER working paper 4355. 6 Michenaud, S., and B., Solnik, 2008, "Applying Regret Theory to Investment Choices: Currency Hedging Decisions," Journal of International Money and Finance 27, 677-694. 7 Campbell, J., K. de Medeiros and L. Viceira, 2010, "Global Currency Hedging," Journal of Finance LXV, 87-122. 8 Please see Global Asset Allocation Special Report, "Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors," dated September 29, 2017, available at gaa.bcaresearch.com. 9 Please see Foreign Exchange Strategy "In Search of A Timing Model," dated July 22, 2016, available at fes.bcaresearch.com. 10 Please see Global Asset Allocation, "Quarterly - December 2016," dated December 15, 2016. 11 Please see Global Asset Allocation, "Quarterly - April 2017," dated April 3, 2017. GAA Asset Allocation

Highlights Portfolio Strategy Industrials stocks are on the verge of a breakout on the back of firming earnings fundamentals. Lift to an above benchmark allocation. Reviving global end-demand is a boon to U.S. machinery equities. Act on the upgrade alert and boost the construction machinery & heavy truck sub-index to overweight. Recent Changes S&P Industrials - Upgrade to overweight. S&P Construction Machinery & Heavy Truck - Lift to overweight. Table 1Sector Performance Returns (%) Feature Equities gained ground last week, cheering the Trump administration's apparent headway in getting a tax bill passed. Chart 1 depicts this euphoria with small- and mid-caps breaking out to all-time highs and the broad based value line arithmetic index also vaulting into uncharted territory. Financials also jumped taking their cue from the bond market selloff as Janet Yellen reiterated that higher interest rates are in store, despite ("probably temporary") low inflation. Beneath the surface, synchronized global growth remains the dominant macro theme and on the eve of earnings season, profits will take center stage. Chart 2 plots the evolution of Q1, Q2 and Q3 2017 EPS growth forecasts using Thomson Reuters/IBES data, with the final datapoint representing actual EPS growth. Notably, forecasts have been coming down substantially only to surprise to the upside once the final numbers are in. Chart 1New Highs Abound Chart 2SPX OEPS Forecasts Vs Actuals Granted, this is the typical profile. EPS numbers tend to be "massaged" ahead of earnings season, but we are surprised by the 9 percentage point drop in Q3 EPS forecasts to a low y/y profit growth hurdle of 6%. A particularly destructive hurricane season likely played a role in this dramatic slide in growth forecasts. By comparison, in Q1 and Q2 the EPS growth forecast declines were 6 and 5 percentage points, respectively. And, on average the positive surprise EPS factor was 470bps (yellow highlight, Chart 2). If recent history is any guide, Q3 EPS will likely surprise to the upside once again. With regard to sector contribution to earnings growth in Q3, Chart 3 shows an extreme concentration in two sectors: energy and tech. These sectors comprise 70% of the growth in EPS for the current quarter. In fact, if one adds health care, industrials and financials, then the percent contribution jumps to 98%. Such high concentration is a risk. But, the recent hurricane-related increase in refining crack spreads and multi-month highs in crude oil signal that, at least, energy EPS will be robust. As a reminder we upgraded the S&P energy sector to overweight in early July.1 The sector revenue growth contribution picture is more diverse. Chart 4 shows the year-over-year sales growth sector contribution for Q3/2017. While energy and tech still dominate the revenue growth landscape, they add up to 44% of the total. Adding consumer staples, industrials and health care elevates this number to 86%, still high, but much less concentrated than the profit contribution figure. Bloomberg's soft versus hard economic data surprise index has historically been an excellent leading indicator of quarterly SPX EPS, and the current message is to expect a fresh all-time high (Chart 5). Chart 3Sector Contribution To Profit Growth Chart 4Sector Contribution To Revenue Growth Chart 5Soft Data Green Light Summing it all up, our sense is that the earnings-led advance in the equity market has staying power. Under such a backdrop, this week we continue to add deep cyclical exposure to our portfolio. Mighty Industrials Industrials stocks have been trading in a well-defined and narrow range since the end of the Great Recession (top panel, Chart 6). But now, conditions are ripe for a breakout in relative share prices. We recommend augmenting S&P industrials exposure to overweight. Valuations have corrected back to the neutral zone and our Technical Indicator (TI) has unwound previously overbought conditions. In fact our TI is steadily sinking, on track to hit one standard deviation below its historical mean, a level that has previously consistently coincided with playable rallies (third & fourth panels, Chart 6). On the earnings fundamental front, our newly introduced S&P industrials operating EPS model is humming (second panel, Chart 6). Rebounding commodity prices, with the aid of a softer U.S. dollar, a pickup in capital goods end-demand, and still generationally low interest rates are key profit model drivers. The industrials sector Cyclical Macro Indicator (CMI) echoes the EPS model's message. The CMI has surged recently, signaling that sell-side analysts are pessimistic on the sector's relative profit outlook (second panel, Chart 7). Chart 6EPS Model Says Buy Industrials Chart 7Domestic Demand... Forward looking indicators of industrials final demand suggest that this high operating leverage deep cyclical sector is on the cusp of flexing its muscle. Domestic capex intentions from a number of regional Fed surveys are the most upbeat in decades (second panel, Chart 8). Pent-up capex demand will likely continue to get unleashed in the coming quarters. While the Trump Administration's health care bill was unsuccessful, the odds are better that a tax bill and/or an infrastructure bill will receive warmer welcomes in Washington. Tack on bankers' willingness to extend credit, and 2018 may morph into a significant domestic capex revival year (Chart 8). The implication is that the nascent industrials profit margin expansion phase has more legs. In fact, the ISM manufacturing survey has been an excellent leading indicator of industrials margins and the current message is to expect a widening in the latter (Chart 8). On the domestic front there are even more signs that industry end-demand is on a solid footing. Non-tech industrial production and core durable goods orders are expanding at a healthy clip. Firming industrials pricing power reflects this vibrant demand backdrop. The upshot is that the path of least resistance for industrials relative profitability is higher (Chart 7). Nevertheless, this tightening demand narrative is not restricted to U.S. shores. Global capital goods demand also continues to firm. The global manufacturing PMI is at a six-year high on the back of synchronized global growth. Chinese wholesale price inflation has also recently reaccelerated likely reflecting increased end-demand (Chart 9). Emerging markets (EM) equities best capture all of this global manufacturing euphoria. Historically, EM equity performance and the relative share price ratio have been positively correlated, and the recent breakout in the former is a harbinger of fresh all-time highs in U.S. industrials relative performance (Chart 9). The greenback's