Fixed Income

Highlights Chart 12017 Bond Returns Treasuries sold off for the third consecutive month in November (Chart 1), and with Congress about to deliver tax cuts and core inflation showing signs of bottoming, the bond bear market is poised to shift into a higher gear. At the moment, the biggest upside risk for bonds is that the Fed continues its hawkish posturing but inflation refuses to comply. That combination would put downward pressure on TIPS breakeven inflation rates and cause the yield curve to flatten further. A flat yield curve increases the odds of a risk-off episode in equities and credit spreads, with a consequent flight into the safety of Treasuries. We do not think the Fed will get it wrong and expect TIPS breakevens to widen alongside rising inflation, easing the flattening pressure on the yield curve. Investors should maintain a below-benchmark duration stance and an overweight allocation to spread product on a 6-12 month investment horizon.   Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 3 basis points in November, dragging year-to-date excess returns down to 285 bps. The average index option-adjusted spread widened 2 bps on the month and now sits at 97 bps. Spreads gapped wider early in the month but then reversed course, ending November not far from where they began. In other words, investment grade corporate bonds remain extremely expensive. We calculate that Baa-rated spreads can only tighten another 39 bps before reaching the most expensive levels since 1989. This represents 3 months of historical average spread tightening. Corporate bonds are essentially a carry trade at this stage of the cycle, but should continue to deliver positive excess returns to Treasuries until inflation pressures mount and the credit cycle comes to an end. We expect the credit cycle will end sometime in 2018.1 Last week's profit data showed that our measure of EBITD increased at an annualized rate of 4% in Q3 (Chart 2), solidly above zero but significantly slower than the 12% registered in Q2. If corporate debt grows by more than 4% in the third quarter, our measure of gross leverage will tick higher (panel 4). As we have shown in prior reports, this would bring the end of the credit cycle closer.2 Quarterly corporate debt growth has averaged just under 6% (annualized) since 2012, so higher leverage in Q3 is likely (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 underperformed the duration-equivalent Treasury index by 2 basis points in November, dragging year-to-date excess returns down to 578 bps. The index option-adjusted spread widened 6 bps on the month, and currently sits at 349 bps. Excess returns were negative in November for only the fourth month since spreads peaked in February 2016. In a recent Special Report we argued that last month's sell-off would prove fleeting, but also cautioned that excess returns are likely to be low between now and the end of the credit cycle.3 The report flagged five reasons why investors might be nervous about their high-yield allocations. The two most important being that spreads are very tight and the yield curve is very flat. Tight spreads imply that investors should not expect much in the way of further capital gains, insofar as much further spread tightening would lead to historically expensive valuations. In a baseline scenario where spreads remain flat, we forecast excess returns to junk of 246 bps (annualized) (Chart 3). An inverted yield curve signals that investors believe the Fed will be forced to cut rates in the future. This makes it an excellent indicator for the end of the credit cycle. When the yield curve is very flat investors are more inclined to view any negative development as a signal that the cycle is about to turn. This leads to more frequent sell-offs. A period of curve steepening led by higher inflation would mitigate the risk. MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 4 basis points in November, bringing year-to-date excess returns up to 35 bps. The conventional 30-year zero-volatility MBS spread was flat on the month, as a 2 bps widening in the option-adjusted spread (OAS) was offset by a 2 bps decline in the compensation for prepayment risk (option cost). Agency MBS OAS continue to look reasonably attractive, especially relative to Aaa-rated credit. And with the pace of run-off from the Fed's balance sheet already well telegraphed, there is no obvious catalyst for further OAS widening. In addition, mortgage refinancings are unlikely to spike any time soon. This will ensure that nominal MBS spreads remain capped at a low level (Chart 4). If bond yields rise during the next 6-12 months, as we expect, then higher mortgage rates will be a drag on refinancings. However, as we showed in a recent report, even if rates move lower, the coupon and age distribution of outstanding mortgages has made refi activity much less sensitive to rates than in the past.4 All in all, with OAS more attractive than they have been for several years, Agency MBS are an alluring alternative for investors looking to scale back exposure to corporate bonds. We anticipate shifting some of our recommended spread product allocation out of corporate bonds and into MBS once we are closer to the end of the credit cycle, likely sometime in 2018. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 28 basis points in November, bringing year-to-date excess returns up to 221 bps. Foreign Agencies and Local Authorities outperformed the Treasury benchmark by 39 bps and 34 bps, respectively. Meanwhile, Sovereign bonds delivered a stellar 93 bps of outperformance. Domestic Agency bonds outperformed by 4 bps, while Supranationals underperformed by 1 bp. We continue to hold a negative view of USD-denominated Sovereign debt. Not only is valuation unattractive compared to similarly-rated U.S. corporate bonds (Chart 5), but historically, periods of sovereign bond outperformance have coincided with falling U.S. rate hike expectations.5 Our Global Fixed Income Strategy team flagged similar concerns in a recent Special Report on the merits of USD-denominated EM debt (both corporate and sovereign).6 The recent moderation in Chinese money and credit growth also heightens the risk of near-term Sovereign underperformance.7 We remain overweight Local Authorities and Foreign Agencies. Year-to-date, those sectors have delivered 256 bps and 402 bps of excess return, respectively, and continue to offer attractive spreads after adjusting for credit rating, duration and spread volatility. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 19 basis points in November (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio moved sharply higher in November, with short maturities bearing the brunt of the sell-off. But even after November's weakness, the average M/T yield ratio remains below its average post-crisis level, and long maturities continue to offer a significant yield advantage over short maturities. Both the Senate and House have already passed their own versions of a tax bill, which now just need to be reconciled before new tax legislation is signed into law. Judging from the two versions of the bill, the following will likely occur: The Muni tax exemption will be maintained, the top marginal tax rate will remain close to its current level, the corporate tax rate will be reduced substantially, the state & local income tax deduction will be at least partially eliminated, the tax exemption for private activity bonds might be removed, and advance refunding of municipal bonds will be outlawed or severely restricted. Last month's poor Muni performance was driven by a surge in supply (Chart 6), almost certainly issuers trying to get their advance refundings done before the passage of the final bill. Given that the other provisions in the bill should not have a major impact on yield ratios (any negative impact from lower corporate tax rates should be mitigated by stronger household demand stemming from the removal of the state & local tax deduction), this back-up in yield ratios could present a tactical buying opportunity in Munis once the bill is passed. Stay tuned.   Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bear-flattened in November, as investors significantly bid up the expected pace of Fed rate hikes but did not correspondingly increase their long-dated inflation expectations. The sharp upward adjustment in rate hike expectations means that investors are now positioned for 69 bps of rate hikes during the next 12 months (Chart 7). Similarly, the July 2018 fed funds futures contract is now priced for 52 bps of rate hikes between now and next July. Even if the Fed lifts rates in line with its dots, we would only see 75 bps of rate hikes between now and next July. Since there are strong odds that the Fed will proceed more gradually, this week we close our short July 2018 fed funds futures position for an un-levered profit of 21 bps. In a Special Report published last week, we presented several scenarios for the slope of the 2/10 yield curve based on different combinations of Fed rate hikes and future rate hike expectations.8 We also noted that the positive correlation between long-maturity TIPS breakeven inflation rates and the slope of the nominal 2/10 yield curve has remained intact this cycle. We conclude that the 2/10 slope will steepen modestly in the first half of 2018, before transitioning to flattening once TIPS breakevens level-off at a higher level. With the 2/5/10 butterfly spread now discounting some mild curve flattening (panel 4), investors should remain long the 5-year bullet versus the duration-matched 2/10 barbell.   TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 15 basis points in November, bringing year-to-date excess returns up to -84 bps. The 10-year TIPS breakeven inflation rate fell 2 bps on the month and, at 1.86%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. As was detailed in last week's Special Report, one of our key views for 2018 is that core inflation will resume its gradual cyclical uptrend, causing long-maturity TIPS breakeven inflation rates to return to their pre-crisis trading range between 2.4% and 2.5%.9 A wide range of indicators, such as our own Pipeline Inflation Indicator and the New York Fed's Underlying Inflation Gauge, already suggest that TIPS breakevens are biased wider (Chart 8). Even more encouragingly, both year-over-year core CPI and core PCE inflation have printed higher in each of the last two months. But even if inflation remains stubbornly low, we think any downside in long-maturity breakevens will prove fleeting. We are quickly approaching an inflection point where if inflation does not rise, the Fed will have to adopt a more dovish policy stance. A sufficiently dovish policy response would limit any downside in breakevens. According to our model, the 10-year TIPS breakeven inflation rate is currently trading in-line with other financial market variables - oil, the trade-weighted dollar and the stock-to-bond total return ratio (panel 2). ABS: Neutral Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 11 basis points in November, bringing year-to-date excess returns up to 92 bps. Aaa-rated ABS outperformed the Treasury benchmark by 10 bps and non-Aaa ABS outperformed by 30 bps. The index option-adjusted spread (OAS) for Aaa-rated ABS tightened 3 bps on the month and, at 31 bps, it remains well below its average pre-crisis trading range. The value proposition in Aaa-rated ABS is not what it once was. At 31 bps, the average index OAS is only 1 bp greater than the average OAS for a conventional 30-year Agency MBS. Agency CMBS are even more attractive, offering an index OAS of 44 bps. Further, the credit cycle is slowly turning against consumer debt. Delinquency rates are rising, albeit off a very low base, but this has caused banks to start tightening lending standards on consumer credit (Chart 9). Tight bank lending standards typically coincide with wider spreads. Importantly, while lending standards are tightening they are not yet very restrictive in absolute terms. In response to a special question from the July 2017 Fed Senior Loan Officer's Survey, banks reported (on net) that lending standards are tighter than the midpoint since 2005 for subprime auto and credit card loans, but are still easier than the midpoint since 2005 for credit card and auto loans to prime borrowers. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 1 basis point in November, dragging year-to-date excess returns down to 180 bps. The index option-adjusted spread (OAS) for non-agency Aaa-rated CMBS widened 3 bps in November, but is still about one standard deviation below its pre-crisis average (Chart 10). With spreads at such low levels in an environment of tightening commercial real estate (CRE) lending standards and falling CRE loan demand, we continue to view the risk/reward trade-off in non-Agency CMBS as quite unfavorable. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 15 basis points in November, bringing year-to-date excess returns up to 112 bps. The index OAS for Agency CMBS tightened 2 bps on the month but, at 44 bps, the sector continues to offer an attractive spread pick-up relative to other low-risk spread product. The Aaa-rated consumer ABS OAS is only 31 bps, and the OAS on conventional 30-year Agency MBS is a mere 30 bps. Such an attractive spread pick-up in a sector that benefits from Agency backing is surely worth grabbing. Treasury Valuation Chart 11Treasury Fair Value Models The current reading from our 2-factor Treasury model (based on Global PMI and dollar sentiment) pegs fair value for the 10-year Treasury yield at 2.81% (Chart 11). Our 3-factor version of the model (not shown), which also incorporates the Global Economic Policy Uncertainty Index, places fair value at 2.79%. The Global Manufacturing PMI edged higher once more in November, up to 54 from 53.5 in October. It is now at its highest level since March 2011. Meanwhile, sentiment toward the dollar remains significantly less bullish than it was in 2015 and 2016 (bottom panel). A higher PMI reading and less bullish dollar sentiment both lead to a higher fair value in our model. At the country level, both the Eurozone and Japanese PMIs ticked higher in November. The Eurozone PMI broke above 60 for the first time since April 2000. The U.S. and Chinese PMIs both moved modestly lower. For further details on our Treasury models please refer to 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 2.39%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report, "2018 Key Views: Implications For U.S. Fixed Income", dated November 28, 2017, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Won't Back Down", dated September 26, 2017, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, "Junk Bond Jitters", dated November 21, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching: Yet Another Update", dated October 10, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Living With The Carry Trade", dated October 17, 2017, available at usbs.bcaresearch.com 6 Please see Global Fixed Income Strategy Special Report, "Examining The Role Of EM Hard Currency Debt In Global Bond Portfolios", dated October 31, 2017, available at gfis.bcaresearch.com 7 Please see China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of China's Business Cycle", dated November 30, 2017, available at cis.bcaresearch.com 8 Please see U.S. Bond Strategy Special Report, "2018 Key Views: Implications For U.S. Fixed Income", dated November 28, 2017, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Special Report, "2018 Key Views: Implications For U.S. Fixed Income", dated November 28, 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)

