Technical

Highlights Based on long-term moving averages and the advance/decline line, the dollar selloff is still only a severe correction. These factors need to be monitored closely as they stand on the edge. To rebound, the dollar will need U.S. inflation to pick up, which will lift the U.S. OIS curve. Signs are accumulating that U.S. inflation will trough toward the end of 2017. Buying the dollar versus the yen is a much safer bet than shorting the euro. The CAD has more upside, especially on its crosses. Feature The U.S. dollar continues to be tested by investors. As paradoxical as it may sound, it is still too early to sound the death knell for the dollar bull market. However, it is not time either to aggressively bet on a rebound. For that to happen, U.S. inflation must regain its footing in a more convincing fashion. Why Isn't The Bull Market Dead? There are many facets to this question, but let's begin with technical considerations. First, the dollar's advance / decline line has not broken down (Chart I-1). A breakdown in this measure would be one of the key technical signals that the dollar has begun a new cyclical downtrend. In the mid-1990s, the dollar did experience a period of correction. During that time frame, the A/D line was also unable to break down, later highlighting that what was initially perceived as the beginning a new bear market was ultimately a prolonged period of consolidation. Chart I-1Still Not A Cyclical Bear Market Still Not A Cyclical Bear Market Still Not A Cyclical Bear Market Second, the dollar's trend has been best approximated by the four-year moving average of monthly prices. Since the Smithsonian Agreement of 1971, during bear markets, the dollar tends to find its ceiling around this indicator, and during bull markets, it tends to put a floor around this moving average (Chart I-2). Today, the dollar has yet to end a month below this measure. Third, positioning in the dollar is now depressed, as investors have purged their stale USD longs (Chart I-3). When one looks at net long speculative positions in EUR/USD - the most convenient and liquid instrument to bet on the dollar - investors are clearly enamored with the euro, which by definition illustrates their dislike of the greenback. Chart I-2No Trend Break For Now No Trend Break For Now No Trend Break For Now Chart I-3Dollar Downside Is Limited Dollar Downside Is Limited Dollar Downside Is Limited Technical indicators argue that we have experienced a painful correction in the USD, but valuation considerations suggest it will be difficult for these technical indicators to deteriorate enough to begin flagging a cyclical bear market. Our long-term fair value model, which incorporates productivity differentials, highlights that the dollar never hit the nosebleed levels associated with bull market tops in 1985 or in 2001 (Chart I-4). The stability in the trade balance and the current account - both have been stable at around 3% of GDP and 2.5% of GDP, respectively - are at odds with the sharp deterioration in the balance of payments that has occurred when the dollar has been genuinely expensive. Our intermediate-term valuation models point to an even more unequivocal conclusion. Based on this metric, the DXY is at its cheapest level since 2009, a discount that historically has been associated with dollar bottoms, at least temporary ones (Chart I-5). This gives us comfort that the A/D line is unlikely to break down for now, or that the dollar will end September significantly below its crucial four-year moving average. However, if these things happen, the dollar could experience significant downside. Chart I-4The Dollar Never Reached Nosebleed Valuations The Dollar Never Reached Nosebleed Valuations The Dollar Never Reached Nosebleed Valuations Chart I-5Big Discount To IRP Big Discount To IRP Big Discount To IRP Economic forces too do not point to a sharp move in the DXY below 91 - one that could drive the dollar down into the low 80s. After a period of deep underperformance, the U.S.'s economic surprises relative to the G10 have begun to stabilize, as have inflation surprises. More saliently, the incredible strength in the U.S. ISM manufacturing index, especially when compared to other PMIs around the world, points to a rebound in the USD, or at the very least, stabilization (Chart I-6). Finally, the market has now all but priced out additional hikes from the U.S. interest rate curve. There are only 30 basis points of hikes priced in over the next 24 months. Moreover, the probability of the fed funds rate remaining between 1% and 1.25% only falls below 50% in September 2018 (Table I-1). This seems to be a sanguine scenario. Chart I-6Cyclical Support ##br## For USD Cyclical Support For USD Cyclical Support For USD Table I-1Investors See U.S. Rates At Current ##br##Levels Until Late 2018 Conflicting Forces For The Dollar Conflicting Forces For The Dollar Bottom Line: The dollar's technicals are not yet indicative of the end of the cyclical bull market. However, they do need to be monitored closely. Additionally, the dollar is trading at a large discount to interest rate parity relationships, and the Federal Reserve is not expected to execute its next hike until late 2018. While these factors may not point to an imminent rebound in the USD, they do suggest that the down-wave in the dollar is very long in the tooth. Chasing the dollar lower is dangerous. Too Early To Bet The House On A Renewed Upleg Chart I-7The Global Deflation Anchor The Global Deflation Anchor The Global Deflation Anchor This observation on the probability of a Fed move brings us to the vital question of what could lift the U.S. interest rate curve higher, and thus the dollar. This would be the outlook for inflation. As Fed Governor Lael Brainard clearly argued this week, the Fed is not meeting its inflation mandate, warranting a slower pace of rate increases as global deflationary forces remain very potent. The dovish path implied by interest rate markets shows that investors already agree with this assessment. There is no denying that inflation has been globally and structurally pulled down by various forces. While the "Amazon effect" has grabbed headlines, Mark McClellan argues in The Bank Credit Analyst this month that the effect of e-commerce on inflation is no greater than that of Walmart in the 1990s - and probably amounts to a meagre 0.1-0.2% depressive impact on inflation.1 Instead, we peg the capacity buildup in EM and China - which has lifted the global capital stock massively since the turn of the millennia - as the main source of global deflation (Chart I-7). Now that global credit growth is lower than it was before 2008, it has become clearer that the global supply side of the economy has expanded faster than underlying demand, resulting in downward pressure on prices. Nonetheless, while there is a lid on inflation, this does not imply that cyclical determinants of inflation have been fully neutered. They simply have become weaker. Inflation can still ebb and flow in response to the business cycle, but the upside is not as strong as it once was. This limits how high nominal interest rate can go, which is why it is hard to envision a terminal rate much above 3% - a very low reading by post-war standards. Here, we continue to see a turning point coming later this year for inflation, one that would pull core PCE closer to the 2% mark wanted by the Fed in 2018. In the background, our composite capacity utilization indicator is now firmly in "no slack" territory, an environment in which inflation tends to perk up and where interest rate exhibit upside (Chart I-8). This is not enough to warrant fears of inflation, but healthy growth in this context should be a red flag for deflationists. This is exactly the set of circumstances we envision for the next 12 months, even if hurricane Harvey and its potential successors create noise in upcoming data. The U.S. economy has benefited from a strong easing in financial conditions since February 2016. The recent fall in real rates, which has been the key driver of the 60 basis-points fall in Treasury yields since December 2016, is now demonstrably reflationary. Lumber prices are once again at the top of their trading range since 2013, and gold prices have regained vigor. In this optic, the ratio of metal to bond prices - adjusted for their very different volatilities - has been a reliable leading indicator of U.S. growth (Chart I-9). Today, it is pointing to an acceleration of GDP growth relative to potential, the very definition of declining slack. Chart I-8Tight U.S. Capacity Is Inflationary Tight U.S. Capacity Is Inflationary Tight U.S. Capacity Is Inflationary Chart I-9Relfation Will Boost U.S. Growth Above Trend Relfation Will Boost U.S. Growth Above Trend Relfation Will Boost U.S. Growth Above Trend The labor market continues to display signs of resilience as well. True, the last employment report was paltry, but August has been marked by seasonal weaknesses for the past seven years. Moreover, August weaknesses have tended to be minimized in the wake of the notorious revisions typical of the U.S. Department of Labor. However, the strength in the labor market components of the NFIB small businesses survey highlights the potential for more job gains going forward. Where this indicator really shines though, is in its capacity to forecast household total wages and salaries (Chart I-10). Today, this gauge highlights that the income of middle class households will accelerate over the next six months. This matters because if the middle class - a category of U.S. households that gather the vast majority of their income from wages - experiences strong income growth, this will create robust support for consumption. With consumption accounting for 70% of U.S. GDP, a boost to this component would go a long way in lifting aggregate growth. Stronger growth in a tight economy is inflationary, and monetary dynamics confirm this risk. The U.S. velocity of money has picked up meaningfully, and now suggests that inflation will gather steam later this year (Chart I-11). Chart I-10The Labor Market Is Still Strong The Labor Market Is Still Strong The Labor Market Is Still Strong Chart I-11Monetary Dynamics Point To More Inflation Monetary Dynamics Point To More Inflation Monetary Dynamics Point To More Inflation We therefore expect that when this turnaround in inflation emerges, investors will re-assess their expectations for the path of U.S. monetary policy, and the dollar will finally be able to resume its upward trek toward new highs. But until inflation turns the corner, the dollar will continue to struggle to rally durably. Bottom Line: The U.S. economy is still on a firming path. With the amount of slack in the economy vanishing and with the velocity of money accelerating, this will lead to a pick-up in inflation late this year. The end of Q4 is likely to prove the moment when the dollar will finally be able to begin firming up. Investment Implications Shorting the Yen Is Still The Safest Bet Shorting the yen remains the best way to play a dollar rebound for now. The yen has not benefited much from the recent bout of risk aversion prompted by the renewed flare-up of in tensions in the Korean peninsula. It remains weak on its crosses like EUR/JPY, CAD/JPY or even AUD/JPY. USD/JPY seems incapable of staying below 108.5, and may even be forming a consolidation pattern reminiscent of the one experienced in 2013 (Chart I-12). In late 2013, this pattern was resolved by U.S. bond yields moving higher. This time is likely to be similar. The recent weakness in Japanese wages remains a key hurdle that the Bank of Japan does not seem able to shake off. Wage growth hit it slowest pace since 2015 and real wages are worryingly weak (Chart I-13). This is not the picture of an economy with any hint of inflation, even if the labor market is tight. Illustrating this point, contrarily to the euro area, Japanese inflation expectations have not kept pace with the U.S. in recent months (Chart I-14). This argues that the BoJ faces the greatest burden of any central bank. With the BoJ now packed with doves, we expect that interest rates and bond yields in Japan will remain capped for the foreseeable future. As a result, if U.S. bond yields can rise in the face of a strong U.S. economy, JGB yields will not follow higher. This will flatter USD/JPY. Chart I-12Consolidation Pattern In USD/JPY Consolidation Pattern In USD/JPY Consolidation Pattern In USD/JPY Chart I-13Falling Labor Income In Japan Falling Labor Income In Japan Falling Labor Income In Japan Chart I-14Japanese CPI Swaps Are Outliers Japanese CPI Swaps Are Outliers Japanese CPI Swaps Are Outliers A More Complex Picture For The Euro As investors have become more comfortable with the economic and political prospects of the euro area, the euro has become increasingly over-owned, but most importantly, has completely deviated from interest rate parity relationship (Chart I-15). At first glance, this would indicate the euro is greatly vulnerable. This reality, along with very long positioning of speculators in EUR/USD, highlights that it will be difficult for the euro to stay above 1.20 in the coming months. However, for the euro to move below 1.15, U.S. inflation has to pick up. Thus, for the remainder of the year, the EUR/USD is likely to remain range bound between these two numbers. Two factors make the picture less clear for EUR/USD than for USD/JPY. First, the European Central Bank is intent on beginning to taper its asset purchases this year, a move that will be announced in October. At yesterday's press conference, ECB President Mario Draghi was unequivocal about this, despite the slight curtailments to the central bank's inflation forecasts. Moreover, the seeming lack of concern vis-à-vis this year's 6% increase in the trade-weighted euro was perceived by investors as a green light to keep betting on a stronger EUR/USD. Second, as we argued five months ago, exchange rate dynamics are more a function of assets' expected returns than just interest rate differentials.2 As Chart I-16 illustrates, when a portfolio of eurozone stocks, bonds and cash outperforms a similar U.S. one, this leads to a durable rally in EUR/USD. Today, the relative performance of this European portfolio is toward the bottom of its historical distribution, and may even be already turning the corner. If this move has durability, inflows into the euro area could push EUR/USD back into the 1.3 to 1.4 range. Chart I-15Euro Is Expensive ##br##To IRP Euro Is Expensive To IRP Euro Is Expensive To IRP Chart I-16Outperforming Euro Area Assets##br### Could Support EUR/USD Outperforming Euro Area Assets Could Support EUR/USD Outperforming Euro Area Assets Could Support EUR/USD The Loonie Will Keep Flying The Bank of Canada delivered another rate hike this week. The BoC continues to focus on closing the Canadian output gap and the strong economy, ignoring weak wages and inflation. The BoC was rather sanguine regarding the slowdown in real estate activity in Toronto, Canada's largest city, and seemed comfortable with the CAD's recent strength, arguing it was a reflection of Canada's strength and not yet an impediment to it. The CAD interpreted this announcement bullishly. We agree. In a Special Report written last July, we argued that the BoC was among the best-placed central banks to tighten policy among the G10.3 Additionally, the CAD is cheap, trading at a 7% discount to PPP. It is also still below its fair value, implied by interest rate differentials. As such, we continue to overweight the Canadian dollar, being long the loonie against the euro and the Aussie. It also has upside against the USD, but could prove vulnerable to a pick-up in U.S. inflation. Thus, we remain committed to buying the CAD on its crosses. Bottom Line: The euro may be expensive relative to interest rate differentials, but the anticipation around the ECB's tapering continues to represent a support under EUR/USD. As a result, this pair is likely to remain range-bound, roughly between 1.2 and 1.15. USD/JPY has more upside as Japanese inflation expectations and wages are sagging, suggesting the BoJ is nowhere near the ECB in terms of moving away from an ultra-accommodative stance. The CAD will continue to experience upside for the remainder of the year; stay long the loonie on its crosses. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see The Bank Credit Analyst Monthly Report, "Did Amazon Kill The Phillips Curve?" dated August 3, 2017, available at bca.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, "The Fed And The Dollar: A Gordian Knot", dated April 14, 2017, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy And Global Alpha Sector Strategy Special Report, "Who Hikes Next?", dated June 30, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The dollar had a particularly eventful week. With Fed officials Brainard and Kashkari unleashing their dovish remarks, the greenback suffered as investors pushed down 10-year yields. While Brainard highlighted her concern over the "recent low readings of inflation", Kashkari took it further and said that the hikes may be "doing real harm" to the economy. Adding to the Fed's concerns, Stanley Fischer, a long-serving Fed official and an ardent supporter of policy normalization, announced his resignation on Wednesday. Mario Draghi's hawkish press conference added further downward pressure on the dollar, with the DXY making a new low of 91.41. It is unlikely that the dollar will be able to meaningfully rally until inflation re-emerges, a year-end event. Report Links: 10 Charts For A Late-August Day - August 25, 2017 Fade North Korea, And Sell The Yen - August 11, 2017 Balance Of Payments Across The G10 - August 4, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 The euro reacted very positively to the ECB monetary policy speech. Draghi highlighted the uncertainty associated with the strong currency, but noted that the ECB doesn't expect it to have a large impact on inflation, which helped the euro hit a high of EUR/USD 1.2018. He nonetheless highlighted that achieving the ECB's price mandate will require "patience" and "persistence" and he expects inflation to hit its target by 2020. Additionally, the ECB lowered its inflation forecasts, while increasing its 2017 growth forecasts. In terms of QE, Draghi clarified that details will be revealed in the next meeting held on October 26, but that interest rates will remain accommodative for an extended period of time. Although President Draghi laid out some concerns about the strong euro, it seems momentum is unlikely to falter unless markets become more positive on the dollar or the pound. We expect this to occur by the end of this year, when inflation picks up again in the U.S. Report Links: 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been negative: Industrial production yearly growth declines substantially from June's 5.5% number, coming in at 4.7%. This data point also underperformed expectations. Housing starts contracted by 2.3% on a YoY basis, also underperforming expectations. Meanwhile, labor cash earnings also contracted by 0.3% on a yearly basis, underperforming expectations. As we highlighted a few weeks ago, multiple indicators are signaling a slowdown in the Japanese economy. The recent batch of negative data seems to confirm this view, which means that the dovish bias of the BoJ will only be further reinforced. Consequently the yen will be the mirror image of U.S. bonds. Given that rate expectations have collapsed to the point that the market is only anticipating 30 basis points in hikes in the U.S. over the next 2 years, risks point upwards for USD/JPY. Report Links: 10 Charts For A Late-August Day - August 25, 2017 Fade North Korea, And Sell The Yen - August 11, 2017 Balance Of Payments Across The G10 - August 4, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in U.K. has been mixed: Markit manufacturing PMI increased from August to July, coming in at 56.9. This data point also outperformed expectations. Meanwhile, both construction and Markit services PMI underperformed expectations coming in at 51.2 and 53.2, respectively. Finally, nationwide house price year-on-year growth also underperformed expectations, coming in at 2.1%. At the beginning of August, we warned of a repricing of rate expectations in the U.K. given that the pass through from the currency was set to dissipate, while the housing market and real disposable income were undergoing a major slowdown. So far, this view has proven correct, with the pound falling against the dollar and the euro. We expect that GBP/USD has further downside on a 12 month basis, as rate expectations in the U.S. have likely found a bottom. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Data out of Australia was not particularly strong: TD Securities Inflation dropped on an annual basis to 2.6% from 2.7%; Gross operating profits contracted at a 4.5% rate, below the expected 4% contraction; Current account balance came in at AUD -9.862 bn, below expectations, following a 59% decrease in the trade balance from the last quarter, and a 4% decrease in the net primary income; Most notably, GDP grew at the expected 1.8% annual rate, albeit faster than the previous growth rate of 1.7%. The RBA decided to leave rates unchanged, but with a slightly hawkish tone. While growth is generally in line with the Bank's forecasts, it was also highlighted that the appreciating exchange rate and low wages remain headwinds for inflation. A brighter housing market was noted as house price increases are slowing down, owing to macroprudential measures. While the Bank sees an improving labor market, we remain skeptical as the underemployment rate has not improved, which is limiting wage growth. Report Links: 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Surprisingly, in spite of the weakness of the U.S. dollar, the kiwi has been falling for the past month. This has been in part due to some weak data coming out of New Zealand: Building permits continued their decline, with a Month-on-Month decline in July of 0.7%. Both the ANZ Activity Outlook and the Business Confidence indicators declines in August relative to July. The New Zealand terms of trade Index underperformed expectations, coming in at 1.5%. Additionally July's number was revised down from 5.1% to 3.9%. The recent weakness in the NZD might be indicative of some weakness permeating from EM, given that the New Zealand economy is highly sensitive to the global economy. If an EM selloff materializes we expect significant downside for the NZD particularly against the yen. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Data has been quite strong out of the Canadian economy recently: The current account deficit was better than expected at CAD -16.32 bn, with the merchandise trade balance also improving; Manufacturing PMI came in at 51.7, beating the expected 51.3; GDP growth came in at an astonishing 4.5% annualized rate; Accordingly, the BoC raised the overnight rate to 1%. Markets were expecting hawkish remarks, but not a hike. The CAD rallied more than 1% against USD on the news, and outperformed all other G10 currencies. Current expectations for a December hike are at 68%, and we agree. The CAD will see further strength against all G10 currencies except USD by the end of the year. Report Links: 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been mixed: Gross Domestic Product yearly growth came in at 0.3%, underperforming expectations and deaccelerating from a month ago. Headline inflation came in line with expectations at 0.5%, it also increase from the previous month reading of 0.3%. Real retails sales underperformed expectations, contracting by 0.7% on a YoY basis. However the SVME PMI outperformed and increased from the July reading, coming in at 61.2. After reaching 1.15 in early August, EUR/CHF has stabilized around to 1.135. Overall the Swiss economy is still too weak for the SNB to change their stance on currency intervention. Core Inflation will have to pick up to at least 1% for the SNB to consider a change in stance and let go of the implied floor in EUR/CHF. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been positive: Retails sales monthly growth came in at 0.4%, recovering from last month negative reading ad outperforming expectations. Manufacturing output growth also outperformed expectations, coming in at 1.5%. Finally registered unemployment came in at 2.7%, declining from last month reading and coming in line with expectations. USD/NOK has continued to go down as rate expectations for the U.S. have decreased and oil prices have increased thanks to the refining shut-downs in Texas due to hurricane Harvey. We expect this trend to reverse once rate expectations in the U.S. start to go up. However, we do expect more downside in EUR/NOK as this cross is much more sensitive to oil prices. Report Links: 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Swedish data was largely downbeat: Retail sales are growing at a 3.7% annual rate, in line with expectations; The Swedish trade balance went into a deficit in July of SEK -0.5 bn from a SEK 5.4 bn surplus in June; Consumer confidence decreased to 100.3 from 102.2 and below the expected 103; Manufacturing PMI also disappointed at 54.7, below the expected 60; Swedish IP is growing at a still high 5.3% annual pace, but less than the previous 8.9% rate; While this data was somewhat weak, Swedish inflation is at or above its target across all measures. The Riksbank left its repo rate unchanged at -0.5%. In its press release, the Bank highlighted high growth and inflation but stated that the rate will not be increased until the middle of 2018. It also increased inflation forecasts, with CPI and CPIF predicted at 2.9% and 2.1% by 2019. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Bloody Potomac - May 19, 2017 Trades & Forecasts Forecast Summary Core Portfolio Closed Trades

Feature Healthy consumer spending driving a booming sales environment, along with the operating leverage that high revenue growth produces, have been the key underpinnings of the nascent revival in the S&P 500 margin expansion. This has occurred against the backdrop of muted wage growth in most sectors which has amplified margin expansion. We recently showed that S&P 500 operating leverage has historically added $1.4 of earnings for every $1 of incremental revenues (please see our Weekly Report of April 17, 2017 for more details). On a trailing 12-month basis, the S&P 500 has added more than $3 of earnings for every $1 of incremental revenues, more than double the historical average operating leverage. Clearly this pace of margin expansion is unsustainable, particularly since the tight labor market seems likely to force a reacceleration in wage growth. A common narrative among investors has been that late-cycle dynamics will soon force a mean reversion in S&P 500 operating margins. However, and while every economic cycle is different, true mean reversion only happens in recessions (Chart 1). Chart 1Margins Can Expand From Here Margins Can Expand From Here Margins Can Expand From Here Further, the absolute margin level of the S&P 500 is far from being without precedent. Since the 1970's, margins have typically peaked for the cycle only after approaching one standard deviation above the trend and the current S&P500 margin is just past halfway there. It is also worth noting that margins can stay extended for a considerable time; margins have surpassed one standard deviation above trend twice this decade without a material retrenchment. Chart 2 shows the high, low and current trailing operating margins of the S&P 500 and the eleven GICS1 sectors. At first glance, it appears that margins are particularly high in the heavyweight financials and IT sectors. Some context is required; both sectors experienced bubbles in the last two decades that saw operating profits plumb extreme lows in the subsequent busts, making their profit ranges appear unusually broad. Chart 3 corrects to exclude two-standard deviation events for all sectors. The message is clear: margins still have significant room to run. Chart 2High, Low And Current Trailing S&P 500 Operating Margins Sector Margin Outlook: Profit Growth Is Not Done Yet Sector Margin Outlook: Profit Growth Is Not Done Yet Chart 3High, Low And Current Trailing S&P 500 Operating Margins, Normalized Sector Margin Outlook: Profit Growth Is Not Done Yet Sector Margin Outlook: Profit Growth Is Not Done Yet Operating margins in isolation only tell part of the story. In Chart 4, we compare profitability to the capital deployed in pursuit of said profits. Capital deployed and its earned return should theoretically plot on a linear function; plotting above the fitted regression line implies insufficient returns, while plotting below the line indicates excess returns. In our analysis, most sectors plot relatively closely to the market line with a few notable outliers. Financials are likely earning significant excess returns on capital, while utilities are waving a warning flag. We reiterate our overweight and underweight ratings on these two sectors, respectively (Chart 4). Chart 4Capital Intensity Of Profits Sector Margin Outlook: Profit Growth Is Not Done Yet Sector Margin Outlook: Profit Growth Is Not