sizable year-to-date depreciation will also boost U.S. industrials exporters' global market share and profits in the back half of 2017, irrespective of where the U.S. dollar drifts in the coming months. Moreover, a softening U.S. currency is commodity/industry pricing power positive, and thus a boon to revenue growth (Chart 10). Finally, over the past two decades, a falling trade-weighted U.S. dollar has been synonymous with a multiple expansion phase and vice versa. Currently, an unsustainably wide gap has opened that will likely narrow via a rerating phase (bottom panel, Chart 10). Chart 8... Capex Upcycle... Chart 9... Global Demand... Chart 10... And Greenback Point Point To A Rerating Phase Bottom Line: Boost the S&P industrials sector to an above benchmark allocation. We are executing this upgrade by lifting the construction machinery & heavy truck sub-index to overweight. Rise Of The Machines Machinery stocks have been in a V-shaped recovery for the past 18 months retracing all of their relative losses since the 2014 highs. Our machinery EPS model is firing on all cylinders, underscoring that the earnings-led recovery has more running room (Chart 11). This buoyant EPS growth backdrop gives us comfort to act on our upgrade alert and lift the S&P construction machinery & heavy truck sub-index to overweight.2 As a reminder, we have already been overweight the S&P industrial machinery index since early April3 and have participated in the machinery index advance. A fresh capex upcycle will likely fuel the next machinery stock outperformance upleg. Not only are expectations for overall capital outlays as good as they get (second panel, Chart 12), but there are also tentative signs that even the previously moribund mining and oil & gas complexes will be capex upcycle participants. While we are not calling for a return to the previous cycle's peak, even a modest renormalization of capital spending plans (i.e. maintenance capex alone would suffice) in these two key machinery client segments would rekindle industry sales growth (top panel, Chart 12). Chart 11EPS Recovery Is In The Early Innings Chart 12Levered To Capex A quick channel check also waves the green flag. Both machinery shipments and new orders are outpacing inventory accumulation (third & fourth panels, Chart 12). Moreover, backlogs are rebuilding at the quickest pace of the past five years (not shown). This suggests that client demand visibility is returning. This machinery end-demand improvement is a global phenomenon. In fact, the bottom panel of Chart 12 shows that global machinery new orders are climbing faster than domestic new order growth. Tack on the reaccelerating global credit impulse courtesy of the latest Bank for International Settlements Quarterly Review and the ingredients are in place for a global machinery export boom (third & fourth panels, Chart 13). Already anecdotally, bellwether Caterpillar's global sales-to-dealers figures suggest that the industry's relative EPS upward trajectory is sustainable (bottom panel, Chart 13). Similar to the global growth synchronization thesis, Caterpillar's regional sales breakdown confirms that all regions are expanding simultaneously led by Asia Pacific - even in the extremely volatile Latin American and laggard EMEA end-markets (Chart 14). Chart 13Global Growth Beneficiary Chart 14CAT Confirms Synchronized Global Growth Importantly, Chinese machinery demand is growing briskly. A cheapened U.S. dollar makes China imports of U.S. machinery more enticing. Beyond the currency dynamics, the dual force of Chinese fiscal spending thrust and credit impulse are also stimulating machinery final demand (Chart 15 on page 12). While Chinese excavator sales growth has likely petered out, it is still near a triple digit growth rate (Chart 15 on page 12). Komatsu's Chinese excavator sales data corroborate the official Chinese data.4 All of this impressive demand backdrop is not yet reflected in relative valuations. The relative forward P/E multiple has deflated of late and investors can initiate fresh positions at a market multiple, which is also the historical mean (Chart 16 on page 12). Chart 15Stable China Is Encouraging Chart 16Room For Valuation Expansion Bottom Line: We are acting on our upgrade alert and lifting the S&P construction machinery & heavy truck index to overweight. The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, PCAR, CMI. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "SPX 3,000?" dated July 10, 2017, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Daily Insight, "Building Up Steam", dated August 18, 2017, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Revenue Revival", dated April 10, 2017, available at uses.bcaresearch.com. 4 http://www.komatsu.com/CompanyInfo/ir/demand_orders/ Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Yesterday, we updated our long materials/short utilities pair trade, initiated on August 21, which has delivered much faster than anticipated. However, it is behind our long U.S. energy stocks/short global gold miners, initiated on the same day. That trade has yielded a return in excess of 10% in its few short weeks; surging global trade appears to be the driver of this switch from liquidity to growth. The second panel of the chart shows Korean & Taiwanese exports as a barometer of global trade; both have been expanding at brisk rates. We recently highlighted that South Korea saw its exports grow by 16% in the first seven months this year with a 31% increase in the first three weeks of September.1 The acceleration in trade points higher for the oil/gold ratio. BCA's Global Synchronicity Indicator, which has historically been closely correlated with relative share price momentum, reaffirms this message (bottom panel), and currently points to continued upward impetus. Overall, the rationale for our pair trade remains unchanged and, if anything, our conviction level is higher than when we initiated it. Thus, despite solid returns out of the gate, we recommend investors stay long S&P energy/short global gold miners. For more details, please see our August 21, 2017 U.S. Equity Strategy Weekly Report titled "Fraying Around The Edges?," available at uses.bcaresearch.com. 1 Please see U.S. Equity Strategy Insight Report titled "Accelerating Global Manufacturing Means More Machines," dated September 22, 2017, available at uses.bcaresearch.com

Dear Client, I had the pleasure of speaking at BCA's Annual New York conference on Monday, where I offered the following trade recommendations. This week's report is a summary of my remarks. Please note we will be publishing our Q4 Strategy Outlook and monthly tactical asset allocation recommendation table next Wednesday. Best regards, Peter Berezin, Chief Global Strategist Global Investment Strategy Highlights Go short the December 2018 fed funds futures contract. Go long global industrial stocks versus utilities. Go short 20-year JGBs relative to their 5-year counterparts. Feature Trade #1: Go Short The December 2018 Fed Funds Futures Contract The hurricanes are likely to dent activity in the third quarter, but leading economic indicators are pointing to faster growth starting in Q4. This can be seen in a variety of measures, including the Conference Board's LEI (Chart 1). U.S. financial conditions have eased sharply this year, thanks to a decline in government bond yields, narrower credit spreads, a weaker dollar, and rising equity prices. Changes in our FCI lead growth by about 6-to-9 months. If history is any