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Highlights The RBA will not hike as quickly as markets expect. Weak wage growth and high underemployment suggest plenty of spare capacity. Inflation is only barely at the bottom of the central bank's range. Massive household debt levels will make it difficult for consumers to handle higher interest rates. Australian banks, although relatively healthy, are still enormously exposed to Australian housing and interest-only mortgages. House prices have nearly quadrupled since 2000 and exhibit the characteristics of a bubble. Still, it will likely take considerable monetary tightening before the bubble bursts. We do not think this will occur anytime soon. Maintain a neutral exposure to Australian government bonds, but enter into a 2-year/10-year Australian government bond yield curve flattener. Feature Chart 1Diverging Trends In##BR##The Australian Economy Australia remains one of the more difficult bond markets on which to take a decisive investment stance at the moment. The recent Moody's downgrade of Australian banks has put the spotlight back on the housing boom Down Under. With home prices continuing to climb - despite the introduction of macro-prudential measures on mortgage lending and with household indebtedness reaching exorbitant levels - investors are becoming increasingly concerned over a potential housing crash that could have spillover effects on the Australian banking system (Chart 1). At the same time, the domestic economy continues to suffer a hangover from the end of the mining boom earlier this decade, with excess capacity keeping inflation pressures subdued. Naturally, this has put the Reserve Bank of Australia (RBA) in a difficult position. Interest rate cuts in response to low inflation would add further fuel to the housing bubble. On the other hand, any attempt to try and normalize the current accommodative monetary policy settings with rate hikes could trigger an unwanted surge in the Australian dollar and prompt a correction in house prices. The latter could lead to financial instability and raise recession risks with consumers already dealing with negative real wage growth, low savings and massive debt loads. In this Special Report, we examine Australia's monetary policy trajectory, analyze its concentrated banking sector and the potential risks from a downturn in house prices, and revisit our positioning on Australian government debt. Our conclusions still lead us to stick with a neutral duration stance and country allocation on Australian debt, but with a bias towards a flatter government bond yield curve. RBA On Hold... For Now Chart 2Aussie Bonds Caught##BR##In The Global Selloff Earlier this month, the RBA decided to leave the cash rate unchanged at 1.5%. The central bank maintained its fairly neutral rhetoric, though they did cite that the "broad-based pick-up in the global economy is continuing." The central bank upgraded its economic forecasts, with real GDP growth now projected to reach slightly above 3% over the next two years. The minutes from that July 4 monetary policy meeting revealed that a discussion over the ideal level of the real cash rate took place.1 The conclusion was that equilibrium inflation-adjusted rate is now around 1%, meaning that the "neutral" nominal rate is 3.5% after adding an inflation expectation of 2.5% (the middle of the RBA inflation target band). That implies that the RBA has lots of catching up to do on interest rates once the next tightening cycle begins. The timing of that discussion on real rates came shortly after the rebound in global bond yields that began after policymakers in other countries, most notably the European Central Bank and the Bank of Canada, began hinting that a move to dial back the emergency monetary easings of 2015/16 was about to begin (Chart 2). With the RBA possibly sending a similar message, investors responded by raising interest rate expectations and bidding up the Australian dollar (AUD). 30bps of RBA hikes are now priced in over the next year, while our proxy for the market-implied pricing of the terminal (i.e. equilibrium) cash rate - the 5-year AUD overnight index swap rate, 5-years forward - shot up to just over 3%. We believe that this market repricing of potential RBA rate hikes is too optimistic. Australian monetary policy must remain highly accommodative for some time. Our more dovish case is based on our assessment of the RBA's policy mandates, which include full employment, price stability and the 'welfare of the Australian people'. Because of Australia's heavy economic exposure to iron ore prices, its largest export, we also include an outlook on the commodity to aid in our forecast of RBA policy. Employment: The latest readings on the Australian labor market have shown marked improvement so far in 2017 (Chart 3). The unemployment rate now sits at 5.6%. Employment growth is accelerating while the participation rate has edged higher in recent months. The National Australia Bank business confidence index is steadily improving, while job vacancies are at a five-year high. In the statement released after the June monetary policy meeting, RBA governor Philip Lowe stated that "forward-looking indicators point to continued growth in employment in the period ahead." Chart 3Labor Demand##BR##Picking Up... Chart 4...But All Signs Point To Lots##BR##Of Spare Labor Capacity While Governor Lowe also noted that the overall employment picture is 'mixed' in some aspects, we are far more pessimistic (Chart 4). The underemployment rate has been rising and now sits only slightly below its almost 50-year high of 8.8%.2 Part-time workers as a percentage of total employment has experienced a structural increase to nearly 33%, while hours worked have declined. Additionally, nominal wages have been flat and real wages are declining. This suggests that there is plenty of slack in labor markets and that Australia is still far from full employment, even with the headline jobless rate sitting slightly below the OECD's current NAIRU estimate of 5.9%.3 Inflation: Core inflation has been slowing since 2014 and only reached an anemic 1.45% in the first quarter of 2017 (Chart 5). Although headline inflation has rebounded over the past year, at 2.1% it remains only at the bottom of the RBA's 2-3% target range. Additionally, the downtrend in inflation expectations for 2017 appears to be intact. Chart 5Inflation Staying Within The RBA 2-3% Target Chart 6Australian Consumer Spending Slowing Weak productivity growth, leading to lackluster wage growth, is keeping overall inflation subdued. The trade-weighted currency has rallied since June, presenting an additional headwind for consumer prices. Even if the recovery in headline inflation persists and starts to pass through to core readings, policymakers will likely err on the side of caution. A higher realized inflation rate will be tolerated in the near term to ensure expectations stay well within the 2-3% target band - the RBA's definition of "price stability" - before any interest rate increases are considered. Consumer: Australian households face a challenging environment. Real wages are declining, with the wage cost index in a downtrend since 2011. Real retail spending growth has been slowing and is nearing negative territory, while consumer sentiment is quite pessimistic (Chart 6). As income growth is lacking, consumers have had to dip into savings to maintain consumption, with the savings rate collapsing from 10% to 5% over the last few years. Part of that decline is likely due to the rising cost of "essentials" spending, such as utilities, health care, education and transportation. The inflation rates for those sectors have been outpacing overall headline and core readings (Chart 7), suggesting that Australian households are saving less just to "make ends meet." Chart 7Spending More On The "Essentials" Overall, Australian consumers remain incredibly indebted. The household debt-to-income ratio is nearing 200% - the fourth highest figure among the OECD countries.4 Households have been able to handle the massive debt loads (so far) due to record-low interest rates, which have allowed debt service ratios to fall in line with long-term averages. However, hiking interest rates against this backdrop of highly leveraged consumers - especially given the huge exposure of Australian household balance sheets to overvalued house prices - could severely test the 'economic prosperity and welfare of the Australian people' element of the RBA's mandates. In other words, the RBA would need to see decisive signs that the economy was pushing up against inflationary capacity constraints before embarking on a tightening cycle, for fear of the spillover effects of pricking the housing bubble too soon (as we discuss later in this report). Iron Ore: Historically, Australia's growth has been tightly linked to the performance of industrial commodities, in particular iron ore which represents nearly 20% of total Australian exports. Our commodity strategists are neutral on iron ore on a cyclical horizon and bearish on a strategic basis. Chinese iron ore import growth has recently ticked up, but should remain subdued as Chinese inventories are still high (Chart 8). Chinese property construction activity, which accounts for roughly 35% of total Chinese steel demand, remains depressed. Globally, iron ore supply is set to increase throughout the year as many mining projects will come on stream. On a longer-term basis, Chinese demand for metals will likely slow due to the ongoing structural economic shift away from excessive reliance on infrastructure investment and house-building to an economy based on consumption and services. Summing it all up, none of the RBA's policy mandates is being threatened in a way that should force policymakers to begin shifting to a less dovish stance. There is little evidence that Australia has reached full employment, inflation and inflation expectations remain within the RBA target band, growth momentum remains moderate and the housing bubble remains an existential risk to the future health of the economy. Additionally, Australian policymakers will want to keep rates as low as possible to ensure that a weaker currency helps prop up exports, support the economy in its transition away from the heavy reliance on mining investment. Real GDP growth fell below 2% and the output gap is still far in negative territory, suggesting plenty of slack (Chart 9). Our own Australian Central Bank Monitor has rolled over and is now barely in the "tight policy required" zone (bottom panel). Projected fiscal drag over the next few years will also dampen growth. RBA growth forecasts appear highly optimistic relative to median economist estimates. All of these factors point to a delay in rate hikes. Chart 8No Big Boost To Iron Ore Prices From China Chart 9No Pressure On The RBA To Hike Rates Bottom Line: Markets are overpricing the potential for RBA tightening. There is still spare capacity in labor markets, inflation is subdued and consumers cannot handle higher rates. Monitoring The Banks In June, Moody's downgraded all Australian banks, citing a "rise in household leverage and the rising prevalence of interest-only and investment loans" (Chart 10). The downgrade raised concern among investors, with banks being the largest component of the Australian equity market, and short positions have noticeably risen. Despite subdued income growth and enormous household debt levels, escalating house prices have supported consumption through the wealth effect, but this is clearly unsustainable. Political pressures are also building, as evidenced by the introduction of a bank levy in South Australia. Chart 10A Relentless Climb In Household Debt The Chairman of the Australian Prudential Regulation Authority (APRA), Wayne Byres, wants to make bank capital levels "unquestionably