Done Yet The upshot of high margins and low capital requirements is above-average return on capital. Consequently, rising valuation multiples move in tandem with ROIC and vice-versa. Our analysis bears that out; financials are relatively far along the continuum along which most of the S&P 500 sectors plot, though still modestly below the fitted regression line indicating fair value. Conversely, real estate, while attractive from a return on capital perspective, is highly overvalued (Chart 5). Chart 5Margin Efficiency And Valuation Sector Margin Outlook: Profit Growth Is Not Done Yet Sector Margin Outlook: Profit Growth Is Not Done Yet This Special Report takes a sector-by-sector view on the margin outlook that supports our thesis of ongoing margin gains delivering an earnings-driven stock market rally. Chris Bowes, Associate Editor U.S. Equity Strategy chrisb@bcaresearch.com Chart 6Oil Stocks Look Set To Decline Oil Stocks Look Set To Decline Oil Stocks Look Set To Decline Chart 7Capital Formation Should Take Off Capital Formation Should Take Off Capital Formation Should Take Off Chart 8Consumers Have Opened Their Wallets Consumers Have Opened Their Wallets Consumers Have Opened Their Wallets Chart 9Surging Global Manufacturing Surging Global Manufacturing Surging Global Manufacturing Chart 10Real Estate Rents Look##br## Set To Decline Real Estate Rents Look Set To Decline Real Estate Rents Look Set To Decline Chart 11The Right Conditions For Industrial##br## Margin Expansion The Right Conditions For Industrial Margin Expansion The Right Conditions For Industrial Margin Expansion Chart 12Dark Clouds On The Horizon ##br##For Health Care Margins Dark Clouds On The Horizon For Health Care Margins Dark Clouds On The Horizon For Health Care Margins Chart 13Utilities Margins Are##br## Likely To Contract Utilities Margins Are Likely To Contract Utilities Margins Are Likely To Contract S&P Energy (Overweight) Chart 14S&P Energy S&P Energy S&P Energy Energy operating profit margins have been on a wild ride, collapsing with the underlying commodity and then partially recovering as the industry rationalized. Analysts are forecasting more of the same, with the industry forecast to generate profits for the first time in more than two years. Pricing power has spiked higher, though from an extremely low base, as the aforementioned industry rationalization has taken hold. Wage growth looks fairly tepid and the net margin impact supports the forecast view of margin expansion. Rampant cost inflation appears to be a thing of the past. Accordingly, the essential component for margin recovery will be top line growth. The key factors in a top-line growth scenario for the energy sector will be a demand-driven recovery in crude oil prices, supported by continued supply-side discipline. The current global economic revival and pause in the U.S. dollar bull market are catalysts for the former while OPEC 2.0 supply cuts (with effective compliance) and lower crude supply are catalysts for the latter. Encouragingly, the rig count remains well below peak levels, Cushing crude oil inventories are contracting on a year-over-year basis and OECD oil stocks appear poised to contract in late autumn/early winter (Chart 6). Net, we are constructive on energy sector margins (Chart 14). S&P Financials (Overweight) Chart 15S&P Financials S&P Financials S&P Financials Margins, though below historic peak levels, have improved dramatically. The stock market has not rewarded the sector for the solid performance, making financials a standout sector where earnings have led prices higher, rather than multiple expansion. A healthy consumer, housing market and corporate sector should lead to strong capital formation which, in turn, implies improving revenue growth for financials. This is captured by our loans & leases model which points to the largest upswing in credit growth of the past 30 years (Chart 7) Banks in particular benefit from a healthy economy as very low unemployment should be accompanied by solid loan quality which makes the industry's margin gains more durable (Chart 7). We expect banks, as the largest segment of the financials sector, to lead the index higher. Pricing power and wage growth have recently been diverging with the former moving steeply positive and the latter falling to the slowest growth of the past 5 years. These moves bode well for future margin expansion; analysts agree, with forecasts pointing to margins approaching twenty-year highs (Chart 15). S&P Consumer Discretionary (Overweight) Chart 16S&P Consumer Discretionary S&P Consumer Discretionary S&P Consumer Discretionary Consumer discretionary margins have inflated dramatically and, despite a moderation in actual and forecast profitability, they remain more than one standard deviation above normal. Wage growth is declining from fairly eye-watering levels but still remains faster than the muted sector pricing power. The net of these points is falling margins, in line with analyst forecasts. Spending has recently poked higher as a much improved household balance sheet and wage growth have made the consumer feel flush enough to start spending some of their accumulated savings of the past few years (Chart 8). This resurgence in demand should mean, barring any external shock, that pricing power will recover, though a tight labor market could present a considerable offset via above-normal wage growth. Within the index, margin strength is particularly notable in Home Improvement Retail and Cable & Satellite; both are benefitting from the themes noted above and have seen revenue growth driving wider margins. The Auto Components index is a rare underperformer with margins shrinking as the companies adjust to slowing North American light vehicle production. Net, we remain positive on consumer discretionary profit growth (Chart 16). S&P Consumer Staples (Overweight) Chart 17S&P Consumer Staples S&P Consumer Staples S&P Consumer Staples Consumer staples margins have seen a general upward trajectory over the past three years, though have recently rolled over. The key culprits have been food & drug deflation with retail struggling to maintain profits. Forecasts are pointing to a resumption of the upward margin trend, in line with our improving proxy measure (Chart 17, bottom panel). Eventually staples will regain some share of the consumer's wallet. The wage bill is moving in the right direction and even a modest uptick in sector pricing power could trigger margin expansion. It is worth noting that consumer staples is our only remaining overweight defensive index as we have drifted toward cyclical sectors with our increasingly bullish stance over the course of the year. Still, we remain confident of a modest sector margin recovery, though expect consumer discretionary to have a better profit growth profile. S&P Telecommunication Services (Neutral) Chart 18S&P Telecom Services S&P Telecom Services S&P Telecom Services S&P telecom services is at the very bottom of the GICS1 sector EPS growth table this year despite easy comparable quarters in 2016; this is reflected in the index's steady downward drift (Chart 18, top panel). Still, margins have started staging a recovery and the sell-side appears reasonably optimistic. The issue is pricing, the weakness of which is taking profits down regardless of margin resilience. Encouragingly, selling prices cannot contract at 10% per annum indefinitely and recent anecdotal evidence from earnings calls suggests that the peak deflationary impulse is likely behind the industry. Impressive labor cost discipline along with even a modest pricing power rebound signal that a grinding higher margin backdrop is likely in the coming months, though our margin proxy is weighed down by still-falling pricing power (Chart 18, bottom panel). S&P Materials (Neutral) Chart 19S&P Materials S&P Materials S&P Materials Margins in the S&P materials index have recovered sharply from their recent lows, with analysts forecasting continued margin expansion. Said margin expansion will be dependent on the industry holding on to the pricing power gains it has made over the past year; we think odds are good this can happen. A global manufacturing rebound appears to be underway; the global manufacturing PMI has recently reaccelerated and jumped to a six year high (Chart 9). Further, it looks likely that a coordinated central bank tightening cycle has begun which should make U.S. exports relatively more attractive, even if the greenback moves laterally from current levels. With respect to chemicals, the dominant materials component industry, a wave of global mergers (Chart 9) should limit price competition while also stripping out some overcapacity which has been a perennial margin overhang. As well, domestic operating conditions have taken a turn for the better as U.S. chemical production has troughed and utilization rates have improved (Chart 9). Still, inventories have surged in advance of the manufacturing recovery (not shown) and any demand misstep could have serious margin implications. Our materials margin proxy points to modest margin gains (Chart 19). S&P Real Estate (Neutral) Chart 20S&P Real Estate S&P Real Estate S&P Real Estate The S&P Real Estate index comprises mostly REITs and does not compare well to the other sectors on an operating margin basis, owing to the vastly different business model. Still, a discussion of drivers of both revenues and costs is worthwhile. Real estate occupancy rates have crested and generationally high supply additions in the apartment space are all but certain to push vacancies higher still (Chart 10). The implication is that rental inflation will remain under intense downward pressure, as has been the case since the beginning of 2016. Worrisomely, credit quality in select commercial real estate (CRE) segments is deteriorating at the margin (Chart 10). Should the trend worsen, REIT margins will deteriorate. According to a recent Fed Senior Loan Officer Survey, bankers are less willing to extend CRE credit. In fact, if one excludes the GFC spike, the tightening in CRE lending standards is near the two previous recessionary highs (Chart 10 on page 8). If banks continue to close the credit taps, CRE prices will suffer a setback. Nevertheless, the tight labor market and accelerating industrial production should keep the appetite for CRE upbeat and prices may have a bit more room to run before reaching a cyclical peak (Chart 20). S&P Industrials (Neutral) Chart 21S&P Industrials S&P Industrials S&P Industrials A demand revival, both domestic and globally, has helped drive a recovery of S&P industrials margins from the mini manufacturing recession of 2015/early-2016. The U.S. dollar bull market has paused (Chart 11), global demand and credit growth has recovered (Chart 11) and domestic optimism abounds (Chart 11); all the conditions look supportive of the consistent margin profile forecast by the sell-side. However, the margin expansion thesis is not without risk; pricing power gains appear to have rolled over while the wage bill, the weakness of which was a significant margin driver, has spiked. The result is that our industrials margin proxy has eased, though we discount the measure as it has not correlated well with observed margins. Still, if demand continues to remain upbeat, the operating leverage impact on the relatively high fixed cost sector should offset labor cost spikes. Net, we expect margins to drift mostly sideways (Chart 21). S&P Health Care (Underweight) Chart 22S&P Health Care S&P Health Care S&P Health Care S&P health care margins are showing warning signs of a potential retreat. Pricing power has worsened significantly since recent highs in 2016 which could warn of a top line contraction, particularly in the context of drug price inflation. Chart 12 shows that since 2005 drug prices have nearly doubled and the slope has actually steepened since 2011. Health care spending in the U.S. comprises over 17% of GDP, the highest in the world, but it has likely plateaued. Real health care spending is decelerating in absolute terms, and had been contracting compared with overall PCE earlier this year (Chart 12). This suggests that selling price blues are demand driven and will likely continue to weigh on health care profits. Not only are selling prices softening, but also the health care sector wage bill is on fire, pushing multi-year highs. Taken together, operating margins will continue to compress, sustaining the recent down drift. Should margins worsen as we expect, the recent updraft in the index price should follow earnings downward (Chart 22). S&P Utilities (Underweight) Chart 23S&P Utilities S&P Utilities S&P Utilities In earlier sections of this report, we have discussed the beneficiaries of growing ebullience in global economic expectations; utilities are at the opposite end of the spectrum. 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 fixed income proxies, utilities among them, will continue to suffer. From a profit perspective, our margin proxy is pointing to a pricing driven recovery. However, contracting natural gas prices, the marginal price setter for the industry, suggest that recent utilities pricing power gains are running on empty (Chart 13). Tack on waning productivity, with labor additions handily outpacing electricity production, and the ingredients for a margin squeeze are in place (Chart 13). Importantly, industry utilization rates are probing multi-decade lows and overcapacity is negative for pricing power. Chart 13 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. Net, we think margin weakness should persist (Chart 23). S&P Information Technology (Underweight) Chart 24S&P Information Technology S&P Information Technology S&P Information Technology Margins in the S&P information technology index are pushing their 20-year highs. However, the sector is a story of leaders and laggards. The technology hardware, storage & peripherals sub-index (almost entirely AAPL), for example, has seen their operating margin roughly double in the past ten years. Conversely, communications equipment is in the midst of a collapse in pricing power as intense competition has engulfed telcos (their principal customer group) and the uncertainty in the federal government has held back outlays. Our margin proxy is pointing to a modest margin contraction, a result of slipping sector pricing power partially offset by a flat to slightly negative sector wage bill. This stands in contrast to sell-side forecasts who expect margins to hit record levels in the next year. We view the sell-side as overly sanguine with respect to margins and expect pricing power to weigh in coming months (Chart 24).