Highlights A more bearish backdrop for bonds, led by the U.S.: Faster global growth, with rebounding inflation expectations, will trigger tighter overall global monetary policy. This will be led by Fed rate hikes and, later in 2018, ECB tapering. Global bond yields will rise in response, primarily due to higher inflation expectations. Growth & policy divergences will create cross-market bond investment opportunities: Global growth in 2018 will become less synchronized compared to 2016 & 2017, as will individual country monetary policies. Government bonds in the U.S. and Canada, where rate hikes will happen, will underperform, while bonds in the U.K. and Australia, where rates will likely be held steady, will outperform. The most dovish central banks will be forced to turn less dovish: The ECB and BoJ will both slow the pace of their asset purchases in 2018, in response to strong domestic economies and rising inflation. This will lead to bear-steepening of yield curves in Europe, mostly in the latter half of 2018. The BoJ could raise its target on JGB yields, but only modestly, in response to an overall higher level of global bond yields. The low market volatility backdrop will end through higher bond volatility: Incremental tightening by central banks, in response to faster inflation, will raise the volatility of global interest rates. This will eventually weigh on global growth expectations over the course of 2018, and create a more volatile backdrop for risk assets in the latter half of the year. Feature BCA's annual Outlook report, outlining the main investment themes that will drive global asset markets in 2018, was sent to all clients in late November.1 In this Weekly Report, we drill down into the specific implications of those themes for global bond markets over the next year. In a follow-up report to be published in two weeks, we will discuss how to piece together those implications into an effective fixed income portfolio for 2018. A More Bearish Backdrop For Bonds, Led First By The U.S., Then By Europe The first major takeaway for bond investors from the BCA Outlook is that the current bullish global backdrop of easy monetary policy, solid growth and low inflation is going to change in the coming year. A robust global economy with broadening inflation pressures will force the major central banks to continue incrementally moving away from extraordinarily accommodative monetary policy settings. This will set up an eventual collision between policy and the markets, the latter of which have benefitted so much from the support of the former during the current bull run for risk assets. The changing monetary backdrop will essentially split 2018 into two halves. The current pro-risk backdrop will be maintained in the first half of the year, with continued above-potential global growth and higher realized inflation in the major developed economies at a time when monetary policy is still too accommodative (Chart 1). This will put upward pressure on global bond yields. There is potential for a significant move higher, as real yields now are too low relative to robust global growth and market-based inflation expectations remain well below central bank inflation targets (Chart 2). Chart 1Central Banks Are##BR##Lagging The Cycle Chart 2Both Global Real Yields AND Inflation##BR##Expectations Are Too Low The trend of rising bond yields will be most acute in the U.S., at least in the first half of 2018. The economy is already operating above potential (Chart 3), and this is before factoring in any impact from the tax cut plan currently being finalized in the U.S. Congress. This fiscal stimulus risks overheating the U.S. economy and will likely encourage the Fed to hike interest rates in 2018 by at least as much as it is currently projecting (75bps after the almost certain rate hike later this month). A faster growth trajectory, combined with a rebound in realized inflation after the 2017 slump, will restore investors' belief that U.S. inflation can move back to the Fed's 2% target. The latter can boost the inflation expectations component of the benchmark 10-year U.S. Treasury yield by as much as 60bps next year. The Fed will feel more emboldened to continue delivering rate hikes if inflation expectations are closer to the central bank's target, thus providing an additional boost to Treasury yields. We project that the 10-year Treasury yield can rise up into the 2.9-3% range, well above the current market forwards. The pressure on global bond yields will not only come from the U.S., according to the BCA Outlook. The booming European economy, freed from the years of fiscal austerity after the Euro Debt Crisis and supported by hyper-easy monetary policy from the European Central Bank (ECB), will continue to grow at an above-trend pace in 2018. Japan is enjoying a very powerful cyclical move (by its own modest post-bubble standards) that should continue given very easy monetary policy, robust profit growth and a historically tight labor market. While China is expected to slow on the back of tighter monetary policy and less fiscal stimulus, growth is still expected to be above 6% in 2018. For all of these economies, inflation is expected to rise alongside growth (to varying degrees) given tight labor markets and diminished levels of global spare capacity. Higher oil prices will also boost global inflation and raise the inflation expectations component of global bond yields, given BCA's above-consensus view on oil prices in 2018 (Chart 4). This will also put bear-steepening pressure on many developed market government bond yield curves as inflation expectations increase, particularly with so many countries operating without much economic slack. This argues for being long inflation protection (i.e. inflation-linked bonds vs. nominals or CPI swaps) in 2018, particularly in the U.S., Euro Area and Japan where inflation expectations are well below central bank targets. Chart 3The Global Output Gap Is Closed Chart 4Rising Oil Will Boost Inflation Expectations The BCA Outlook noted that government bond valuations are poor in most countries, with inflation-adjusted (real) yields well below long-run historical averages (Chart 5). We see higher inflation expectations translating directly into higher global bond yields next year, with little room for real yields to decline as an offset. Chart 5Valuation Ranking Of Developed Bond Markets The latter half of 2018 will see increased worries about future U.S. growth after the Fed has delivered a few more rate hikes and U.S. monetary policy potentially shifts into restrictive territory. At the same time, the strength in global growth and, especially, inflation will cast doubts on the need for continued aggressive bond buying by the ECB and the Bank of Japan (BoJ). Unlike last year, the ECB will be unable to wiggle its way out of the politically difficult decision to begin tapering its asset purchases when the latest program ends in September. Even the BoJ may be forced to alter its current "yield curve control" strategy by raising the target on longer-term JGB yields in response to pressures from better domestic growth and rising global bond yields. Thus, the pressures for higher bond yields will rotate away from the U.S. in the latter half of 2018 towards Europe and possibly Japan. Other developed economy central banks, like the Bank of England (BoE), the Bank of Canada (BoC), the Reserve Bank of Australia (RBA) and the Swedish Riksbank will also be faced with decisions on dialing back monetary accommodation in 2018. Although we anticipate that only the BoC and the Riksbank could credibly deliver on monetary tightening given robust growth and, in the case of Sweden, rapidly rising inflation. Which leads to the second major takeaway from the BCA 2018 Outlook ..... Growth & Policy Divergences Will Create Cross-Market Bond Investment Opportunities The BCA Outlook noted that growth expectations for 2018 still look too cautious in many countries. For example, the IMF is forecasting growth in the developed economies will slow from 2.2% to 2% next year, led by decelerations in the Euro Area, Japan, the U.K., Canada and Sweden (Table 1). At the same time, growth in the emerging economies is optimistically projected to accelerate to a 4.9% pace in 2018, even as China's economy cools to 6.5%. Inflation is expected to modestly increase across most of the world, but remain below central bank targets in many countries. So upside growth surprises, particularly in the U.S. and Europe, will continue to be a major investment theme in 2018. Table 1IMF Global Growth & Inflation Forecasts For 2018 Are Too Pessimistic The growth trends, however, may be more divergent than seen in 2017. This leads to potential cross-market bond trading opportunities by playing relative central bank expectations. The OECD's leading economic indicators are accelerating in the U.S., Europe and Japan; potentially peaking at a very high level in Canada; and outright slowing in the U.K. and Australia (Chart 6). When looking at our central bank discounters, which measure the amount of interest rate changes that are currently priced into money market curves, there are some notable discrepancies with the leading indicators (Chart 7). Chart 6More Divergent##BR##Growth... Chart 7...Will Lead To More Divergent##BR##Monetary Policies The market is now pricing in multiple rate hikes in 2018 from the Fed and BoC, modest increases from the BoE and RBA, and no move from the ECB and BoJ. Given the trends in the leading indicators, rate hikes from the Fed and the BoC are likely, while the BoE and RBA will be hard pressed to raise rates at all next year. Thus, U.S. Treasuries and Canadian government bonds are likely to underperform in 2018, while U.K. Gilts and Australian government bonds can be relative outperformers against a backdrop of rising global bond yields. The outlook for the ECB and BoJ, and the implications for bond yields in Europe and Japan, are a special case that represents the third major takeaway from the BCA Outlook ... The Most Dovish Central Banks Will Be Forced To Turn Less Dovish Chart 8ECB Will Fully Taper By The End Of 2018 The BCA Outlook noted that growth in both the Euro Area and Japan has done very well versus the U.S. over the past four years, essentially matching U.S. growth on a per capital basis (i.e. adjusting for faster population growth in the U.S.). In the Euro Area, an end to the painful fiscal austerity after the 2011-13 sovereign debt crisis was a big driver of the economic strength. The BCA Outlook noted that the drag from tighter fiscal policy during the crisis years was equivalent to around 10% of GDP in Greece and Portugal and 7% of GDP in Ireland and Spain. There has been little fiscal tightening in the following three years, which allowed growth in those economies to catch up rapidly. Add in extremely easy financial conditions - low borrowing rates, a cheap euro, and booming European equity and credit markets - and it is no surprise that the Euro Area economy has enjoyed robust growth over the past couple of years. Looking ahead to 2018, the outlook for Euro Area growth still looks very positive. The OECD leading indicator is rising steadily (Chart 8, top panel). The stock of non-performing loans that has clogged up banking systems in the Peripheral European economies is being whittled down - even in Italy where efforts to fix the many problems of its banks are starting to bear fruit (second panel). At the same time, there will be continued upward pressure on Euro Area inflation in 2018. This will mostly come from higher headline inflation related to higher oil prices (third panel), but also from a grind higher in core inflation and wage growth with the Euro Area unemployment rate already at the OECD's estimate of full employment (bottom panel). The Euro Area economy is likely to expand at an above-potential pace over 2% in the first half of 2018, while headline inflation is set to accelerate back towards the ECB's 2% target. This means that the ECB will have to go through another long conversation with the markets about the future of the asset purchase program. Only the outcome will be different than in 2017 as the economic and inflation arguments for continuing with ECB bond buying will be much harder to justify - especially to the hard money core of the ECB led by Germany. Already, the reduced pace of ECB bond buying set for next year, with the monthly purchases cut in half to €30bn/month, implies a significant slowing of Euro Area monetary liquidity (Chart 9). This will put upward pressure on German Bund yields, but with the move being more concentrated in the latter half of the year as the talk of a true ECB taper, perhaps as soon as the end of 2018, builds. Thus, we see Euro Area government debt being an outperformer in the first half of 2018 and an underperformer in the second half. A move in the benchmark 10-year German Bund yield to the 0.8-1.0% range by year-end is a reasonable target. This would reflect the rise in global bond yields that we expect (i.e. the 10-year U.S. Treasury pushing close to 3%), more normalization in Euro Area inflation expectations and the market pulling forward the timing of future ECB rate hikes. Our base case is still that the ECB will not hike policy interest rates until late 2019, however, which will limit the upside for Euro Area yields next year to some degree. In Japan, the BoJ will continue with its current yield curve targeting regime, aiming to cap 10-year JGBs yields through its bond purchases. This is the most effective way to try and boost Japanese inflation through a weaker yen (Chart 10). The BoJ hopes that this will then lead to rising wage growth as workers demand more pay in response to higher realized inflation. Only if there is a pickup in core/wage inflation in Japan can the BoJ have any chance of reaching its 2% inflation target. Chart 9ECB Tapering Will Put European Yields##BR##Under Upward Pressure Chart 10BoJ Will Keep Rates Low To Boost Inflation##BR##Through A Weaker Yen The current BoJ yield target is around 0% on the 10-year JGB. There has been talk of late from some BoJ officials that the yield target could be raised in response to the strengthening Japanese economy. This is likely just talk to placate BoJ board members who were against the yield curve targeting regime in the first place (it was a very close 5-4 vote to implement the new policy framework in September 2016). Yet the BoJ could conceivable raise the yield target by a modest amount in the context of a bigger move higher in global bond yields. According to a simple econometric model of the 10-year JGB yield unveiled by the BoJ in 2016, a 10bp move higher in the 10-year U.S. Treasury yield would raise the fair value of the JGB yield by 2.7bps (Table 2).2 That model currently shows that JGB yields are about 8bps above fair value (around 0%) at the moment. If the 10yr U.S. Treasury yield were to rise to 3%, however, the current level of the JGB yield would be 7bps too low, which would represent the limit of "overvaluation" on this model since 2013 (Chart 11). Under such a scenario, the BoJ raising the yield target to 0.2%, for example, would not be an unusual response - and it would still be consistent with keeping yield differentials wide enough to generate a weaker yen. Table 2Bank Of Japan 10-Year##BR##JGB Yield Model Chart 11BoJ Could Face Pressure To Raise##BR##The Yield Target If UST Yields Rise In any event, the boost to global monetary liquidity from the asset purchases of the ECB and BoJ will fade next year as both central banks will buy a smaller number of bonds than in 2017. Which brings us to the final main takeaway from the 2018 BCA Outlook .... The Low Market Volatility Backdrop Will End Through Higher Bond Volatility The Outlook noted that the conditions underpinning the growth and liquidity driven bull markets for risk assets will start to turn more negative by mid-2018. Tightening financial conditions, especially as the Fed delivers more rate hikes, will eventually start to weigh on global growth expectations. There is even a very real possibility that the Fed will engineer a U.S. recession in 2019 through tighter monetary policy. At the same time, the Fed will be in the process of its balance sheet runoff, while the ECB and BoJ will be buying smaller amounts of bonds. As we have noted many times this year in Global Fixed Income Strategy reports, a slower growth rate of central bank balance sheets will weigh on the performance of risk assets in 2018 (Chart 12). Add in the risk of growth expectations starting to deteriorate in response to tighter monetary policy in the U.S. (and in China, as well), and markets may become increasingly more volatile later next year - starting with more volatile government bond yields (Chart 13). Chart 12Central Bank Liquidity Tailwind To##BR##Risk Assets Will Fade In 2018 Chart 13The Low Market Vol Backdrop Will End##BR##Through Rising Bond Vol A higher volatility backdrop raises the risk for so many global fixed income markets that have benefitted from investors stretching for yield in order to try and achieve adequate returns. In Chart 14, we show the historical range of yields for global government bonds and spread product (using the benchmark indices for each country or sector) dating back to 2000. The gray dots in the chart represent the current yield for each fixed income category and shows how yields are at historic lows in all markets. Chart 14Historical Range Of Bond Yields For Various Fixed Income Markets, 2000-2017 In Chart 15, we present the historic range of volatility-adjusted yields (the same yields from the previous chart, divided by the trailing 12-month realized index total return volatility of each sector). In this chart, the gray dots again represent the current readings. The blue squares show how volatility-adjusted yields would look if the median volatility of each asset class since 2000 was used in the denominator instead of the latest low level of volatility. Chart 15Historical Range Of VOLATILITY-ADJUSTED Bond Yields##BR##For Various Fixed Income Markets, 2000-2017 As can be seen in the chart, many of the sectors that currently have reasonably attractive volatility-adjusted yields, like U.S. Investment Grade, U.S. High-Yield, and hard-currency Emerging Market debt, will look much less compelling if volatility were to increase to more "normal" levels. The market response will be typical in such a higher volatility environment, as yields would increase to compensate for the greater volatility of returns. The current low volatility regime will end when higher inflation and less accommodative central banks raise interest rate volatility and, eventually, future growth uncertainty. We see that inflection point occurring sometime next year, leading to a more challenging environment for global fixed income "carry trades" that are also focused on global growth, like developed market corporate bonds and emerging market debt. In terms of the investment strategy implications, we end this report with a quote taken directly from the 2018 BCA Outlook: "Given our economic and policy views, there is a good chance that we will move to an underweight position in risk assets during the second half of 2018." Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see the December 2017 edition of The Bank Credit Analyst, "Outlook 2018 - Policy And The Markets: On A Collision Course", available at bca.bcaresearch.com and gfis.bcaresearch.com. 2 The model can be found in this report: https://www.boj.or.jp/en/announcements/release_2016/rel160930d.pdf The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Watching The Warning Signals Recommended Allocation Two of the three indicators we have focused on all year as reliable signals of recession (and, therefore, of the timing for reducing exposure to risk assets) have wobbled in the past month. But, for now, we are not too concerned about this, and continue to argue that the current bull market has maybe another year to run, until a possible 2019 recession starts to get priced in. Global growth indicators are showing no signs of slowdown, with the Global Manufacturing PMI at 53.5, and 26 of the 29 markets for which Markit runs its survey returning a PMI above 50 - close to the highest percentage on record (Chart 1). However, the flattening yield curve in the U.S. has raised concerns: the gap between the yield on two-year and 10-year Treasuries has fallen to less than 60 bps (Chart 2). But a flattening yield curve is not unusual when the Fed is tightening policy, and historically the curve has needed to invert before it became a recession signal. Also of concern was a jump in early November in high-yield spreads, which have also been a good lead indicator for recession (Chart 3). The rise was caused by poor earnings from lowly-rated telecoms companies, which triggered a sell-off in junk bond ETFs. But the rise in spreads remains insignificant, and has mostly reversed since. Chart 1Global Growth Looks Fine... Chart 2But Should We Worry About The Yield Curve... Chart 3...And Rising Credit Spreads? BCA's macro view, as laid out in detail in our recent 2018 Outlook,1 is that the strong growth that has been a positive for risk assets this year will slowly become a negative next year as it is increasingly accompanied by rising inflation. Two-thirds of countries globally now have unemployment below the NAIRU (Chart 4). In the U.S., employment has reached a level at which the Philips Curve has historically been "kinky", associated with an acceleration in wage growth (Chart 5). Upside surprises in inflation will mean that the Fed will hike three or four times next year (compared to the market's expectation of only 1½ hikes), 10-year bond yields will rise to above 3%, and the dollar will appreciate. Chart 4Unemployment Is Below Nairu In Most Places Chart 5The 'Kinky' U.S. Philips Curve What are the implications of this scenario for portfolio construction? We continue to recommend an overweight on risk assets on the 12-month time horizon, as we would expect equities to outperform bonds until Fed policy tightens above the neutral level (which is still about five rate hikes away, as long as core PCE inflation picks up to 2%, as we expect - Chart 6). However, the risks to this scenario are rising. The Fed could stubbornly push ahead with rate hikes even if inflation remains subdued. Chinese growth could slow if the authorities misjudge the timing of structural reforms. Our geopolitical strategists argue that, while investors overestimated political risks at the start of 2017, now they are underestimating the risks (North Korea, NAFTA renegotiation, China trade issues, Italian elections).2 With valuations stretched, small shocks could trigger a disproportionate negative market reaction. More risk-averse investors, therefore, might choose to reduce exposure now, at the risk of leaving some money on the table. Equities: If global equities have further upside, as we believe, higher beta markets such as the euro zone (average beta to global equities over the past 20 years: 1.2) and Japan (beta: 0.9) are likely to continue to outperform. Both have central banks that remain accommodative, our models suggest further upside for earnings growth into next year (Chart 7), and valuations are less stretched than in the U.S. While EM equities are also high beta, we think they are likely to lag next year: higher U.S. interest rates, a stronger U.S. dollar, potential slowdown in China, and sluggish domestic demand in most major emerging economies all represent significant headwinds. Chart 6How Long Until Rates Above Neutral? Chart 7Euro and Japan Earnings Have Upside Fixed Income: A combination of higher inflation and a more aggressive Fed is not a positive environment for government bonds. We expect the yield curve to steepen over the next six months, as the market prices in higher inflation and fiscal deficits (after the U.S. tax cut), but to resume flattening mid next year, as the Fed pushes ahead with rates hikes, and worries about the risk of a policy error emerge. For now, we remain underweight duration, and prefer inflation-linked over nominal bonds. For spread product, while valuations are stretched, we see some attractiveness. As long as the global expansion continues, U.S. investment grade bonds should see a carry pickup over Treasuries of around 100 bps, and high-yield bonds one of around 250 bps (adjusting for likely defaults) - even if we don't assume further spread contraction. In a world of continuing low rates, that remains alluring. Currencies will continue to be driven by relative monetary policy. While we see the Fed tightening more than the market expects, the ECB will not raise rates until late 2019, since underlying inflationary pressures in the euro zone are much weaker. This is largely in line with what the futures market is pricing in. Interest rate differentials (and an unwind of the current large speculative long-euro positions) should cause some weakness of the euro versus the dollar. We expect the Bank of Japan to stick to its 0% target for 10-year JGBs, which means that the yen will also weaken, to below 120 to the dollar, if U.S. interest rates rise in line with our forecasts (Chart 8). Emerging market currencies have already fallen by 1.3% since early September as U.S. rates rose, and amid signs of economic weakness in some emerging economies. We expect this to continue. Chart 8Yen Is Driven By U.S. Rates Chart 9China Is What Matter For Metals Commodities: Our energy strategists recently raised their target for Brent and WTI crude to an average over the next two years of $65 and $63 respectively, with risk of upside surprises in the event of geopolitical disruptions (Venezuela, Kurdistan etc.). They see the OPEC agreement being extended possibly to December 2018, and argue that backwardation of the oil curve (futures prices lower than spot) and rising extraction costs will delay the response of shale oil producers to the higher price. The outlook for industrial commodities depends, as always, on China, which now comprises greater demand for base metals than the rest of the world put together (Chart 9). The risk of a slowdown in Chinese infrastructure spending next year makes us wary on metals such as iron ore, and markets such as Australia and Brazil. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see The Bank Credit Analyst Special Report, "2018 Outlook - Policy And The Markets On A Collision Course," dated 20 November 2017, available at bca.bcaresearch.com 2 Please see Geopolitical Strategy Weekly Report, "From Overstated To Understated Risks," dated 22 November 2017, available at gps.bcaresearch.com GAA Asset Allocation

Dear Client, In this report, we image a hypothetical timeline of key economic and financial events spanning the next five years. The events described in the report correspond with our view that the global economy will continue to expand into the second half of 2019, before succumbing to a recession and a decade of stagflation in the 2020s. This warrants an overweight position in risk assets for the next 6-to-12 months, but a much more cautious stance thereafter. Charts 1-4 provide a visual representation of how we see the main asset classes evolving over the coming years. Best regards, Peter Berezin, Chief Global Strategist Feature I. The Blow-Off Phase December 4, 2017: U.S. stocks fall by 1.7% on reports that Mitch McConnell does not have enough votes to get the tax bill through the Senate. A sell-off in high-yield markets and a tightening of financial conditions in China aggravate the situation. December 13, 2017: The Fed hikes rates by 25 basis points, taking the Fed funds target range to 1.25%-to-1.5%. December 14, 2017: Global equities continue to weaken. The S&P 500 suffers its first 5% correction since June 2016. December 15, 2017: The correction ends on news that the Senate will consider a revised bill which trims the size of corporate tax cuts and uses the savings to finance a temporary reduction in payroll taxes. President Trump and House leaders promise to go along with the proposal. The PBoC also injects fresh liquidity into the Chinese financial system. December 29, 2017: Global equities rally into year-end. The S&P 500 hits 2571 on December 29, placing it just shy of its November high. The dollar also strengthens, with EUR/USD closing at 1.162. The 10-year Treasury yield finishes the year at 2.42%. January 10, 2018: The global cyclical bull market in stocks continues. European and Japanese indices power higher. Both the NASDAQ and the S&P 500 hit fresh record highs. EM stocks move up but lag their DM peers, weighed down by a stronger dollar. January 12, 2018: U.S. retail sales surprise on the upside. Department store stocks, having been written off for dead just a few months earlier, end up rising by an average of 40% between November 2017 and the end of January. February 14, 2018: The euro area economy continues to grow at an above-trend pace. Nevertheless, inflation stays muted due to high levels of spare capacity across most of the region and the lagged effects of a stronger euro. The 2-year OIS spread between the U.S. and the euro area widens to a multi-year high. February 26, 2018: China's construction sector cools a notch, but industrial activity remains robust, spurred on by a cheap currency, strong global growth, and rising producer prices. Chinese H-shares rise 13% year-to-date, beating out most other EM equity indices. March 14, 2018: The U.S., Canada, and Mexico reach a last-minute deal to preserve NAFTA. The Canadian dollar and Mexican peso breathe a sigh of relief. March 16, 2018: In a surprise decision, Donald Trump nominates Kevin Hassett as Fed vice-chair. Trump cites the "tremendous job" Hassett did in selling the GOP's tax cuts. A number of Fed appointments follow. Most of the picks turn out to be more hawkish than investors had expected. This gives the greenback further support. March 18, 2018: Pro-EU parties do better than anticipated in the Italian elections. Italian bond spreads compress versus the rest of Europe. March 21, 2018: The Fed raises rates again, bringing the fed funds target range up to 1.50%-to-1.75%. April 8, 2018: Bank of Japan governor Kuroda is granted another term in office. He pledges to remain single-mindedly focused on eradicating deflation. April 11, 2018: Chinese core CPI inflation reaches 2.9%. Producer price inflation stays elevated at 6%. A major market theme in 2018 turns out to be how China went from being a source of global deflationary pressures to a source of inflationary ones. April 30, 2018: U.S. core PCE inflation jumps 0.3% in March, reaching 1.7% on a year-over-year basis. Goods and service inflation both pick up, while the base effects from lower cell phone data charges in the prior year drop out of the calculations. May 17, 2018: Oil prices continue to rise on the back of ongoing discipline from OPEC and Russia, smaller-than-expected shale output growth, and production disruptions in Libya, Iraq, Nigeria, and Venezuela. June 13, 2018: Strong U.S. growth in the first half of the year, a larger-than-projected decline in the unemployment rate, and higher inflation keep the Fed in tightening mode. The FOMC hikes rates again. June 25, 2018: Global capital spending accelerates further. Global industrial stocks go on to have a banner year. June 27, 2018: Wage growth in the U.S. accelerates to a cycle high. Donald Trump takes credit, stating that "this wouldn't have happened" without him or his tax cuts. July 31, 2018: The Japanese labor market tightens further. The unemployment rate falls to 2.6%, 1.2 percentage points below 2007 levels, while the ratio of job vacancies-to-applicants moves further above its early-1990s bubble high. A number of high-profile companies announce plans to raise wages. August 2, 2018: A brief summer sell-off sees global equities dip temporarily, but strong global earnings growth keeps the cyclical bull market in stocks intact. August 28, 2018: The London housing market continues to weaken, with home prices falling by 9% from their peak. The rest of the U.K. economy remains fairly resilient, however. EUR/GBP closes at 0.87. August 31, 2018: The Greek bailout program ends and a new one begins. Greece's economy continues to recover, but Tsipras fails to obtain debt relief from creditors. September 7, 2018: The U.S. unemployment rate falls to a 49-year low of 3.7%, nearly a full percentage below the Fed's estimate of NAIRU. September 26, 2018: The Fed raises rates again. By now, the market has gone from pricing in only two hikes for 2018 at the start of the year to pricing in almost four. September 27, 2018: Profit growth in the U.S. moderates somewhat as higher wage costs take a bite out of earnings. Nevertheless, stock market sentiment remains buoyant. Retail participation, which had been dormant for years, takes off. CNBC sees a surge in viewers. Micro cap stocks go wild. October 7, 2018: The outcome of Brazil's elections shows little appetite for major structural reforms. Economic populism lives on. October 31, 2018: Realized inflation and inflation expectations continue grinding higher in Japan, triggering market speculation that the BoJ will abandon its yield-curve targeting policy. The resulting rally in the yen is short-lived, however. At its monetary policy meeting, the Bank of Japan indicates that it has no near-term plans to modify its existing strategy. November 6, 2018: The Democrats narrowly regain control of the House but fail to recapture the Senate. Investors shrug off the results, figuring correctly that a Republican Senate will keep Trump's corporate tax cuts in place and that Democrats will agree to extend the expiring payroll tax cut and other tax measures that benefit the middle class. December 7, 2018: The U.S. unemployment rate falls to 3.5%. Donald Trump tweets "You're welcome, America". December 19, 2018: The Fed raises rates for the fourth time that year - one more hike than it had signaled in its December 2017 "dot plot" - taking the fed funds target range to 2.25%-2.5%. December 31, 2018: The MSCI All-Country Index finishes up 12% for the year (in local-currency terms), led by the euro area and Japan. U.S. stocks gain 8%. EM equities manage to rise 6%. Small caps edge out large caps, value stocks beat growth stocks, and cyclical stocks outperform defensives. December 31, 2018: The 10-year U.S. Treasury yield finishes the year at 3.05%. German bund yields reach 0.82%, U.K. gilt yields rise to 1.7%, Canadian yields hit 2.3%, and Australian yields back up to 3%. Japanese 10-year yields remain broadly flat, but the 20-year yield moves up 40 basis points to nearly 1%. Credit spreads finish the year close to where they started, providing a modest carry pick-up over high-quality government bonds. December 31, 2018: The DXY index rises 4% to 98. EUR/USD closes at 1.11, USD/JPY at 123, GBP/USD at 1.31, and AUD/USD at 0.76. The Canadian dollar manages to edge up against the greenback on the year, with CAD/USD finishing at 0.81. The Chinese yuan also strengthens to 6.4 versus the dollar. December 31, 2018: Brent and WTI spot prices finish the year at $65 and $63, respectively. Copper and metal prices are broadly flat for the year, having faced the dueling forces of a stronger dollar (a negative) and above-trend global growth (a positive). Gold sinks to $1,226. II. The Clouds Darken February 22, 2019: The global economy starts to decelerate. The slowdown is led by China, where the government's crackdown on shadow banking activities begins to take a bigger toll on growth. Most measures of U.S. economic activity also soften somewhat in the first two months of the year. Investors take heart in the hope that the economy will achieve a soft landing, allowing the Fed to moderate the pace of rate hikes. February 27, 2019: In an otherwise mundane day, the S&P 500 edges up 0.3% to 2832. Little do investors know that this marks the cyclical peak in the U.S. stock market. March 13, 2019: Hopes that the Fed can take its foot off the brake are dashed when the Bureau of Labor Statistics reveals that inflation rose by more than expected in February. U.S. core CPI inflation increases to 2.9% while the core PCE deflator accelerates to 2.4%. Market chatter turns from whether the Fed can slow the pace of rate hikes to whether it needs to start hiking more rapidly than once-per-quarter. The S&P falls 2.1% on the day. March 20, 2019: The Fed lifts the funds rate target range to 2.5%-to-2.75% and signals a readiness to keep hiking rates. The 10-year Treasury yield rises to 3.3%. EUR/USD sinks to 1.08. The first quarter of 2019 marks a watershed of sorts. In 2018, the Fed raised rates because of stronger growth; in 2019, it kept raising them because of brewing inflation. As it turned out, risk assets were able to tolerate the former, but not the latter. March 29, 2019: The U.K. does not leave the EU two years after Britain invoked Article 50 of the Lisbon Treaty. The EU votes to prolong negotiations given growing political support within Britain for the country to remain part of the European bloc. April 5, 2019: The S&P 500 sinks further and is now 10% below its February high, returning close to where it was at the start of 2018. The increasingly sour mood on Wall Street does not appear to be hurting Main Street very much, however. The U.S. unemployment rate edges down further to 3.4%. Euro area growth remains resilient. May 31, 2019: The Brazilian government announces that the fiscal deficit will come in larger than originally expected. USD/BRL slips to 3.45. June 4, 2019: Jens Weidmann, who had gone out of his way to soften his hawkish rhetoric over the preceding months, is chosen to succeed Mario Draghi, whose term expires in October. Nevertheless, the euro still strengthens on the news. June 6, 2019: Markets temporarily regain their composure. The S&P 500 gets back to within 4% of its all-time high. The reprieve does not last long, however. June 12, 2019: The Fed hikes rates, taking the fed funds target range to 2.75%-to-3%. The FOMC cites inflation as its primary concern. July 8, 2019: Global risk assets weaken anew as a fiscal crisis grips Brazil. Turkey, South Africa, and a number of other emerging markets show increasing signs of fragility. August 20, 2019: Korean exports, a leading indicator of the global business