strong." His recent comments indicate that Australian banks will need to raise capital before 2020 to adhere to global standards, with some estimates reaching as high as $20bn (in USD). This process is crucial for instilling confidence in markets that banks can meet these targets through organic capital generation or dividend re-investment plans. As the increased capital required is relatively small - only 2% of the capital base of the Australian banks - it should not be difficult to raise that amount. The greatest risk to the financial system is still the exposure to Australian housing. For the four major banks, Australian housing loans make up slightly over 50% of their lending mix, far greater than for U.S. banks prior to the Great Financial Crisis of 2008 (Chart 11). Of those loans, approximately 40% are non-traditional (interest-only, sub-prime, reverse mortgages). Several macro-prudential measures have been implemented by Australian financial regulators to decrease risks within the banking sector. The regulations have been focused on interest-only loans, which are more vulnerable to rate rises. Such loans are riskier, typically shorter in maturity and requiring larger deposit amounts. Banks are tightening their lending standards for these loans and risk weights will likely be increased, thereby requiring more capital. Additionally, the standard variable rate on interest-only loans has increased by 30-35bps and APRA has imposed a 30% cap on interest-only loans as a percentage of new loans. This will cause a meaningful decline in the risk profile of banks' mortgage books, as consumers with interest-only loans will shift to less expensive principal-plus-interest loans. Another source of risk is the Australian banks' increasing reliance on offshore short-term wholesale funding. When credit growth outpaces deposit growth, which has been the case, banks need to balance the equation through increased wholesale funding. This raises the potential for a liquidity crunch, as capital may be unavailable during a crisis. Credit growth to the private sector is slowing, though, reducing the immediate need for this type of funding. Additionally, authorities are prompting banks to substitute away from the heavy reliance on short-term wholesale funding through the implementation of a net stable funding ratio. This is defined as the available amount of stable funding (i.e. core deposits, equity and long-term wholesale funding) over the required regulatory level of stable funding. Banks will have until 2018 to increase this ratio above 100%. As a result, long-term wholesale debt issuance rose sharply in 2016 and that amount is projected to be relatively similar for 2017. Overall, current metrics suggest that Australian banks are fairly healthy, even before the additional capital requirements. Tier 1 capital ratios have gradually increased since 2007 and are fairly strong, non-performing loans are subdued and net interest margins are rising (Chart 12). In fact, Tier 1 ratios are substantially higher in Australia than they were in the U.S. prior to the Global Financial Crisis. Return-on-assets and return-on-capital have bounced slightly, although increasing capital will certainly dampen the earnings prospects for the Australian banks. Chart 11Australian Banks Heavily Exposed##BR##To Risky Mortgage Lending Chart 12Aussie Banks In##BR##Good Shape Right Now... Since the Moody's downgrade, credit default swap spreads for Australian banks have actually declined to near the 2014 lows, suggesting markets are not concerned about the risk of future bank stresses. We remain concerned, however. Macro-prudential measures on mortgage loan sizes and higher capital requirements are certainly welcome and will reduce perceived risks within the banking sector. However, these measures have done little to curb the rise in Australian house prices. Given their huge exposure to Australian housing, the banks will likely not be able to withstand a meaningful decline in house values - the outlook for which depends critically on the RBA's future monetary policy path. Bottom Line: Australia bank metrics are fairly healthy but they will need to raise more capital. This should not be too problematic. However, the banks' massive exposure to Australian housing, elevated number of interest-only mortgage loans and heavy reliance on short-term wholesale funding present substantial risks. Even if the bank capital levels are 'unquestionably strong,' they will not be enough to withstand a meaningful downturn in house prices. When Will The Housing Bubble Burst? House prices in Australia have nearly quadrupled since 2000. With the exception of Perth, house prices in the other major cities have continued their massive run-up over the last year, suggesting macro-prudential measures have done little to cool the market (Chart 13). Price gains have been supported by robust demand, both domestic and foreign. However, the steady rise in debt-fueled speculation (i.e. loans for investment purposes), the magnitude of the price increases, and the lack of any correction in over 25 years, suggest Australian housing is indeed in the midst of a bubble. On the supply side, steadily rising completions over the past decade have not curbed price gains (Chart 14). While construction has slowed since its peak at the end of 2016 and building approvals have declined, we find the argument that there has been a shortage in supply to be fairly weak. In fact, the rate of dwelling completions has outpaced population growth since 2012 and dwelling completions per 1,000 people are much higher in Australia than its G7 counterparts. Chart 13...Just Don't Prick##BR##The Housing Bubble Chart 14Supply Not Rising Enough To##BR##Slow House Price Growth History teaches us that bubbles never deflate calmly. Nevertheless, we view the likelihood of a systemic crash over the next 6-12 months as highly unlikely. While growth estimates may not meet the RBA's lofty goals, Australia will also not experience its first recession in over 25 years, which would crimp housing demand. The two most likely candidates to act as a catalyst for a housing downturn are therefore: a slowdown in capital inflows from Chinese property buyers and/or a shift to restrictive monetary policy from the RBA. It will not require a complete halt in capital inflows from China, simply a considerable slowdown, for the Australian housing market to come under pressure. While there is always a possibility for Chinese authorities to clamp down on outflows, particularly if the RMB comes under pressure, we view this as fairly unlikely. Current capital outflows have eased a bit and a long-term goal is to deregulate the capital account. Continued capital liberalization in China will aid in maintaining capital flows into Australian housing. Additionally, the millionaire class in China is growing and the private sector wants to diversify its assets. While Australian house prices are expensive, prices are far more affordable than those metropolitan areas such as Hong Kong, indicating Chinese money will continue to drift into Australian real estate. Chart 15A Long Way From Restrictive Policy Rates The more likely candidate for a bursting of the housing bubble is through the monetary policy channel. In the case of the U.S., multiple Fed rate hikes in the mid-2000s pushed monetary conditions into restrictive territory, prompting the housing crash. As we previously argued, the RBA will likely stay on hold for an extended period due to a lack of serious inflation pressures. Yet even if the RBA were to begin tightening sooner than we expect, it will take multiple rate hikes before monetary conditions become even close to restrictive. Using a simple measure of the equilibrium RBA cash rate, like a combination of Australian potential GDP growth and a five-year moving average of headline CPI inflation or the Taylor Rule formulation that we introduced in a recent Weekly Report, it is clear that the RBA is a long way from a restrictive policy stance (Chart 15).5 Bottom Line: Australian house prices have nearly quadrupled since 2000 and exhibit the characteristics of a bubble. Still, it will likely take considerable monetary tightening before the bubble bursts. We do not think this will occur anytime soon. Investment Implications We currently hold a neutral recommended stance on Australian government debt, both in terms of duration exposure and country allocation in global fixed income portfolios. Australian bond yields are above the lows seen in 2016 but have yet to break out of the structural downtrend with the benchmark 10-year now at 2.67% (Chart 16). We hesitate to go outright overweight on Australian debt in our model bond portfolio, however, even with our relatively dovish view on the RBA's future policy moves. Without any slowing in house prices, and with realized and expected inflation having clearly bottomed after last year's downturn, a big move lower in Australian bond yields is unlikely. At best, Australian yields will not rise by as much as we expect to see in the U.S. or Euro Area over the next 6-12 months. At the same time, if that view pans out, the Australian currency will likely underperform which will erode into the returns of an overweight Australian bond position (either through currency hedging costs or the outright losses on unhedged currency exposure). We do, however, see an opportunity to enter into an Australian 2-year/10-year yield curve flattening position (Chart 17). As previously mentioned, the short end of the curve will be anchored by an inactive central bank. The long end, however, faces multiple downward pressures. Macro-prudential measures and political pressures will continue to dampen credit growth. While we believe there is scope for realized inflation to grind a bit higher in the coming quarters, longer-term inflation expectations are likely to remain well-anchored. Additionally, the economic surprise index is elevated after several positive data releases and has plenty of scope for disappointment, which will limit any rise in longer-dated bond yields. Chart 16No Bear Market##BR##In Australian Bonds Chart 17Enter A 2yr/10yr##BR##Australian Curve Flattener The added benefit of entering a curve flattener is that the trade will likely work if our RBA view turns out to be wrong in a hawkish direction. If the RBA does indeed begin to hike rates sooner than we expect to deal with an improving economy or to begin deflating the housing bubble, this should put flattening pressure on the curve as the market prices in additional future rate increases. Only in the case of a breakout in longer-term inflation expectations that bear-steepens the curve, or a severe economic downturn that prompts RBA rate cuts and bull-steepens the curve, will a flattening trade underperform. Given our views on Australian growth and inflation, we see more likely scenarios where the curve flattens than steepens, particularly versus the only modest amount of flattening currently priced in the forwards. Bottom Line: Enter into a 2-year/10-year Australian government bond yield curve flattener. The short end of the curve will be anchored by an inactive central bank. On the long end, slowing credit growth, fiscal drag and an elevated economic surprise index will put downward pressure on yields. Patrick Trinh, Associate Editor Patrick@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 http://www.rba.gov.au/monetary-policy/rba-board-minutes/2017/2017-07-04.html 2 The "underemployed" is defined as full-time workers on reduced hours for economic reasons and part-time workers who would like, and are available, to work more hours. 3 NAIRU = Non-Accelerating Inflation Rate Of Unemployment. 4 https://data.oecd.org/hha/household-debt.htm 5 Please see BCA Global Fixed Income Strategy Weekly Report, "Dangerous Duration", dated July 11 2017. Available at gfis.bcaresearch.com.