Highlights A broad survey on various valuation ratios suggests that Chinese investable equities' exceptional cheapness in the past several years has essentially vanished. Valuation is no longer a compelling reason for staying positive. Multiples of Chinese equities have been rerated in the past two years. This asset class is currently trading at a slight premium over its historical norms as well as other emerging markets, but it is still at discounts to developed bourses and the all-country-world averages. Remain bullish on Chinese investable equities due to our positive stance on the cyclical outlook of economy and profits. Feature Chinese industrial profits increased by 16.5% in July from a year ago, as released early this week. This is a mild deceleration compared with the 19.1% pace a month earlier, which the authorities attributed to temporary factory shutdowns due to extreme summer heat. Irrespective, the latest profit numbers confirm that the economy is passing its peak growth rate in this mini cycle upturn, but overall business activity remain fairly robust. Looking forward, we see limited downside in China's cyclical growth outlook, as discussed in various recent reports.1 Chinese equities have also experienced a mini melt-up in recent weeks. So far this year, Chinese investable stocks, measured by the MSCI China Free index, have rallied by almost 40% in dollar-terms, significantly outpacing all major global and EM benchmarks. Importantly, the total return index of Chinese investable stocks, price appreciation and dividend income combined has recently broken above a long-term resistance, reaching an all-time high (Chart 1). While the strong performance of Chinese equities has validated our positive stance on China's growth and profit profile, the sharp rally in prices also raises a red flag on potential froth and complacency. A closer look at the valuation picture of Chinese equities is well warranted. Conventional Valuation Indicators At the onset, conventional valuation indicators for the broad Chinese investable equity universe currently do not look demanding compared with historical norms (Chart 1, bottom panel). Our composite valuation indicator, which combines several conventional yardsticks such as trailing and forward price-to-earnings, price-to-book, price-to-cash and dividend yield, has crawled out of the "undervalued" extreme that lasted for several years, but it is not yet overvalued. Most conventional valuation indicators are currently roughly in line with their respective long-term averages (Chart 2). Chart 1Chinese Investable Stocks Are No Longer ##br##Exceptionally Cheap Chinese Investable Stocks Are No Longer Exceptionally Cheap Chinese Investable Stocks Are No Longer Exceptionally Cheap Chart 2Most Valuation Indicators ##br##Are Back To Historical Means Most Valuation Indicators Are Back To Historical Means Most Valuation Indicators Are Back To Historical Means Compared with other emerging bourses, Chinese investable equities have also been re-rated. In fact, Chinese equities' outperformance against the EM benchmark since mid-last year has been entirely driven by relative multiples expansion (Chart 3). Our relative composite valuation indicator suggests Chinese investable equities are trading at a moderate premium over the EM benchmark, after a few years of deep discount. Most valuation indicators of Chinese equities are slightly higher than the EM benchmark, but are still significantly lower than their peers in the developed market (Chart 4). Chart 3Chinese Equities Have Been Rerated ##br##Against EM Chinese Equities Have Been Rerated Against EM Chinese Equities Have Been Rerated Against EM Chart 4Chinese Equities Are Trading At Premium##br## Against EM, But Not DM Chinese Equities Are Trading At Premium Against EM, But Not DM Chinese Equities Are Trading At Premium Against EM, But Not DM Weight-Adjusted Valuation Indicators A major issue of conducting historical and cross-country comparisons of valuation indicators is the ever-changing constituents in the indexes. The benchmark to evaluate P/B ratios of tech companies should be categorically different from those of banks, as should the price-to-cash ratios for retailers and utility firms. A simple lump-sum aggregate of a conventional valuation indicator ignores the different sector weights among different markets, which could be misleading. This is particularly important for China, as its juvenile equity universe is constantly evolving and rapidly changing (Chart 5). The largest sector by weight in the Chinese investable market in the past 10 years has shifted from telecom to energy to banks, with the baton more recently being passed to information technology. Currently, IT firms account for over 40% of the MSCI China Free index, up from less than 10% three years ago, while banks have dropped from a peak of 44% to 25% currently. The shifting sector weights within the Chinese equity universe also reflect the rapidly changing structure of the underlying Chinese economy. Chart 5Chinese Investable Equities Sector Breakdown A Closer Look At Chinese Equity Valuations A Closer Look At Chinese Equity Valuations One way to deal with this issue is some sort of "controlled weight" valuation indicator by holding sector weights constant. Chart 6 shows the simple averages of various valuation ratios of the 10 Global Industry Classification Standard (GICS) sectors.2 With the exception of dividend yield, the equal-weighted valuation indicators are more expensive than their respective market weight-based versions, according to our calculation. This means that some smaller-weight sectors are more dearly valued compared with the large weights, particularly banks. However, none of the valuation ratios appear extreme in a historical context. How do Chinese equities compare with other markets? Table 1 summarizes equal-sector-weight valuation indicators. Overall, Chinese equities are trading at a slight premium over emerging markets, but are still at 10-20% discounts to developed bourses and the all-country-world averages. Table 1 A Closer Look At Chinese Equity Valuations A Closer Look At Chinese Equity Valuations Cyclically-Adjusted P/E Ratios The Cyclically Adjusted Price Earnings (CAPE) multiple (also known as the Shiller P/E) compares the equity price to the earnings in a full business cycle extended over many years, rather than just one random year. Typically, CAPEs are calculated by dividing the equity price by the 10-year average of real earnings, which smooths out the business cycle and theoretically better captures what equity investors are paying for companies' long term earning streams. Chart 7 shows that CAPEs are well above 20 times for the U.S. and Japanese markets, and around 16 times for U.K. and euro area stocks - all have experienced some multiples expansion since the global financial crisis. In China's case, the CAPE for investable equities has been hovering at around 10 times, near a record low and significantly below the level of the other major indexes. In fact, the CAPE of investable Chinese shares has barely stopped falling amid the rally in prices. Chart 6Average Versus Market-Weight Valuation Ratios Average Versus Market-Weight Valuation Ratios Average Versus Market-Weight Valuation Ratios Chart 7Cyclically Adjusted P/E: A Global Comparison Cyclically Adjusted P/E: A Global Comparison Cyclically Adjusted P/E: A Global Comparison Investment Conclusions Taken together, the valuation picture of Chinese investable stocks has become mixed, as its total return index has reached an all-time high. This asset class is no longer obviously undervalued compared with both historical norms and its EM peers. Some viewed Chinese equities' exceptional cheapness in the past several years as a "value-trap," which has proven to be a costly mistake and has been discredited. Now the "easy trade" is over, and valuation is no longer a compelling reason for staying positive on Chinese equities. On the other hand, a broad survey on various valuation ratios does yet not conjure up images of an overly extended market, both compared with historical averages and other global benchmarks, particularly DM bourses. Lack of valuation froth means Chinese investable shares are not yet subject to the pull of mean reversion. Cyclically, we remain optimistic on China's growth and earnings outlook, which should continue to push up stock prices. Valuation indicators are never good timing tools, but they should be closely monitored going forward to assess the risk-return tradeoff of holding Chinese equities. We will dig deeper into domestic A shares in an upcoming report. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Monitoring Chinese Capital Outflows And The RMB Internationalization Process", dated August 24, 2017, available at cis.bcaresearch.com. 2 Includes Consumer Discretionary, Consumer Staples, Energy, Financials, Health Care, Industrials, Information Technology, Materials, Telecommunication Services and Utilities. Real Estate is included in Financials, due to its limited data availability as a stand-alone GICS sector. Cyclical Investment Stance Equity Sector Recommendations

Highlights The rise in the yen sparked by the verbal confrontation between the U.S. and North Korea is creating an opportunity to buy USD/JPY. The DXY is set to stabilize and may even rebound, removing a key support for the yen. The U.S. economy is showing signs of strength, and the bond market is expensive, a backup in yields is likely. Rising U.S. bond yields should be poisonous for the yen Until higher bond yields cause an acute selloff in risks assets, an opportunity to buy USD/JPY is in place for investors. Feature After benefiting from the U.S. dollar's generalized weakness, the yen has received a renewed fillip thanks to the rising tensions between North Korea and the U.S. If the U.S. were indeed to unleash "fire and fury" on North Korea, safe-haven currencies like the yen or Swiss franc would obviously shine. While the verbal saber-rattling will inevitably continue, our colleagues Marko Papic and Matt Gertken - head and Asia specialist respectively of our Geopolitical Strategy service - expect neither the U.S. nor North Korea to go to war. Historically, North Korea has behaved rationally, and it only wants to use the nuclear deterrent as a bargaining chip. Meanwhile, the U.S does not want to invest the time, energy, and money required to enact a regime change in that country. Additionally, China is already imposing sanctions on Pyongyang, and Moon Jae-in, South Korea's new president, wants to appease its northern neighbor. With cooler heads ultimately likely to prevail, will the yen rally peter off, or should investors position themselves for additional USD/JPY weakness? We are inclined to buy USD/JPY at current levels. DXY: Little Downside, Potential Upside Most of the weakness in USD/JPY since July 10 has been a reflection of the 3.7% decline in the DXY between that time and August 2nd. However, the dollar downside is now quite limited and could even reverse, at least temporarily. The dollar is currently trading at its deepest discount since 2010 to our augmented interest rate parity model, based on real interest rate differentials - both at the long and short-end of the curve - as well as global credit spreads and commodity prices (Chart I-1). Crucially, the euro, which accounts for 58% of the dollar index, is its mirror image, being now overvalued by two sigma, the most since 2010 (Chart I-2). Confirming these valuations, investors have now fully purged their long bets on the USD, and are most net-long the euro since 2013. Chart I-1DXY Is Cheap... DXY Is Cheap... DXY Is Cheap... Chart I-2...But The Euro Is Not ...But The Euro Is Not ...But The Euro Is Not Valuations are only an indication of relative upside and downside; the macro economy dictates the directionality. While U.S. financial conditions have eased this year, they have tightened in Europe, resulting in the biggest brake on euro area growth relative to the U.S. in more than two years (Chart I-3). This is why euro area stocks have eradicated their 2017 outperformance against the S&P 500, why PMIs across Europe have begun disappointing, and why the euro area economic surprise index has rolled over - especially when compared to that of the U.S. The improvement in U.S. economic activity generated by easing financial conditions also has implications for the dollar. As Chart I-4 illustrates, the gap between the U.S. ISM manufacturing index and global PMIs has historically led the DXY by six months or so. This gap currently points to a sharp appreciation in the dollar. Chart I-3Easing Versus Tightening FCI Easing Versus Tightening FCI Easing Versus Tightening FCI Chart I-4PMIs Point To USD Rally PMIs Point To USD Rally PMIs Point To USD Rally If the dollar were indeed to stop falling, let alone appreciate, this would represent a hurdle for the yen to overcome, especially as the outlook for U.S. bond yields is pointing up. Bottom Line: Before North Korea grabbed the headlines, the USD/JPY selloff was powered by a weakening dollar. However, the dollar has limited downside from here. It is trading at a discount to intermediate-term models, while macroeconomic momentum is moving away from the euro area and toward the U.S. - a key consequence of the tightening in European financial conditions vis-à-vis the U.S. Additionally, the strong outperformance of the U.S. ISM relative to the rest of the world highlights that the dollar may even be on the cusp of experiencing significant upside. The Key To A Falling Yen: Treasury Yields Upside An end to the fall in the USD is important to end the downside in USD/JPY. However, rising Treasury yields are the necessary ingredient to actually see a rally in this pair. We are optimistic that U.S. bond yields can rise from current levels. The U.S. job market remains very strong. The JOLTS data this week was unequivocal on that subject. Not only are there now 6.2 million job openings in the U.S., but the ratio of unemployed to openings has hit its lowest level since the BLS began publishing the data, suggesting there is now a limited supply of labor relative to demand. Additionally, the number of unfilled jobs is nearly 30% greater than it was at its 2007 peak, pointing to an increasingly tighter labor market. We could therefore see an acceleration in wage growth going into the remainder of this business cycle, even if structural factors like the "gig-economy", the increasing role of robotics, or even the now-maligned "Amazon" effect limit how high wage growth ultimately rises. The Philips curve, when estimated using the employment cost index and the level of non-employment among prime-age workers, still holds (Chart I-5). Thus, a tight labor market in conjunction with continued job-creation north of 100,000 a month should put upward pressure on wages. Even when it comes to average hourly earnings, glimmers of hope are emerging. Our diffusion index of hourly wages based on the industries covered by the BLS cratered when wage growth slowed over the past year. However, it has hit historical lows and is beginning to rebound - a sign that average hourly earnings should also reaccelerate (Chart I-6). Chart I-5The Philips Curve Still Works Fade North Korea, And Sell The Yen Fade North Korea, And Sell The Yen Chart I-6Even AHE Are Set To Re-Accelerate Even AHE Are Set To Re-Accelerate Even AHE Are Set To Re-Accelerate The job market is not the only source of optimism, as U.S. capex should continue to be accretive to growth. Despite vanishing hopes of aggressive deregulation, the NFIB small business survey picked up this month. Even more importantly, various capex intention surveys as well as the CEO confidence index point to continued expansion of corporate investment (Chart I-7). Healthy profit growth is providing both the necessary signal and the source of funds to engage in this capex. This will continue to lift the economy. This is essential to our bond and our yen views, as it points to higher U.S. inflation. In itself, economic activity is not enough to generate higher prices. However, when this happens as aggregate capacity utilization in the economy is becoming tight, inflation emerges. As Chart I-8 shows, today, our composite capacity utilization indicator - based on both labor market conditions and the traditional capacity utilization measure published by the Federal Reserve - is in "no-slack" territory, a condition historically marked by bouts of inflation. Chart I-7U.S. Capex To Boost Growth Further U.S. Capex To Boost Growth Further U.S. Capex To Boost Growth Further Chart I-8No Slack Plus Growth Equals Inflation No Slack Plus Growth Equals Inflation No Slack Plus Growth Equals Inflation The recent increase to a three-year high in the "Reported Price Changes" component of the NFIB survey corroborates this picture, also pointing to an acceleration in core inflation (Chart I-9). But to us, the most telling sign that inflation will soon re-emerge is the behavior of the U.S. velocity of