cycle, decelerate once again. Global PMIs sag, as do most measures of business confidence. September 25, 2019: Despite a slowing U.S. economy, the Fed hikes rates again, bringing the fed funds target range to 3%-to-3.25%. The FOMC justifies the decision based on the fact that the unemployment rate is below NAIRU, core inflation is above the Fed's 2% target, and real rates are less than 1%. To assuage markets, Jay Powell suggests that the Fed could keep rates on hold in December. This turns out to be more prescient than he realizes. It will be another three years before the Fed raises rates again. By then, Powell is no longer the Fed chair. September 30, 2019: Commodity prices tumble, further adding to the pressure facing emerging markets. The U.S. yield curve inverts for the first time during this business cycle. The dollar, which previously strengthened due to a hawkish Fed, now starts strengthening on flight-to-safety flows back into the U.S. The yen appreciates even more than the greenback. October 15, 2019: The bottom falls out of the Canadian housing market. Home sales dry up and prices begin to sink. The Canadian dollar, which peaked back in February at 83 cents, falls to 74 cents against the U.S. dollar. October 19, 2019: A failed North Korean launch lands a missile 80 kilometres from Japanese shores. Prime Minister Abe pledges swift retaliation. October 21, 2019: The negative feedback loop between a rising dollar, falling commodity prices, and EM stress intensifies. Sentiment towards emerging markets deteriorates dramatically. Rumours begin to swirl that Brazil will miss a debt payment. October 23, 2019: Trump tweets "Dopey Rocketman thinks he is so smart, but we know where all his hideouts are. Sweet dreams!" October 24, 2019: News reports are abuzz about a massive buildup of troops on the North Korean side of the border. Panic grips Seoul. Asian bourses sell-off, taking global stock markets down with them. III. The Reckoning October 25, 2019: All hell breaks loose. North Korea's state broadcaster announces that Kim Jong-un has been "incapacitated". It later turns out that the tubby tyrant was killed by a group of military officers. Having not slept for days, Kim had become increasingly erratic and paranoid. Convinced that he was surrounded by spies and that Trump had deployed a secret weapon to read his mind, he ordered the execution of many people in his inner circle. Fearing for their lives, his henchmen decided to strike first. October 31, 2019: North Korea's new military rulers signal a desire for closer relations with China and a less belligerent posture towards the South. Over the coming decades, historians will debate whether Trump's tactics were a reckless gambit that luckily paid off, or the work of a master strategist playing 3D chess while everyone else was playing backgammon. Trump himself wastes no time in taking credit for ousting the Kim dynasty. November 4, 2019: The relief investors feel from the ebbing of tensions in the Korean Peninsula does not last long. The turmoil in emerging markets intensifies. A series of high-profile defaults rock the Chinese corporate debt market. Copper and iron ore prices nosedive. Brent swoons to $39/bbl. November 5, 2019: The head of Brazil's central bank resigns after the government pressures it to increase its holdings of government bonds in an effort to ward off an imminent default. The Brazilian real falls to nearly 6 against the dollar. Other EM currencies plunge. The Turkish lira is particularly badly hurt. December 6, 2019: The pain on Wall Street finally spreads to Main Street. U.S. payrolls rise by only 19,000 in November. Subsequent revisions ultimately show a drop of 45,000 for that month. The NBER will eventually go on to declare November as the start of the recession. December 11, 2019: Having raised rates just three months earlier, the FOMC cuts rates by 25 basis points and signals that it is willing to keep easing if economic conditions deteriorate further. December 16, 2019: Markets initially cheer the prospect of lower rates, but the euphoria is quickly forgotten. Credit spreads soar as investors price in an increasingly bleak economic outlook. Commercial real estate prices fall. Banks further tighten lending standards. IV. A Global Recession December 19, 2019: The recession spreads around the world. The ECB ditches plans to raise rates. The U.K., Sweden, Norway, Canada, Australia, and New Zealand all cut rates. In the emerging world, Korea, Taiwan, and Poland reduce interest rates, but a number of other countries - most notably, Turkey, South Africa, and Malaysia raise rates in a desperate bid to prop up their currencies so as to keep the local-currency value of their foreign-currency obligations from spiraling out of control. December 31, 2019: The S&P 500 closes at 2194, down 21% for the year. Most other bourses fare even worse. The U.S. dollar, which peaked against the euro at $1.02 just six weeks earlier, finishes at $1.07. The 10-year Treasury yield closes at 2.37%, down 68 basis points on the year. The 10-year German bund yield falls back to 0.5%. January 11, 2020: In a surprise twist, WikiLeaks reveals that the CIA has found no credible evidence that Russia had any material influence over the 2016 elections, but that Putin has been trying to cultivate the impression that it did. The document disparagingly notes that "Putin has relished the U.S. media's characterization of him as a master political manipulator with global reach, when in fact he is just the ruler of an impoverished, demographically depleted, militarily overextended country." The Mueller probe fizzles out. January 27, 2020: Voting in the Democratic primaries begins. Kamala Harris, Elizabeth Warren, and Sherrod Brown lead a crowded field of hopefuls. Bernie Sanders and Joe Biden choose not to run. Brown enjoys the biggest lead against Trump in head-to-head polls, but his support among primary voters is weighed down by his status as a cisgendered white male. January 28, 2020: On the other side of the Atlantic, the U.K. holds another referendum - this one to ratify the separation agreement reached with the EU. The terms of the agreement are widely regarded as being highly unfavorable to the U.K. Prime Minister Corbyn, having formed a coalition government with the Liberal Democrats and the SNP following elections in late 2018, makes it clear that a rejection of the deal is tantamount to a vote to stay in the EU. With the British economy in the doldrums, 53% of voters reject the deal. The U.K. remains in the EU. EUR/GBP falls to 0.84. January 29, 2020: The Fed cuts rates by another 25 basis points. Hiking rates once per quarter was good enough when unemployment was falling. However, now that the economy is on the rocks, the Fed reverts to a more aggressive loosening cycle, cutting rates once per meeting. Even so, a growing chorus of voices both inside and outside the Fed argue that it is not doing enough. February 17, 2020: Kamala Harris and Elizabeth Warren pull out ahead in the Democratic primaries. Similar to the Clinton/Sanders duel in 2016, Warren polls best among younger, whiter voters, while Harris leads among minorities and establishment Democrats. March 10, 2020: Donald Trump, seeing his poll numbers tank after the post-Korea bump, unilaterally raises trade barriers across a wide variety of industries. Foreign producers retaliate, leading to a contraction in global trade. April 26, 2020: Warren's relentless characterization of Harris as a shill for moneyed interests pays off. The Massachusetts senator secures the Democratic nomination. Hollywood celebrities line up to support Warren. Taylor Swift's silence on the matter is deafening, leading to a further increase in her album sales. June 5, 2020: The U.S. unemployment rate surges to 5.1%. Corporate America sees a wave of business closings, with the retail sector being particularly badly hit. July 21, 2020: The bellwether German IFO index falls to a multi-year low. Germany's manufacturing sector feels the pinch from the collapse in demand for capital equipment, especially from emerging markets. Merkel's popularity plummets after it is revealed that she tried to suppress data that more than half of asylum seekers classified as children were actually adults. Support for the Alternative for Deutschland Party, which by this time has greatly moderated its anti-EU rhetoric, rises sharply. August 17, 2020: The trade-weighted yen continues to strengthen, pushing Japan deeper into recession. In response, the Japanese government announces a major new stimulus package. In the clearest attempt yet to link fiscal with monetary policy, the authorities pledge to start issuing consumption vouchers to households, the value of which will be incrementally increased until long-term inflation expectations rise to the Bank of Japan's 2% target. The policy proves to be a smashing success. September 9, 2020: The U.S. presidential campaign ends up being even more divisive than the one in 2016. Unlike four years earlier, equities rally at any glimmer of hope that Trump will win. However, with unemployment rising, such moments prove few and far between. September 22, 2020: Senator Warren states on the campaign trail that she will not renominate Jay Powell in 2022 for a second term as Fed chair if she is elected president. Lael Brainard's name is floated as a likely replacement. V. The Return Of Stagflation October 13, 2020: Green shoots appear in the U.S. economy, marking the end of the recession. The unemployment rate rises for another two months, peaking at 6.8% in December. Other economies also begin to turn the corner. November 3, 2020: The tentative improvement in U.S. economic data happens too late to bail out Trump. Elizabeth Warren wins the presidential election. Warren loses Ohio but picks up Pennsylvania, Michigan, and Wisconsin. An influx of Democratic voters from Puerto Rico puts her over the top in Florida. The Democrats take back control of the Senate. November 4, 2020: The S&P 500 barely moves the day after the election, having already priced in the outcome months earlier. Still, at 2085, the index is 26% below its February 2019 peak. December 2, 2020: President-elect Warren pledges to introduce a major spending package after she is inaugurated. She brushes off concerns from some economists that fiscal stimulus is coming too late, noting that the unemployment rate is more than three points higher than it was one year earlier. Stocks rally on the news. January 27, 2021: The FOMC votes to keep rates on hold at 1%. Lael Brainard dissents, arguing that further monetary stimulus is necessary. March 19, 2021: The Chinese government shifts more bad loans from commercial banks into specially-designed state-owned asset management companies. The banks generally receive well above-market prices for their loans. Chinese bank shares move higher. April 2, 2021: Congress proposes to significantly raise taxes on higher-income earners and corporations with more than 500 employees and use the proceeds to fund an expansion of the Affordable Care Act. It also promises to introduces a "Tobin tax" on financial transactions. The post-election stock market rally fades. June 8, 2021: In a seminal speech, Lael Brainard argues that current inflation measures fail to adequately correct for technological improvements and other methodological issues. She suggests that this leads to an overstatement of the true level of inflation. The implication, she concludes, is that an inflation target of 2.5%-to-3% would be consistent with the Fed's existing mandate. September 24, 2021: Many Trump-era deregulation measures are rolled back. Anti-trust efforts are also ramped up. Despite an improving economy, the S&P 500 sinks to 2031, marking a five-year low. November 17, 2021: A wave of panic selling grips Wall Street. The S&P 500 crashes to 1969, down 31% from its February 2019 peak. As is often the case, this marks the bottom of the equity bear market. The subsequent recovery, however, proves to be tepid and prone to numerous setbacks. January 31, 2022: Thanks to ample fiscal stimulus, inflation in Japan rebounds from its recession lows. Aggregate income growth slows as more Japanese workers exit the labor force, but spending holds up as health care expenditures continue to climb. Japan's current account moves into a structural deficit position. February 16, 2022: Lael Brainard succeeds Jay Powell as Fed chair. The decision by Republicans in 2013 to reduce the number of senators necessary to approve appointments to the Fed board from 60 to 51 ensures smooth sailing for Brainard during congressional hearings and the confirmation of a slew of highly dovish candidates over the subsequent two years. April 6, 2022: China belatedly introduces modest financial incentives to encourage couples to have more children. The public jokingly dubs this as the new "at least one child policy". It ends up having little effect. Future Chinese scholars will end up describing China's failure to arrest the decline in its population as its greatest geopolitical blunder. July 20, 2022: The U.S. becomes the latest country to introduce strict restrictions on the use of bitcoin. Although the U.S. government never says so, fears that bitcoin and other cryptocurrencies will eat into the $75 billion in seigniorage revenue that the Treasury earns every year underpins the decision. The price of bitcoin falls to $550, down 95% from its all-time high. September 29, 2022: Japan officially abandons its yield-curve targeting regime. The 30-year yield rises to 2.5%. Faced with onerous long-term debt-servicing costs and stagnant tax revenues, the government starts refinancing much more of its debt through short-term borrowings. The Bank of Japan obliges, keeping short-term rates near zero. The combination of negative short-term real rates and higher inflation allows Japan to reduce its debt-to-GDP ratio over time. This proves to be the modus operandi for Japan and many other fiscally-challenged governments over the coming decades. October 18, 2022: Productivity growth in most developed economies continues to disappoint. For the first time in modern history, the flow of new workers entering the labor force are no better skilled or educated than the ones leaving. With potential GDP growing at a lackluster pace, output gaps disappear, setting in motion the acceleration in inflation over the remainder of the decade. The U.S. 10-year Treasury yield rises to 4%. It will be over 6% by the middle of the decade. November 22, 2022: The price of gold surpasses its previous high of $1895/oz. The 2020s turn out to be an excellent decade for bullion. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Chart 1Market Outlook: Equities Chart 2Market Outlook: Bonds Chart 3Market Outlook: Currencies Chart 4Market Outlook: Commodities Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Idea 1: Long Eurodollar, short Euribor - December 2022 interest rate futures contracts. Alternatively just go outright long the Eurodollar contract. Idea 2: Long EUR/USD Idea 3: Underweight Basic Materials equities versus market. Alternative expressions are to go short the LMEX index, or underweight Norway (OMX) versus Ireland (ISE). Idea 4: Long Norwegian 10-year bonds, short German 10-year bunds. Idea 5: Long U.K. 10-year gilts, short Irish 10-year bonds. Feature Question 1: Where Is The Worrying Imbalance? Last week, in the Quantum Theory Of Finance,1 we pointed out that when bond yields reach ultra-low levels, the payoff profile from bonds becomes highly asymmetric. When yields approach a lower bound, they cannot fall much further but they can rise a lot. Meaning that bond prices have very limited potential for gains, but have great potential for sudden and deep losses. Chart of the WeekThe Norway Versus Euro Area Bond Yield Spread Is Too Wide The unattractive asymmetric payoff profile - known as negative skew - applies to both nominal and real returns. This is because negative skew is concerned about deep nominal losses over a relatively short period. In which case, a deep nominal loss will be a deep real loss too.2 As equity returns always possess negative skew we can say that at ultra-low bond yields, bond risk becomes equity-like. Given this risk equalization, equities no longer justify a risk premium over bonds. And the lower prospective return required from equities means that today's equity valuations and prices become a lot richer. But the new delicate balance of valuations is conditional on bond yields remaining ultra-low. This is because the unattractive negative skew on a 10-year bond's returns disappears when its yield moves up into the 'high 2s' (Chart I-2). At this point, risk is no longer equalized and the equity risk premium must fully re-emerge - requiring today's equity market valuation and price to drop, perhaps substantially. However, the ensuing fight to havens would then once again pull bond yields back down from the 'high 2s'. It follows that the rise in expected interest rates is self-limiting. Any policy interest rate expectation already in the 'high 2s' - such as the Eurodollar December 2022 contract - cannot sustainably rise much further, whereas those that are still some way below - such as the Euribor December 2022 contract - can (Chart I-3). Which leads to our first investment idea. Chart I-2Bonds Become Much More ##br##Risky At Ultra-Low Yields Chart I-3The Euro Area/U.S. Interest Rate Expectation ##br##Spread Is Too Wide Investment idea 1: Long Eurodollar, short Euribor - December 2022 interest rate futures contracts. Alternatively just go outright long the Eurodollar contract. Question 2: Which Is The Safest Currency To Hold? Chart I-4Euro/Dollar Just Tracks ##br##The Bond Yield Spread To reiterate, at ultra-low bond yields, bond returns offer a highly unattractive payoff profile. Put simply, you can quickly lose a lot more money - in both nominal and real terms - than you can make! Now observe that the payoff profile for a foreign exchange rate just tracks the bond yield spread (Chart I-4). This means that when a central bank has already taken bond yields close to their lower bound, its currency possesses a highly attractive payoff profile called positive skew. In essence, as the ECB is at the realistic limit of ultra-loose policy, the direction of policy rate expectations cannot go significantly lower. Conversely, policy rate expectations for the Federal Reserve (for 2022) are not far from our upper bound of the 'high 2s'. So these expectations cannot go significantly higher without threatening a risk-asset selloff. On this basis, EUR/USD has more scope to gap up than to gap down. Investment idea 2: Long EUR/USD But be aware that investment ideas 1 and 2 are highly correlated with each other! Question 3: Where Are We In The Global Growth Mini-Cycle? Global growth experiences remarkably consistent - and therefore predictable - 'mini-cycles', with half-cycle lengths averaging 8 months. As the current mini-upswing started in May we can infer that it is likely to end in early 2018. So one surprise in 2018 could be that global growth slows in the first half rather than in the second half - contrary to what the consensus is expecting. That said, half-cycle lengths do have some degree of variation: the current upswing might be a few months longer or shorter than the average. So how can we avoid positioning too early or too late for the next turn? The answer is to focus on investments that have already fully priced the current upswing, so that timing becomes less of an issue. On this basis, we propose that the rally in industrial metals and Basic Materials equities is already extended. Our technical indicator which captures herding and groupthink correctly identified the trough at the end of 2015, the mini-peak at the end of 2016, and is now signalling that the latest rally is likely to fade (Chart I-5 and Chart I-6). Chart I-5Metals Have Fully Priced ##br##The Mini-Upswing... Chart I-6...And The Metal Rally Is Reaching##br## Its Technical Limit Investment idea 3: Underweight Basic Materials equities versus market. Alternative expressions are to go short the LMEX index, or underweight Norway (OMX) versus Ireland (ISE). Question 4: Will Inflation Lift Off? The ECB's continued indulgence with ultra-loose monetary policy would make you think that the euro area is on the edge of a deflationary abyss. In fact, inflation has been running comfortably within a 0-2% band for almost two years. Will inflation edge closer to the ECB's 2% point target? Given our view on the growth mini-cycle, not immediately. In the first half of 2018, inflation may even edge lower within the 0-2% band, but this global dynamic will affect inflation in all jurisdictions, not just in the euro area. There is nothing wrong with inflation running comfortably within a 0-2% band. Now that we know that nominal interest rates can go slightly negative, a 0-2% inflation band even permits negative real interest rates. The big mistake is to aim for an arbitrary point target, like 2%. This is because inflation is a non-linear phenomenon, and a defining characteristic of a non-linear phenomenon is that it cannot hit an arbitrary point target.3 It is our high conviction expectation that the major central banks will eventually change their point targets for inflation into target bands such as 0-2% or 1-3%. But afraid to lose credibility, they will not change tack abruptly. In the meantime, we notice that the Norges Bank is undershooting its 2.5% inflation target by considerably more than the ECB is undershooting its 2% target (Chart I-7). Yet the yield spread between Norwegian and euro area bonds has not caught up with this reality (Chart of the Week). Chart I-7The Norges Bank Is Undershooting Its Inflation Target By More Than The ECB Investment idea 4: Long Norwegian 10-year bonds, short German 10-year bunds. Question 5: Will Political Risk Re-emerge? Political events have had a hand in three of the sharpest recent moves in financial markets. The vote for Brexit catalysed a 15% decline in the pound; the vote for Trump triggered an 80 bps spike in the 10-year T-bond yield, and the vote for Macron unleashed a 10% rally in the euro. Political change disrupts markets if it dislocates the long-term expectations embedded in economic agents and financial prices. The vote for Brexit changed expectations about the U.K.'s long-term trading relationships; the election of Trump changed expectations about fiscal stimulus, the tax structure, and protectionism (perhaps unrealistically); and the election of Macron exorcised the potential chaos of a Le Pen presidency. Chart I-8The U.K. Versus Ireland Bond ##br##Yield Spread Is Too Wide In contrast, the recent (disputed) vote for independence in Catalonia, and the breakdown of coalition discussions in Germany barely moved the markets - because neither event changed expectations of long-term economic outcomes. As investors, this is the test we should apply to all political events. In 2018, the evolution of Brexit has the potential to move markets. This is because hard Brexiters and the EU27 are on a collision course. Specifically, the issue of the Irish border is insoluble. It is Brexit's Gordian knot. Theresa May has promised the hard Brexiters that the U.K. will leave the EU customs union and single market. She has also promised the Northern Ireland Unionists - who are propping up May's minority government - that there will be no hard border between Northern Ireland and the Republic of Ireland or the rest of the U.K. But these promises are irreconcilable. The Republic of Ireland will veto a border that threatens the Good Friday peace agreement; the Northern Ireland Unionists will not tolerate the border moving to the Irish Sea, which would effectively take Northern Ireland into the EU customs union and single market; and the EU27 will block a Hong Kong type 'free port' status for Northern Ireland - as this would remove the integrity of harmonized standards across the EU. Eventually, the impenetrable Irish border problem is likely to be the roadblock to a hard Brexit. But first there needs to be a collision. And the collision could move markets. With the yield spread between U.K. 10-year gilts and Irish 10-year bonds near a 2-year wide (Chart I-8), this leads us to our fifth investment idea. Investment idea 5: Long U.K. 10-year gilts, short Irish 10-year bonds. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Special Report 'The Quantum Theory Of Finance' November 23 2017 available at eis.bcaresearch.com. 2 For example if the nominal return over 3 months was a very painful -10%, and inflation was running at -10% per annum, the real return over 3 months would be a still very painful -7.5%. 3 Please see the European Investment Strategy Weekly Report 'Three Mantras For Investors' August 17 2017 available at eis.bcaresearch.com. Fractal Trading Model* Ahead of the OPEC meeting on November 30, the WTI crude oil price is vulnerable to any disappointment - because its rally is technically very extended. This week's trade recommendation is to expect a retracement of 7.5% with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Chart I-9 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions.Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Highlights China stands out as the most likely candidate to send negative shock waves through EM and commodities in 2018. Granted the ongoing policy tightening in China will likely dampen money growth further, the only way mainland nominal GDP growth can hold up is if the velocity of money rises meaningfully, offsetting the drop in money growth. Assigning equal probabilities to various scenarios of velocity of money, the outcome is as follows: one-third probability of robust nominal growth (continuation of the rally in China-related plays) and two-third odds of a non-trivial slowdown in nominal growth with negative ramifications for China-related plays. Hence, we reiterate our negative stance on EM risk assets Feature The key question for emerging markets (EM) in 2018 is whether a slowdown in Chinese money growth will translate into a meaningful growth deceleration in this economy, and in turn produce a reversal in EM risk assets. This week we address the above question in detail elaborating on what could make China's business cycle defy the slowdown in its monetary aggregates and how investors should approach such uncertainty. Before this, we review the status of financial markets going into 2018. Priced To Perfection Or A New Paradigm? Several financial markets are at extremes. Our chart on the history of financial market manias reveals that some parts of technology/new concept stocks may be entering uncharted territory (Chart I-1). Tencent's share price, for instance, has surged 11-fold since January 2010. Chart I-1History Of Financial Markets Manias: They Lasted A Decade This is roughly on par with the prior manias' average 10-year gains. As this chart indicates, the manias of previous decades run wild until the turn of the decade. It is impossible to know whether technology/new concept stocks will peak in 2018 or run for another two years. Regardless whether or not the mania in tech/new concept stocks endures up until 2020, some sort of mean reversion in their share prices is likely next year. This has relevance to EM because the magnitude of the EM equity rally in 2017 has been enormously boosted by four large tech/concept stocks in Asia. Our measure of the cyclically-adjusted P/E (CAPE) ratio for the U.S. market suggests that equity valuations are reaching their 2000 overvaluation levels (Chart I-2, top panel). The difference between our measure and Shiller's measure of CAPE is that Shiller's CAPE is derived by dividing share prices by the 10-year moving average of EPS in real terms (deflated by consumer price inflation). Our measure is calculated by dividing equity prices by the time trend in real EPS (Chart I-2, bottom panel). Our CAPE measure assumes that in the long run, U.S. EPS in real terms will revert to its time trend. Meanwhile, the Shiller CAPE is based on the assumption that real EPS will revert to its 10-year mean. Hence, the assumptions behind our CAPE model are quite reasonable if not preferable to those of Shiller's P/E. Remarkably, the U.S. (Wilshire 5000) market cap-to-GDP ratio is close to its 2000 peak (Chart I-3). With respect to EM equity valuations, the non-financial P/E ratio is at its highest level in the past 15 years (Chart I-4). EM banks have low multiples and seem "cheap" because many of them have not provisioned for NPLs. Hence, their profits and book values are artificially inflated. In short, excluding financials, EM stocks are not cheap at all, neither in absolute terms nor relative to DM bourses. Chart I-2A Perspective On U.S. Equity Valuation Chart I-3The U.S. Market Cap-To-GDP ##br##Ratio Is Close To 2000 Peak Chart I-4EM Non-Financial Equities Are Not Cheap Such elevated DM & EM stock market valuations might be justified by currently low global long-term bond yields. Yet, if and when long-term bond yields rise, multiples will likely shrink. The latter will overpower the profit growth impact on share prices, as multiples are disproportionately and negatively linked to interest rates - especially when interest rates are low - but are proportionately and positively linked to EPS.1 As a result, a small rise in long-term bond yields will lead to a meaningful P/E de-rating. Despite very high equity valuations, U.S. advisors and traders are extremely bullish on American stocks. Their sentiment measures are at all time and 11-year highs, respectively. So are copper traders on red metal prices (Chart I-5). The mirror image of the strong and steady rally in global stocks is record-low implied volatility. The aggregate financial markets' implied volatility index is at a multi-year low (Chart I-6). Finally, yields on junk (high-yield) EM corporate and sovereign bonds are at all-time lows (Chart I-7). They are priced for perfection. Chart I-5Bullish Sentiment On Copper Is Very Elevated Chart I-6Aggregate Global Financial Markets ##br##Implied VOL Is At Record Low Chart I-7EM Junk Bond Yields Are At Record Low Are we in a new paradigm, or are we witnessing financial market extremes that are unsustainable? In regard to the timing, can these dynamics last throughout 2018 or at least the first half of next year, or will they reverse in the coming months? We have less conviction on the durability of the U.S. equity rally, but our bet is that EM risk assets will roll over in absolute terms and begin underperforming their DM peers very soon. What could cause such a reversal in EM risk assets? China stands out as the most likely candidate to send negative shock waves through emerging markets and commodities. China: "Financial Stability" Priority Entails Tighter Policy The Chinese authorities are facing unprecedented challenges: The outstanding value of broad money in China (measured in U.S. dollars) is now larger than the combined U.S. and euro area broad money supply (Chart I-8, top panel). Chart I-8Beware Of Money Excesses In China As a share of its own GDP, broad money in China is much higher compared to any other nation in history (Chart I-8, bottom panel). In brief, there is too much money in China and most of it - $21 trillion out of $29 trillion - has been created by the banking system since early 2009. We maintain that the enormous overhang of money and credit in China represents major excess/imbalances and has nothing to do with the nation's high savings rate.2 Rather, it is an outcome of animal spirits running wild among bankers and borrowers over the past nine years. Easy money often flows into real estate and China has not been an exception. Needless to say, property prices are hyped and expensive relative to household income. Policy tightening amid lingering excesses and imbalances makes us negative on China's growth outlook. In a nutshell, we place more weight on tightening when there are excesses in the system, and downplay the importance of tightening in a healthy system without excesses. Importantly, excessive money creation seems to finally be pushing inflation higher. Consumer price services and core consumer price inflation rates are on a rising trajectory (Chart I-9, top and middle panels). As a result, banks' deposit rates in real terms (deflated by core CPI) have plunged into negative territory for the first time in the past 12 years (Chart I-9, bottom panel). Remarkably, the People's Bank of China's existing $3 trillion of international reserves is sufficient to "back up" only 13% and 11% of official M2 and our measure of M3, respectively (Chart I-10). If Chinese households and companies decide to convert 10-15% of their deposits into foreign currency and the PBoC takes the other side of the trade, its reserves will be exhausted. Chart I-9China: Inflation Is Rising And ##br##Real Deposit Rate Is Negative Chart I-10China: Low Coverage Of ##br##Money Supply By FX Reserves Therefore, reining money and credit expansion is of paramount importance to China's long-term financial and economic stability. "Financial stability" has become the key policy priority. "Financial stability" is policymakers' code word for containing and curbing financial imbalances and bubbles. Having experienced the equity bubble bust in 2015, policymakers are determined to preclude another bubble formation and its subsequent bust. Consequently, the ongoing tightening campaign will not be reversed in the near term unless damage to the economy becomes substantial and visible. By the time the authorities and investors are able to identify such damage in the real economy, China-related plays in financial markets will be down substantially. Chart I-11China: Corporate Bond Yields And Yield Curve Faced with significant excesses in money, leverage and property markets, the Chinese authorities have been tightening - and have reinforced their policy stance following the Party's Congress in October. There is triple tightening currently ongoing in China: 1. Liquidity tightening: Money market rates have climbed, and onshore corporate bond yields are rising (Chart I-11, top panel). Remarkably, the yield curve is flat, pointing to weaker growth ahead (Chart I-11, bottom panel). 2. Regulatory tightening: The China Banking Regulatory Commission (CBRC) is forcing banks to bring off-balance-sheet assets onto their balance sheets, and is reining banks' involvement in shadow banking activities. In addition, financial regulators are trying to remove the government's implicit "put" from the financial system, and thereby curb speculative and irresponsible investment behavior. Finally, many local governments are tightening investors' participation in the real estate market. 