guide, U.S. growth will rise to about 3% in the first half of 2018 (Chart 2). Growth could even temporarily rise above that level if Congress enacts significant unfunded tax cuts, as we expect it will. Chart 1U.S. Leading Economic Indicator Pointing Higher Chart 2Easier Financial Conditions Will Boost U.S. Growth Contrary to popular belief, the Phillips curve is far from dead. It has just been dormant for the better part of 30 years because the unemployment rate has hovered along the flat side of the curve. The closest the economy came to overheating was in the late 1990s, but any inflationary pressures back then were choked off by turmoil in emerging markets, a surging dollar, and collapsing commodity prices.1 If U.S. growth accelerates over the next few quarters, the unemployment rate is likely to fall to 3.5% by the end of next year - well below the Fed's end-2018 projection of 4.1%, and even below the low of 3.8% reached in 2000. At that point, the U.S. economy will find itself on the steep side of the Phillips curve (Chart 3). Chart 3U.S. Economy Has Moved Into The 'Steep' Side Of The Phillips Curve As Chart 4 illustrates, our wage survey indicator - a propriety measures that combines the results of 13 separate employer surveys - is pointing to faster wage growth. Rising wages should boost consumer spending. With the output gap all but extinguished, faster demand growth will lead to higher inflation. This is already being telegraphed by the ISM manufacturing index (Chart 5). Chart 4Survey Data Point To Higher Wage Growth Ahead Chart 5Strong ISM Signaling A Rise In Inflation If inflation accelerates, there is little reason why the Fed would not continue raising rates in line with the dots, which call for one more hike in December and three hikes in 2018. That's 100 basis points of hikes between now and the end of next year, considerably more than the 40 bps that the market is currently discounting. We went short the December 2018 fed funds futures contract three weeks ago. The trade has gained 20 basis points so far, but my discussion this morning suggests that it has plenty of juice left. Trade #2: Go Long Global Industrial Stocks Versus Utilities Economists are a bit like stock market analysts - they are generally too optimistic. As a result, they usually end up having to revise their growth estimates down over time. That has not been the case this year: Global growth estimates have been marching higher (Chart 6). Capital spending tends to accelerate in the mature phase of business-cycle expansions, as a growing number of firms realize that they have insufficient capacity to meet rising demand. We are starting to see that now. A variety of indicators - including capital goods orders and capex intention surveys - are pointing to further gains in business spending. This is captured in our model estimates, which project that global capex will grow at the fastest pace in six years (Chart 7). Chart 6Global Growth Estimates Accelerating Despite Stalled U.S. Growth Chart 7Global Capex On The Upswing A burst of capital spending should benefit global industrial stocks. Conversely, rising global yields will hurt rate-sensitive utilities (Chart 8). Industrials are no longer cheap, but relative to utilities, valuations do not seem especially stretched, implying further room for re-rating (Chart 9). Chart 8Higher Bond Yields Will Hurt Utilities Chart 9Relative Valuations Are Not Stretched Trade #3: Go Short 20-Year JGBs Relative To Their 5-Year Counterparts The deflationary mindset remains firmly entrenched in Japan. CPI swaps are pricing in inflation of only 0.5% over the next twenty years (Chart 10). Not only do investors expect the Bank of Japan to continue to miss its 2% target, they don't even think that inflation will rise from today's miserly levels. They could be in for a big surprise. Many of the structural drivers of deflation in Japan are fading. Land prices have stopped falling for the first time in 25 years, and bank balance sheets are in good shape (Chart 11). Goods prices are also rising again, thanks in part to a cheaper yen (Chart 12). Profit margins have soared, giving firms the wherewithal to pay their workers more. Chart 10Deflationary Mindset Remains Deeply Entrenched... Chart 11A...But Deflationary Pressures Are Abating Chart 11B Chart 12ACorporate Pricing Power Has Improved Chart 12B Companies have been reluctant to raise wages, but that may be starting to change. Our wage trend indicator is showing signs of life (Chart 13). As in the U.S., the Phillips curve in Japan tends to become kinked at very low levels of unemployment. Japan's unemployment rate now stands at 2.8%, almost a full percentage point below 2007 levels. As the labor market heats up, companies will have to compete more intensively for a shrinking pool of available workers. This could spark a tit-for-tat cycle where wage hikes by one company lead to hikes by others. Chart 13ATentative Signs of Wage Growth Chart 13B Chart 14Demographic Inflection Point? The government has been hoping for such a bidding war to break out. It will get its wish. The ratio of job openings-to-applicants has soared, and is now even higher than at the peak of the bubble in 1990 (Chart 14). Amazingly, Japan's labor market has tightened over the past few years despite tepid GDP growth and a steady influx of women into the labor force. However, now that female participation in Japan exceeds U.S. levels, this tailwind to labor supply will dissipate. Meanwhile, the retirement of aging Japanese baby boomers will accelerate. The largest number of births in Japan occurred between 1947 and 1949. These workers will reach 70 over the next two years, the age at which most Japanese retire. How should investors play this theme? Considering that inflation is still far from the Bank of Japan's 2% target, it is doubtful that the BoJ will abandon its yield curve targeting regime any time soon. But as inflation expectations begin to rise, ultra long-term yields - which are not subject to the BOJ's cap - will increase. This suggests that shorting 20-year JGBs relative to their 5-year counterparts will pay off in spades. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Is The Phillips Curve Dead Or Dormant?" dated September 22, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Our market neutral trade long materials/short utilities has delivered much faster than we had anticipated, returning more than 6% since the August 21st inception. Three key factors explain the exceptional performance right out of the gate: the ongoing shift from defensives toward cyclicals, increasingly supportive macro data and softness in the U.S. dollar. Our relative Cyclical Macro Indicator (top panel) is currently as skewed toward a cyclical portfolio tilt as it has been at any point in the past twelve years. The same can be said for the ISM manufacturing index, which has further accelerated since we initiated the trade (second panel). Lastly, the export-oriented materials manufacturers enjoy a twofold benefit from the year-to-date depreciation in the greenback: global market share gains and pricing power led top and bottom line growth (third panel). In contrast and in a relative sense, domestic-dependent utilities companies suffer from the U.S. dollar's softness. Our relative EPS model (bottom panel) captures these forces and indicates, despite solid gains in its first month, profits from this trade should persist. Accordingly, we recommend maintaining a long S&P materials/short S&P utilities pair trade.

Special Report

Liquidity is the lifeblood of the economy and financial markets, but it is a slippery concept that means different things to different people. Liquidity falls into four categories: monetary, balance sheet, financial market transaction liquidity, and funding liquidity. Overall liquidity conditions are reasonably constructive for risk assets at the moment. Financial market and balance sheet liquidity are adequate. Monetary policy is extremely easy, although the low level of money and credit growth underscores that the credit channel of monetary policy is still somewhat impaired. Funding liquidity is as important as monetary liquidity for financial markets. It has recovered from the Great Financial Crisis (GFC) lows, but it is far from frothy. Unwinding the Fed's balance sheet represents a risk to investors because QE played such an important role in reducing risk premia in financial markets. The unwind should not affect transactions liquidity or balance sheet liquidity. It should not affect the broad monetary aggregates either. The bond market's reaction will be far more important than balance sheet shrinkage. As long as the Fed can limit the bond market damage via forward guidance, then funding liquidity should remain adequate and risk assets should take the Fed's unwind in stride. It will be a whole different story, however, if inflation lurches higher. The technical impact of balance sheet unwind on the inner workings of the credit market is very complicated. Asset sales could lead to a shortage of short-term high-quality assets, unless it is offset with increased T-bill issuance. However, a smaller balance sheet could, in fact, improve funding liquidity to the extent that it frees up space on banks' balance sheets. Liquidity has been an integral part of BCA's approach to financial markets going back to the early days of the company under the tutelage of Editor-in-Chief Hamilton Bolton from 1949 to 1968. Bolton was ahead of his time in terms of developing monetary indicators to forecast market trends. Back then, the focus was on bank flows such as the volume of checks cashed because capital markets were still developing and most credit flowed through the banking system. Times changed, monetary policy implementation evolved and financial markets became more important and sophisticated. When money targeting became popular among central banks in the 1970s, central bank liquidity analysis focused more on the broader monetary aggregates. These and other monetary data were used extensively by Anthony Boeckh, BCA's Editor-in-Chief from the 1968 to 2002, to forecast the economy and markets. He also highlighted the importance of balance sheet liquidity (holdings of liquid assets), and its interplay with rising debt levels. Martin Barnes continued with these themes when writing about the Debt Supercycle in the monthly Bank Credit Analyst. "Liquidity" is a slippery concept, and it means different things to different people. In this Special Report, we describe BCA's approach to liquidity and highlight its critical importance for financial markets. We provide a list of indicators to watch, and also outline how the pending shrinkage of the Fed's balance sheet could affect overall liquidity conditions. A Primer On Liquidity We believe there are four types of liquidity that are all interrelated: Central Bank Liquidity: Bank reserves lie at the heart of central bank liquidity. Reserves are under the direct control of the central bank, which are used as a tool to influence general monetary conditions in the economy. The latter are endogenous to the system and also depend on the private sector's desire to borrow, spend and hold cash. Bullish liquidity conditions are typically associated with plentiful bank reserves, low interest rates and strong growth in the monetary aggregates. Balance Sheet Liquidity: A high level of balance sheet liquidity means that plenty of short-term assets are available to meet emergencies. The desire of households, companies and institutional investors to build up balance sheet liquidity would normally increase when times are bad, and decline when confidence is high. Thus, one would expect strong economic growth to be associated with declining balance sheet liquidity, and vice versa when the economy is weak. Of course, deteriorating balance sheet liquidity during good times is a negative sign to the extent that households or business are caught in an illiquid state when the economy turns down, jobs are lost and loans are called. Financial Market Transaction Liquidity: This refers to the ability to make transactions in securities without triggering major changes in prices. Financial institutions provide market liquidity to securities markets through their trading activities. Funding Liquidity: The ability to borrow to fund positions in financial markets. Financial institutions provide funding liquidity to borrowers through their lending activities. The conditions under which these intermediaries can fund their own balance sheets, in turn, depend on the willingness of banks and the shadow banking system to interact with them. The BIS definition of funding liquidity is a broad concept that captures a wide range of channels. It includes the capacity of intermediaries that participate in the securitization chain to access the necessary funding to originate loans, to acquire loans for packaging into securities, and finance various kinds of guarantees. The availability and turnover of collateral for loans is also very important for generating funding liquidity, as we discuss below. These types of liquidity are interrelated in various ways, and can positively or negatively reinforce each other. It is the interaction of these factors that determines the economy's overall ease of financing. See Box II-1 for more details. BOX II-1 How Liquidity Is Inter-Related Central bank liquidity, which is exogenously determined, is the basis for private liquidity creation (the combination of market transaction and funding liquidity). The central bank determines the short-term risk-free rate and the official liquidity that is provided to the banking system. If the central bank hikes rates or provides less official liquidity, appetite for private lending begins to dry up. Private sector liquidity is thus heavily influenced by monetary policy, but can develop a life of its own, overshooting to the upside and downside with swings in investor confidence and risk tolerance. Financial market liquidity and funding liquidity are closely interrelated. When times are good, markets are liquid and funding liquidity is ample. But when risk tolerance takes a hit, a vicious circle between market transaction and funding liquidity develops. The BIS highlights the procyclical nature of private liquidity, which means that it tends to exhibit boom-bust cycles that generate credit excesses that are followed by busts.1 The