money. For the past 20 years, changes in velocity - as measured by the ratio of nominal GDP to the money of zero maturity - have lead gyrations in core inflation, reflecting increasing transaction demand for money. Today, the increase in velocity over the past nine months points to a rebound in core inflation by year-end (Chart I-10). Chart I-9The Pricing Behavior Of Small Businesses ##br##Points To An Inflation Pick Up The Pricing Behavior Of Small Businesses Points To An Inflation Pick Up The Pricing Behavior Of Small Businesses Points To An Inflation Pick Up Chart I-10Reaching Escape ##br##Velocity Reaching Escape Velocity Reaching Escape Velocity Expecting higher inflation is not the same thing as expecting higher interest rates and bond yields. However, we believe this time, higher inflation will result in higher yields. First, the Fed wants to push interest rates higher. Fed Chairwoman Janet Yellen and her acolytes have been very clear about this, with the "dot plot" anticipating rates to rise to 2.9% by the end of 2019. While the Fed's preference and reality can be at odds, this is currently not the case. Our Fed monitor continues to be in the "tighter-policy-needed" zone. While it is undeniable that it is doing so by only a small margin, higher inflation - as we expect - would only push this indicator higher. Moreover, the diffusion index of the components of the Fed monitor is already pointing toward an improvement in this policy gauge (Chart I-11). Chart I-11The Fed Monitor Will Pick Up The Fed Monitor Will Pick Up The Fed Monitor Will Pick Up Second, the Fed may have increased rates, and the spread between U.S. policy rates and the rest of the world may have widened, but the dollar has weakened this year. This counterintuitive result highlights that the Fed's effort has had little impact in tightening liquidity conditions. In fact, as we have mentioned, because of the lower dollar and higher asset prices, financial conditions have eased, suggesting liquidity remains plentiful. As such, like in 1987 or 1994, this is only likely to re-invigorate the Fed in its confidence that it can hike rates further, as liquidity conditions remain massively accommodative. Third, beyond the Fed's reaction function, what also matters are investors' expectations. At the time of writing, investors only expect 45 basis points of rate hikes over the upcoming 24 months, which is a reasonable expectation only if inflation does not move back toward the Fed's 2% target. However, our work clearly points toward higher inflation by year end. In a fight between the Fed's "dot plot" and the OIS curve, right now, we would take the side of the Fed. Fourth, it is not just 2-year interest rate expectations that seems mispriced, based on our view on U.S. growth, inflation, and the Fed. U.S. Treasury yields are also trading at a 36 basis points discount to the fair-value model developed by our U.S. Bond Strategy sister service (Chart I-12). Continued good news on the job front and an uptick in inflation would likely do great harm to Treasury holders. Finally, the oversold extreme experienced by the U.S. bond market in the wake of the Trump victory has been purged. While we are not at an oversold extreme, our Composite Technical Indicator never punched much into overbought territory during the Fed tightening cycle from 2004 to 2006 (Chart I-13). Moreover, with no more stale shorts, an upswing in U.S. economic and inflation surprises should help put upward pressure on U.S. bond yields. Confirming the intuition laid out above, the copper-to-gold ratio, a measure of growth expectations relative to reflation, has now broken out - despite the North Korean risks. In the past, such a development signaled higher yields (Chart I-14). With this in mind, let's turn to the yen itself. Chart I-12U.S. Bonds Are##br## Too Expensive U.S. Bonds Are Too Expensive U.S. Bonds Are Too Expensive Chart I-13Stale Shorts Have Been Purged, ##br##But Overbought Conditions Are Unlikely Stale Shorts Have Been Purged, But Overbought Conditions Are Unlikely Stale Shorts Have Been Purged, But Overbought Conditions Are Unlikely Chart I-14Where The Copper-To-Gold Ratio Goes, ##br## So Do Bond Yields Where The Copper-To-Gold Ratio Goes, So Do Bond Yields Where The Copper-To-Gold Ratio Goes, So Do Bond Yields Bottom Line: The U.S. economy looks healthy. The labor market is strong, and capex continues to offer upside. Because capacity utilization is tight and money velocity is accelerating, inflation should begin surprising to the upside through the remainder of 2017. With the market pricing barely two more hikes over the course of the next 24 months and U.S. bonds trading richly, such an economic backdrop should result in higher U.S. bond yields. Yen At Risk, Even If Volatility Rises JGB yields have historically displayed a low beta to global bond yields. As a result, when global bond yields rise, the yen tends to weaken. USD/JPY is particularly sensitive to yield upswings driven by actions in the Treasury market. This contention is even truer now than it has been. The Bank of Japan is targeting a fixed yield curve slope and does not want to see JGB yields rise much above 10 basis points. With the paucity of inflation experienced by Japan - core-core inflation is in a downtrend, ticking in at zero, courtesy of tightening financial conditions on the back of a stronger yen - this policy remains firmly in place. Emerging signs of weakness in Japan highlight that the BoJ is likely to remain wedded to this policy, even as Shinzo Abe's popularity hits a low for his current premiership. The recent fall in the leading indicator diffusion index suggests that industrial production - which has been a bright spot - is likely to roll over in the coming months (Chart I-15). This means the improvement in capacity utilization will end, entrenching already strong deflationary pressures in Japan. This only reinforces the easing bias of the BoJ, and truncates any downside for Japanese bond prices. Chart I-15The Coming Japanese IP Slowdown The Coming Japanese IP Slowdown The Coming Japanese IP Slowdown In short, while JGB yields might still experience some downside when global yields fall, they will continue to capture none of the potential upside. This makes the yen even more vulnerable to higher Treasury yields than it was before. Hence, based on our view on U.S. inflation and yields, USD/JPY is an attractive buy at current levels. But what if the rise in U.S. bond yields causes a correction in risk assets, especially EM ones? Again, monetary policy differences and the trend in yields will dominate. As Chart I-16 illustrates, USD/JPY has a much stronger correlation with dynamics in the bond markets than it has with EM equity prices. Chart I-16Yen: More Like Bonds Than Anything Else Yen: More Like Bonds Than Anything Else Yen: More Like Bonds Than Anything Else Chart I-17USD/JPY Falls Only When EM Selloffs Are So Acute That They Cause Bond Rallies USD/JPY Falls Only When EM Selloffs Are So Acute That They Cause Bond Rallies USD/JPY Falls Only When EM Selloffs Are So Acute That They Cause Bond Rallies Moreover, as the experience of the past three years illustrates, only once EM selloffs become particularly acute does USD/JPY weaken (Chart I-17). Essentially, the EM selloff has to be so severe that it threatens the Fed's ability to tighten policy, and therefore causes U.S. bond yields to fall. It is very possible that a rise in Treasury yields will ultimately generate this outcome, but in the meantime the rise in U.S. bond yields should create a tradeable opportunity to buy USD/JPY. Bottom Line: With Japan still in the thralls of deflation and the BoJ committed to fight it, JGB yields have minimal upside. Therefore, higher Treasury yields are likely to do what they do best: cause USD/JPY to rally. This might ultimately lead to a selloff in EM stocks, but in the meanwhile, a playable USD/JPY rally is likely to emerge. Thus, we are opening a long USD/JPY trade this week. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The U.S. labor market continues to strengthen, with the JOLTS Survey's Job Openings and Hires both ticking up. The NFIB Survey also shows signs of strength as the Business Optimism Index steadied at lofty levels, coming in at 105.2. Unit labor costs disappointed, but this supports U.S. equities. Nonfarm productivity also outperformed, pointing to improving living standards. U.S. data has turned around, with data surprises improving relative to the euro area. These dynamics are likely to prompt a resumption of the greenback's bull market. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Look Ahead, Not Back - June 9, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Euro area data has been mixed: German current account underperformed, with both exports and imports contracting on a monthly rate, and underperforming expectations. The trade balance, however, outperformed; German industrial production failed to meet expectations, even contracting on a monthly basis; Italian industrial production outperformed both on a monthly and yearly rate, but remains well below capacity European data has begun to show the pain inflicted by tightening financial conditions. Relative to the U.S., the economic surprise index has rolled over. If this trend continues, EUR/USD will struggle to appreciate more this year, and may even weaken if U.S. inflation can improve. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data has been negative in Japan: Labor cash earnings yearly growth went from 0.6% in May to a contraction of 0.4% in June, underperforming expectations. Machinery orders yearly growth fell down sharply, contracting at a 5.2% rate and underperforming expectations. The Japanese economy continues to show signs of weakness, which means that the Bank of Japan will not let 10-year JGB yields rise above 10 basis points. In an environment of rising U.S. bond yields this will cause the yen to fall. However the question remains: Could a selloff in EM prompted by a rising dollar help the yen? This should not be the case, at least for now, as the yen is much more correlated with U.S. bond yields than it is with EM stock prices. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been mixed: BRC like-for-like retail sales yearly growth came in at 0.9%, outperforming expectations. However, the RICS Hosing Price Balance - a crucial bellweather for the British economy - came in at 1%, dramatically underperforming expectations. Also, the trade balance underperformed expectations, falling to a 12 billion pounds deficit for the month of June as exports sagged. As we mentioned on our previous report, we expect the pound to suffer in the short term, as the high inflation produced by the fall in the pound following the Brexit vote is starting to weigh on consumers. Furthermore, house prices are also suffering, and could soon dip into negative territory. All of these factors will keep the BoE off its hawkish rhetoric for longer than priced by the markets. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 AUD gains are reversing as the U.S. dollar rebounds from a crucial support level. This has also occurred due to mixed Chinese and Australian data: Chinese trade balance beat expectations, however, both exports and imports underperformed; Chinese inflation underperformed expectations; Australian Westpac Consumer Confidence fell to -1.2% from 0.4% in August; This is largely in line with our view that the rally in AUD was would only create a better shorting opportunity. Underlying structural and fundamental issues will remain a headwind for the AUD for the remainder of the year. Iron ore inventories in China are also at an all-time high, which paints a dim picture for Australian mining and exports going forward. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 On Wednesday, the RBNZ left their Official Cash Rate unchanged at 1.75%. Overall, the bank signaled that it will continue its accommodative monetary policy for "a considerable period of time". Furthermore the RBNZ's outlook for inflation, specifically tradables inflation, remains weak. Finally, the bank also showed concern for the rise in the kiwi, stating that "A lower New Zealand Dollar is needed to increase tradables inflation and help deliver more balanced growth". Overall, we continue to be positive on the kiwi against the AUD. While the outlook for tradable-goods inflation might be poor, this is a variable determined by the global industrial cycle.. Being a metal producer, Australia is much more exposed to these dynamics than New Zealand, a food producer. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Data continues to look positive for Canada: Housing Starts increased by 222,300, beating expectations; Building permits also increased at a monthly pace of 2.5%, also beating expectations. CAD has experienced some downside as the stretched long positioning that emerged in the wake of the BoC's newfound hawkishness are being corrected. While we expect the CAD to outperform other commodity currencies, based on rate differentials and oil outperformance, USD/CAD should is likely to trend higher as U.S. inflation bottoms. EUR/CAD should trend lower by the end of this year as euro positioning reverts. As a mirror image, CAD/SEK may appreciate based on the same dynamics. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Last week we highlighted the possibility of a correction in EUR/CHF, given that it had reached highly overbought levels. This prediction turned out to be accurate, as EUR/CHF fell by almost 2% this week, as tensions between North Korea and the United States continue to escalate. Meanwhile on the economic front, Switzerland continues to show a tepid recovery: Headline inflation went from 0.2% in June to 0.3% in July, just in line with expectations. The unemployment rate continues to be very low at 3.2%, also coming in according to expectations. Inflation, house prices and various economic indicators are all ticking up, however, the economic recovery is still too weak to cause a major shift in monetary policy. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 The krone has fallen this week against the U.S. dollar, even as oil prices have remained relatively flat. This highlights a key theme we have mentioned before: USD/NOK is more sensitive to rate differentials than it is to oil prices. We expect these rate differentials to continue to widen, as the Norwegian economy remains weak, and inflation will likely remain below the Norges Bank target in the coming years. On the other hand, U.S. yields are set to rise, as a tight labor market will eventually lift wages higher and thus increase rate expectations. Meanwhile EUR/NOK, which is much more sensitive to oil prices than USD/NOK, will keep going down, as inventory drawdowns caused by the OPEC cuts should continue pushing up Brent prices. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Data in Sweden was mixed: New Orders Manufacturing yearly growth fell from 7.3% to 4.4%. Industrial production yearly growth increased from 7.5% in May to 8.5% in June, outperforming expectations. The Swedish economy continues to exhibit signs of strong inflationary pressures. Overall we continue to be bullish on the krona, particularly against the euro, as the exit of Stefan Ingves at the end of this year should give way for a more hawkish governor, who would respond to the strength in the economy with a more hawkish stance. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Bloody Potomac - May 19, 2017Xx Trades & Forecasts Forecast Summary Core Portfolio Closed Trades