Highlights Portfolio Strategy The chemicals bear market is over. Synchronized global growth, receding global capacity and improving domestic operating conditions compel us to lift exposure to neutral. As a result, our materials sector exposure also moves to the neutral column. While chemicals and materials are beneficiaries of an upgrade in global economic expectations, utilities sit at the opposite end of the table, and thus warrant a downgrade to a below benchmark allocation. Recent Changes S&P Chemicals - Upgrade to neutral, lock in profits of 10.2%. S&P Materials - Lift to neutral, take profits of 12.8%. S&P Utilities - Trim to underweight. Table 1 Feature Equities broke out last week. While still early, earnings season served as a catalyst and outweighed political/reform uncertainty and the budding global tightening interest rate cycle. Barring any unforeseen surprises, profits will remain the focal point in the coming weeks and sustain the equity blow-off phase. Two weeks ago we highlighted three ways to SPX 3,0001, and posited that this was a reasonable peak cycle level before the next recession hits. This week we dissect GICS1 sector profit composition and conclude that low double-digit EPS growth is attainable in 2018. Table 2 shows sector contribution to the S&P 500's profit growth in calendar 2017 and 2018, sector earnings weights for these two years and current market cap weights using Standard & Poor's data. Table 2Earnings Decomposition Charts 1 & 2 portray the high sector profit contribution concentration, with four sectors comprising 82% of the earnings growth year-over-year in 2017. For calendar 2018 such concentration still exists, but the same four sectors' profit contribution weight falls to 70% (based on bottom up estimates). Chart 1Sector Contribution To 2017 Profit Growth Chart 2Sector Contribution To 2018 Profit Growth Charts 3-5 show the sector earnings weight minus their market capitalization weight. Energy is the clear standout, but keep in mind that this resource sector is coming off a very depressed absolute profit level. As of Q1/2017, energy stocks have the widest gap of -574bps among the 11 sectors, with tech, real estate and staples also registering a small negative gap of roughly -100bps. The upshot is that even on modest assumptions, the energy sector's profit weight can renormalize close to its market cap weight (bottom panel, Chart 4). Chart 3Profit Weight... Chart 4... VS. Market Cap Weight... Financials is another standout sector. This early cyclical sector has consistently delivered a positive profit/market cap weight differential with the exception of the GFC. In fact, the 12-year average gap up to end-2007 has been over 700bps with a range of 425-1140bps, despite a rising financials market cap weight (second panel, Chart 3). Financials now sit near the bottom of the pre-crisis profit/market cap gap range. If our bullish thesis on financials (please see the May 1st Weekly Report) pans out, then this sector should command a larger share of the S&P 500's earnings pie with the profit/market cap gap widening closer to the pre-GFC average, assuming a cyclical earnings recovery. In sum, while sector profit contribution composition is highly concentrated in both 2017 and 2018, the earnings recovery is broad based with over three quarters of the 63 S&P 500 sector indexes we cover registering expanding forward EPS growth (Chart 6). Energy and financials profits will likely continue to surprise to the upside, and suggest that low double-digit EPS growth is realistic for the broad market. Our S&P 500 macro based profit model also corroborates this message. Chart 5... Across Sectors Chart 6Broad Based EPS Recovery One risk to our forecast is an oil price relapse that would put our energy profit assumptions offside. However, our Commodity & Energy strategists continue to expect higher crude oil prices into 2018. This week we continue to tweak our portfolio and add cyclical exposure by upgrading a deep cyclical sector, while simultaneously downgrading a defensive one. Chemicals No Longer Deserve An Underweight In the summer of 2014 we went underweight the S&P chemicals index, anticipating an earnings underperformance phase. We were expecting a deflationary industry impulse on the back of a slipup in global growth at a time when the chemicals manufacturers were furiously adding capacity to benefit from lower domestic feedstocks. This view has largely panned out, and it no longer pays to remain bearish on this highly cyclical industry. In line with our recent tweaks in our U.S. equity portfolio toward a more cyclical bent, we recommend locking in gains of 10.2% and upgrading the S&P chemicals index to a benchmark allocation. Three factors underpin our more neutral bias: synchronized global growth, receding global capacity and improving domestic operating conditions. The global manufacturing PMI has recently reaccelerated and jumped to a six year high. Similarly, the U.S. ISM manufacturing survey also vaulted higher. Synchronized global growth suggests that final demand is on the upswing and should bode well for chemical top- and bottom-line growth (Chart 7). Such synchronized global growth is giving way to a coordinated G10 Central Bank (CB) tightening cycle. Already, the BoC lifted rates recently and likely other CBs will take cover under the Fed's leadership and follow suit. Given that U.S. CPI continues to surprise to the downside, this implies that the U.S. dollar will remain under pressure as the Fed's next hike is penciled in only for December. This is significant for the export relief valve of U.S. chemical producers. As the euro shoots higher, U.S. exports become more competitive in the global chemicals market place and result in market share gains versus their Eurozone competitors (top panel, Chart 8). Currently, it seems as if U.S. chemicals exports are displacing German exports: German chemicals factory orders have plummeted on a short-term rate of change basis opening a wide gap with rebounding U.S. chemical exports (bottom panel, Chart 8). Chart 7Levered To Global Gross Chart 8Global Market Share Gains Global chemicals M&A supports our expectation of demand-driven pricing power gains. The current wave of mega-mergers started at the end of 2015 with the historic tie-up of Dow Chemical and DuPont. It has since grown to include more than half of the S&P chemicals sector by market cap and has a value greater than the previous seven years combined (Chart 9). We think the benefits of consolidation are twofold: First, reduced revenues of the past decade have left the industry with outsized cost structures; consolidation should sweep that away under the guise of synergy, driving margins higher. Second, industry overcapacity has historically impaired profitability due to soaring overhead and more competitive pricing; greater scale should impose greater capital discipline. Finally, domestic operating conditions have taken a turn for the better. Industry shipments have staged a 10 percentage point recovery from the 2015 trough and are now rising at a healthy clip. Chemical production has troughed and the firming U.S. leading economic indicator signals that output is on the verge of expanding. This improving domestic final demand backdrop is reflected in higher resource utilization rates. The upshot is that pricing power gains have staying power (Chart 10). Nevertheless, there are also three headwinds that merit close attention and prevent us from turning outright bullish. U.S. capacity additions are worrisome and, if not held in check, risk sabotaging the nascent pricing power recovery. Moreover, a wholesale and manufacturing inventory channel check suggests that there is a modest supply buildup. If there is any demand mishap it could also prove deflationary for chemical manufacturers. Tack on the recent spike in our chemicals wage bill proxy, and a profit margin squeeze could rapidly materialize (Chart 11). Chart 9M&A Boom Is Pricing Power