Great Financial Crisis of 2008 is a perfect example. The Fed lifted the fed funds rate by 400 basis points between 2004 and 2006. Nonetheless, the outsized contraction in private liquidity, resulting from the plunge in asset prices related to U.S. mortgage debt, was a key driver of the crash in risk asset prices. Liquidity Indicators: What To Watch (1) Monetary Liquidity Key measures of central bank liquidity include the monetary base and the broad money aggregates, such as M1 and M2 (Chart II-1). Central banks control the amount of reserves in the banking system, which is part of base money, but they do not control the broad monetary aggregates. The latter is determined by the desire to hold cash and bank deposits, as well as the demand and supply of credit. Box II-2 provides some background on the monetary transmission process and quantitative easing. BOX II-2 The Monetary Transmission Process And Qe Before the Great Recession and Financial Crisis, the monetary authorities set the level of short-term interest rates through active management of the level of bank reserves. Reserves were drained as policy tightened, and were boosted when policies eased. The level of bank reserves affected banks' lending behavior, and shifts in interest rates affected the spending and investment decisions of consumers and businesses. Of course, it has been a different story since the financial crisis. Once short-term interest rates reached the zero bound, the Fed and some other central banks adopted "quantitative easing" programs designed to depress longer-term interest rates by aggressively buying bonds and thereby stuffing the banking system with an excessive amount of reserves. Many feared the onset of inflation when QE programs were first announced because investors worried that this would contribute to a massive increase in credit and the overall money supply. Indeed, there could have been hyper-inflation if banks had gone on a lending spree. But this never happened. Banks were constrained by insufficient capital ratios, loan losses and intense regulation, while consumers and businesses had no appetite for acquiring more debt. The result was that the money multiplier - the ratio of broad money to the monetary base - collapsed (top panel in Chart II-1). Bank lending standards eventually eased and credit demand recovered. Broad money growth has been volatile since 2007 but, despite quantitative easing, it has been roughly in line with the decade before. The broad aggregates lost much of their predictive power after the 1980s. Financial innovation, such as the use of debit cards and bank machines, changed the relationship between broad money on one hand, and the economy or financial markets on the other. Despite the structural changes in the economy, investors should still keep the monetary aggregates and the other monetary indicators discussed below in their toolbox. While the year-to-year wiggles in M2, for example, have not been good predictors of growth or inflation on a one or two year horizon, Chart II-2 shows that there is a long-term relationship between money and inflation when using decade averages. Chart II-1The Monetary Aggregates Chart II-2Long-Run Relationship Between M2 And Inflation Other monetary indicators to watch: M2 Divided By Nominal GDP (Chart II-3): When money growth exceeds that of nominal GDP, it could be interpreted as a signal that there is more than enough liquidity to facilitate economic activity. The excess is then available to purchase financial assets. Monetary Conditions Index (Chart II-3): This combines the level of interest rates and the change in the exchange rate into one indicator. The MCI has increased over the past year, indicating a tightening of monetary conditions, but is still very low by historical standards. Dollar Based Liquidity (Chart II-3): This includes Fed holdings of Treasurys and U.S. government securities held in custody for foreign official accounts. Foreign Exchange Reserves (Chart II-3): Central banks hold reserves in the form of gold, or cash and bonds denominated in foreign currencies. For example, when the People's Bank of China accumulates foreign exchange as part of its management of the RMB, it buys government bonds in other countries, thereby adding to liquidity globally. Interest Rates Minus Nominal GDP Growth (Chart II-4): Nominal GDP growth can be thought of as a proxy for the return on capital. If interest rates are below the return on capital, then there is an incentive for firms to borrow and invest. The opposite is true if interest rates are above GDP growth. Currently, short-term rates are well below nominal GDP, signaling that central bank liquidity is plentiful. Chart II-3Monetary Indicators (I) Chart II-4Monetary Indicators (II) (2) Balance Sheet Liquidity Chart II-5 presents the ratio of short-term assets to total liabilities for the corporate and household sectors. It is a measure of readily-available cash or cash-like instruments that make it easier to weather economic downturns and/or credit tightening phases. The non-financial corporate sector is in very good shape from this perspective. The seizure of the commercial paper market during the GFC encouraged firms to hold more liquid assets on the balance sheet. However, the uptrend began in the early 1990s and likely reflects tax avoidance efforts. Households are also highly liquid when short-term assets are compared to income. Liquidity as a share of total discretionary financial portfolios is low, but this is not surprising given extraordinarily unattractive interest rates. The banking system is being forced to hold more liquid assets under the new Liquidity Coverage Ratio requirement (Chart II-6). This is positive from the perspective of reducing systemic risk, but it has negative implications for funding liquidity, as we will discuss below. Chart II-5Balance Sheet Liquidity Chart II-6Bank Balance Sheet Liquidity (3) Financial Market Transaction Liquidity: Transactions volumes and bid-ask spreads are the main indicators to watch to gauge financial market transaction liquidity. There was a concern shortly after the GFC that the pullback in risk-taking by important market-makers could severely undermine market liquidity, leading to lower transaction volumes and wider bid-ask spreads. The focus of concern was largely on the corporate bond market given the sharply reduced footprint of investment banks. The Fed's data on primary dealer positioning in corporates shows a massive decline from the pre-crisis peak in 2007 (Chart II-7). This represents a decline from over 10% of market cap to only 0.3%. The smaller presence of dealers could create a liquidity problem for corporate debt, especially if market-making dealers fail to adequately match sellers with buyers during market downturns. Yet, as highlighted by BCA's Global Fixed Income Strategy team, corporate bond markets have functioned well since the dark days of the Lehman crisis.2 Reduced dealer presence has not resulted in any unusual widening of typical relationships like the basis between Credit Default Swaps and corporate bond spreads. Other market participants, such as Exchange Traded Funds, have taken up the slack. Daily trading volume as a percent of market cap has returned to pre-Lehman levels in the U.S. high-yield market, although this is not quite the case for the investment-grade market (Chart II-8). Chart II-7Less Market Making Chart II-8Corporate Bond Trading Volume That said, it is somewhat worrying that average trade sizes in corporates are smaller now compared to pre-crisis levels - perhaps as much as 20% smaller according to estimates by the New York Fed. This is likely the result of the reduced risk-taking by the dealers and the growing share of direct electronic trading. Thus, it may feel like liquidity is impaired since it now takes longer to execute a large bond trade, even though transaction costs for individual trades have not been increasing. The bottom line is that financial market liquidity is not as good as in the pre-Lehman years. This is not a problem at the moment, but there could be some dislocations in the fixed-income space during the next period of severe market stress when funding liquidity dries up. (3) Funding Liquidity: There are few direct measures of funding liquidity. Instead, one can look for its "footprint" or confirming evidence, such as total private sector credit. If credit is growing strongly, it is a sign that funding liquidity is ample. Box II-3 explains why international credit flows are also important to watch for signs of froth in lending. BOX II-3 The Importance Of International Credit Flows The BIS highlights that swings in international borrowing amplify domestic credit trends. Cross border lending tends to display even larger boom-bust cycles than domestic credit, as can be seen in the major advanced economies in the lead up to the GFC, as well as some Asian countries just before the Asian crisis in the late 1990s (Chart II-9). When times are good, banks and the shadow banking system draw heavily on cross-border sources of funds, such that international credit expansion tends to grow faster during boom periods than the credit granted domestically by banks located in the country. Since G4 financial systems intermediate a major share of global credit, funding conditions within the G4 affect funding conditions globally, as BIS research shows.3 This research also demonstrates that financial cycles have become more highly correlated across economies due to increased financial integration. Booms in credit inflows from abroad are also associated with a low level of the VIX, which is another sign of ample funding liquidity conditions (Chart II-10). These periods of excessive funding almost always end with a financial crisis and a spike in the VIX. Chart II-9International Credit Is Highly Cyclical Chart II-10International Credit Booms Lead Spikes In The VIX Other measures of funding liquidity to watch include: Chart II-11Market Measures Of Funding Liquidity Libor-OIS Spread (Chart II-11): This is a measure of perceived credit risk of LIBOR-panel banks. The spread tends to widen during periods of banking sector stress. Spreads are currently low by historical standards. However, libor will be phased out by 2021, such that a replacement for this benchmark rate will have to be found by then. Bond-CDS Basis (Chart II-11): The basis is roughly the average difference between each bond's yield spread to Treasurys and the cost of insuring the bond in the CDS market. Arbitrage should keep these two spreads closely aligned, but increases in funding costs tied to balance sheet constraints during periods of market stress affect this arbitrage opportunity, allowing the two spreads to diverge. The U.S. high-yield or investment grade bond markets are a good bellweather, and at the moment they indicate relatively good funding liquidity. FX Basis Swap (Chart II-11): This is analogous to the bond-CDS basis. It reflects the cost of hedging currencies, which is critically important for international investors and lending institutions. The basis swap widens when there is financial stress, reflecting a pullback in funding liquidity related to currencies. The FX swap basis widened during the GFC and, unlike other spreads, has not returned to pre-Lehman levels (see below). Bank Leverage Ratios (Chart II-12): The ratio of loans to deposits is a measure of leverage in the banking system. Banks boost leverage during boom times and thereby provide more loans and funding liquidity to buy securities. In the U.S., this ratio has plunged since 2007 and shows no sign of turning up. Primary Dealers Securities Lending (Chart II-13): This is a direct measure of funding liquidity. Primary dealers make loans to other financial institutions with the purpose of buying securities, thereby providing both funding liquidity and market liquidity. Historically, shifts in dealer lending have been correlated with bid-ask spreads in the Treasury market. Securities lending is also correlated with the S&P 500, although it does not tend to lead the stock market. Dealer loans soared prior to 2007, before collapsing in 2008. Total loans have recovered, but have not reached pre-crisis highs, consistent with stricter regulations that forced the deleveraging of dealer balance sheets. Chart II-12U.S. Bank Leverage Chart II-13Securities Lending And Margin Debt NYSE Margin Debt (Chart II-13): Another direct measure of funding liquidity. The uptrend in recent years has been steep, although it is less impressive when expressed relative to market cap. Bank Lending Standards (Chart II-14): These surveys reflect bank lending standards for standard loans to the household or corporate sectors, but their appetite for lending for the purposes of securities purchases is no doubt highly correlated. Lending standards tightened in 2016 due to the collapse in oil prices, but they have started to ease again this year. Table II-1 provides a handy list of liquidity indicators split into our four categories. Taking all of these indicators into consideration, we would characterize liquidity conditions in the U.S. as fairly accommodative, although not nearly as abundant as the period just prior to the Lehman event. Monetary conditions are super easy, while balance sheet and financial market liquidity are reasonably constructive. In contrast, funding liquidity, while vastly improved since the GFC, is still a long way from the pre-Lehman go-go years according to several important indicators such as bank leverage. Moreover, the Fed is set to begin the process of unwinding the massive amount of monetary liquidity provided by its quantitative easing program. Chart II-14Bank Lending Standards Table II-1Liquidity Indicators To Watch Fed Balance Sheet Shrinkage: What Impact On