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 Synchronized Global Growth Synchronized Global Growth Chart 2Muted Core Inflation Muted Core Inflation Muted Core Inflation Chart 3G10 Central Banks Map Cyclical Indicator Update Cyclical Indicator Update Chart 4Easy Financial Conditions Boost Margins Easy Financial Conditions Boost Margins Easy Financial Conditions Boost Margins Chart 5Buoyant Breadth Bodes Well Buoyant Breadth Bodes Well Buoyant Breadth Bodes Well Table 1SPX Dividend Discount Model Cyclical Indicator Update Cyclical Indicator Update SPX EPS & Multiple Sensitivity Cyclical Indicator Update Cyclical Indicator Update ERP Analysis Cyclical Indicator Update Cyclical Indicator Update Chart 6Healthy Rotation Healthy Rotation Healthy Rotation Chart 7Falling Correlations Boost The S&P 500 Falling Correlations Boost The S&P500 Falling Correlations Boost The S&P 500 Falling Correlations Boost The S&P500 Falling Correlations Boost The S&P 500 Chart 8Interest Rate Sensitives Come Out On Top Interest Rate Sensitives Come Out On Top Interest Rate Sensitives Come Out On Top Chart 9Underowned... Underowned... Underowned... Chart 10...And Undervalued Defensives ...And Undervalued Defensives ...And Undervalued Defensives Chart 11Earnings Growth Set To Accelerate Earnings Growth Set To Accelerate Earnings Growth Set To Accelerate Chart 12Consumers Are Feeling Flush Consumers Are Feeling Flush Consumers Are Feeling Flush Chart 13Improving Fundamentals Signal A Trough Improving Fundamentals Signal A Trough Improving Fundamentals Signal A Trough Chart 14Staples Remain The Household's Choice Staples Remain The Household's Choice Staples Remain The Household's Choice Chart 15Weaker Rents And Higher Vacancies Bode Ill Weaker Rents And Higher Vacancies Bode Ill Weaker Rents And Higher Vacancies Bode Ill Chart 16Profits Look Set To Downshift Strong Fundamental Support Profits Look Set To Downshift Strong Fundamental Support Profits Look Set To Downshift Chart 17Cyclical Recovery Driving Backlogs Lower Cyclical Recovery Driving Backlogs Lower Cyclical Recovery Driving Backlogs Lower Chart 18Margin Recovery Appears Priced In Margin Recovery Appears Priced In Margin Recovery Appears Priced In Chart 19Pricing Collapse Driving Earnings Decline Pricing Collapse Driving Earnings Decline Pricing Collapse Driving Earnings Decline Chart 20Productivity Declines Will##br## Keep A Cap On Valuations Productivity Declines Will Keep A Cap On Valuations Productivity Declines Will Keep A Cap On Valuations Chart 21Valuations At Risk##br## When Inflation Returns Valuations At Risk When Inflation Returns Valuations At Risk 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 Financials S&P Financials 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 Consumer Discretionary S&P Consumer Discretionary 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 Energy S&P Energy 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 Consumer Staples S&P Consumer Staples 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 Real Estate S&P Real Estate 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 Health Care S&P Health Care 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 Industrials S&P Industrials 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 Utilities S&P Utilities 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 Telecommunication Services S&P Telecommunication Services 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 Materials S&P Materials 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 S&P Technology S&P Technology 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 Style View Style View Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com Chris Bowes, Associate Editor chrisb@bcaresearch.com

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

Dear client, This week, we are sending you an abbreviated Weekly Report as we co-authored a Special Report on Wednesday with our sister Geopolitical Strategy service. In our Special Report, available on our website, we argue that Italy's flirtation with leaving the euro area is rooted in its positive experience with devaluations in the 1990s. However, we note that this time is different and devaluing the euro through exit will not be a panacea, as financial market linkages would cause a deep domestic recession that could be brought forward by the mere reality of a referendum on the topic. As such, we think that Italy is unlikely to leave the Euro Area, but that it will remain a drag on the Eurozone - one that will force the European Central Bank to stay a bit more dovish than warranted by conditions in the broader Euro Area. Best regards, Mathieu Savary, Vice President Foreign Exchange Strategy Feature Chart I-1The Dollar At A Critical Spot The Dollar At A Critical Spot The Dollar At A Critical Spot Since the end of last week, the dollar has staged a small rebound. This rebound was of the utmost importance as it materialized at an important level. Had DXY punched below the 96 level, the dollar could have sold off toward 93 in a matter of weeks. However, if the dollar can remain above 96, the greenback is likely to have formed a trough for the remainder of 2017 as it will rest above an important congestion zone that has been in place since early 2015 (Chart I-1). What are the odds of the greenback moving back to 93? We think that right now the balance of probability is in favor of a continued rebound. A call on DXY is first and foremost a call on the euro, as EUR/USD represents 60% of this index. We'll thus focus on the dynamics in this pair. Currently, nominal short rate differentials remain in the dollar's favor. As Chart I-2 illustrates, interbank rate spreads between the Euro Area and the U.S. are broadly supportive of the USD. Additionally, in both the late 1990s and in 2005-06, this spread had been much more negative than at present. BCA still expects the spread to grow more negative as the Federal Reserve continues on its intended policy path, while we also believe it will take a few more years before the ECB can begin lifting rates.1 Real rate differentials paint a similar picture. The euro's strength in the second quarter has emerged in spite of a move in real rate spreads in favor of the USD. As Chart I-3 shows, this divergence has mostly reflected dynamics at the short end of the yield curve, but over the past month and a half the real interest rate difference at the 10-year maturity has also diverged from the EUR/USD's path. Chart I-2EUR/USD Short Rate Differentials ##br##Can Grow Deeper EUR/USD Short Rate Differentials Can Grow Deeper EUR/USD Short Rate Differentials Can Grow Deeper Chart I-3EUR/USD Has Dissociated##br## From A Key Driver EUR/USD Has Dissociated From A Key Driver EUR/USD Has Dissociated From A Key Driver Technically, the dollar is beginning to look attractive against the euro as well. Our positioning indicator - based on sentiment, net speculative positions, and the euro's advanced/decline line - shows that investors are already positioned the most euro bullish since 2012 (Chart I-4). Our intermediate-term technical indicator is also at highly overbought levels, highlighting the euro's limited upside potential. Most importantly though, these moves have happened as the Euro Area economic surprise index massively beat the U.S. one (Chart I-4, bottom panel). This means that Europe's economic outperformance has been driving the euro's strength, unlike in 2015 when the surge in the European surprise index relative to the U.S. was reflective of the euro's 2014 collapse. This paints a picture where much good European news has been priced into EUR/USD during the recent rally. At current levels, the mean-reverting nature of the relative surprise index suggests that European surprises are unlikely to continue to beat U.S. ones by such a margin going forward. This means that the already overbought euro is likely to lose a key support. Finally, as we highlighted two weeks ago, global analysts have already ratcheted up their year-end estimates for EUR/USD (Chart I-5). Not only are their forecasts at levels that have in recent years been indicative of a peak, but the speed and magnitude of their adjustments has also been exceptional. This corroborates that the positive momentum in the Eurozone vis-à-vis the U.S. has already been internalized by market participants. If anything, this favorable relative economic momentum must only grow going forward for the euro to rally further. However, European LEIs have already rolled over relative to the U.S. as the latter looks set to exit its soft patch in the coming months (Chart I-6). Chart I-4Good News Already ##br##In The Euro Good News Already In The Euro Good News Already In The Euro Chart I-5Investors Have Already##br## Bought The Euro Investors Have Already Bought The Euro Investors Have Already Bought The Euro Chart I-6The Economic Tailwinds For The ##br##Euro Are Beginning To Fade The Economic Tailwinds For The Euro Are Beginning To Fade The Economic Tailwinds For The Euro Are Beginning To Fade Bottom Line: DXY has rebounded at a crucial level. If it can stay above 96, this would suggest that its correction is over. We are willing to make this bet as the euro - the key component of the DXY - has dissociated from rate differentials on strong optimism toward the economic outlook for Europe - at the exact time that investors have become more incredulous of the Fed's intentions. Due to these dynamics, EUR/USD is now massively overbought and at risk of a further pullback. Cutting Loose Short USD/JPY Last week, we closed our short USD/JPY position at a 4.2% gain. We did so because we see an increasingly less-supportive environment for the yen. To begin with, the U.S. Treasury notes' fair-value model used by our U.S. Bond Strategy service highlights that U.S. bond yields are currently quite expensive, and could be set to rise anew (Chart I-7). Because JGBs possess a very low beta relative to U.S. yields, an environment where global rates rise tends to be associated with rate differentials moving in favor of USD/JPY, often prompting a rally in the latter. Also, the Bank of Japan is keenly aware that it will be very difficult to achieve its 2% inflation target. The yen's recent strength has exerted a significant tightening in Japanese financial conditions that will drag down inflation (Chart I-8). Hence, the BoJ will continue to be among the most dovish central banks in the world. Additionally, while Japanese industrial production has been strong, it looks set to soften in the coming months, which will give further reason to the BoJ to talk down the yen: Japanese industrial production is very much a function of financial conditions. We are entering a window where the recent tightening in Japanese financial conditions should begin to bite industrial production. The growth rate of the Japanese shipments-to-inventories ratio has rolled over, historically a precursor of a slowdown in industrial production (Chart I-9). Chart I-7T-Notes Are Expensive T-Notes Are Expensive T-Notes Are Expensive Chart I-8Japanese FCI Points To Lower Inflation Japanese FCI Points To Lower Inflation Japanese FCI Points To Lower Inflation Chart I-9Japanese IP Will Turn Japanese IP Will Turn Japanese IP Will Turn Finally, the annual growth rate of Japan's industrial production is heavily influenced by China's economic dynamics, as EM represents 43% of Japanese exports. Two months ago, the Keqiang index - a barometer of strength for the Chinese economy based on credit growth, railway freight volumes, and electricity production - hit its highest level since June 2010, levels only recorded in early 2007, early 2005, and early 2004. Even though we do not anticipate it to crater, we do expect its recent rollover to deepen further in response to the recent wave of policy tightening in China. This should result in some weakness for Japan's industrial production. In practice there is little additional actions the BoJ can implement to ease policy further. However, because investors are currently so negative on the prospects for further Fed rate increases, with only 40 basis points priced in over the next 24 months, a re-assurance by the BoJ that easy policy is here to stay could put upward pressure on USD/JPY. While we remain worried about EM assets, we think that shorting the AUD or the NZD against the yen represents better portfolio protection than shorting USD/JPY. Bottom Line: USD/JPY has a generous amount of upside from here. Investors are too pessimistic regarding the Fed's ability to increase rates over the next 24 months. Meanwhile, the recent tightening in Japanese financial conditions is a headache for the BoJ, as it points to weaker inflation and a slowdown in industrial production. Hence, we expect the BoJ will try to talk down the yen over the coming months. EUR/NOK At An Interesting Spot Chart I-10If Brent Doesn't Fall Below,##br## EUR/NOK Is A Short If Brent Doesn't Fall Below $40, EUR/NOK Is A Short If Brent Doesn't Fall Below $40, EUR/NOK Is A Short The price action in EUR/NOK caught our eye this week. EUR/NOK is at a critical level and has rallied as investor optimism toward the Euro Area economy continues to grow. Meanwhile, oil prices have collapsed to US$45/bbl. Since Norway is an economy heavily geared to oil-price gyrations, this bifurcation created an ideal combination to generate a EUR/NOK rally. However, by discounting these developments, EUR/NOK has now entered massively overbought territory. Additionally, as Chart I-10 illustrates, the cross has only traded at higher levels at the depth of the financial crisis in the first quarter of 2009 and the early days of 2016. In both instances, Brent was trading below US$40/bbl. A selling opportunity could soon emerge. Our Commodity And Energy Strategy service continues to expect a deepening of the adjustment in global oil inventories as the OPEC 2.0 deal remains in vigor and compliance stays in place.2 This means a move below US$40/bbl for Brent is very unlikely, and the upside in EUR/NOK is extremely limited. While in the coming weeks a move in Brent to between US$44/bbl and US$42/bbl could happen, we think this limited downside points to an attractive risk-reward ratio to shorting this cross. We are currently long CAD/NOK and short EUR/CAD, with the latter having greater potential downside than EUR/NOK. However, due to Canada's deep integration with the U.S. economy, the EUR/CAD trade is often affected by dynamics in the U.S. dollar. Shorting EUR/NOK is thus a cleaner play on oil and removes much of the risk associated with the greenback's fluctuations. Finally, yesterday, the Norges Bank policy release displayed less dovish tone than anticipated by the market. This kind of surprise would create an additional support to being short EUR/NOK. Bottom Line: EUR/NOK looks set to weaken. Over the past 10 years, it has only traded above current levels when Brent prices were below US$40/bbl. Based on our commodity team's analysis, such a move is very unlikely. Thus, any short-term weakness in oil prices should be used to sell EUR/NOK. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled, "Central Banks Are Sticking To Their Guns", dated June 6, 2017, available at fes.bcaresearch.com 2 Please see Commodity & Energy Strategy Weekly Report titled "Time For "Whatever It Takes" In Oil?", dated June 2, 2017, available at ces.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The ECB's meeting was in line with expectations, the governing council increased its growth forecast, decreased its inflation forecast, removed it easing bias, but maintained that easy policy was key to support its objectives. Going forward, growth will have to remain just as strong for European inflation dynamics to emerge. Financial conditions between the U.S. and the euro area are moving in favor of U.S. growth, and thus, the USD. EUR/USD momentum is stretched, but it can rise further. EUR/USD at 1.15 in the coming weeks is a risk to our view. However, EUR/USD forecasts have already been ratcheted upward, and their capacity to lift the euro is losing steam. Feature The European Central Bank hit the mark yesterday with a performance that was bang on in terms of expectations, as illustrated by the euro's muted response. The governing council increased its growth forecast by 0.1% each year and curtailed its inflation forecast by an average of 0.2% until 2019, inclusively (Table I-1). Moreover, while the ECB statement removed its future easing bias, in the press conference ECB President Mario Draghi made it crystal clear that this was because deflationary risks were evaporating, but the economy still needed extremely easy conditions in order to stay on the trajectory envisioned by the ECB. Chart I- As a result, despite this adjustment in forward guidance, the ECB elected to keep its asset purchases in place, even leaving the door open for time extensions and size increases if conditions warrant. After all, in the eyes of the ECB - and it is an assessment we share - the great performance of the European economy has been and remains dependent on the continuation of a very easy policy stance. In this optic, we study the outlook for growth dynamics in Europe, especially in relation to the U.S., as this is what will determine the future path of relative policy. If European policy can move in a more hawkish fashion relative to the Federal Reserve as well as current expectations, then the euro bear market will be over. Growth And Financial Conditions For the euro to rally further, the ECB has to be able to beat market expectations and the Fed has to continue to underwhelm. So far this has not happened, but markets are forward looking and are behaving as if both central banks will follow these paths. To expect a tightening of ECB policy relative to the Fed's, European growth will have to continue outperforming U.S. growth. As we argued last week, the slack in the European jobs market is much greater than that in the U.S.1 Without outstanding growth, European inflationary dynamics will remain hampered by low wage growth. Meanwhile, the Fed is facing an environment congruent with high rates (Chart I-1), something that markets are ignoring as they are only anticipating two more hikes into June 2019, beyond the one anticipated next week. So what kind of future growth dynamics are we anticipating? World growth may not be about to plunge, but global activity is set to soften as China and the U.S. have been tightening monetary conditions in an environment replete with excess capacity. Indicators are already responding to this policy shift. Our diffusion index of global leading economic indicators has already rolled over sharply, a precursor to softening global LEIs (Chart I-2). This is a bigger problem for Europe than the U.S. Since 2010, the beta of euro area LEIs to global LEIs has been around 0.8, while for the U.S. the sensitivity is around 0.2. Thus, deteriorating growth conditions are a greater handicap for Europe, a region still much more reliant on trade and manufacturing as sources of growth. Chart I-1The Fed And Its Mandate The Fed And Its Mandate The Fed And Its Mandate Chart I-2Global Growth Passing Its Zenith Global Growth Passing Its Zenith Global Growth Passing Its Zenith Meanwhile, purely domestic economic conditions have been buoyant in the euro area and quite morose in the U.S., though the picture seems to be reversing. To make this judgment, we begin by evaluating a global growth factor, a global economic force that lifts or pulls down all boats, similar to a tide. Such a global growth factor should not just affect various countries through trade, but it should also impact their economies through financial linkages. In order to evaluate this phenomenon, we conducted a Principal Component Analysis (PCA) of the LEIs of 21 countries. We found that the combined factor 1 and factor 2 explains nearly 50% of global growth dynamics (Chart I-3). Once we estimated this global growth factor, we then proceeded to estimate how much it contributes to LEI gyrations in the U.S. and euro area, using the factor loadings of both relative to the two main components revealed by the PCA. With that information in hand, we then simply subtracted the European and U.S. impact from their respective LEIs. What is left reflects purely endogenous changes in the LEIs for the euro area and the U.S. This same procedure can be applied to any country. Through this exercise, we can see very well that European domestic conditions have been rebounding sharply since 2012. However, the pure domestic element of the U.S. LEIs has been falling steadily since late 2014, shortly after the U.S. dollar began its 27% rally (Chart I-4). Chart I-3The Tide That##br## Lifts All Boats The Tide That Lifts All Boats The Tide That Lifts All Boats Chart I-4A Look At Purely Domestic##br## Growth Dynamics A Look At Purely Domestic Growth Dynamics A Look At Purely Domestic Growth Dynamics To a large degree, these differentiated dynamics make sense. 