Positive Chart 10Firming Domestic Backdrop Chart 11Three Risks To Monitor Bottom Line: There is tentative evidence that the bear market in chemicals producers is over. Take profits of 10.2% since inception and upgrade the S&P chemicals index to neutral. This will also move the S&P materials index to a benchmark allocation. Upgrade Materials To Neutral Chemicals stocks comprise over 73% of the S&P materials index, and this bump to a neutral stance also moves the broad materials index to a benchmark allocation, resulting in 12.8% profits for our portfolio since inception. Chinese economic data have been in a broad based recovery mode, and real GDP troughed mid-year 2016. Wholesale manufacturing and raw materials prices are climbing steadily (Chart 12), with core and services CPI also accelerating in marked contrast with the developed markets. This is impressive given the current dual Chinese monetary tightening via the currency and interest rate channels and modest deceleration in the fiscal thrust. China matters to materials producers as it is the largest commodity consumer. Thus, China's fortunes are closely aligned with the overall materials sector. Historically, the Keqiang Index has been positively correlated with materials revenue growth and the current message is positive. Similarly, the firming Chinese pricing backdrop also bodes well for materials EPS prospects (third & fourth panels, Chart 12). While we take Chinese data with a pinch of salt, the recently surging Australian dollar suggests that China is at least not relapsing (middle panel, Chart 13). Beyond China, the emerging markets are also in a cyclical recovery mode. The emerging Asia leading economic indicator (EALEI) has enjoyed a V-shaped recovery in the aftermath of the late-2015/early-2016 global manufacturing recession. Appreciating EM currencies corroborate the EALEI message, and should continue to underpin materials exports (top & bottom panels, Chart 13). Chart 12Recovering China... Chart 13... And EM Are A Boon For Materials Not only are emerging markets reviving, but also advanced economies are in excellent shape. Synchronized global growth and the coordinated brewing tightening cycle should lead to a selloff in most G7 bond markets. At a minimum, this implies that relative materials performance has put in a cyclical trough (top panel, Chart 14). Importantly, materials producers have made significant headway in improving their finances. The sector's interest coverage ratio (EBIT/interest expense) has bounced smartly and net debt/EBITDA has also dropped by a full turn. Bond investors have taken notice and this balance sheet improvement is reflected in the collapse in junk materials bond yields (yield shown inverted, middle panel, Chart 14). Our newly introduced S&P materials relative EPS model captures this positive macro backdrop for the sector and signals that the relative EPS recovery still has breathing room (Chart 15). However, a few risks hold us back from getting overly excited about materials stocks. First, Chinese money supply growth is not responsive. M1 growth is decelerating and M2 growth is plumbing all-time lows. Second, commodity inflation is also showing signs of fatigue. Similarly, U.S. core PCE and CPI inflation are stalling (Chart 16). This is significant because basic materials are synonymous with hard assets and excel in times of inflation, but falter in times if disinflation/deflation (please refer to our early December inflation-related Special Report). Finally, from a domestic operating perspective, our materials wage bill proxy has sharply reaccelerated giving us cause for concern, especially if there is a pricing power letdown. Under such a backdrop, profit margins would suffer a squeeze, and thereby profits would underwhelm (wage bill shown inverted, bottom panel, Chart 16). Chart 14Improving Finances Chart 15EPS Recovery Has Breathing Room Chart 16Three Risks Keep Us At Bay Netting all out, the S&P materials outlook has brightened a notch, but not sufficiently to turn us into bulls. Bottom Line: Lift the S&P materials sector to a benchmark allocation, and lock in profits of 12.8% since inception. Trim Utilities To Underweight Chart 17Blackout Warning While chemicals and materials are beneficiaries of an upgrading in global economic expectations, utilities sit at the opposite end of the table (global manufacturing PMI shown inverted, top panel, Chart 17), and therefore warrant a downgrade to a below benchmark allocation. Now that the Fed is ready to start unwinding its balance sheet, the ECB is preparing the waters for QE tapering and a slew of CBs are on the cusp of a new tightening interest rate cycle, there are high odds that still overvalued fixed income proxies will continue to suffer. Synchronized global growth and coordinated tightening in monetary policy spells trouble for bonds. Our sister publication U.S. Bond Strategy expects a bond selloff for the remainder of the year. Given that utilities essentially trade as a proxy for bonds, this macro backdrop leaves them vulnerable to a significant underperformance phase (Treasury yield shown inverted, bottom panel, Chart 17). Importantly, the stock-to-bond (S/B) ratio and utilities sector relative performance also has a tight inverse correlation (S/B shown inverted, second panel, Chart 17). The implication is that downside risks remain acute. Without the support of continued declines in bond yields, or of indiscriminate capital flight from all riskier assets, utilities advances depend on improving fundamentals. The news on the domestic operating front is grim. Contracting natural gas prices, the marginal price setter for the industry, suggest that recent utilities pricing power gains are running on empty (Chart 18). Tack on waning productivity, with labor additions handily outpacing electricity production, and the ingredients for a margin squeeze are in place (Chart 18). Importantly, industry utilization rates are probing multi-decade lows and overcapacity is negative for pricing power. Chart 18 confirms that utilities construction is relentless at a time when turbine and generator inventories have been hitting all-time highs. This is a deflationary backdrop, and suggests that sell-side analyst optimism is wrong footed. Put differently, it is unreasonable to expect profits to grow fast enough to support continued overvaluation (Chart 19). Chart 18Pricing Power Blues Chart 19Valuation Crunch Ahead Bottom Line: We are making room for the niche S&P materials upgrade to neutral by downgrading the equally small S&P utilities sector to a below benchmark allocation. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see the July 10th, 2017 U.S. Equity Strategy Service Report titled "SPX 3,000?", available at www.bcaresearch.com Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

The country's top 5 banks, collectively representing 80% of the S&P 500 bank index all reported Q2 EPS ahead of analyst expectations. The story was no different with investment banks as heavyweights GS and MS both reported solid earnings beats. As one would expect, both indexes responded by...falling? A couple of factors are at play in the market moves. First, market volatility, especially debt market volatility, has been subdued and that has decreased trading revenues across the board. Second, growth expectations are very high and a flattened yield curve is making investors worried about the achievability of top line estimates. We expect both of these to be transitory. As global monetary policy tightens, a bond selloff should gain momentum and inject a more normal level of volatility into markets. Coincidentally, the U.S. dollar will likely remain under downward pressure and inflation expectations should rise, driving a steepening of the yield curve. Bank earnings should continue to outpace the broad market as a result, especially given the nascent recovery in credit growth, making any near-term weakness an excellent entry point. Stay overweight.

Highlights China's strong second-quarter growth numbers released early this week confirmed the synchronized global growth upturn within the major economies. Our model is predicting an imminent increase in the PBoC's benchmark lending rate. Higher rates in China are reflective rather than restrictive. The PBoC will likely maintain a tightening bias, but this should not lead to major growth disappointments. The latest MFWC pledges "re-regulation" of the financial industry and remains committed to developing capital markets. Increasing supplies of equities through IPOs will put some downward pressure on stock prices - especially in the domestic small cap space. Feature The Bank of Canada hiked its policy rate by 25 basis points last week, the second major central bank to tighten after the Federal Reserve in the current cycle. While it is unclear whether central bankers maintain secret communication channels, effectively there appears to be a "coordinated recalibration" of monetary policies among major central banks, due largely to a synchronized growth upturn within the major economies. China's strong second-quarter growth numbers released early this week fit with this broad theme. There are rising odds that the People's Bank of China (PBoC) will join the proverbial global party with rate hikes. In addition, the Chinese authorities have pledged a tougher stance on the financial industry. Reflective Or Restrictive? China's latest data have shown across-the-board strength of late. Most indicators have surprised to the upside, rectifying our positive assessment.1 With the latest growth numbers, our model is predicting an imminent increase in the PBoC's benchmark lending rate (Chart 1). The model follows a modified version of "Taylor's Rule," in which external factors are also considered for open economies. In China's case, both improvement in growth and the Fed's interest rate hikes have played a strong role in setting the stage for higher policy rates in China. The model currently predicts 50 to 75 basis points in rate hikes by the PBoC. Historically, our interest rate model has done a reasonably good job in capturing the major turning points in China's policy rate cycles. This time around, the country's interest rate reforms may have complicated the model's predicting power. In short, the PBoC is in the process of diminishing the importance of the benchmark lending rate, while promoting market-based interest rates. The central bank has theoretically fully liberalized commercial bank interest rates since 2015, and therefore it is unclear whether it will abandon benchmark policy rates, which is viewed as an outdated tool. Instead, the PBoC has been trying to build an interest rate "corridor" in which it uses monetary and liquidity measures to guide market interest rates. The upper band of the interest rate corridor appears to be the interest rates of the PBoC's lending facilities - the cost for financial institutions to borrow from the central bank - while the lower band is the interest rate the PBoC pays on commercial banks' excess reserves (Chart 2). In this vein, the 6-month Medium Term Lending Facilities (MLF) interest rate has already been raised by 20 basis points since late last year, and interbank rates have been guided higher. Chart 1Rising Odds Of PBoC Rate Hikes Chart 2Interest Rate Corridor' ##br##Has Been Lifted Higher Chart 3Bank Loan Rate Is On The Rise Nonetheless, the upturn in our interest rate model justifies higher rates engineered by the PBoC. Regardless of whether the PBoC explicitly raises its policy lending rate, interest rates in China have already moved higher (Chart 3). Tighter liquidity and higher bond yields since late 2016 suggest that average bank lending rates should have increased by probably 50 basis points in recent months. Higher rates in China are a reflection of stronger growth rather than policy tightening to tame business activity, at least for now. After all, China's nominal GDP growth has rebounded from 6.4% in late 2015 to 11.1% in the second quarter of 2017 - a sharp turnaround in nominal business activity that calls for higher interest rates. Similarly, recent hawkish - or less dovish - rhetoric from other central banks all reflect improving growth where "emergency" levels of monetary accommodation are no longer needed (Chart 4). With the exception of Japan, BCA Central Bank Monitors, which measure pressure on central bankers to raise or reduce interest rates, have mostly climbed above zero of late, underscoring the need for tighter money among most developed countries. By the same token, it is premature to conclude that any policy tightening by the PBoC will lead to major growth problems in China. Chart 4Emergency' Levels Of Accommodation No Longer Needed Where does the RMB fit in? The PBoC's tightening bias suggests there is less incentive to target a lower exchange rate, both against the dollar and in trade-weighted terms. The central bank will continue to intervene to smooth out volatility. From investors' perspectives, the risk-return profile of taking a direct bet on the RMB is not attractive in either direction: we doubt there is meaningful upside in the RMB against the dollar in the near term, but the odds of significant RMB/USD depreciation have been further reduced. In other words, the RMB/USD exchange rate is still largely dominated by broader dollar performance, and the RMB is not a "high beta" currency to play the dollar. In short, we maintain our positive view on China's growth outlook, as discussed in greater detail in last week's bulletin. The PBoC will likely maintain a tightening bias, but this should not lead to major growth disappointments. Financial Reforms And Markets As growth has mostly surprised to the upside, policymakers' focus appears to have shifted to controlling financial risks, as highlighted by the key messages from the 5th National Financial Work Conference (NFWC) this past weekend. The NFWC convenes twice a decade, and usually sets the policy tone for the following years. Compared with the previous meeting five years ago that featured "deepening reforms and promoting development" as the key theme of the financial industry, the current session clearly strikes a more conservative tone. Top leadership declared that the financial sector must serve the needs of the "real economy," and that preventing systemic financial risks is the government's "eternal theme." Importantly, a cabinet level committee has been established to coordinate regulatory oversight on the financial industry - a task currently shared between the central bank and three regulators. The overall message from the latest NFWC is consistent with the regulatory crackdown on financial excesses since late last year.2 Overall, we share policymakers' sentiment that China's financial sector deregulation in recent years has gone too far.3 The dramatic leverage-fueled equity market boom-bust cycle in 2015 offered a crude awakening to the authorities against imprudent financial deregulation. Meanwhile, reform measures also ushered in a proliferation of institutions that prolonged financial intermediation channels. Without proper regulatory coordination, the authorities' attempts to reduce excesses has typically pushed speculative activity off the books of financial institutions, making it even more difficult to monitor and regulate. In fact, regulations on the financial sector have already been tightened of late. Derivatives, internet-based financing firms and asset-backed securities have all been put under much tighter regulatory scrutiny. The macro-prudential assessment (MPA) on financial institutions has been adopted since earlier this year - the latest MFWC suggests that "re-regulation" of the financial industry will continue in the coming years. The long-term impact of tighter control over the financial sector on the economy and financial markets remains to be seen. On one hand, imprudent financial deregulation and prolonged financial intermediation channels have done little to address the financing needs of small private enterprises, but have amplified risks and raised funding costs for the overall corporate sector - a suboptimal outcome that needs to be corrected. On the other hand, China's vast domestic savings need to be properly intermediated to the economy. We have long held the view that so long as the banking sector and debt instruments play the dominant role in financial intermediation, the accumulation of debt in the overall economy is all but inevitable.4 In this vein, any attempt to block financial intermediation aimed at "deleveraging" will prove both ineffective and counterproductive, with unintended consequences. An easier bet is that the authorities will remain committed to developing capital markets, both equities and corporate bonds, to provide alternative funding sources for the corporate sector. Procedures for initial public offerings (IPOs) and debt issuances will be simplified. The share of debt and equities in total social financing will continue to grow from a structural point of view (Chart 5). From investors' perspective, increasing supplies of equities through IPOs will put some downward pressure on stock prices - especially in the domestic small cap space, where multiples are unsustainably high and will continue to be de-rated (Chart 6). There are certainly some compelling growth stories among small caps that are worth cherry-picking, but overall investors should remain cautious for this asset class. Chart 5Debt And Equity Issuance##br## On A Structural Uptrend Chart 6Domestic Small Caps##br## Will Continue To Derate Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "China Outlook: A Mid-Year Revisit," dated July 13, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "China: Financial Crackdown And Market Implications," dated May 18, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "Legacies Of 2015," dated December 16, 2015, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Special Reports, "Chinese Deleveraging? What Deleveraging!" dated June 15, 2016, and "The Great Debate: Does China Have Too Much Debt Or Too Much Savings?" dated March 23, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

When Hunter Harrison took over the reins at CSX, the expectation was a repetition of his slashing of costs with the deployment of his Precision Scheduled Railroading. In his first full quarter as CEO, he appears to have done just that. However, the real surprise (and the one with direct read-through to the sector as a whole) was the pricing gains on the already-known strong quarterly volume; this bodes exceptionally well for the sector. Our upgrade of the sector to overweight last month was based on firming pricing driven by rising volumes (including coal); the CSX results confirm that expectation. In fact, the industry appears to be enjoying the best pricing power of the past 5 years, according to the latest PPI release (middle panel). Our rails EPS model captures this pricing strength and continues to indicate a surge in profit growth relative to the S&P 500. We reiterate our overweight position. The ticker symbols for the stocks in this index are: BLBG: S5RAIL -UNP, CSX, NSC, KSU.

The Fed will likely start renormalizing the balance sheet later this year and the ECB is preparing to taper asset purchases. In the G10, the BoC recently tightened monetary policy and more central banks are lining up to lift generationally low policy rates (see Chart 3 of our Cyclical Indicator Update published this week). This global liquidity hand-off to global growth is a boon to early-cyclical financials equities. The industrial metals/precious metals ratio moves with the ebb and flow of global growth, and is an excellent growth/liquidity indicator. Currently, this gauge has jumped on the back of a synchronized global growth backdrop. The upshot is that the financials sector outperformance phase is in the early stages, and we reiterate our early-May upgrade to an above benchmark allocation.

Our Consumer Discretionary Cyclical Macro Indicator (CMI) has snapped back after a tough year, driven by improving real wage growth. Higher home prices, a tighter labor market and increasing disposable income have consumers feeling flush, which should boost discretionary outlays. Importantly, consumer deleveraging is far advanced with the debt service ratio hovering near decade lows. Further, our Consumer Drag Indicator remains near its modern high, suggesting EPS gains will prove resilient. Although somewhat expensive from a historical perspective, our Valuation Indicator (shown in this week's Cyclical Indicator Update) remains close to the neutral zone, underscoring that profits will be the primary sector price driver. Our Technical Indicator (shown in this week's Cyclical Indicator Update) has fully recovered from oversold levels, and is flirting with the buy zone, underscoring additional recovery potential. We continue to recommend an overweight position, favoring the media-oriented sub-indices.

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

Dear Client, I am visiting clients this week, and as such there will be no Weekly Report. Instead, we are sending you this Special Report written by my colleague Jonathan LaBerge. Jonathan argues that while the recent acceleration of the Canadian economy is genuine, the rise in Canadian household debt-to-income over the past 16 years has been so large that a credit-driven downturn in spending is now virtually unavoidable over the long run. I hope you will find this report both interesting and informative. Best regards, Peter Berezin, Chief Strategist Global Investment Strategy Highlights The recent economic improvement in Canada is genuine. In isolation, this supports the Bank of Canada's decision to gradually raise interest rates. However, over the long run, the historical experience suggests that the substantial leverage of Canadian households will ultimately cause a serious credit-driven downturn. Several myths about Canada's housing market have obscured the true extent of its credit market imbalances, heightening the risk that policymakers will ultimately overplay their hand when tightening monetary conditions. There are multiple potential triggers that could eventually spark a credit-driven downturn in Canada, but none of them seem likely to have a major impact on the economy over the coming 6-12 months. Favor a pro-cyclical stance over the coming year, but look to shift to a bearish structural view at some point beyond the immediate investment horizon. Feature Several developments over the past few months have altered the outlook for the Canadian economy. However, these events have not had a consistent impact on the narrative for Canadian assets. Whereas a sharp rebound in real GDP growth and a hawkish pivot from the Bank of Canada have been signs of a strengthening economy, the crisis surrounding Home Capital Group (a Canadian non-bank mortgage lender) was an ominous sign for many investors concerned about the deeply imbalanced Canadian housing market.1 In this report we argue that the cyclical improvement in the Canadian economy is legitimate, and that the Bank of Canada is likely to move forward with gradual policy tightening following Wednesday's move. However, the rise in Canadian household debt-to-income over the past 16 years has been so large that a credit-driven downturn in spending is now virtually unavoidable over the long run, rather than a risk. We highlight how, in many ways, the imbalances in the Canadian housing market are even worse than the market narrative would suggest. We also provide a checklist of factors to monitor in order to judge when Canada's day of reckoning will arrive. For now, it does not appear to be imminent. From an investment standpoint, our conclusions imply that investors should pursue a "two-staged" approach when allocating to Canadian assets. Over the coming 6-12 months, a cyclical improvement in the economy means that Canadian risky asset prices and government bond yields are likely to rise, and we believe that this stage is worth playing. But over the secular horizon, the reverse is likely to unfold, meaning that a rally in Canadian assets over the coming year will create excellent "selling conditions" for investors looking to position for a bearish structural view. Economic Momentum Is Spurring Tighter Monetary Policy... The Bank of Canada is now back on a path towards tighter monetary policy, and a close examination of the Canadian economy, as well as our outlook for global oil inventories, supports the BoC's view: Real consumer spending picked up significantly in Q1, rising from 2.7% to 3.1% on a year-over-year basis. Chart 1 highlights that the rise in real spending has been supported by a rebound in employment growth and consumer confidence (the latter is at a 9-year high). On the employment side, Chart 1 also shows that the acceleration in job growth is not limited to provinces that are strongly associated with oil sands production. In fact, the chart shows that employment in Canada excluding Alberta and Saskatchewan has been in an uptrend since mid-2014, when fiscal and monetary policy began to respond to the shock from a collapse in the price of oil. All Canadian employment cylinders are now firing, given the job recovery in oil sands provinces. Real Canadian gross fixed capital formation turned positive in Q1 after a significant decline into negative territory, and a simple model based on business confidence, oil prices, and the Canadian dollar (stripped of its correlation with oil) suggests that it will continue to accelerate modestly over the coming year (Chart 2). Chart 1Genuine Signs Of A Stronger Economy Chart 2Further Gains In Investment Likely Chart 3 shows a model for oil prices, based on global industrial production, oil production, OECD oil inventories, and oil consumption in the major countries and China. If OPEC is successful in reducing inventories to their 5-year moving average, as BCA's commodity strategists expect, the model implies that oil prices will rise materially. This is likely to provide a tailwind for the Canadian economy, at least in nominal terms. While the pace of tightening is likely to be gradual because of the weakness in Canadian core inflation, Chart 4 suggests that the decline in inflation over the past few months may simply represent the correction towards more fundamentally-justified levels. The chart shows a model of core inflation based on lagged real core consumer spending and the Canadian dollar (as a proxy for imported inflation/deflation), and highlights that actual inflation has overshot the model value over the past three years. But the chart also shows that the fundamentally-justified level of core inflation remains in an uptrend, suggesting that recent weakness is likely temporary and is thus not an impediment to higher policy rates over the coming year. Chart 3Falling Inventories Will Be Bullish For Oil Chart 4The Dip In Core Inflation Is Temporary Bottom Line: The recent economic improvement in Canada is genuine and, in isolation, supports the Bank of Canada's decision to gradually raise interest rates. ...But It Will All Likely End In Tears Chart 5Higher Household Leverage Than In The U.S. Pre-Crisis While we agree that the Bank of Canada is on a path to gradually raise interest rates over the coming year and that the economy is currently in good shape, the odds are good that tighter policy (and/or other factors) will eventually inflict considerable damage to the Canadian economy via the housing market and its impact on highly leveraged consumers. In this regard, the pickup in Canadian economic growth likely represents a happy moment in an otherwise sad story. Chart 5 compares Canada's mortgage debt-to-disposable income, total household debt-to-GDP, and the total household debt service ratio to that of the U.S. The chart neatly illustrates the fundamental basis for a bearish secular outlook for the Canadian economy, which is that household debt levels have risen enormously since 2000, to a level that is worse today than in the U.S. in 2007. "So what?" ask some investors. Household debt levels vary significantly across countries, meaning that an elevated level of household debt-to-income does not necessarily spell economic doom. Chart 6 counters this point by showing the relationship between the historical change in household debt-to-GDP (y-axis) versus the starting point for the ratio (x-axis) during episodes of significant household leveraging. The change in debt-to-GDP is shown as a 10-year average of the year-over-year change in the ratio, in order to compare Canada's recent debt binge with other long-term booms in credit. In terms of very significant increases in household credit-to-GDP from an already above-average level, Chart 6 shows that Canada's experience (an average yearly increase of 3.3%) has been among the most severe cases. The chart also shows that while there are a few exceptions, other observations in the neighborhood of Canada's have had a strong tendency to be associated with harsh economic consequences once the credit binge has come to an end. In particular, while the chart shows that the countries at the center of the euro area sovereign debt crisis saw a more rapid rise in household debt-to-GDP than observed in Canada, this occurred from a lower base. When measuring the total change in household debt-to-GDP, Canada has experienced almost the same magnitude rise from 2000 to today as what occurred in Spain and Portugal during the last economic cycle. In terms of a comparison with the U.S., Chart 7 presents a long-term perspective on the inverse relationship between household credit growth and real per capita consumption in the U.S. The chart highlights that 10-year upcycles in household debt-to-GDP correlate well, with a lag, to 10-year downcycles in real per capita spending. Periods where the relationship is less tight have tended to be associated with less severe increases in household debt-to-GDP, suggesting that investors can be more confident that debt growth will eventually negatively impact consumer spending the stronger the credit binge has been. Chart 6The Historical Experience Of Household Leveraging Does Not Paint A Pretty Picture For Canada Chart 7Upcycles In Household Leveraging Correspond To Downcycles In Real Spending As a final point, Chart 7 underscores a sobering fact: The U.S. has only seen two instances of a 3% or greater average annual rise in household debt-to-GDP over the course of a decade: the first was in the 1920s, and the second was from 1998 to 2007. Clearly, in both cases the rise in debt ended very poorly for the U.S. economy. This, along with the prevalence of serious debt crises following credit binges similar in magnitude to Canada's experience, makes it clear that a credit-driven downturn in spending is a highly probable event for the Canadian economy over the long run, rather than a risk. Bottom Line: The available historical evidence suggests that the substantial leveraging of Canadian households that has already occurred will ultimately cause a serious credit-driven downturn. Debunking Some Housing Market Myths: It's Worse Than You Think Chart 816 Years Of Too-Easy Money The risk that the Bank of Canada will eventually "over-tighten" is magnified by the fact that there is still an ongoing debate within Canada about whether any housing market imbalances even exist. Many market participants still employ several arguments about the Canadian housing market that, at first blush, appear to mitigate the risk of serious long-term consequences of Canada's debt boom. But these arguments are flawed, and an in-depth review of these fallacies highlights the economic risk of higher interest rates. Myth #1 - Sustainable Demand And Affordability The first myth about Canada's housing market is that the rise in house prices and household debt is sustainable because of how long the boom has lasted without consequence. However, besides the ominous historical experience highlighted in Charts 6 and 7 above, Chart 8 makes it clear that the substantial build-up in Canadian household debt since 2000 has occurred primarily due to too-easy monetary policy, rather than legitimate housing market fundamentals. The chart presents Canadian household debt-to-GDP versus the Bank of Canada's target for the overnight rate. The dotted line in panel 2 is a Canadian version of the well-known Taylor rule of monetary policy, with panel 3 showing the difference between the actual policy rate and that prescribed by the rule. The chart shows that the rise in household debt-to-GDP began precisely when the policy rate fell below the Taylor rule, and that this gap has persisted for the past 16 years. We acknowledge that the Bank of Canada felt it was necessary to keep interest rates relatively low during the last economic cycle because of the persistent strength in the Canadian dollar (which acts to restrain exports). But whatever drag on growth that occurred from a strong currency was not large enough to prevent low interest rates from sparking an enormous rise in household leverage. Myth #2 - No Foreign Money Effect The second myth about the Canadian housing market is that there is no substantial effect on house prices from foreign money and that, by extension, foreign transaction taxes should be discouraged. To us, the issue is not the specific residency status of a particular buyer, but rather whether the housing market is being supported by an inflow of foreign capital. While data limitations make it difficult to prove with certainty that Canada has been struck with a tidal wave of capital from China (with Hong Kong acting as the conduit), Charts 9 and 10 show that the circumstantial evidence is overwhelming. The story that emerges from the charts is that the peak in Chinese real GDP growth in 2010 marked the beginning of significant capital outflow from the country, which appears to have moved through Hong Kong, and was perhaps accelerated by Xi Jinping's crackdown on cronyism that began in 2013. Panel 2 of Chart 9 shows that the average absolute value of Hong Kong's "net errors and omissions" line from the balance of payments spiked after mid-2010,2 as did Canada's "other investment liabilities" with a lag. Chart 10 shows that this period also saw a sharp rise in visitor arrivals to Canada from China and Hong Kong, a rise in the share of Canadian bank loans to nonresidents, and a meteoric rise in house prices in Vancouver and Toronto. Chart 11 presents data from Global Financial Integrity, a Washington-based think tank that tracks illicit financial flows globally. While the data is only available with a lag, the chart shows that GFI's estimate of illicit financial outflows from China has risen significantly following the global financial crisis, which is consistent with the narrative presented in Charts 9 and 10. Chart 9Very Strong Circumstantial Evidence... Chart 10...Of Foreign Capital Inflows Chart 11Clear Evidence Of Chinese Capital Flight Myth #3 - Tight Supply The third myth concerning Canadian housing is the argument that housing supply is tight, which justifies the exponential move in house prices. First, it should be noted that while residential investment as a share of GDP was indeed low in the late-1990s, it rose back to its long-term average within the first three years of the housing boom, and has recently risen to a 27-year high (Chart 12). A similar trend can be observed in housing starts and the number of unsold housing inventories. As such, it seems difficult to make the case that the extraordinary rise in house prices and household debt that we have observed over the past 16 years is ultimately due to scarce housing supply. Chart 13 makes this point more saliently, by presenting a scatterplot of the median house price-to-income ratio versus the population density of several major global markets. Ultimately, in any true market economy, genuine housing supply constraints must be related to high density or else there would be ample room to build additional housing units. Two points are noteworthy: Chart 12There Is No Supply Problem Chart 13'There's Nowhere To Build!': Yeah, Right! The median house price-to-income ratio for Toronto and Vancouver deviate enormously from the level that would be implied by their density given the relationship across global housing markets. Based purely on this analysis of relative density, Toronto and Vancouver house prices are 80% and 140% overvalued, respectively. Around the globe, the housing markets that appear to be the most overvalued relative to population density appear to be the geographically closest to China (Vancouver, Australia, Hong Kong, and the West Coast of the U.S.), which echoes our conclusions about foreign capital inflow above. Myth #4 - A Healthier Canadian Household Debt Distribution The fourth myth concerning Canadian housing is the idea that the household debt binge that we have observed has been a "healthier" rise than what occurred in the U.S. during the last economic cycle. The argument is that the rise in debt in the U.S. from 2001 - 2007 predominantly occurred among "subprime" borrowers, and that this is not occurring in Canada. Comparing Canada to the U.S. last cycle is difficult due to the lack of data on the distribution of Canadian household debt-to-income ratios by income percentile. However, some inferences can be drawn from the OECD's wealth distribution database, and they suggest that Canadian household debt is, in fact, quite concentrated. Chart 14 presents the relationship between the number of households with debt and the median debt-to-income ratio of indebted households, from 2010 to 2012 (depending on the observation). The chart shows that while only about half of Canadian households are indebted (in line with the average of the countries shown and below that of the U.S.), among those with debt the median debt-to-income ratio is substantially higher than most other countries. This is also reflected in Chart 15, which shows that Canada has a high rank of significantly indebted households as a share of all indebted households,3 more so that the U.S. Investors should note that Canada's rank today is likely to be higher than that shown in Chart 15, given that several other highly indebted countries (such as the Netherlands and Portugal) have actually experienced household deleveraging since 2010. Chart 14High Concentration... Chart 15...Of Household Indebtedness Myth #5 - The "CMHC Backstop" The fifth and final myth concerning Canadian housing is the fact that the economy is not significantly exposed to a housing market downturn because of the Canada Mortgage and Housing Corporation's mortgage insurance coverage protects Canadian banks. It is true that the CMHC can act as a backstop for the economy by helping to mitigate mortgage default losses. But Chart 16 highlights that there have been some substantial changes over the past few years in the CMHC's footprint in the mortgage market that casts significant doubt on whether it would be able to materially blunt the losses that are likely to occur from systemic mortgage defaults. First, the chart shows that while half of mortgages in Canada had CMHC insurance coverage in 2010, this has fallen by 14 percentage points in just six years (to 36%). This means that almost 2/3rds of Canadian mortgages are not CMHC-insured. Second, while the CMHC has been aggressive in building equity over the past several years (perhaps in anticipation of a significant housing bust!), this equity buffer is still small relative to its total loans (9%) and is fractional as a share of total Canadian residential mortgage credit (1.5%). As such, while we agree that the CMHC is an effective backstop against idiosyncratic risk in the mortgage market, it is simply too small to act as a credible buffer against large-scale losses. Bottom Line: Several myths about Canada's housing market have obscured the true extent of its credit market imbalances, heightening the risk that policymakers will ultimately overplay their hand when tightening monetary conditions. When Will The Party Come To An End? From our perspective, the most likely catalysts for a credit-driven downturn in spending are a reversal of the factors that drove the rise in household debt in the first place. Chart 17 presents a three-phase view of the rise in household debt-to-income since 2000, and summarizes the major drivers of rising leverage in each phase given our analysis above: persistently easy monetary policy (phase I), fiscal and monetary easing (phase II), and foreign capital inflow (phase III). Given this, higher interest rates, fiscal drag, and/or a shock to foreign capital would appear to be the most likely triggers for a credit-driven downturn: Chart 16A Substantially Lower CMHC Footprint Chart 17The Major Drivers Of Rising Household Leverage Higher Interest Rates: Tighter monetary policy is an obvious (and most likely) trigger for a major reversal in the Canadian housing market. It is not yet clear how aggressively the Bank of Canada will raise interest rates over the coming 6-12 months, but Chart 18 highlights that the household debt service ratio will quickly rise to a new high even if the Bank of Canada hikes rates by 150 bps over a two-year period, owing to the relatively short maturity of Canadian mortgage contract terms. Still, the chart shows that this does not occur until mid-2019 at the earliest. Fiscal Drag: IMF forecasts for Canada's cyclically-adjusted primary balance suggest that government spending and investment will remain a positive contributor to growth into next year (Chart 19). But beginning in 2019, fiscal policy is forecast to become a persistent drag on growth, and it is even possible that the sharp deceleration in fiscal thrust set to occur next year could act as the proximate cause of serious problems in the Canadian housing market. Chart 18Not An Imminent Threat, But Watch Out Chart 19Fiscal Drag Set To Begin In 2019 Chart 20Macroprudential Measures Didn't Kill The Vancouver Housing Market A Domestically-Driven Shock To Foreign Capital Inflow: Some investors have pointed with concern to dramatic declines in the sales-to-listings ratios in Vancouver and Toronto following foreign taxation announcements in these markets. We agree that the impact of new or existing macroprudential measures may eventually cause a severe fallout in the housing market, but for now the experience of Vancouver suggests that such an event is not imminent. Chart 20 presents the 3- and 12-month rate of change in Vancouver house prices, with the vertical line denoting the announcement of the foreign transaction tax. While it is clear that the tax sharply slowed the rate of appreciation in Vancouver house prices, it did not cause an outright decline (the 3-month rate of change only briefly turned negative before returning to positive territory). Cyclically, we would become more concerned were we to observe a combination of additional restrictions on foreign capital inflow, higher minimum down payment thresholds for houses priced at or below median levels, and a significantly lower allowable gross/total debt service ratio. An Externally-Driven Shock To Foreign Capital Inflow: We noted earlier in the report that there is strong circumstantial evidence showing that Canada's property market is benefiting from large capital inflows from China, with Hong Kong acting as the conduit. Given this, the Canadian housing market could be subject to a shock from exogenous changes in the flow of this capital, perhaps triggered by cyclical changes in China's economy or, more likely, actions by Chinese policymakers to materially slow the pace of capital flight. While it is very difficult on a high frequency basis to track whether the impact of foreign capital on Canada's housing market is growing or weakening, the indicators shown in Charts 9 and 10 on page 9 form the basis of our monitoring effort. The list above has focused on potential triggers that are specific to the factors that led to the build-up in Canadian household debt. Clearly there are additional macro factors that could trigger the onset of a major debt payback period in Canada, and chief among these would be the next U.S. or global recession. For example, we recently noted how continued tightening from the Fed could set the stage for a U.S. recession in 2019, which could easily trigger either a prolonged period of stagnant Canadian growth or an active deleveraging event.4 Bottom Line: There are multiple potential triggers that could eventually spark a credit-driven downturn in Canada, but none of them seem likely to have a major impact on the economy over the coming 6-12 months. Investment Implications Canadian household leverage has risen enormously over the past 16 years, and a detailed analysis of Canada's housing market shows that an eventual credit-driven downturn in spending is a highly probable event for the Canadian economy over the long run (rather than a risk). However, among the most probable triggers for a serious housing market shock, only higher interest rates are set to occur over the coming year. Given that monetary tightening will be gradual in its pace, it does not seem probable that a major downturn in spending is imminent. From an investment standpoint, these conclusions imply the following stance towards Canadian dollar assets over the coming 6-12 months: Overweight the Canadian dollar: The cyclical improvement in the Canadian economy, along with our bullish view on oil prices, suggests that the Canadian dollar is set to appreciate over the coming year. We acknowledge that our constructive view on oil prices is contrarian and that, for now, we are ahead of the market. Continued weakness in oil prices remains the chief risk to a bullish stance on the CAD. But our detailed analysis of the global oil market strongly implies that the current level of oil inventories is too high and is set to draw materially over the coming months, which will be undoubtedly positive for oil prices barring the development of a major global demand shock. Maintain Canadian equities on upgrade watch: Canadian equities have materially underperformed their global peers over the past six years, due to fairly significant de-rating from overvalued levels as well as a downtrend in relative 12-month forward earnings (mostly vs the U.S.; Chart 21). Relative performance in common-currency terms has also been hurt by a declining Canadian dollar. Looking out over the next year, there are at least some tentative signs to be optimistic about Canadian stocks. First, Chart 22 highlights that Canadian stocks are now moderately cheap relative to their global peers based on a composite valuation indicator. Second, our expectation of an uptrend in oil prices would likely bolster relative forward earnings, and could act as a re-rating catalyst for the broad market. Chart 21Multiples And Earnings Have Worked Against Canadian Stocks Chart 22No Longer Expensive Underweight Canadian bonds within a hedged global fixed-income portfolio: Canadian government bonds have recently underperformed their global peers, and this trend is likely to continue in response to tighter monetary policy. Over the longer term, the likelihood of a major credit-driven downturn in spending means that the secular investment implications for Canada are precisely the opposite of that described above. This means that investors should pursue a "two-staged" approach to investing in Canadian assets. The fact that the Canadian economy is currently accelerating and a significant reversal in the Canadian housing market does not seem to be imminent means that there is an opportunity for Canadian assets to potentially outperform (or underperform in the case of government bonds) over the coming 6-12 months. Such a period of cyclical improvement would likely (temporarily) dampen investor concerns about a major housing market correction, creating much better "selling conditions" for Canadian risky assets than from current levels. We acknowledge that the "two-stage" nature of this strategy is nuanced, and we have provided a checklist of potential triggers for the housing market in this report so that investors can gauge the likelihood that a material payback period is about to begin. We will continue to monitor both the cyclical improvement in the Canadian economy and the magnitude of imbalances in the household sector, and will provide investors with regular updates as they develop. Stay tuned! Bottom Line: Investors should pursue a "two-staged" approach when allocating to Canadian assets. Favor a pro-cyclical stance over the coming 6-12 months, but look to shift to a bearish structural view at some point beyond the immediate investment horizon. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Appendix A A Quick Recap Of Home Capital: Not A Systemic Issue In April, the share price of Home Capital Group (a Canadian non-bank mortgage lender) collapsed by 75% in response to a major liquidity crisis for the firm. The crisis ultimately stemmed from a set of mortgage loans with falsified income documentation, which to many outside observers was strongly reminiscent of the aberrant practices of U.S. subprime lending institutions during the last cycle that eventually spawned the global financial crisis. However, as highlighted below, Home Capital Group's problems were largely idiosyncratic (i.e., not systemic) in nature: Home Capital's business model involves lending to Canadians who lack a stable credit history, but who are generally otherwise creditworthy (commonly referred to as "near-prime" borrowers). Since these borrowers subsequently build a credit history by staying current on their mortgage loans with Home Capital, they often switch to a big-five bank after the term of the loan is complete. As such, Home Capital faces substantial client retention challenges, which is an idiosyncratic income statement problem rather than a balance sheet problem with systemic implications. To combat the tendency of its loan book to shrink, in 2014 Home Capital increased the size of its sales force by partnering with a set of established mortgage brokers. Some of the loans that had been originated by these brokers had falsified income documentation, which led to an internal investigation. Following the investigation, the company failed to disclose the results to investors during a period where the company's operating performance was impacted by the fraud. This eventually led to enforcement action from the Ontario Securities Commission. The disclosure of enforcement, along with several other events (such as the termination of its CEO in late-March) severely eroded investor confidence in the firm and essentially caused a bank run. From a macro perspective, there are two important takeaways from this series of events. First, it is important to note that Home Capital experienced a liquidity rather than a solvency crisis. While the former can, of course, lead to the latter, the run on Home Capital did not occur because of deteriorating loan performance, unlike what occurred in the U.S. with the subprime market. Indeed, Home Capital's first quarter results show that net impaired loans as a percent of gross loans have continued to trend lower over the past several quarters (Chart A1). Second, the fact that Home Capital's mortgage book tends to shrink underscores the underlying creditworthiness of at least some of its borrowers, because these households would probably not be able to shift their mortgages to the big-five banks if loan qualification was an issue. As a final point, Chart A2 presents some perspective about the apparent prevalence of mortgage fraud in Canada by showing the number of U.S. mortgage loan fraud suspicious activity reports (SARs) in the lead-up to the subprime financial crisis. The chart not only shows the sharp rise in the number of SARs from 2002-2003 to 2007-2008, but it also shows that the volume of reports numbered in the tens of thousands. By contrast, Canadian news stories reporting on a rise in the number of mortgage fraud complaints in Canada quote a trivially small number of cases. For example, a recent article from the Vancouver Sun stated that British Colombia's Financial Institutions Commission statistics "show complaints roughly doubled from 109 in 2013 to about 200 in 2016, and about a third of complaints allege loan application fraud."5 Chart A1No Deterioration In Loan Performance Chart A2No Evidence That This Is Happening In Canada While it is technically correct to state that this is a doubling in the rate of fraud cases, it is from what appears to be an extremely small base. Adjusting by a factor of 10 to account for the difference in population, Canada would need to see 3,000-to-6,000 cases of mortgage fraud per year in order to be comparable to what occurred in the U.S. in the latter half of the housing market bubble. There is simply no evidence that mortgage fraud on this scale of magnitude is occurring. 1 See Appendix A on page 19 for a review of the Home Capital debacle and why concerns of systemic mortgage fraud are quite likely overblown. 2 If Hong Kong has been a conduit for capital flight from China, the flow of capital would only temporarily show up in Hong Kong's balance of payments. For example, one quarter of significant capital inflow might be followed by a quarter of significant capital outflow as the money enters from China and exits towards the rest of the world. As such, we use the absolute value of Hong Kong's net errors and omissions line to see whether the magnitude of the flow has increased. 3 Defined as having a debt-to-income ratio in excess of 3. 4 Please see Global Investment Strategy Weekly Report, "The Timing Of The Next Recession," dated June 16, 2017, available at gis.bcaresearch.com. 5 Sam Cooper, "Regulator Tracks The Rise In Mortgage Fraud Complaints In B.C. As House Prices Jump," Vancouver Sun, June 19, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

U.S. airlines have been enjoying some of their highest profits in history, lifted by the collapse in oil prices and cheap financing and the market has rewarded them handsomely (bottom panel). However, the last year has seen a trend shift as excess profits have been eaten away at by the always-cutthroat competition. Further, the stringent labor cost control of the past decade will be difficult to maintain in such a profitable environment. Delta Air Lines (DAL) Q2 results offer some insight; unit revenues grew 2.5% while non-fuel unit costs grew 7.3%. The impact of these margin hits is likely to be magnified if, as we expect, oil prices recover. Overall, we think the sector's best days are receding into the contrails. Stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5AIRL -DAL, LUV, AAL, UAL, ALK.