Liquidity? Given that the era of quantitative easing has been a positive one for risk assets, it is unsurprising that investors are concerned about the looming unwind of the Fed's massive balance sheet. For example, Chart II-15 demonstrates the correlation between the change in G4 balances sheets and both the stock market and excess returns in the U.S. high-yield market. Chart II-16 presents our forecast for how quickly the Fed's balance sheet will contract. Following last week's FOMC meeting we learned that balance sheet reduction will begin October 1. For the first three months the Fed will allow a maximum of $6 billion in Treasurys and $4 billion in MBS to run off each month. Those caps will increase in steps of $6 billion and $4 billion, respectively, every three months until they level off at $30 billion per month for Treasurys and $20 billion per month for MBS. Chart II-15G4 Central Bank Balance Sheets Chart II-16Fed Balance Sheet We have received no official guidance on the level of bank reserves the Fed will target for the end of the run-off process. However, New York Fed President William Dudley recently recommended that this level should be higher than during the pre-QE period, and should probably fall in the $400 billion to $1 trillion range.4 In our forecasts we assume that bank reserves will level-off once they reach $650 billion. In that scenario the Fed's balance sheet will shrink by roughly $1.4 trillion by 2021. The level of excess reserves in the banking system will decline by a somewhat larger amount ($1.75 trillion). In terms of the impact of balance sheet shrinkage on overall liquidity conditions, it is useful to think about the four categories of liquidity described above. (1) Monetary Liquidity The re-absorption of excess reserves will mean that base money will contract (i.e. the sum of bank reserves held at the Fed and currency in circulation). However, we do not expect this to have a noticeable impact on the broader monetary aggregates, credit growth, the economy or inflation, outside of any effect it might have on the term premium in the bond market. The reasoning is that all those excess reserves did not have a major impact on growth and inflation when they were created in the first place. This was because the credit channel of monetary policy was blocked by a lack of demand (private sector deleveraging) and limited bank lending capacity (partly due to regulation). Banks were also less inclined to lend due to rising loan losses. Removing the excess reserves should have little effect on banks' willingness or ability to make new loans. In terms of asset prices, some investors believe that when the excess reserves were created, a portion of it found its way out of the banking system and was used to buy assets directly. That is not the case. The excess reserves were left idle, sitting on deposit at the Fed. They did not "leak" out and were not used to purchase assets. Thus, fewer excess bank reserves do not imply any forced selling. Nonetheless, the QE program certainly affected asset prices indirectly via the portfolio balance effect. Asset purchases supported both the economy and risk assets in part via a weaker dollar and to the extent that the policy lifted confidence in the system. But most importantly, QE depressed long-term interest rates, which are used to discount cash flows when valuing financial assets. QE boosted risk-seeking behavior and the search for yield, partly through the signaling mechanism that convinced investors that short-term rates would stay depressed for a long time. The result was a decline in measures of market implied volatility, such as the MOVE and VIX indexes. Could Bond Yields Spike? The risk is that the portfolio balance effect goes into reverse as the Fed unwinds the asset purchases. The negative impact on risk assets will depend importantly on the bond market's response. As highlighted in the Overview section, there will be a sharp swing in the flow of G4 government bonds available to the private sector, from a contraction of US$600 billion in 2017 to an increase of US$200 billion in 2018. Focusing on the U.S. market, empirical estimates suggest that the Fed's shedding of Treasurys could boost the 10-year yield by about 80 basis points because the private sector will require a higher term premium to absorb the higher flow of bonds. However, the impact on yields is likely to be tempered by two factors: Banks are required by regulators to hold more high-quality assets than they did in the pre-Lehman years in order to meet the new Liquidity Coverage Ratio. The BCA U.S. Bond Strategy service argues that growing bank demand for Treasurys in the coming years will absorb much of the net flow of Treasurys that the Fed is no longer buying.5 As the FOMC dials back monetary stimulus it will be concerned with overall monetary conditions, including short-term rates, long-term rates and the dollar. If long-term rates and/or the dollar rise too quickly, policymakers will moderate the pace of rate hikes and use forward guidance to talk down the long end of the curve so as to avoid allowing financial conditions to tighten too quickly. Thus, the path of short-term rates is dependent on the dollar and the reaction of the long end of the curve. It is difficult to estimate how it will shake out, but the point is that forward guidance will help to limit the impact of the shrinking Fed balance sheet on bond yields. Indeed, the Fed is trying hard to sever the link in investors' minds between balance sheet policy and signaling about future rate hikes, as highlighted by Chair Yellen's Q&A session following the September FOMC meeting. The bottom line is that the impact on monetary liquidity of a smaller Fed balance sheet should be minimal, although long-term bond yields will be marginally higher as a result. That said, much depends on inflation. If the core PCE inflation rate were to suddenly shift up to the 2% target or above, then bond prices will be hit hard, the VIX will surge and risk assets will sustain some damage. The prospect of a more aggressive pace of monetary tightening would undermine funding liquidity, compounding the negative impact on risk assets. (2) Funding Liquidity Chart II-17Tri-Party Repo Market Has Shrunk By unwinding its balance sheet, the Fed will be supplying securities into the market and removing cash. This will be occurring at a time when transactions in the tri-party repo market have fallen to less than half of their peak in 2007 due to stricter regulation (Chart II-17). This market has historically been an important source of short-term funding, helping to meet the secular rise in demand for short-term, low-risk instruments, largely from non-financial corporations, asset managers and foreign exchange reserve funds. If the Fed drains reserves from the system and T-bill issuance does not increase substantially to compensate, a supply shortage of short-maturity instruments could develop. We can see how this might undermine the Fed's ability to shift short-term interest rates higher under its new system of interest rate management, where reverse repos and the interest rate paid on reserves set the floor for other short-term interest rates. However, at the moment we do not see the risk that fewer excess reserves on its own will negatively affect funding liquidity. Again, any impact on funding liquidity would likely be felt via a sharp rise in interest rates and pullback in the portfolio balance effect, which would occur if inflation turns up. But this has more to do with rising interest rates than the size of the Fed's balance sheet. Indeed, balance sheet shrinkage could actually improve funding liquidity provided via the bilateral repo market, securities-lending, derivatives and prime brokerage channels. These are important players in the collateral supply chain. A recent IMF working paper emphasizes that collateral flows are just as important in credit creation as money itself.6 Collateral refers to financial instruments that are used as collateral to fund positions, which can be cash or cash-like equivalents. Since pledged collateral can be reused over and over, it can generate significantly more total lending than the value of the collateral itself. The Fed's overnight reverse-repo facility includes restrictions that the collateral accessed from its balance sheet can only be used in the tri-party repo system. Thus, the Fed's presence in the collateral market has reduced the "velocity of collateral." Table II-2 shows that the reuse rate of collateral, or its velocity, has fallen from 3.0 in 2007 to 1.8 in 2015. Table II-2Collateral Velocity The combination of tighter capital regulations and Fed asset purchases has severely limited the available space on bank balance sheets to provide funding liquidity. Regulations force banks to carry more capital for a given level of assets. Fed asset purchases have forced a large portion of those assets to be held as reserves, limiting banks' activity in the bilateral repo market. There is much uncertainty surrounding this issue, but it appears that an unwind the Fed's balance sheet will free up some space on bank balance sheets, possibly permitting more bilateral repo activity and thus a higher rate of collateral velocity. It may also relieve concerns about a shortage of safe-haven assets. Nonetheless, we probably will not see a return of collateral velocity to 2007 levels because stricter capital regulations will still be in place. What About Currency Swaps? Some have argued that this removal of cash could also lead to an appreciation of the U.S. dollar. In particular, Zoltan Pozsar of Credit Suisse has observed a correlation between U.S. bank reserves and FX basis swap spreads.7 There is also a strong correlation between FX swap spreads and the U.S. dollar (Chart II-18). Chart II-18FX Basis Swap And Reserves One possible chain of events is that, as the Fed drains cash from the market, there will be less liquidity in the FX swap market. Basis swap spreads will widen as a result, and this will cause the dollar to appreciate. In this framework, the unwinding of the Fed's balance sheet will put upward pressure on the U.S. dollar. However, it is also possible that the chain of causation runs in the other direction. The BIS has proposed a model8 where a stronger dollar weakens the capital positions of bank balance sheets. This causes them to back away from providing liquidity to the FX swap market, leading to wider basis swap spreads. In this model, a strong dollar leads to wider basis swap spreads and not the reverse. If this is the correct direction of causation, then we should not expect any impact on the dollar from the unwinding of the Fed's balance sheet. At the moment it is impossible to tell which of the above two theories is correct. All we can do is monitor the correlation between reserves, FX basis swap spreads and the dollar going forward. Conclusions: Overall liquidity conditions are reasonably constructive for risk assets at the moment. Financial market and balance sheet liquidity are adequate. Monetary policy is extremely easy, although the low level of money and credit growth underscores that the credit channel of monetary policy is still somewhat impaired and/or constrained relative to the pre-Lehman years. Funding liquidity has recovered from the Great Financial Crisis lows, but it is far from frothy. More intense regulation means that funding liquidity will probably never again be as favorable for risk assets as it was before the crisis. But, hopefully, efforts by the authorities to reduce perceived systemic risk mean that funding liquidity may not be as quick to dry up as was the case in 2008, in the event of another negative shock. Unwinding the Fed's balance sheet represents a risk to investors because QE played such an important role in reducing risk premia in financial markets. However, we believe that the bond market's reaction will be far more important than balance sheet shrinkage. As long as the Fed can limit the bond market damage via forward guidance, then risk assets should take the Fed's unwind in stride. It will be a whole different story, however, if inflation lurches higher. The technical impact of balance sheet unwind on the inner workings of the credit market is very complicated and difficult to forecast. Asset sales could lead to a shortage of short-term high-quality assets. However, this is more a problem in terms of the Fed's ability to raise interest rates than for funding liquidity. A smaller balance sheet could, in fact, improve funding liquidity to the extent that it frees up space on banks' balance sheets. Mark McClellan Senior Vice President The Bank Credit Analyst Ryan Swift Vice President U.S. Bond Strategy 1 D. Domanski, I. Fender and P. McGuire, "Assessing Global Liquidity," BIS Quarterly Review (December 2011). 2 Please see BCA Global Fixed Income Strategy Weekly Report, "Global Interest Rate Strategy For The Remainder Of 2017," dated July 18, 2017, available at gfis.bcaresearch.com 3 E. Cerutti, S. Claessens and L. Ratnovski, "A Primer on 'Global Liquidity'," CEPR Policy Portal (June 8, 2014). 4 William C. Dudley, "The U.S. Economic Outlook and the Implications for Monetary Policy," Federal Reserve Bank of New York (September 07, 2017). 5 Please see BCA U.S. Bond Strategy Weekly Report, "The Great Unwind," dated September 19, 2017, available at usbs.bcaresearch.com 6 M. Singh, "Collateral Reuse and Balance Sheet Space," IMF Working Paper (May 2017). 7 Alexandra Scaggs, "Where would you prefer your balance sheet: Banks, or the Federal Reserve?" Financial Times Alphaville (April 13, 2017). 8 S. Avdjiev, W. Du, C. Koch, and Hyun S.Shin, "The dollar, bank leverage and the deviation from covered interest parity," BIS Working Papers No.592 (Revised July 2017).