2012 marked the apex of the euro area crisis. The improvement in the domestic component of the European LEIs coincided with Mario Draghi's "whatever it takes" speech. This moment was crucial as it resulted in the normalization of private sector borrowing costs across the Eurozone. Thanks to the ensuing compression in break-up risk premia, Italian and Spanish private lending rates collapsed by 110 and 240 basis points over the following 24 months, respectively. Easy money was finally being transmitted to the private sector. Chart I-5Massive Tightening In 2014 Massive Tightening In 2014 Massive Tightening In 2014 In the U.S., the deterioration began after the dollar perked up massively, but also, after the Fed began tapering its purchases of securities, events associated with a 300 basis-point increase in the Wu-Xia shadow fed funds rate (Chart I-5). The combined effect of this monetary tightening resulted in a significant brake on economic activity, one made most evident by the deceleration in the domestic component of the LEIs. These forces seems to be reversing. Today, the dollar is trading in line with its March 2015 level, and while the fed funds rate has increased by 75 basis points, this still pales in comparison to the large increase in the shadow fed funds rates recorded between May 2014 and November 2015. Meanwhile in Europe, the lagged effects of the massive 15% decline in the trade-weighted euro between June 2014 and March 2015 is dissipating. These monetary dynamics partially explain why the domestic element of the European LEIs is rolling over while the U.S. one is improving. However, we think financial conditions play a larger role. U.S. financial conditions have greatly eased in recent months, while financial conditions in Europe have been deteriorating, suggesting domestic growth conditions will follow a similar path (Chart I-6). These crosscurrents are especially evident when looking at the relative European and U.S. domestic growth impulses vis-a-vis their relative financial conditions. Currently, the purely endogenous elements of growth in the euro area look set to roll over against those of the U.S. So if the international and domestic elements of growth in Europe are set to slow relative to the U.S., when should these dynamics begin to affect market pricing? Historically, the German Ifo survey has been one of the most reliable bellwethers of European economic activity. The same can be said of the ISM in the U.S. While the ISM rolled over three months ago, the Ifo is still at all-time highs. However, historically, one of the most reliable leading indicators of the Ifo has been none other than the ISM itself. Hence, the likelihood that the Ifo rolls over sharply by September is high, especially in the context of the observations made above (Chart I-7). With expectations that European growth will remain strong but that the U.S. is incapable of generating inflation, a weak ISM is well known, but a weak Ifo would be a surprise. Chart I-6Follow The Financial Conditions Follow The Financial Conditions Follow The Financial Conditions Chart I-7Where The ISM Goes, The IFO Follows Where The ISM Goes, The IFO Follows Where The ISM Goes, The IFO Follows When the Ifo underperforms the ISM, the euro tends to suffer (Chart I-8). This was not true in 2001, but back then the euro was trading 15% below its long-term fair value, and the U.S. was entering a recession. Today, the euro is trading at a more modest 5% discount to its long-term fair value, and BCA believes the U.S. is not on the verge of a recession. Moreover, on a short-term basis, the euro is already trading 6% above its interest rate and risk-aversion implied tactical fair value. Chart I-8If No U.S. Recession Emerges, A Falling IFO Equals A Falling Euro If No U.S. Recession Emerges, A Falling IFO Equals A Falling Euro If No U.S. Recession Emerges, A Falling IFO Equals A Falling Euro These dynamics also imply that the massive positive skew in economic surprises between the euro area and the U.S. should soon end, which is likely to prompt a re-think of the relative monetary policy stance between the ECB and the Fed, and therefore put an end to the recent sharp rally in the euro. Bottom Line: The ECB did not surprise markets this week. Yet, Mario Draghi made it very clear that despite an upgrade to forward guidance, the path toward achieving the central bank's inflation target continues to require very easy policy. How easy? Our view is that based on global dynamics and financial conditions, European growth could slow in the coming months, delaying the point in time when the euro area output gap closes. Meanwhile, investors are too conservative regarding the U.S.'s growth and inflation prospects, and therefore are not anticipating enough rate hikes from the Fed. What To Do With Momentum? The key issue for now is that the euro's momentum is extremely powerful and hard to fight. Indeed, the euro seems to have dissociated from fundamentals. While aggregate real rate differentials continue to move in favor of the U.S. dollar, the euro is ignoring these dynamics and instead has become overtaken by powerful flows into the euro area (Chart I-9). These dynamics may be stretched, but they could still have additional room to run. Non-commercial traders have fully purged their short bets on EUR/USD, and they have accumulated the most long-euro positions in three years. Additionally, our composite sentiment indicator, based on the positioning, sentiment, and 13-week rate-of-change in the currency, is now at elevated levels relative to the past three years (Chart I-10). The violence of these shifts highlights an improving risk-reward ratio to shorting the euro, but this could be of little solace: historically, both the composite sentiment measure and positioning in the euro have hit much higher levels. Technical indicators point to similar dilemmas. Both the EUR/USD intermediate-term technical indicator and its 13-week rate of change have hit levels congruent with a reversal (Chart I-11). However, these indicators have also displayed inertia in the past, with occasions such as in 2013, where their elevated readings did not preclude a higher EUR/USD. Chart I-9EUR/USD Is A Lone Wolf EUR/USD Is A Lone Wolf EUR/USD Is A Lone Wolf Chart I-10EUR/USD Is Overbought But...(1) EUR/USD Is Overbought But...(1) EUR/USD Is Overbought But...(1) Chart I-11EUR/USD Is Overbought But...(2) EUR/USD Is Overbought But...(2) EUR/USD Is Overbought But...(2) As a result, we are highly cognizant of the risks to our positive bet on the DXY (which due to its near 60% weighting in the euro is equivalent to a short euro bet). But the good news in the euro seems well priced in. In line with the 8% surge in the euro this year, the average analyst forecast for the euro for Q4 2017 moved from EUR/USD 1.05 to EUR/USD 1.12 (Chart I-12, top panel). Recent peaks in the euro have materialized when these forecasts hit 1.13, which we are very close to. At these levels, the optimism toward Europe seems fully discounted. Chart I-12When To Be Contrarian In FX When To Be Contrarian In FX When To Be Contrarian In FX In fact, the gap between the euro itself and the forecast is now decreasing (Chart I-12, bottom panel). This suggests that each new forecast upgrade is lifting the euro less and less, implying that buyers have already internalized these increasing forecasts and need ever better news, especially on the wage and inflation front, to lift the euro higher. Hence, while worried that the EUR/USD could move to 1.15 in a blink of an eye before reversing, we remain cautiously optimistic on our negative EUR/USD and our positive DXY stances. Bottom Line: At this point, the key problem with our view is that momentum is clearly in the euro's favor, a dangerous position for euro bears. While most indicators highlight that EUR/USD is overbought, these same metrics could in fact remain overbought for longer. However, investors have already massively upgraded their EUR/USD forecasts suggesting that much news is in the price, especially as each successive upgrade is showing diminishing returns in their capacity to lift EUR/USD spot rates. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled "Capacity Explosion = Inflation Implosion", dated June 2, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The soft patch in the U.S. economy continues: Unit labor costs growth has softened to 2.2%, a less-than-expected pace of 2.5%; Non-Manufacturing/Services sectors are looking weak with both PMI and ISM measures underperforming; Consumer credit also grew by USD 8.2 bn, underperforming the expected USD 15.5 bn. As a result, the dollar remains weak. While the data is worrying, we stand with the Fed's view. The Fed will hike in June, and when this soft patch proves temporary, it is likely that a September hike will materialize. With the ECB constrained in its capacity to move to a hawkish stance, it is possible for the USD to see some upside sooner rather than later. Report Links: Capacity Explosion = Inflation Implosion - June 2, 2017 Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 The euro has witnessed a particularly strong two months due to positive surprises in data, but momentum somewhat slowed this week due to mixed data: Services PMI in Spain, Italy and France underperformed expectations, while Germany and the overall euro area outperformed; Retail sales increased at a 2.5% annual rate; German factory orders increased by 3.5% annually, which was less than expected. Even worse they contracted by 2.1% on a monthly basis; Overall GDP growth in the euro area outperformed expectations, being revised to 1.9%. Furthermore, Draghi reiterated the need for extremely easy conditions in order to stay on the path to reach the target inflation rate, especially as inflation forecasts were downgraded. If the European data cannot keep up with its current blistering pace, investors should again begin to wonder about the ECB's capacity to move away from what remain a dovish stance. Report Links: Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent economic data has been mixed in Japan: Consumer confidence came in at 43.6, increasing from last month. Bank lending annual growth came in at 3.2%, beating expectations. However, GDP annualized growth was greatly revised downward to 1%. Although we continue to be bullish on the yen on a short term basis, it would be preferable to play yen strength by shorting NZD/JPY rather than USD/JPY, as we believe that the correction in the U.S. dollar has run its course. Thus, we are looking to exit our short USD/JPY trade once it reaches 108. On a cyclical basis, the yield curve target implemented by the BoJ, along with a hawkish fed will weigh on Japanese real rates vis-à-vis U.S ones and consequently push the yen downward. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data has been mixed in the U.K.: Construction PMI came in at 56, blowing past expectations. Halifax house price annual growth came in at 3.3%, also outperforming expectations. However, Markit Services PMI came below expectations at 53.8. The results of the elections happening as of the date of this writing will create some volatility in the pound. A greater majority government by the conservatives would likely be a boost to the pound, as it will give Prime Minister May more leeway when negotiating the exit of the U.K. from the European Union. On the other hand, if labor wins enough seats to create a hung parliament, the pound could suffer as political uncertainty will once again reign supreme. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 The Aussie experienced an upbeat week, appreciating almost 2.5%. A few positive data was recorded: TD Securities Inflation increased at a 2.8% annual rate, more than the previous 2.6% reading; GDP growth increased 1.7% annually, beating both yearly and quarterly expectations. Chinese imports were very strong, coming in at 22% growth on an annual pace, suggesting continued intake by the Middle Kingdom of what Australia exports. The GDP was a key driver in this week's rally. However, while the headline number was great, the details were more worrisome. Inventories led GDP growth, while exports subtracted most from it. This is peculiar considering that terms of trade increased at a 24.8% annual rate. This also predates the near 40% decline in iron ore futures. The trade balance for April also missed expectations greatly, coming in at 555 million, compared to the expected 1.95 million, setting up a poor start for Australia's second quarter. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 The kiwi economy continues to improve: Headline and core inflation have both surpassed the 2% threshold, reaching 2.2% and 2.3% respectively in the first quarter of 2017. Meanwhile, nominal retail sales are growing at a healthy 7.5%. Considering the continued strength in the kiwi economy, the NZD should continue to outperform the AUD on a cyclical basis, given that Australia is much more sensitive to a slowdown in Chinese economic activity, which is beginning to suffer in response to the tightening campaign by the PBoC. On the other hand the upside for the NZD against the U.S. dollar remains limited. Not only is NZD/USD overbought on a short term basis, but the tight correlation between the kiwi and commodity prices should eventually weigh on this currency. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 The CAD went through a rough patch this week: The seasonally-adjusted measure of PMIs delivered a disappointing 53.8 reading compared to the expected 62; Building permits are contracting at a 0.2% monthly pace; Housing starts increased at 194,700, which was less than expected; On the plus side, house price growth was at 3.9% yoy, beating expectations of 3.3%. Oil was also a big player in the loonie's weakness. Crude oil inventories were higher than expectations by roughly 6 million barrels: a 3.464 million barrels decline in inventories was expected, while inventories increased at a 3.295 million barrels. The CAD remains oversold, but we remain bullish on it in the G10 space as investors have rarely been so short the Canadian currency as they currently are. Report Links: Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent economic data in Switzerland has been very positive: The unemployment rate came in at 3.2%, beating expectations. Headline inflation came in at 0.5%, higher than last month and beating expectations. Yesterday, the ECB underwehlmed bulls, as ECB president Mario Draghi stated that asset purchases will "run until the end of December 2017, or beyond, if necessary". We expect the ECB to ultimately find it very difficult to switch to a hawkish bias, especially relative to relative to other central banks, as pricing power in the euro area remains muted. On the other hand, Switzerland is slowly recovering, and a removal of the implied floor by the SNB on EUR/CHF could happen as early as the end of the year. Thus, we are already shorting this cross to take advantage of such an event. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 On Wednesday, oil inventories rose by 3.3 million against expectations of a 3.5 million draw. This caused oil prices to plunge by almost 4%. Nevertheless, the response of USD/NOK has been somewhat muted. This is in part due to the fact that real rate differentials matter more than oil for USD/NOK. Indeed, while oil is down almost 15% on the year, the NOK has actually appreciated slightly in the year against the dollar, given that rates in the U.S. have decreased substantially during the year. Thus, given that we expect a more hawkish Fed than the market anticipates, we are USD/NOK bulls. Additionally, we are also bullish on CAD/NOK, as the Norges Bank is likely to have a much more dovish bias than the BoC going forward. Report Links: Exploring Risks To Our DXY View - May 26, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 The SEK has been depreciating this week on the back of disappointing industrial production figures, with the yearly measure increasing at a meagre 0.8% pace, much less than the anticipated 4.2%. Moreover, IP experienced a monthly contraction of 2.4%. Additionally, the recent Financial Stability Report also highlighted that "further measures need to be introduced to increase the resilience of the household sector and reduce risks", as well as vulnerabilities in the Swedish banking system. While we think USD/SEK's weakness is nearing its end, EUR/SEK will likely see some weakness in the near future, given its expensive level. Report Links: Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