3. Anti-corruption campaign is embracing the financial institutions: The powerful anti-corruption commission is planning to dispatch groups of inspectors to examine financial institutions' activities. This could dampen animal spirits among bankers and shadow banking organizations. The Outlook: The "Knowns"... In China, broad money growth has already slumped to an all-time low (Chart I-12). The money as well as the credit plus fiscal spending impulses both point to a considerable slowdown in the mainland's industrial cycle and overall economic activity (Chart I-13). Chart I-12China: Broad Money ##br##Growth Is At All-Time Low Chart I-13China: Money And Credit & ##br##Fiscal Impulses Are Negative The slowdown is not limited to money growth; there are a few real business cycle indicators that are already weakening. For example, the growth rate of property floor space sold and started has slumped to zero (Chart I-14). Electricity output and aggregate freight volume growth have both decisively rolled over (Chart I-15). Chart I-14China: Property Starts Are Set To Contract Again Chart I-15China: A Few Signs Of Slowdown That said, based on the past correlation between money and credit impulses on the one hand and the business cycle on the other, China's economy should have slowed much more, and its negative impact on the rest of the world should have already been felt (Chart I-13, on page 9). This has been the key pillar of our view on EM, but it has not yet transpired. Is it possible that the relationship between money/credit impulses and the business cycle has broken down? If so, why? And how should investors handle such uncertainty? Bottom Line: China's ongoing policy tightening will ensure that money and credit impulses remain negative for some time. Can the country's industrial sectors de-couple from its past tight correlation with money and credit? ...And The "Unknowns" By definition, the only way to sustain nominal economic growth in the face of a decelerating money supply is if the velocity of money increases. This is true for any economy. Nominal GDP = Money Supply x Velocity of Money Provided China's policy tightening will likely further dampen money growth, the only way nominal GDP growth can hold up is if the velocity of money rises meaningfully, offsetting the drop in money growth. This is the main risk to our view and strategy. Chart I-16 portrays all three variables. Chart I-16China: Money, Nominal GDP ##br##And Velocity Of Money Even though the velocity of money has fallen structurally over the past nine years (Chart I-16, bottom panel), it has risen marginally in 2017, allowing the mainland's nominal economic growth to hold up despite a considerable relapse in money supply growth. Notably, this has been the reason why our view has not worked this year. What is the velocity of money, and how can we forecast its fluctuations and, importantly, the magnitude of its variations? The velocity of money is one of the least understood concepts in economic theory. The velocity of money is anything but stable. In our opinion, the velocity of money reflects animal spirits of households and businesses as well as government spending decisions. Forecasting animal spirits and the magnitude of their variations is not very a reliable exercise. In a nutshell, the banking system (commercial banks and the central bank) creates money via expanding its balance sheet - making loans to or acquiring assets from non-banks. However, commercial banks have little direct influence on the velocity of money. The latter is shaped by non-banks' decisions to spend or not (i.e., save). Significantly, non-banks' spending and saving decisions do not alter the amount of money in the system. Yet they directly impact the velocity of money. The banking system creates money, and non-banks churn money (make it circulate). At any level of money supply, a rising number of transactions will boost nominal output, and vice versa. Further, there is a great deal of complexity in the interaction between money supply and its velocity. Both are sometimes independent, i.e. they do not influence one another, but in some other cases one affects the other. For example, with the ongoing triple tightening in China and less money being originated by the banking system, will households and businesses increase or decrease their spending? Our bias is that they will not increase spending. This is especially true for the corporate sector, which has record-high leverage and where access to funding has been tightening. It is also possible that rising velocity will lead to more money creation as more spending leads to higher loan demand and banks accommodate it - i.e., originating more loans/money. These examples corroborate that money supply and the velocity of money are not always independent of each other. On the whole, it is almost impossible to reliably forecast the magnitude of changes in velocity of money. In the same vein, it is difficult to forecast animal spirit dynamics in any economy. Chart I-17U.S.: The Rise In Velocity Of Money ##br##Overwhelmed Slowdown In Money One recent example where nominal GDP has decoupled from broad money growth is the U.S. Chart I-17 demonstrates that in the past 12 months, U.S. nominal GDP growth has firmed up even though broad money (M2) growth has slumped. This decoupling can only be explained by a spike in the velocity of M2. In other words, soaring confidence and animal spirits among U.S. households and businesses have boosted their willingness to spend, even as the banking system has created less money and credit growth has slowed considerably over the past 12 months. Going back to China, how should investors consider such uncertainty in changes in the velocity of money? Investing is about the future, which is inherently uncertain. Hence, an investment process is about assigning probabilities to various scenarios. Provided the velocity of money is impossible to forecast, we assign equal probabilities to each of the following scenarios for China in 2018 (Figure I-1): One-third odds that the velocity of money rises more than the decline in broad money growth, producing robust nominal GDP growth; One-third probability that the velocity of money stays broadly flat - the outcome being meaningful deceleration in nominal GDP growth; A one-third chance that the velocity of money declines - the result being a severe growth slump. Figure I-1How Investors Can Consider Uncertainty Related To Velocity Of Money In short, a positive outcome on China-related plays has a one-third probability of playing out, while a negative outcome carries a two-thirds chance. This is why we continue to maintain our negative view on EM and commodities. Commodities Our view on commodities and commodity plays is by and large shaped by our view on China's capital spending. Given the credit plus fiscal spending impulse is already very weak, the path of least resistance for capital expenditures is down. Besides, the government is clamping down on local governments' off-balance-sheet borrowing and spending (via Local Government Financing Vehicles). A deceleration in capital expenditures in general and construction (both infrastructure and property development) in particular is bearish for industrial metals (Chart I-18). Money and credit impulses herald a major downturn in Chinese imports values and volumes (Chart I-19). Chart I-18Industrial Metals / Copper Are At Risk Chart I-19China Will Be A Drag On Its Suppliers As to China's commodities output reductions, last week we published a Special Report3 on China's "de-capacity" reforms in steel and coal. The report concludes the following: The path of least resistance for steel, coal and iron ore prices is down over the next 12-24 months. China's "de-capacity" reforms in steel and coal will continue into 2018 and 2019, but the scale and pace of "de-capacity" will diminish. Importantly, the mainland's steel and coal output will likely rise going forward as new capacity using more efficient and ecologically friendly technologies come on stream. The capacity swap policy introduced by the authorities has been allowing steel and coal producers to add new capacity in order to replace almost entirely obsolete capacity. The combination of demand slowdown and modest production recovery will weigh on non-oil raw materials. As for oil, the picture is much more complicated. Oil prices have been climbing in reaction to declining OECD inventories as well as on expectations of an extension to oil output cuts into 2018. One essential piece of missing information in the bullish oil narrative is China's oil inventories. In recent years, China has been importing more crude oil than its consumption trend justifies. Specifically, the sum of its net imports and domestic output of crude oil has exceeded the amount of refined processed oil. This difference between the sum of net imports and production of crude oil and processed crude oil constitutes our proxy for the net change of crude oil inventories. Chart I-20 shows that our proxy for mainland crude oil inventories has risen sharply in recent years. This includes both the nation's strategic oil reserves as well as commercial inventories. There is no reliable data on the former. Therefore, it is impossible to estimate the country's commercial crude oil inventories. Chart I-20China: Beware Of High Chinese Oil Inventories Nevertheless, whether crude oil inventories have risen due to a build-up of strategic petroleum reserves or commercial reserves, the fact remains that crude oil inventories in China have surged and appear to be reaching the size of OECD total crude and liquid inventories (Chart I-20). In short, China has been a stabilizing force for the oil market over the past three years by buying more than it consumes. Without such excess purchases from China, oil prices would likely have been much weaker. Going forward, the pace of Chinese purchases of crude oil will likely slow due to several factors: (a) China prefers buying commodities on dips, especially when it is for strategic inventory building. With crude oil prices having rallied to around $60, the authorities might reduce their purchases temporarily, creating an air pocket for prices, and then accelerate their purchases at lower prices; (b) Commercial purchases of oil will likely decelerate due to tighter money/credit, possibly high inventories and a general slowdown in industrial demand for fuel. Bottom Line: Raw materials and oil prices4 are at risk from China and overly bullish investor sentiment. Beyond Commodities The slowdown in China will impact not only commodities but also non-commodity shipments to the mainland (Chart I-21). In fact, 47% of the nation's imports are commodities and raw materials and 45% are industrial/capital goods - i.e., China's imports are heavily exposed to investment expenditures, not consumer spending. This is why money/credit impulses correlate so well with this country's imports. Consistently, China's broad money (M3) impulse leads EM corporate profit growth by 12 months - and currently heralds a major EPS downtrend (Chart I-22). In addition, aggregate EM narrow money (M1) growth also points to a material slump in EM EPS (Chart I-23). Chart I-21China Is A Risk To ##br##Non-Commodity Economies Too Chart I-22Downside Risk To EM EPS The only EM countries that are not materially exposed to China and commodities are Turkey and India. The former is a basket case on its own. Indian stocks are expensive and will have a difficult time rallying in absolute terms when the EM equity benchmark relapses. As for Korea and Taiwan, their largest export destination is not advanced economies but China. China accounts for 25% of Korea's exports and 28% of Taiwan's. This compares to a combined 22% of total Korean exports and 20% of total Taiwanese exports going to the U.S. and EU combined Can robust growth in the U.S. and EU derail the growth slowdown in China when capital spending slows? This is very unlikely, in our view. Chart I-24 portends that China's shipments to the U.S. and EU account for only 6.6% of Chinese GDP, while capital spending and credit origination constitute 45% and 25% of GDP, respectively. Chart I-23EM M1 And EM EPS Chart I-24What Drives Chinese Growth? A final word on tech stocks. EM's four large-cap tech stocks (Tencent, Ali-Baba, Samsung and TSMC) have gone exponential and are extremely overbought. At this juncture, any strong opinion on tech stocks is not warranted because they can sell off or continue advancing for no fundamental reason. We have been recommending an overweight position in tech stocks, and continue recommending overweighting them, especially Korean and Taiwanese semiconductor companies. As for Tencent and Alibaba, these are concept stocks, and as a top-down house we have little expertise to judge whether or not they are expensive. These are bottom-up calls. Investment Strategy EM Stocks: Asset allocators should continue to underweight EM versus DM, and absolute-return investors should stay put. Our overweights are Taiwan, China, Korean tech stocks, Thailand, Russia and central Europe. Our underweights are Turkey, South Africa, Brazil, Peru and Malaysia. Chart I-25EM Currencies: A Canary In ##br##Coal Mine For EM Credit? Stay short a basket of the following EM currencies: ZAR, TRY, BRL, IDR and MYR. We are also shorting the COP and CLP. Unlike in 2014-2015, EM currencies will depreciate not only versus the U.S. dollar but also the euro. For traders who prefer a market neutral currency portfolio, our recommended longs (or our currency overweights) are TWD, THB, SGD, ARS, RUB, PLN and CZK. INR and CNH will also outperform other EM currencies. Continue underweighting EM sovereign and corporate credit relative to U.S. investment grade bonds. The mix of weaker EM/China growth, lower commodities prices and EM currency depreciation bode ill for already very tight EM credit spreads (Chart I-25). Within the sovereign credit space, our underweights are Brazil, Venezuela, South Africa and Malaysia and our overweights are Russia, Argentina and low beta defensive credits. The main risk to EM local currency bonds is EM currency depreciation. With foreign ownership of EM domestic bonds at all-time highs, exchange rate depreciation could trigger non-trivial selling pressure. Among local currency bond markets, the most vulnerable are Turkey, South Africa, Indonesia and Malaysia. The least vulnerable are Korea, Russia, China, India, Argentina and Central Europe. Other high-conviction market-neutral recommendations: Long U.S. banks / short EM banks. Long U.S. homebuilders / short Chinese property developers. Long the Russian ruble / short oil. Long the Chilean peso / short copper. Long Big Five state-owned Chinese banks / short small- and medium-sized banks. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 For example, given that interest rates are in the denominator of the Gordon Growth model, a one percentage point change in interest rates from a low level can have a significant impact on the fair value P/E ratio. 2 Please refer to the Emerging Markets Strategy Special Reports from October 26, 2016, November 23, 2016 and January 18, 2017; available on ems.bcaresearch.com 3 Please refer to the Emerging Markets Strategy Special Report titled "China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed," dated November 22, 2017, link available on page 22. 4 This is the Emerging Markets Strategy team's view and is different from BCA's house view on commodities. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Special Report

Highlights Higher Treasury Yields: As core inflation returns to the Fed's target in 2018 the 10-year TIPS breakeven inflation rate will rise by at least 50 basis points and the nominal 10-year Treasury yield will move above 2.80%. This is substantially higher than the 1-year forward rate of 2.49%. Maintain a below-benchmark portfolio duration stance. TIPS Over Nominal Treasuries: TIPS will outperform nominal Treasury securities in 2018 as long-maturity TIPS breakeven inflation rates widen alongside rising core inflation. The passage of tax cuts in the first half of next year would speed up the adjustment in breakevens. Curve Steepeners, Then Flatteners: The slope of the yield curve is positively correlated with TIPS breakeven inflation rates. Look for mild curve steepening in the first half of 2018 as breakevens widen, transitioning to flattening once breakevens level-off around mid-year. The Cyclical Sweet Spot Comes To An End: The cyclical sweet spot of solid growth and low inflation that has been driving the outperformance of spread product will come to an end in 2018. The catalyst will be higher inflation. We will start paring exposure to spread product once long-maturity TIPS breakeven inflation rates approach our target range of 2.4% to 2.5%, probably in the middle of next year. A Year Of Low Returns: Spreads are not that far from all-time expensive levels, meaning there is limited room for spread compression at this late stage of the credit cycle. Excess returns from spread product will be very similar to carry in 2018 - at least until inflation rises and it is time to prepare for a sustained period of spread widening. Feature BCA's Outlook for 2018 was published last week.1 That report laid out the macroeconomic themes that will impact markets during the next year. In this week's report we expand on those themes and discuss what they mean for U.S. fixed income markets specifically. We identify five key implications. Implication 1: Higher Yields One important theme for 2018 will be the resumption of the cyclical uptrend in inflation. As was stated in the Outlook: The historical evidence still suggests that once the labor market becomes tight, inflation eventually does accelerate. A broad range of data indicates that the U.S. labor market is indeed tight and the Atlanta Fed's wage tracker is in an uptrend, albeit modestly. Two other factors consistent with an end to disinflation are the lagged effects of dollar weakness and a firming in oil prices. Non-oil import prices have now moved decisively out of deflationary territory while oil prices in 2017 have averaged more than 20% above year-ago levels. Rising inflation mustn't necessarily translate into higher yields, but the Treasury market is not currently priced for the possibility that core inflation will ever re-gain the Fed's 2% target. Chart 1 shows the nominal 10-year Treasury yield split into its two main components: Chart 110-Year Treasury Yield Components The compensation for future inflation - proxied by the 10-year TIPS breakeven inflation rate. The real 10-year Treasury yield - proxied by the 10-year TIPS yield. As has been stated repeatedly in this publication, in an environment where realized inflation is well-anchored around the Fed's 2% target the 10-year TIPS breakeven inflation rate has historically traded in a range between 2.4% and 2.5% (Chart 1, top panel). The 10-year TIPS breakeven inflation rate currently sits at 1.84%. This means that by the time core inflation returns to the Fed's 2% target, a feat we think will be achieved in 2018, the 10-year TIPS breakeven inflation rate will impart 56 to 66 basis points of upside to the nominal 10-year Treasury yield. It is possible that any increase in the compensation for inflation protection could be offset by falling real yields. However, it is highly unlikely that the 10-year real yield would decline while the Fed is hiking rates, unless there is a sharp downward adjustment in our 12-month Fed Funds Discounter2 (Chart 1, panel 2). On that front, the market is currently priced for between two and three rate hikes during the next 12 months. This expectation could be revised even higher in the near-term as inflation recovers, but that faster pace of rate hikes is unlikely to be sustained for any significant period of time. All in all, the discounter appears not that far from its fair value, meaning that the 10-year real yield should impart some modest additional upside to the 10-year nominal yield on a 6-12 month horizon. To summarize, if core inflation returns to the Fed's target in 2018, then the nominal 10-year Treasury yield will move into a range between 2.90% and 3.00% (Chart 1, bottom panel), conservatively assuming no additional upside or downside from real yields. This is substantially above the 1-year forward rate of 2.49%, and we therefore advocate a below-benchmark portfolio duration stance. The Importance Of Synchronized Growth It was also observed in the Outlook that, according to the IMF, the median output gap for 20 advanced economies will shift from -0.1% in 2017 to +0.3% in 2018. If these forecasts pan out, then 2018 will also be the first year since the recession that more than 50% of those 20 economies have output gaps in positive territory. Meanwhile, the IMF estimates that the U.S. output gap has been essentially closed since 2015 (Chart 2). In other words, the U.S. has been leading the global economic recovery for the past few years but this is now starting to change. The rest of world is quickly catching up and the global economic recovery is now much more synchronized. This is critically important for U.S. bond yields because it lessens the impact of foreign inflows. For example, when U.S. growth was far outpacing growth in the rest of the world in 2014 and 2015, any increase in U.S. Treasury yields also widened the spread between U.S. yields and yields in the rest of the world. The wider gap encouraged foreign inflows to the U.S. bond market and limited how high U.S. yields could rise. Now, with the global economic recovery more synchronized, U.S. yields will have to increase by much more to have the same impact on the spread between U.S. yields and yields in the rest of the world. In our view this is an extremely bond-bearish development that often goes under-appreciated. Our 2-factor Treasury model attempts to quantify the impact of synchronized global growth on the U.S. 10-year Treasury yield (Chart 3). The model uses Global Manufacturing PMI as its proxy for global growth, and bullish sentiment toward the U.S. dollar as a proxy for the synchronization of the global recovery - a less synchronized recovery should lead to increased bullishness toward the dollar and vice-versa. The model's current reading pegs fair value for the 10-year Treasury yield at 2.69%. Chart 2Rest of World Playing Catch-Up Chart 32-Factor Treasury Model Bottom Line: As core inflation returns to the Fed's target in 2018 the 10-year TIPS breakeven inflation rate will rise by at least 50 basis points and the nominal 10-year Treasury yield will move above 2.80%. This is substantially higher than the 1-year forward rate of 2.49%. Maintain a below-benchmark portfolio duration stance. Implication 2: TIPS Over Nominal Treasuries It should be obvious that if the forecasts in the prior section pan out then TIPS will substantially outperform nominal Treasury securities as breakeven inflation rates widen in 2018. In our opinion the low level of long-maturity TIPS breakeven inflation rates represents the greatest source of medium-term value in U.S. bond markets. Chart 4Breakevens Biased Wider In addition, a wide range of indicators, such as our own Pipeline Inflation Indicator and the New York Fed's Underlying Inflation Gauge, already suggest that breakevens are biased wider (Chart 4). With the Fed engaged in a rate hike cycle, evidence of price pressures in the realized inflation data will be required before breakevens see significant upside. Our base case forecast is that the 10-year TIPS breakeven rate will reach our target range of 2.4% to 2.5% around the same time that core PCE inflation reaches 2%, probably in the middle of next year. However, there is one political risk that could speed up that adjustment. Namely, if Congress manages to pass tax cuts in the first half of 2018. From the Outlook: The U.S. tax system is desperately in need of reform [...]. However, the economy does not need stimulus from net tax giveaways given that it is operating close to potential. That would simply boost demand relative to supply, create overheating, and give the Fed more reason to get aggressive. The Republican's initial tax plan has some good elements of reform such as cutting back the personal mortgage interest deduction, eliminating some other deductions and making it less attractive for companies to shift operations overseas. However, many of these proposals are unlikely to survive the lobbying efforts of special interest groups. The net result probably will be tax giveaways without much actual reform. [...] There inevitably will be contentious negotiations in Congress but we assume that the Republicans will eventually come together to pass some tax cuts by early next year. Fiscal stimulus from tax cuts at this late stage of the cycle would be very inflationary, and judging by the sharp increase in TIPS breakevens that followed President Trump's election last November, the market has already figured this out. The passage of a tax bill early next year would no doubt speed up the return of long-maturity TIPS breakevens to our target range. Bottom Line: TIPS will outperform nominal Treasury securities in 2018 as long-maturity TIPS breakeven inflation rates widen alongside rising core inflation. The passage of tax cuts in the first half of next year would speed up the adjustment in breakevens. Implication 3: Curve Steepeners, Then Flatteners Another recommendation that follows from rising inflation is that the yield curve will steepen as long-maturity TIPS breakeven inflation rates rise. We have previously observed that changes in the slope of the 2/10 Treasury curve are positively correlated with changes in the 5-year/5-year forward TIPS breakeven inflation rate. Crucially, this positive correlation remains intact even when the Fed is hiking rates.3 In the current rate hike cycle (which started in December 2015) we observe that monthly changes in the 2/10 nominal Treasury slope have been positively correlated with monthly changes in the 5-year/5-year forward TIPS breakeven rate in 22 out of 24 months (Chart 5). It stands to reason that we should expect the yield curve to steepen as TIPS breakevens rise. Chart 52/10 Nominal Treasury Slope Vs. TIPS Breakeven Inflation Rate 5-Year/5-Year Forward ##br##(December 2015 - Present) However, we caution that curve steepening is probably only a story for the first half of 2018. Steepening will transition to flattening once long-dated TIPS breakevens reach our 2.4% to 2.5% target range, and in the meantime, there is a limit to how steep the yield curve can get. Let's assume that the Fed's median projection of a 3% terminal fed funds rate is reasonably accurate. It follows that the 10-year Treasury yield is unlikely to rise much above 3% before the end of the recovery. We can also calculate what the 2-year Treasury yield will be under different scenarios for the fed funds rate and the 2-year/fed funds slope. The latter can be thought of as simply the number of rate hikes the market expects during the subsequent two years. With these assumptions we can craft scenarios for where the 2/10 Treasury slope will be under different conditions, and these scenarios are presented in Table 1. The shaded cells in Table 1 are the scenarios that cause the 2/10 Treasury slope to steepen from its current level of 59 bps. Table 1Scenarios For The Number Of Fed Rate Hikes By ##br##The Time That Inflation Returns To Target For example, by the time that inflation recovers to the Fed's 2% target, the nominal 10-year Treasury yield will most likely be in a range between 2.8% and 3.25%. If the Fed only delivers two rate hikes between now and then it is very likely that the yield curve will steepen. This is shown in the section of Table 1 labelled "2 Rate Hikes". However, if the Fed lifts rates four times between now and the time that inflation returns to target, then it is much more likely that the 2/10 curve will flatten. These scenarios are shown in the top three rows of Table 1. The message is that the order of events matters. In our base case scenario, inflation starts to recover early next year and long-dated TIPS breakeven inflation rates reach our 2.4% to 2.5% target by mid-2018. At that point it is quite likely that the Fed will have only hiked rates a couple of times and the curve will have steepened. More rapid rate hikes, however, would severely limit the amount of potential steepening. We continue to advocate positioning for 2/10 steepening via a long position in the 5-year bullet versus a short position in the duration-matched 2/10 barbell. At present, the 2/5/10 butterfly spread is priced for 4 bps of 2/10 curve flattening during the next six months, so even mild curve steepening will lead to outperformance during that timeframe.4 We will shift from curve steepeners to flatteners once TIPS breakevens return to our target range. Bottom Line: The slope of the yield curve is positively correlated with TIPS breakeven inflation rates. Look for mild curve steepening in the first half of 2018 as breakevens recover, transitioning to flattening once breakevens re-normalize around mid-year. Implication 4: The Cyclical Sweet Spot Comes To An End From the Outlook: The perfect environment for markets has been moderate economic growth, low inflation and easy money. [...] We are assuming that growth is strong enough to encourage central banks to keep moving away from hyper-easy policies, setting up for a collision with markets. If growth slows enough that recession fears spike, then that also would be bad for risk assets. Sustaining the bull market requires a goldilocks growth outcome of not too hot and not too cold. Chart 6The "Fed Put" Is Still In Place This publication has named that goldilocks environment the "cyclical sweet spot" for risk assets. Essentially, as long as inflation is below the Fed's target, the Fed must respond to any economic weakness (or tightening of financial conditions) by adopting a more accommodative policy stance. The market knows that this "Fed put" is in place and that makes it very difficult to get a meaningful sell-off. In fact, the last major sell-off in corporate credit (in 2014/15) only occurred because the market assumed that the Fed would not deviate from its projected rate hike path even though commodity prices were plunging, causing defaults in certain exposed industry groups. Notice in Chart 6 that our 24-month Fed Funds Discounter stayed flat as spreads widened. Spreads only tightened in early 2016 after the Fed capitulated. So under what conditions will the "Fed put" disappear? Logically, if inflation were much higher the Fed would be less inclined to support markets at any sign of trouble. This is the reason that, while we remain overweight spread product versus Treasuries for now, we expect the cyclical sweet spot for spreads will come to an end next year. Long-maturity TIPS breakeven inflation rates approaching our target range of 2.4% to 2.5% will be the first signal that it is time to pare exposure. The importance of supportive monetary policy for spread product performance is also evident when looking at our three favorite credit cycle indicators (Chart 7). Historically, three conditions must be met before a sustained period of spread widening can occur. Chart 7Credit Cycle Indicators Our Corporate Health Monitor must be in "deteriorating health" territory (Chart 7, panel 2). Fed policy must be restrictive. This can be proxied by an inverted yield curve, or a real fed funds rate above its estimated equilibrium level (Chart 7, panels 3 & 4). Bank Commerical & Industrial lending standards must be in "net tightening" territory (Chart 7, bottom panel). For the time being only corporate health is sending a negative signal, but once inflation recovers we will be at increasing risk of monetary conditions turning restrictive. Tighter lending standards tend to follow restrictive monetary policy with a short lag. Bottom Line: The cyclical sweet spot of solid growth and low inflation that has been driving the outperformance of spread product will come to an end in 2018. The catalyst will be higher inflation. We will start paring exposure to spread product once long-maturity TIPS breakeven inflation rates approach our target range of 2.4% to 2.5%, probably in the middle of next year. Implication 5: A Year Of Low Returns From the Outlook: Our estimates indicate that a balanced portfolio will deliver average returns of only 3.3% a year over the coming decade, or 1.3% after inflation. That is down from the 4% and 1.9% nominal and real annual returns that we estimated a year ago, reflecting the current more adverse starting point for valuations. Heading into 2018 almost all U.S. spread product sectors are indeed faced with a more adverse starting point for valuations. Chart 8 compares today's option-adjusted spread (OAS) with the OAS at the end of 2016 for seven major spread products. With the exception of MBS, all sectors currently have lower spreads than at they did at the beginning of 2017. Chart 8Less Value In Spread Product Starting valuation is only one component of excess returns. Capital gains/losses from the change in spreads is the other. However, the deeper we move into the credit cycle the less room there is for further spread compression. In fact, we have previously calculated that the average spread for the investment grade Corporate bond index can only tighten another 35 bps before it reaches all-time expensive levels. This represents only 3 months of historical average spread tightening. The same calculation for the High-Yield index shows that the spread can only tighten another 145 bps, representing 4 months of average tightening.5 In other words, there is not much potential for spread compression at this late stage of the credit cycle and excess returns will be very similar to carry in 2018 - at least until inflation rises and it is time to prepare for a sustained period of spread widening. Chart 9 shows annualized 2017 year-to-date excess returns for each sector alongside projected excess returns for 2018 under two scenarios. The "flat spread" scenario assumes that spreads stay flat at current levels, while the "optimistic" scenario assumes that spreads tighten to all-time expensive valuation levels. Chart 92018 Excess Return Projections For investment grade corporate bonds even this extremely optimistic scenario would only provide excess returns of 363 bps, just 121 bps above this year's likely returns. For High-Yield, the optimistic scenario would provide excess returns of 637 bps, a mere 148 bps above this year's likely returns. For consumer ABS and domestic Agency bonds, the projections from our optimistic scenario do not even surpass this year's likely excess returns. Bottom Line: Spreads are not that far from all-time expensive levels, meaning there is limited room for spread compression at this late stage of the credit cycle. Excess returns from spread product will be very similar to carry in 2018 - at least until inflation rises and it is time to prepare for a sustained period of spread widening. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see Outlook 2018, "Policy And The Markets: On A Collision Course", dated November 20, 2017, available at bca.bcaresearch.com 2 Our 12-month Fed Funds Discounter measures the number of rate hikes priced into the overnight index swap curve for the next 12 months. 3 Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com 4 For further details on our yield curve models and how we calculate the amount of steepening/flattening priced into the butterfly spread please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com 5 These numbers refer to the spread tightening necessary to reach all-time lows on the 12-month breakeven spread for each index. We calculate the 12-month breakeven spread as OAS divided by duration. Fixed Income Sector Performance

Highlights Risk assets continue to rise despite a flattening yield curve. Individual investors are more sanguine than institutional investors as stocks make new highs. The S&P 500 is testing the top of a key channel. Will it break out or break down? Bond market sentiment, positioning and technicals today vs. 1994. Feature Risk-on returned to financial markets last week as the S&P 500 hit a new all-time high and oil prices reached a 2-year high. Credit spreads narrowed as well. This occurred despite growing investor angst regarding the flattening yield curve. At 58 basis points, the 2/10 yield curve is still in positive territory, but the recent flattening could be interpreted as heralding a Fed policy mistake. We, too, are concerned. The flattening curve is being driven by the Fed's determination to continue lifting short-term rates even in the face of subdued inflation readings. Our base case outlook sees inflation grinding higher in the coming months, leading to a temporarily steeper curve. Nonetheless, we will re-evaluate our asset allocation if the curve continues to flatten and core inflation remains stuck in a range. BCA expects U.S. stocks to outperform Treasuries in 2018. S&P 500 EPS growth and margins will hold up through mid-year, supported by an above-trend domestic economic expansion in 1H 2018, a dose of fiscal stimulus and accelerating economic activity outside the U.S. Still, many investors are concerned that sentiment and valuations are signaling that a pullback is nigh. Sanguine Sentiment Our technical and sentiment indicators are not flashing red as in previous bear markets, but neither are they giving an all-clear for U.S. equity investors. Sentiment levels are a bigger concern than technical indicators and investors should monitor both for signs of an equity sell-off. BCA's U.S. equity sentiment indicator is elevated, although not at an extreme (Chart 1). Remarkably, in contrast to previous market troughs, individual Investors (panel 2) are more sanguine than either financial advisors (panel 3) or traders (panel 4). Bullishness among traders is at a 10-year high. Typically, after a long bull run, institutions are more cautious about equities than the oft-maligned individual investor. Several other sentiment surveys illustrate the divergence in sentiment between institutions and individuals. As per the American Institute of Individual Investors, the percentage of small investors who are bearish (Chart 2, 35%, panel 2) is in the middle of a 30-year range while the percentage of bulls (29%, panel 3) is at the low end. Moreover, Chart 3 shows the gap in the expectation between households and professionals on future stock market returns (as tallied by the Yale School of Management's International Center for Finance) and on buying the dips (panel 4). That said, individuals and institutions are more aligned on the likelihood of a stock market crash in the next six months. None of the three sentiment indicators from the Yale survey are at an extreme. Chart 1Overall Sentiment Levels Elevated##BR##But Not At Extremes Chart 2Individuals Are Not##BR##Overly Bullish Active managers have reduced equity risk since the beginning of Q4 (Chart 4). At 61%, the average equity exposure of institutional investors surveyed by the NAAIM1 is at the lowest level since May 2016 and is nearly half the 102% exposure at the start of 2017. The March 2017 reading was the highest since 2007, just before the S&P 500 peak in October 2007. Chart 3Gap Between Individual##BR##And Institutional Investors Chart 4Active Managers Still##BR##Overweight Equities... Similarly to previous bear markets, BCA's equity speculation index moved into "high speculation" territory in early 2017 and remains so as the year ends and range bound on average at somewhat lower levels. Net speculative positions of S&P 500 stocks are in balance, however, and do not signal that market risk-taking is rampant (Chart 5). Moreover, the dispersion of equity volatility of new high and lows of the S&P500 is quite wide, ranging from over 20% to below 5%, over previous historical periods since 1994. Although volatility is not a leading indicator of future equity market returns, good or bad, the current low level of volatility, especially over the short-term, 6 months to 1-year, may be longer-lasting, having peaked from over 15% only since early 2016 and now closer to 5%. Longer-term volatility, for example, based on 2-, 3- and 4-years, still remains above 10%. It is not unusual for both short-term and long-term volatility to eventually converge, as seen in post-bear market phases, especially in the mid-2000s (Chart 6). Chart 5Speculation High, But Not At Extremes Chart 6Equity Vol Remains Low Warning Signs From Technicals? On balance, the technical indicators we monitor do not suggest that the market is stretched. Chart 7 shows that the S&P 500 is testing the top end of the 2009-2017 recovery trend channel. A failure to break out of the channel may result in some near-term consolidation for U.S. equities. However, a definitive break above 2616 would imply another upleg for stocks. The escalating advance/decline line is also in a bullish trend (Chart 7). The other technical indicators we monitor fall into two categories. Some are elevated, but not at extremes. Others are still in the middle of the range and are not a concern. The S&P 500 is 6% above its 200-day moving average, in the upper end of its post-2000 range, which is well below the recent highs set in 2009, 2011 and 2013. The S&P's distance from its 50-day MA is in a similar position (Chart 8, panels 1 and 2). BCA's composite technical measure is in the middle of the 2007-2017 range, and is not a concern (Chart 9, panel 5). Moreover, the percent of NYSE stocks above their 10- and 30-week highs are midway in their recent range. Furthermore, new highs minus new lows is at neutral lows (Chart 6, panel 2). Chart 7Breakout...Or Breakdown##BR##At Top Of Channel? Chart 8S&P Not Elevated Vs.##BR##Moving Averages Chart 9U.S. Stocks Not##BR##Overextended Bottom Line: Neither sentiment nor technical indicators are flashing red, although the fact that institutional managers are heavily overweight stocks is worrying. We continue to recommend stocks over bonds in the next 12 months, but acknowledge that risks to BCA's stance are climbing. Investors should be prudent with risk assets, paring back any maximum overweight positions and holding some safe-haven assets within diversified portfolios. BCA's U.S. Equity Strategy service maintains a positive technical stance on the energy sector2 and notes that technicals in the consumer discretionary sector look washed out.3 BCA downgraded consumer discretionary from overweight to neutral on September 25, 2017 despite the attractive technical backdrop of the sector. Is It 1994 - Again? BCA's U.S. Bond Strategy service puts fair value on the U.S. 10-year Treasury at 2.69%,4 and rates may climb as high as 3.0% in 2018 if inflation returns to the Fed's 2.0% target. Fundamentals (elevated inflation, above-trend U.S. growth, a more aggressive Fed) support our bond view. However, what does the technical picture in the bond market tell investors? Charts 10 and 11 show the sentiment and technical indicators for the bond market in 2017 and 1994. The duration positioning of portfolio managers in late 2017 matches the situation in 1994. At 100%, portfolio duration is the highest since March 21, 2017. This positioning implies that the market is vulnerable to a spike in rates, as it was in 1994 when the Fed's 75-basis point rate hike in February caught the market off guard. In October 1994, portfolio duration was 103%. While BCA views a Fed policy mistake as a risk to our bullish equity call in 2018, a 1994-style surprise from the Fed is unlikely. In 1994, the Fed's policy intentions were opaque, at best. Since then, the Fed has become increasingly transparent and frequently seeks a "buy-in" from the market before boosting rates. Chart 10Bond Market Positioning,##BR##Sentiment And Technicals In 1994.... Chart 11...And In##BR##2017 The 10-year Treasury yield is currently in an uptrend as it was in early 1994. Today, yields have climbed 80 bps off their post-Brexit lows in mid-2016. The 10-year yield troughed in October 1993 at 5.19%, and rose 60 bps before the Fed's shock rate hike in early 1994. However, in 1994 yields were only beginning to enter the second decade of what would become a 35-year fall in bond yields. BCA's view is that the 1.57% yield in June 2016 marked the end of that multi-year decline. The bond market in late 2017 is as oversold as the bond market was in early 1994, although it took different paths to get to the same juncture. According to BCA's Composite Bond Indicator, the bond market in late 1993 and early 1994 was working off a deeply overbought position. However, by early 1994, bonds were modestly oversold. BCA's bond measure was deeply oversold in late 2016 and early 2017, but shifted into overbought territory in the summer. Today, bonds are modestly oversold. Panel 4 of Charts 10 and 11 show that Fed rate hikes were not priced in at the end of 1993 and in early 1994; today, a few increases are priced in. Investors were net purchasers of bond funds in 1993 and 1994, which is the same as the current situation. In 1993, however, investors were shedding bond funds while individuals are now adding to their bond positions. Bottom Line: Several sentiment and technical indicators in the bond market echo the scenario in 1994. Nonetheless, 25 years of increased Fed transparency means it would be unlikely that the market will be surprised by the Fed's next rate increase. Still, with a new Fed Chair, a record number of vacancies on the Fed's Board and an unprecedented unwinding of its balance sheet, a policy misstep by the Fed would threaten BCA's position on the economy, equities and bonds in 2018. A bigger risk may be that the bond market is still priced for the low inflation environment to persist. Accordingly, if there is an upside surprise on inflation, bonds could be hit hard on a re-assessment of the Fed's rate path. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 National Association of Active Investment Managers. 2 Please see BCA Research's U.S. Equity Strategy Weekly Report "Invincible", published November 6, 2017. Available at uses.bcaresearch.com. 3 Please see BCA Research's U.S. Equity Strategy Weekly Report "Resilient", published September 25, 2017. Available at uses.bcaresearch.com. 4 Please see BCA Research's U.S. Bond Strategy Portfolio Allocation Summary "Into The Fire", published November 7, 2017. Available at usbs.bcaresearch.com.

Special Report

Feature When things get ultra-small, the laws that describe the universe change radically. Classical physics breaks down and we have to turn to quantum physics to explain behaviour that seems strange and counterintuitive. In this short Special Report, we would like to extend the quantum principle into the financial world. When interest rates get ultra-low, the laws that describe the behaviour of financial markets also change radically. Classical financial theory breaks down and we have to turn to what we will call the quantum theory of finance. Figure I-1AThe Quantum Theory Of Physics Figure I-2BThe Quantum Theory Of Finance Some Interest Rates Are Not Allowed Somebody once said the test of a good theory is that you should be able to write it on the front of a T-shirt. What would the T-shirt for the quantum theory of physics say? Probably this: "For a physical system, energies take discrete values and some energies are not allowed." What would the T-shirt for the quantum theory of finance say? Probably this (Figure I-1): "For a financial system, interest rates take discrete values, and some interest rates are not allowed." At large scales, the granularity that defines the energy of all physical system and the interest rates in a financial system is not apparent. Allowable values seem a continuum, and all values are allowed. Chart I-1A Promise To Keep The Policy Interest Rates##br## Ultra-Low Pulls Down Bond Yields But at ultra-small scales for both energy and interest rates, the granularity of the values becomes very apparent and this granularity becomes the dominant driver of physical systems and, we would argue, financial systems too. Policy interest rates do not have to take discrete values, but in practice they do move in steps. More importantly, some policy interest rates are not allowed. Policymakers accept that there exists a 'lower bound' to interest rates - perhaps slightly negative - below which there would be an exodus of bank deposits. Hence, this lower bound marks the limit of allowable interest rates. When policy interest rates approach this lower bound, central banks can turn to a second strategy: they can promise to keep rates at this lower bound for an extended period of time. Thereby they can pull down long-term interest rates towards the lower bound too (Chart I-1). To do this, they must convince the market that their promise is genuine. Enter quantitative easing (QE). In the words of ECB Chief Economist Peter Praet, "the credibility of promises to follow a certain course for policy rates in the future is enhanced by asset purchases." QE is nothing more than "a signalling channel which reinforces the credibility of forward guidance on (ultra-low) policy rates." Once bond yields approach ultra-low levels, we begin to see some of the strange effects of the quantum theory of finance. When bond yields cannot fall much further, they can only stabilize or rise, leaving the bond investor with a highly asymmetric payoff (Chart I-2 and Chart I-3) - technically known as negative skew. Chart I-2When Bond Yields Become Ultra-Low, Potential Losses Become Larger Than Potential Gains Chart I-3Bonds Become Much More Risky At Ultra-Low Yields Put simply, a distribution with negative skew produces values that usually turn out to be slightly higher than the mean and rarely, values substantially lower than the mean (Figure I-2). For financial returns negative skew means frequent small gains and infrequent large losses. The opposite is true for positive skew. Figure I-2Distributions With Negative And Positive Skew This brings us to an important point. Empirical and theoretical evidence now proves that investors are not concerned about small fluctuations around an investment's mean return. Instead, they are concerned about large and sudden losses. Hence, the classical use of volatility1 σ as a standard measure of risk is wrong.2 The truth is that risk premiums are a compensation for holding assets that provide positive cash flows but may occasionally suffer very large losses, erasing a large proportion of wealth. In other words, assets with negative skew. Hope And Fear Move In Quanta Too There is compelling theoretical evidence linking risk premiums to negative skew. It comes from a branch of behavioural finance developed by Daniel Kahneman and Amos Tversky, called prospect theory. In their seminal 1979 paper in Econometrica,3 Kahneman and Tversky proposed that "choices among risky prospects exhibit several pervasive effects that are inconsistent with the basic tenets of (classical) utility theory." Contrary to classical utility theory, people do not think in terms of final wealth (utility). In practice, people think in terms of gains and losses. And within these gains and losses, people tend to overweight low probability events by very large amounts - contributing to the attractiveness of both gambling and insurance. In prospect theory, the value of any gain or loss is multiplied by a 'decision weight'. Decision weights measure the impact on the investor of a specific prospect. Prospect theory finds that people tend to ascribe large decision weights to low probability events. Why? Remarkably, Kahneman and Tversky found the answer comes from quantum theory (what they called a quantal effect). "There is a limit to how small a decision weight can be attached to an event, if it is given any weight at all. Because people are limited in their ability to comprehend and evaluate extreme probabilities, highly unlikely events are either ignored or overweighted." Just like the energies of a physical system, or policy interest rates, the feelings of hope and fear occur in quanta and not in a continuum. You move stepwise from 'no hope' to 'some hope' to 'a lot of hope'. You move stepwise from 'no fear' to 'some fear' to 'a lot of fear'. Furthermore, the step from no hope to some hope and the step from some fear to no fear are especially large. You significantly overpay for a lottery ticket versus your expected gain because it takes you from no hope to some hope of winning a life-changing fortune. Likewise, you overpay for the insurance on your home versus your expected loss because it takes you from some fear to no fear of a ruinous loss. In exactly the same way, investment risk premiums are the return compensation for holding assets that may occasionally suffer ruinous losses - in other words, investments that exhibit negative skew (Table I-1 and Chart I-4). Table I-1At Low Bond Yields, Bonds Have ##br## Extreme Negative Skew Chart I-4Bonds Become Much More Risky##br## At Ultra-Low Yields Applying The Quantum Theory To Markets So now let's pull together what the quantum theory of finance tells us: A lower bound to interest rates - perhaps slightly negative - defines the 'quantum limit' of allowable interest rates. When bond yields approach this lower bound, prospective returns from bonds suffer strong negative skew, meaning the prospect of a rare but ruinous loss. The quantum step from 'no fear' to 'some fear' means that negative skew requires a risk premium. Therefore, at low bond yields the valuation relationship between bonds and equities changes radically. Given that equity returns always possess negative skew, we can say that at low bond yields, bond risk becomes equity-like. So the excess return demanded on equities relative to bonds - the equity risk premium - should compress, or indeed fully disappear (Chart I-5). This means that at low bond yields equity prospective returns should become bond-like. Justifying much richer equity valuations today. Chart I-5At Low Bond Yields, The Excess Prospective Return On Equities Over Bonds Disappears However, the conditionality on the negative skew of bonds is crucial. The negative skew on a 10-year bond starts to fade when the bond yield is at 2% and completely disappears at 3%, at which point the equity risk premium must fully re-emerge. Removing the justification for the richer equity valuations. Markets tend to move en masse, so we infer that the rich valuation of equity markets would be at risk of correction if a mainstream 10-year bond yield broke well north of 2.5%. At current yields, the 10-year bond closest to the 2.5%-3% 'red zone' is the U.S. T-bond. And a breach into the 'high 2s' would trigger us to de-risk our portfolio. However, the flight to investment havens that would follow a sell-off in risk assets would also curtail the rise in bond yields. No mainstream bond yield can realistically rise beyond 3% - and stay there - in the foreseeable future. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Root mean squared 2 Please see Quantitative Finance, Risk premia: asymmetric tail risks and excess returns, by Y. Lemperiere et al. 3 Please see Econometrica Volume 47 Number 2 March 1979, Prospect theory: an analysis of decision under risk, by Daniel Kahneman and Amos Tversky.