GAA DM Equity Country Allocation Model Update The model has increased its allocation to Netherland, Italy, France and Germany, the underweight in Australia is also reduced by half. All these are financed by a large reduction in the U.S. overweight, mostly due to the change in liquidity and technical indicators, compared to previous month as shown in Table 1 As shown in Table 2 and Charts 1, 2 and 3, Level 2 model ( the allocation among the 11 non-U.S. DM countries) outperformed its benchmark by 119 basis points (bps) in May, largely a result from the overweight of the euro area versus the underweight in Canada and Australia. Level 1 model, the allocation between U.S. and non-U.S., underperformed by 22 bps in May due to the large overweight in the U.S. Overall, the aggregate GAA model outperformed its MSCI World benchmark by 13 bps in May and by 157 bps since going live. Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see the January 29th, 2016 Special Report "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model". http://gaa.bcaresearch.com/articles/view_report/18850. Table 1Model Allocation Vs. Benchmark Weights GAA Model Updates GAA Model Updates Table 2Performance (Total Returns In USD) GAA Model Updates GAA Model Updates Chart 1 GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World Chart 2 GAA U.S. Vs. Non U.S. Model (Level1) GAA U.S. Vs. Non U.S. Model (Level1) Chart 3 GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of May 31, 2017. The model continues to overweight cyclical versus defensive sectors. However, the model has turned overweight utilities on the back of improved technicals. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Chart 4Overall Model Performance Overall Model Performance Overall Model Performance Table 3Allocations GAA Model Updates GAA Model Updates Table 4Performance Since Going Live GAA Model Updates GAA Model Updates Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com

Highlights U.S. Politics: We recommend that investors look through the political noise in D.C., which is unlikely to arrest the current cyclical economic upturn. Maintain a pro-growth asset allocation within fixed income portfolios: below-benchmark duration, favoring corporate credit over government bonds, especially in the U.S. Duration Checklists: An update of our Duration Checklists shows that the backdrop remains conducive to rising Euro Area bond yields, while the upward pressures on U.S. yields have diminished somewhat. The majority of the indicators, however, continue to point to higher U.S. Treasury and German Bund yields. Europe: Reduce European duration exposure, but wait for wider spread levels before moving out of European government bonds into U.S. Treasuries. Feature The Economy Trumps Politics Chart of the WeekHas Anything Really Changed? Has Anything Really Changed? Has Anything Really Changed? A whiff of panic swept across global financial markets last week, as the political risk bugaboo came back with a vengeance. In the U.S., the deepening morass surrounding President Trump's decision to fire former FBI Director Comey, and the potential links to the ongoing investigation of the White House's ties to Russia, raised concerns that Trump's ambitious pro-growth policy agenda would never make it out of Congress. Even this year's darling in the Emerging Markets, Brazil, suffered a huge financial rout after news broke of corruption allegations against the current president. Amid growing talk of a potential impeachment of Trump, the market action was a classic risk-off move, with equity markets falling, the VIX finally waking from its slumber and safe-haven assets like gold, U.S. Treasuries and the Japanese yen rallying. The euro climbed to new 2017 highs versus the U.S. dollar, without any changes in expectations about potential policy moves from the European Central Bank (ECB), as the market knocked down the probability of a June Fed rate hike (Chart of the Week). Some creative commentators called these market moves "the Trump fade" - the beginnings of a reversal of the so-called "Trump trade" that has sent U.S. equity prices and bond yields higher since the U.S. election on expectations of a large U.S. fiscal stimulus. We remain skeptical, however, that expectations of tax cuts and increased government spending have been the main drivers of the post-election boost in U.S. stock prices and Treasury yields, as the current cyclical upturn in global growth was already underway before Trump's election victory. Our colleagues at the BCA Geopolitical Strategy service note that, despite Trump's terrible overall approval ratings (Chart 2), his support among his Republican voters remains strong (Chart 3). Thus, an impeachment is only likely if the Republicans were to lose control of the House of Representatives in next year's U.S. midterm elections. Fear of that outcome should motivate the GOP to try and push through tax and healthcare reform well ahead of the 2018 midterms, in order to present a positive economic message to voters.1 Unless the evidence against Trump becomes so damning that even the Republicans in Congress have to focus on impeachment instead of policy, investors should ride out any market volatility associated with worries that the Trump economic agenda is at risk. Chart 2Trump's Support Abysmal Fade The "Trump Fade" Fade The "Trump Fade" Chart 3GOP Not Yet Willing To Impeach Trump Fade The "Trump Fade" Fade The "Trump Fade" Even without a boost to growth from D.C., however, we continue to expect the U.S. economy to grow above 2.5% in 2017. This above-trend pace will keep the Fed in play for at least two additional rate hikes before year-end, as it would give policymakers confidence that U.S. inflation expectations would return back the Fed's 2% target. In addition, as we discuss in the next section, the cyclical upturn in the Euro Area economy is showing no signs of cooling off, which will put more pressure on the ECB to begin preparing the markets for an eventual tapering of its asset purchases. The recent decline in bond yields is unlikely to persist much longer. Bottom Line: We recommend that investors look through the political noise in D.C., which is unlikely to arrest the current cyclical economic upturn. Maintain a pro-growth asset allocation within fixed income portfolios: below-benchmark duration, favoring corporate credit over government bonds, especially in the U.S. Checking In On Our Duration Checklists In a Special Report published back in February, we introduced a list of indicators to follow to assess the likely direction of U.S. Treasury and German Bund yields.2 We called these our "Duration Checklists", incorporating data on economic growth, inflation, investor risk aversion and market technicals to judge whether our bias to maintain a below-benchmark duration stance should be maintained. This week, we provide an update on those Checklists. The current message from the Checklists is that there is reduced upward pressure on bond yields from the overall strength of the global economy than existed four months ago. Domestic forces, however, are still pointing to higher yields in the U.S. and, especially, the Euro Area (Table 1). Specifically: Table 1A More Bond-Bearish Backdrop For Bunds Than USTs Fade The "Trump Fade" Fade The "Trump Fade" Global economic activity indicators have lost some momentum. While the global leading economic indicator (LEI) is still rising, our global LEI diffusion index has fallen sharply and is now below the 50 line, indicating that a more countries now have a falling LEI. In addition, the global ZEW index has drifted a touch lower, global data surprises are no longer positive, and the global credit impulse has ticked downward (Chart 4). Only the rising LEI warrants a "check" in our Checklists (i.e. justifies our current below-benchmark duration stance). U.S. & European domestic economic activity remains in good shape. Consumer and business confidence remains at strong levels on either side of the Atlantic, with corporate profit growth still accelerating (Charts 5 & 6). Only the modest decline in the U.S. manufacturing purchasing managers' index (PMI) is worthy of an "x" in our U.S. Checklist, although the index remains well above 50 and is not pointing to a more serious deterioration in the U.S. economy. Chart 4Global Growth Backdrop Has##BR##Turned Less Bond-Bearish Global Growth Backdrop Has Turned Less Bond-Bearish Global Growth Backdrop Has Turned Less Bond-Bearish Chart 5U.S. Economic Strength##BR##Still Supports Higher UST Yields U.S. Economic Strength Still Supports Higher UST Yields U.S. Economic Strength Still Supports Higher UST Yields Chart 6Euro Area Growth Is##BR##Gaining Upward Momentum Euro Area Growth Is Gaining Upward Momentum Euro Area Growth Is Gaining Upward Momentum Inflation pressures have eased a bit, especially in the U.S. The slowing momentum in global energy prices has taken some of the steam out of headline inflation in both the U.S. and Europe. Wage inflation has eased up a bit in the U.S., even with the labor market running at full employment (Chart 7). Wage growth and core inflation have recently ticked higher in the Euro Area, however, while the unemployment rate there has fallen to within less than a percentage point away from the OECD estimate of the NAIRU (Chart 8).3 The only indicators worthy of a "check" are the unemployment gap in both the U.S. and Euro Area, although we will give a potential "check" (with a question mark) to European wage inflation. If the recent uptick gains additional momentum, the case for the ECB to begin moving to a less accommodative policy stance will be much stronger. Chart 7Inflation Pressures On UST Yields Have Eased Inflation Pressures On UST Yields Have Eased Inflation Pressures On UST Yields Have Eased Chart 8Core Inflation & Wages Bottoming Out In Europe? Core Inflation & Wages Bottoming Out In Europe? Core Inflation & Wages Bottoming Out In Europe? There is still a pro-risk bias among global investors. U.S. and Euro Area equity markets are still in bullish trends, trading well above their 200-day moving averages. At the same time, corporate credit spreads remain tight and option-implied equity volatility is very low (even after last week's pop in the U.S. on the Trump drama). All indicators are worthy of a "check", suggesting that easier financial conditions can lead to higher bond yields (Charts 9 & 10). We are, however, giving an "x" to the European Checklist for the deviation of the Stoxx 600 from its moving average, as it is now at the +10% extreme that we defined as being potentially bond-bullish as it could foreshadow a near-term correction of an overheated stock market. Chart 9Still Generally A Risk-Seeking Backdrop In The U.S. Still Generally A Risk-Seeking Backdrop In The U.S. Still Generally A Risk-Seeking Backdrop In The U.S. Chart 10Strong Risk-Seeking Behavior In Europe Strong Risk-Seeking Behavior In Europe Strong Risk-Seeking Behavior In Europe Bond markets no longer look technically stretched. The sharp move higher in yields at the end of 2016 left all our indicators of yield momentum at bearish extremes (for bond prices). With bond yields pulling back from 2017 highs, however, the momentum measures all look neutral at the moment and are not an impediment to higher yields (Charts 11 & 12). The same goes for duration positioning in the U.S., with the net longs on 10-year Treasury futures now at the highest level since 2007. All of the technical indicators in our Checklists warrant an "check". Chart 11UST Technicals No##BR##Longer Stretched UST Technicals No Longer Stretched UST Technicals No Longer Stretched Chart 12Technicals Are No Impediment##BR##To Higher Yields In Europe Technicals Are No Impediment To Higher Yields In Europe Technicals Are No Impediment To Higher Yields In Europe Summing it all up, our Duration Checklists show that the majority of indicators are still pointing to higher bond yields in the U.S. and Europe, although not as decisively as when we first published the Checklists in February. There are more "check" on the European side of the ledger, however, suggesting that there is more room for European government bond yields to rise relative to U.S. Treasuries. This would indicate a potential trade opportunity to cut allocations to Europe and raise allocations to the U.S. Chart 13UST-Bund Spread Is Now Too Low UST-Bund Spread Is Now Too Low UST-Bund Spread Is Now Too Low The recent decline in U.S. yields, however, has narrowed the U.S. Treasury/German Bund spread to levels that make putting on a tightening trade unattractive on a tactical basis. (Chart 13). The gap between the data surprise indices in the U.S. and Euro Area already reflects the recent soft patch for the U.S. economy (middle panel). That spread in the surprise indices now at historically wide levels, suggesting more potential for Treasury yields to rise if the U.S. data begins to rebound soon, as we expect. Also, the gap between U.S. and Euro Area inflation expectations has narrowed alongside the recent downtick in U.S. core inflation (bottom panel), although we expect the decline in U.S. core inflation to be short-lived given the persistent tightness of the U.S. labor market. Net-net, we would prefer to see a wider Treasury-Bund spread before making switching our country exposure out of Europe and into the U.S. We can, however, listen to the message from our Checklists and reduce our duration exposure in Europe. Specifically, we are cutting our allocations to the longer maturity buckets (5 years out to 30 years) by 50% in our model portfolio for Germany, France and Italy, putting the proceeds into the 1-3 year buckets (see the table on Page 12). This will reduce our overall recommended portfolio duration by just over 1/10th of a year, as well as put an additional bear-steepening curve tilt within our European government allocations. We are comfortable with that bias, given the growing risk that the ECB will soon begin signaling a tapering of asset purchases once the current program expires at the end of the year. Bottom Line: An update of our Duration Checklists shows that the backdrop remains conducive to rising Euro Area bond yields, while the upward pressures on U.S. yields have diminished somewhat. The majority of the indicators, however, continue to point to higher U.S. Treasury and German Bund yields. Reduce European duration exposure, but wait for wider spread levels before moving out of European government bonds into U.S. Treasuries. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment", dated May 17 2017, available at gfis.bcaresearch.com 2 Please see BCA Global Fixed Income Strategy Special Report, "A Duration Checklist For U.S. Treasuries & German Bunds", dated February 15 2017, available at gfis.bcaresearch.com 3 Non-Accelerating Inflation Rate Of Unemployment. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Fade The "Trump Fade" Fade The "Trump Fade" Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns