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Highlights A potential rise in U.S. inflation and China's growth slowdown represent formidable headwinds to EM risk assets. A manifestation of these tectonic macro shifts will be a U.S. dollar rally and weakening commodities prices. These two will dent the EM risk asset rally. Strong DM growth will not offset the impact of a slower Chinese economy on EMs and commodities. A new fixed-income trade: bet on a steeper swap curve in Mexico relative to Canada. Feature The global macro landscape in 2018 will be shaped by the two tectonic shifts: U.S. fiscal stimulus amid vigorous growth, and policy tightening in China amid lingering credit and money excesses. The former will grease the wheels of the already robust U.S. economy, generating a whiff of inflation and fueling a further selloff in the U.S. bond market. China's tightening will in turn weigh on commodities prices and curtail the emerging market (EM) economic recovery. A manifestation of these tectonic macro shifts will be a U.S. dollar rally and weakening commodities prices producing formidable headwinds to EM risk assets. As such, we are reiterating our recommendation to underweight EM risk assets versus their DM peers. As to the absolute performance, we believe EM risk assets are close to a major market top. A Whiff Of U.S. Inflation Strong U.S. growth could in fact be damaging to EM financial markets, as it will likely augment U.S. consumer price inflation. Investors are currently extremely sanguine on U.S. inflationary pressures. An upside surprise to inflation will lift U.S. interest rate expectations further, supporting the greenback and hurting EM carry trades. There is some evidence that U.S. inflation is about to pick up: The New York Federal Reserve underlying inflation gauge is rising, signaling higher inflation ahead (Chart I-1). The nascent revival in the MZM (money of zero maturity) impulse presages a trough in inflation (Chart I-2). Chart I-1Fed Price Pressure Gauge Signifies Higher Inflation Chart I-2U.S. Money Growth And CPI The weak U.S. dollar will also help augment inflation in America. U.S. import prices from emerging Asia and Mexico have been rising - even before the latest carnage in the U.S. dollar (Chart I-3). This will filter through into higher domestic price pressures. Chart I-3U.S. Import Prices Are Rising In brief, fiscal stimulus amid buoyant growth as well as overwhelming optimism among consumers and businesses is creating fertile ground for companies to raise prices. This will amplify corporate profit growth but will also lead to higher inflation. We are not making a case that U.S. inflation is about to surge. Our thesis is that market participants are very complacent on inflation. The money market is pricing in only 96 basis points in rate hikes in 2018-'19. In the meantime, the term premium in the U.S. yield curve is extremely depressed. Therefore, even modest inflation surprises will likely produce an additional meaningful selloff in U.S./DM bond markets. Will global share prices rise in response to strong corporate profit growth, or sell off in the face of higher U.S. inflation? Our hunch is that share prices will suffer as rising bond yields cause multiples to shrink. Rising bond yields will overpower the profit growth impact on share prices. The basis is that multiples are disproportionately and inversely linked to percentage change interest rates but are proportionately and positively linked to EPS.1 At still-low yields, a 50-basis-point rise in bond yields constitutes a sizable percentage change in the bond yield, likely leading to a meaningful P/E de-rating. Current sky-high bullish sentiment towards equities combined with elevated valuations and overbought conditions will mean that even a modest rise in inflation readings will likely trigger equity market jitters. EMs will underperform DMs amid such a selloff, as the former has benefited much more than the latter from low interest rates. Bottom Line: U.S. fiscal stimulus is arriving at a time when final demand is robust, the labor market is tight and business and consumer confidence is buoyant. This will encourage companies to raise prices, resulting in a whiff of U.S. inflation. The latter will rattle markets in the months ahead. China: Tightening Amid Credit/Money Excesses Inflation in China has already been steadily rising (Chart I-4). Interest rates adjusted for inflation remain low. Rising inflation along with still-lingering credit and money excesses necessitates policy tightening. We have written extensively about China's ongoing tightening trifecta - liquidity tightening, increased regulatory oversight and clampdown as well as an anti-corruption crackdown in the financial industry.2 Regulatory tightening in particular could inflict a particular bite as it outright constrains banks' ability to originate credit. This tightening has already led to record low broad money growth, and credit growth is downshifting too (Chart I-5). The cumulative impact of this tightening will play out in the months ahead, weighing further on money and credit growth and ultimately on final demand. Chart I-4China: Inflation Is In Steady Uptrend Chart I-5China: Broad Money And Credit Growth On the fiscal front, local government spending has languished in recent months (Chart I-6, top panel) and general (central plus local) government spending growth has been lackluster (Chart I-6, bottom panel). In 2017, local government annual spending amounted to RMB 19 trillion, or 22% of nominal GDP. Central government expenditures are about 6-fold smaller. Local governments rely on land sales to replenish their coffers, but timid money growth points to weaker land sales ahead (Chart I-7). In the meantime, their annual borrowing is restricted by the central government. Overall, this will constrain local government expenditures in 2018. Chart I-6China: Government Expenditures Chart I-7China: Land Sales To Slump The combined credit and fiscal spending impulse heralds a relapse in mainland imports of goods and commodities (Chart I-8). This constitutes a major threat to commodities prices, and consequently to EM. A pertinent question is whether financial markets will react to rising U.S. inflation or a slowdown in Chinese growth. Clearly, one could argue that strong U.S. growth would offset a mainland growth slump, resulting in a stable global macro environment. However, financial markets are an emotional discounting mechanism, and they do not always follow rational thinking. For example, in the first half of 2008 - just a few months ahead of the Global Financial Crisis - global financial markets were preoccupied with mounting global inflation due to strong growth in EM/China. At the time, oil and many other commodities prices were literally surging, and U.S. bond yields were climbing (Chart I-9). Global financial markets were not concerned with the ongoing U.S. recession, shrinking bank loans and deflating house prices. Chart I-8China's Impact On Rest Of The World Chart I-92008: An Inflation Scare Just ##br##Before Deflationary Bust In retrospect, financial markets traded on the theme of rising global inflation in the first half of 2008 even though the U.S. was already in a recession, and was heading into the most severe deflationary bust of the past 80 years. Similarly, the financial markets today could trade on the U.S. inflation theme for a couple months, even though China will be slowing. Bottom Line: China's policy tightening is particularly dangerous because it is occurring amid substantial and still-lingering credit, money and property market excesses. Won't Strong DM Growth Support China And Other EMs? Our investment stance on EM has been and remains negative, despite our positive view on U.S. and European growth. The key rationale for this stance is that EMs are much more leveraged to China than to the U.S. and Europe. Hence, our view assumes de-synchronization of growth between EM and DM. In our opinion, an EM slowdown will be largely due to China's deceleration and the latter's impact on commodities prices and non-commodity economies in Asia via trade. South America, Russia, South Africa, Malaysia and Indonesia are commodities producers, and as such are sensitive to fluctuations in commodities prices. The rest of Asia - Korea, Taiwan, Singapore, Thailand and the Philippines - are still exposed to the mainland economy as the latter is their largest export destination. Thus out of the EM sphere, China's dynamics will have a limited impact on only Mexico, India, and Turkey. However, Mexico is at risk of a NAFTA abrogation, while Turkey is at risk of runaway inflation and monetary profligacy. India on the other hand has its own problems and its bourse is unlikely to do well, given it is overbought and expensive. Furthermore, while we are bullish on the growth outlook in central European economies, they are too small to matter from an EM benchmark perspective. It might be useful to contemplate the late 1990s macro dynamics when major decoupling occurred between DM and EM. The booming economies of the U.S. and Europe did not prevent recurring crises in EM in the second half of the 1990s. Chart I-10 illustrates that U.S. and European imports growth was surging at that time, but EM stocks and currencies collapsed. What's more, despite the economic boom in DM during that period - U.S. and euro area real GDP growth rates averaged 4.2% and 2.6%, respectively, between 1996 and 1998 - commodities prices were in a bear market (Chart I-11). Chart I-10EM Crises In 1997-98: U.S. And ##br##Europe's Imports Were Booming Chart I-11Booming DM GDP And ##br##Falling Commodities Prices One might suspect that EM crises in the second half of the 1990s occurred because booming DM growth led to rising U.S. bond yields. However, Chart I-12 portrays that U.S. bond yields actually fell in 1997 and 1998 due to the deflationary shock stemming from the EM turmoil. Chart I-12EM Crises Occurred Amid ##br##Falling U.S. Bond Yields By and large, the 1997-98 EM crises occurred despite buoyant DM growth and falling DM bond yields. Nowadays, advanced economies carry much smaller weight in global trade and GDP than they did 20 years ago. Furthermore, EMs are much less dependent on exporting to DMs than they were two decades ago. In addition, China was not an economic powerhouse 20 years ago like it is today, and it did not buy as much from the rest of EMs as it does today. Presently, China holds the key to the EM outlook, and the link is through Chinese imports of goods and commodities. As China's credit and fiscal spending impulse suggests, mainland imports are likely to slow, weighing on commodities prices (refer to Chart I-8 on page 6). To be sure, we are not suggesting that EMs are facing crises similar to what transpired in 1997-98. The point of this comparison is to highlight that robust DM growth in of itself is not sufficient to head off an EM downturn if the latter faces a negative shock from China. With respect to DM growth benefiting China itself, it is critical to realize that China's exports to the U.S. and EU together account for only 6.6% of Chinese GDP (Chart I-13). By far, the largest component of the mainland economy is capital spending, constituting 42% of GDP. Construction and infrastructure are an integral part of capital expenditures, and they are very sensitive to money/credit cycles. Finally, from a global trade perspective, China and the rest of EM account for 46% of global imports, while the U.S. and EU account for 20% and 15%, respectively (Chart I-14). Hence, the total import bill of EM including China is larger than that of the U.S.'s and EU's imports combined. This entails that the pace of global trade growth is set to moderate if EM/China domestic demand decelerates. Chart I-13What Drives Chinese Economy: ##br##Capex Not Exports To DM Chart I-14Important Of EM/China In Global Trade Bottom Line: Strong DM growth will not offset the impact of a slower Chinese economy on EMs and commodities. Investment Conclusions A manifestation of the above-discussed tectonic macro shifts - a rise in U.S. inflation and China's slowdown - will be a U.S. dollar rally and weakening commodities prices. These two macro shifts will produce a perfect storm for EM risk assets. As a harbinger of a forthcoming selloff in EM exchange rates and DM commodities currencies (AUD, NZD and CAD), their implied volatility measures are already picking up (Chart I-15). As to a China/Asia slowdown, Korean, Taiwanese and Singaporean manufacturing output volume growth rates have already relapsed (Chart I-16). Their exports and corporate profits still appear robust because of rising prices. This certifies that there are inflationary pressures, even in Asia. Chart I-15Currency VOLs Are Rising Chart I-16Asian Manufacturing Output Volume All in all, we maintain a negative stance on EM risk assets in absolute terms and recommend underweighting them versus their DM peers. Within the EM universe, our equity market overweights are Taiwan, India, Korean technology, Thailand, Russia, central Europe and Chile. Our underweights are South Africa, Turkey, Brazil, Peru and Malaysia. Among currencies, our favorite shorts are the TRY, the ZAR, the MYR and the BRL. For investors who prefers relative EM currency trades, we recommend the following longs for crosses: RUB, TWD, THB, CNY and INR. For fixed-income trades, please refer to our open position table on page 18. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Mexico: Bet On A Steeper Swap Curve Relative To Canada For Mexican financial markets, the key uncertainty at the moment is the outcome of the ongoing NAFTA negotiations. Mexico's macro backdrop argues for considerable central bank easing, as inflation is about to roll over and domestic demand is extremely weak. However, if the U.S. pulls out of NAFTA - the odds of which are considerable, as our Geopolitical Strategy team has argued3 - the peso will sell off and interest rates are likely to rise. How should investors position themselves in Mexican fixed-income markets given this binominal outcome from the NAFTA negotiations and uncertainty over its timing? One way is to position for a swap curve steepening in Mexico, and hedge it by betting on a swap curve flattening in Canada by entering the following pair trades (Chart II-1): Chart II-1Mexico, Canada And Their ##br##Relative Swap Curve Receive 6-month and pay 10-year swap rates in Mexico Pay 6-month and receive 10-year swap rates in Canada In A Scenario Where The U.S. Withdraws From NAFTA: The Mexican swap curve would invert due to short-term rates going up more than long-term rates. In Canada, potential risks from NAFTA abrogation and tightening monetary policy amid frothy property markets and high household debt will cap upside in its long-term interest rates. With its long-term bond swap rates at par with those in the U.S., it seems as though the Canadian fixed income market is underpricing the risk of potential growth disappointments beyond the near run. In essence, should the U.S. withdraw from NAFTA, the loss realized on the Mexican steepener leg would partially be offset by the potential gain on the Canadian flattener leg. In A Scenario Where The U.S. Does Not Withdraw From NAFTA: The Mexican swap curve would start steepening. The rationale is that domestic dynamics suggest inflation has peaked and Banxico should begin its easing cycle soon. Monetary and fiscal policies have been extremely restrictive in Mexico, and considerable monetary easing is justified going forward: A significant part of the rise in inflation in 2017 was caused by peso depreciation in 2016. Last year's peso rally suggests that inflation should start to roll over soon (Chart II-2). Besides, one-off effects on inflation - such as the gasoline subsidy removal that took place at the end of 2016 - will subside as the base effect it has caused fades. In brief, the consumer inflation rate will rapidly decline, justifying substantial monetary easing. Banxico's 425 basis points in rate hikes since the end of 2015 are still filtering through the economy. The persistent slowdown in money and credit growth will continue to weigh on domestic demand for the time being. Notably, retail sales volume and gross fixed capital formation are both contracting while domestic vehicles sales are shrinking sharply (Chart II-3). Chart II-2Mexico: Inflation Is Set To Drop Chart II-3Mexico: Consumer And Business ##br##Spending Are Extremely Weak Due to currently high inflation, real wage growth remains weak. This will continue to weigh on consumer spending (Chart II-4). Fiscal policy has been tightening. Fiscal expenditures, excluding interest payments, are contracting in nominal terms (Chart II-5). Chart II-4Mexico: Real Wage Growth Is Very Timid Chart II-5Mexico: Fiscal Policy Is Super Tight Canada is currently on the opposite side of the business cycle spectrum relative to Mexico. The Canadian economy is very strong, being led by domestic demand. Real consumer spending is growing at its fastest pace in nearly 10 years, while the unemployment rate is at 40-year lows. Moreover, a record proportion of Canadian firms are having difficulty meeting demand because of capacity constraints and a tight labor market (Chart II-6, top and middle panel). Chart II-6Canadian Economy Is ##br##Above Full-Employment As such, the output gap is positive and growing, which has historically led to rising inflation (Chart II-6, bottom panel). Robust growth and rising inflation will force the Bank of Canada to hike rates further. In the meantime, real estate and consumer credit in Canada are overextended, leaving the Canadian consumer at risk from much higher interest rates. The threat that monetary tightening will hurt domestic demand in the future will cap the swap curve in Canada relative to Mexico. On the whole, in the scenario where the U.S. remains in NAFTA, the potential for swap curve steepening in Canada is less than in Mexico. Investment Recommendations We have been recommending that investors maintain a neutral stance across all asset classes in Mexico and wait for clarity on NAFTA negotiations before going overweight the country's currency, fixed-income markets and possibly equities relative to their EM peers. In the face of lingering NAFTA uncertainty, fixed-income investors should contemplate the following relative trade: Receive 6-month and pay 10-year swap rates in Mexico / pay 6-month and receive 10-year swap rates in Canada. Overall, this trade is exposed to minimal losses in the scenario where the U.S. withdraws from NAFTA but is exposed to considerable gains where the U.S. remains in NAFTA, making the overall risk/reward attractive. Provided the NAFTA negotiations could drag till year-end, this trade offers a reasonable risk-reward for traders. It offers a profitable opportunity to profit from Mexico's swap curve steepening, while limiting downside in case NAFTA is terminated before year-end. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 This is due to the fact that interest rates are in the denominator of the Gordon Growth model while EPS/dividends are in the numerator. 2 Please refer to Emerging Markets Strategy Weekly Report, titled "Questions For Emerging Markets," dated November 29, 2017, the link is available on page 19. 3 Please refer to the Geopolitical Strategy Special Report, titled "Nafta - Populism Vs. Pluto-Populism," dated November 10, 2017, the link is available at gps.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Neutral Prior to our midsummer upgrade to neutral, our key concern for the S&P chemicals index was that perennial overcapacity would put a ceiling on margin improvement. Since then surging global demand growth has driven producer prices sky high (second panel), in line with our expectations. More surprising is the newly-found industry discipline which has thus far refrained from splurging on new capacity (third panel), likely assisted by a wave of consolidation in the space. The upshot is that our productivity proxy has perked up to its highest level in nearly a decade, as have sell-side earnings expectations. While it remains too early for us to turn bullish, the outlook has certainly brightened for chemicals; maintain a neutral stance. The ticker symbols for the stocks in this index are: BLBG: S5CHEM - APD, ARG, CF, DOW, EMN, ECL, DD, FMC, IFF, LYB, MON, MOS, PPG, PX, SHW.

Highlights Duration Checklist: Our Duration Checklists continue to point to a bearish backdrop for global bond yields. A continued below-benchmark overall portfolio duration stance is warranted. There is not enough of a difference between the U.S. & European portions of the Checklist to suggest a big imminent move in the U.S. Treasury-German Bund spread is in the cards. UST-Bund Spread: A big cyclical turn in the Treasury-Bund spread is coming, but not before the ECB begins to seriously signal an end to its asset purchases and the Fed delivers a few more rate hikes. There will be better levels to move to a long Treasury/short Bund position by the summer. Feature Chart of the WeekUST-Bund Gap Still##BR##Reflects Policy Differences With the 10-year yield on both U.S. Treasuries and German Bunds hitting new cyclical highs on an intraday basis yesterday (2.72% and 0.70%, respectively), it is clear that the backdrop for global government bond markets is still bearish. The yield differential between the two markets remains quite wide, however, with the cyclical European economic performance rapidly catching up to that in the U.S. This is raising the odds that European Central Bank (ECB) will have to soon begin signaling a move to a less accommodative policy stance that will raise European bond yields further away from historically low levels. The continued strength of the Euro versus the U.S. dollar is a sign that investors are already expecting a big compression in U.S. bond yields versus European equivalents (Chart of the Week). Should investors position now for an eventual tightening of the Treasury-Bund spread? Or is it possible that the spread widens even further, thus providing a better entry point to profit from a spread tightening move? In this Weekly Report, we investigate the drivers of the Treasury-Bund spread to provide some clues as to its future direction. Our conclusion is that, from a medium-term strategic perspective, a narrowing of the Treasury-Bund spread is highly probable, but there is still potential for widening in the next few months. Checking In On Our Duration Checklist: Still Bearish, But With No Big Signal For U.S.-German Spreads In early 2017, we introduced a list of indicators to monitor in order to determine if our strategic below-benchmark duration stance on U.S. Treasuries and German Bunds should be maintained.1 This list, which we dubbed our "Duration Checklist", contained elements focused on economic growth, inflation, central bank policy biases, investor risk appetite and bond market technicals. The vast majority of indicators in the Checklist have accurately pointed to a cyclical backdrop for rising yields throughout the past year, despite the surprising drop in global inflation witnessed in 2017 (Table 1). Table 1The Message From Our Duration Checklist Is Still Bearish For Both USTs & Bunds With bond yields hitting fresh cyclical highs this week, it is a good time to provide another update of our Duration Checklist to see how conditions have changed since our last update in September. Specifically, we are looking for any differences in the individual U.S. and European components of the Checklist that can inform our view on the UST-Bund spread. Global growth momentum is accelerating to the upside. The global leading economic indicator (LEI) continues to climb steadily higher, even with global growth already in a solid uptrend (Chart 2). The global ZEW index, measuring investor sentiment towards growth in the major developed economies, has started to accelerate. The Citigroup Global Data Surprise index is at the highest level since 2004 (!), while our global credit impulse indicator has picked up sharply - both of which should keep global bond yields under upward pressure. We are giving a "check" to all these elements of our Duration Checklist, indicating that a defensive stance on overall duration exposure should be maintained. The only indicator in the "global" section of our Duration Checklist that is not pointing to higher bond yields is our global LEI diffusion index, which has fallen to just below the 50 line. This suggests a potential narrowing of the breadth of the current global upturn, which warrants an "x" in the Checklist. Domestic economic growth in both the U.S. and Euro Area remains solid. Manufacturing PMIs in both the U.S. (the ISM index) and Europe remain high and are rising, as is consumer and business confidence on both sides of the Atlantic (Charts 3 & 4). Corporate profit growth is solid both in the U.S. and Europe, with our models suggesting that earnings should expand at a double-digit pace again in 2018. All these indicators earn a "check" in our Duration Checklist. Chart 2Majority Of Global Growth Indicators##BR##Still Pointing To Higher Yields Chart 3U.S. Growth##BR##Remains Solid Chart 4A Booming European##BR##Economy Is Bearish For Bunds Inflation signals are mixed both in the U.S. and Europe. This remains the portion of our Checklist that has the greatest number of conflicting signals. While the rapid rise in oil prices over the past several months is putting upward pressure on headline U.S. inflation (Chart 5), the equally fast increase in the EUR/USD exchange rate is helping offset much of that increase in the Euro Area (Chart 6). Unemployment is below the OECD's estimate of the full employment NAIRU rate in the U.S., yet both Average Hourly Earnings growth and the Atlanta Fed Wage Tracker are decelerating. Unemployment in the Euro Area is now back to the OECD'S NAIRU level for the first time since the Great Recession, but wage inflation has only risen modestly. Chart 5U.S. Inflation Still Subdued,##BR##Despite Higher Oil & Low Unemployment Chart 6A Puzzling Lack Of##BR##Euro Area Core Inflation For the U.S. inflation side of our Checklist, we are giving a "ü" to the accelerating oil price (in U.S. dollar terms) and the unemployment gap, but an "x" to decelerating wage inflation. In the Euro Area, we give a "check" to the unemployment gap and a weak "check" to wage inflation which is in a mild uptrend. The stable momentum in the Euro-denominated Brent oil price earns an "x" in the Checklist, however. Both the Fed and ECB Are Looking To Tighten Monetary Policy. The Fed remains in a tightening cycle and with U.S. growth strong, core inflation bottoming out and the labor market still tight, there is no reason why the Fed should not deliver on its projected three rate hikes in 2018. The ECB just reduced the size of its monthly asset purchases in response to the robust Euro Area economic growth and modest pickup in inflation. The latest comments from various ECB officials suggests that, if core inflation rebounds after the recent unusual dip, then additional moves to less accommodative monetary policy (tapering first, rate hikes later) should be expected. So for both the U.S. and Europe, we place a "check" in this portion of the Duration Checklist. Investors risk appetite remains strong. The surge in global stock markets seen so far in 2018 has definitely played a role in the backup in global bond yields, as investors have been allocating out of fixed income into equities. Within our Duration Checklist framework, a bearish signal for bonds occurs if the percentage deviation of equity indices from their 200-day moving average is positive but is not yet at 10% - a stretched level that has typically preceded significant equity corrections. The S&P 500 index is now 14% above its 200-day average, and thus earns an "x" in that element of the Duration Checklist. The other parts of the U.S. side of the Checklist - tight corporate bond spreads and a low level of the VIX volatility index - both warrant a "check" as an indication of intense investor risk appetite that lessens the appeal of government bonds (Chart 7). In the Euro Area, the Stoxx 600 index is only 4% above its 200-day moving average, but with tight credit spreads and a low level of the VStoxx volatility index (Chart 8). All these elements earn a "check" in our Duration Checklist. Chart 7High Risk Appetite In the U.S.,##BR##But Risk Assets Look Stretched Chart 8Still A Pro-Risk Bias##BR##Among Euro Area Investors Bond market momentum is not overly stretched, although short positioning is an issue. In the U.S., the 10-year Treasury yield is only 35bps above its 200-day moving average, well below the 90-100bps levels seen at previous yield peaks (Chart 9). Price momentum for the 10-year is right on the zero line, suggesting no stretched extreme that would precede a reversal. Both of those indicators earn a "check" in the Checklist. Positioning is a problem in the U.S., however, with the CFTC data on Treasury futures showing a net short position on the 10-year contract among speculators. From the point of view of our Duration Checklist, a big net short is a bullish signal for bonds from a contrarian perspective. Thus, positioning warrants an "x" in the U.S. side of the Checklist. In Europe, the 10-year Bund yield is now 22bps above its 200-day moving average. This is below the previous peaks around the 50bps level. Price momentum is also hovering just above the zero line and is no impediment to a move higher in yields (Chart 10). Both of these pieces of the Duration Checklist score a "check". Note that due to a lack of available data, we do not include a positioning component on the European side of the Checklist. Chart 9USTs Not Oversold,##BR##But Positioning Getting Stretched Chart 10Bunds Not Yet At##BR##Oversold Extremes The net conclusion from our Duration Checklist is that the majority of indicators continue to point to upward pressure on U.S. Treasury and German Bund yields. Thus, a below-benchmark duration stance is still warranted for both markets. There are only a few potentially bullish signals in the Checklist. The overshoot in U.S. equity markets and the large net short position in Treasury futures are both sending a more positive signal for Treasuries, while the more stable momentum in the Euro denominated oil price is also a positive for Bunds. None of those is enough to prompt a change in our recommended below-benchmark duration stance. At the same time, there is not enough of a difference between the U.S. and European sides of the Checklist to provide a signal for the future direction of the Treasury-Bund spread. For that, we must dig a bit deeper into the drivers of that spread, which we cover in the next section. Bottom Line: Our Duration Checklists continue to point to a bearish backdrop for global bond yields. A continued below-benchmark overall portfolio duration stance is warranted. There is not enough of a difference between the U.S. & European portions of the Checklist to suggest a big imminent move in the U.S. Treasury-German Bund spread is in the cards. How To Play The Treasury-Bund Spread - Tactically Wider, Structurally Narrower The Treasury-Bund spread, like most cross-country bond yield spreads, is driven mostly by economic growth and inflation differentials. In the past, the U.S. and European economic cycles have rarely been in sync, which creates gaps in growth, inflation and monetary policy between the two regions. This usually leads to the Fed and ECB (and the Bundesbank before it) rarely having interest rates at similar levels, or moving at a similar pace, thus creating large cyclical swings in the Treasury-Bund spread. At the moment, however, the 200bp gap between 10-year Treasuries and German Bunds mostly reflects the 4.6 percentage point gap between the unemployment rates in the U.S. and Europe. The spread has been far less correlated to the difference in inflation rates between the two economies. Reported headline inflation in the U.S. is only 30bps above the same measure in Europe, with core inflation only 60bps higher in the U.S. (Chart 11). The latter may be more critical for the future direction of the Treasury-Bund spread, however. The dip in Euro Area core inflation back below the 1% level at the end of 2017 was a surprise given the strength of European growth last year, with real GDP reaching a well-above potential pace of 2.8%. Core inflation must rise from the current 0.9% level for the ECB to consider any move to a tighter monetary policy stance, as this would give the central bank confidence that its 2% inflation target would be reached in the medium-term. The markets seem to be pricing in a recovery of Euro Area core inflation in the coming months. Our Euro Area months-to-hike indicator, which measures the number of months until the first full 25bp rate hike is priced into the EUR Overnight Index Swap (OIS) curve, is now down to 17 months. As the interest rate markets have pulled forward the date of the next ECB rate hike to June 2019, the currency markets have followed suit with the euro rallying to a 3-year high last week (Chart 12). Chart 11Big Gaps Between Yields & Unemployment,##BR##Small Gaps In Inflation Chart 12Markets Are Acting Like##BR##Core Inflation Will Rebound In Europe A rebound in Euro Area core inflation is the first step towards seeing a convergence of the Treasury-Bund spread. The key is how the ECB responds to that move. Looking across the full spectrum of maturities, the moves in the yield gap between U.S. Treasuries and German government bonds have historically occurred alongside changes in relative inflation expectations (Chart 13). This makes sense, as to the extent that inflation expectations were climbing at a faster rate in the U.S. than in Europe, the market would price in a higher future Fed funds rate relative to European policy rates and, thus, widen the Treasury-Bund spread (and vice versa). That correlation between relative inflation expectations and the Treasury-Bund spread has broken down in recent years. The specific timing of that breakdown can be traced back to the August 2014 speech given by Mario Draghi at the Fed's Jackson Hole conference, marked by the vertical line in Chart 13. In that speech, Draghi introduced the idea that the ECB could begin buying government bonds to fight deflation pressures in Europe. That sent a powerful signal to the markets not to expect any movement in European policy rates for some time - the typical response seen in recent years to an announcement by a central bank that it was ramping up asset purchases. If Euro Area core inflation begins to rise in the coming months, the ECB's "forward guidance" can start to work in reverse. The ECB will be forced to signal further reductions in its asset purchases, likely all the way to zero in a full taper scenario. Markets will then begin to price in both higher inflation expectations and ECB rate hikes, resulting in a normalization of the Treasury-Bund spread through higher Bund yields. Until that inflation upturn happens in Europe, however, it will be difficult to get much of a tightening of the Treasury-Bund spread. In Chart 14, we present the spread versus the difference between policy rates in the U.S. and Europe (top panel), the ratio of the U.S. and Euro Area unemployment rates (middle panel), and the gap between U.S. and European headline inflation (bottom panel). At the moment, the Treasury-Bund spread is being held at an elevated level by the relative unemployment rates, with the spread looking wide versus the inflation differential. The much lower U.S. unemployment rate, which is driving the Fed to continue slowly hiking interest rates while the ECB keeps policy rates near zero, is preventing any meaningful decline in the Treasury-Bund spread. Chart 13UST-Bund Spread Has Divorced##BR##From Inflation During ECB QE Chart 14UST-Bund Spread Reflects Policy##BR##& Unemployment Differentials We have combined these three variables into a simple econometric model to explain the Treasury-Bund spread (Chart 15). We also added the size of the balance sheets of the Fed and ECB as separate variables, to account for the impact of bond purchases from each central bank. This model shows that a) the predicted value of the spread continues to steadily rise and b) the current spread is below one standard deviation away from that predicted value - a level equal to 237bps on the spread. That implies that there is still room for Treasury yields to climb higher versus Bunds before the spread becomes "too wide". Additional spread widening will be much harder to come by in the near-term, however. The gap between data surprise indices between the U.S. and Euro Area - which correlates well to the momentum in the Treasury-Bund spread - is relatively stretched, at a time when U.S. bond managers are already very underweight duration exposure (Chart 16). Yet with the forward curves already pricing in some mild tightening over the next year (top panel), betting on Treasury-Bund spread widening is a positive carry trade. One final point in favor of a wider Treasury-Bund spread is that the spread momentum is not yet close to the extremes seen in previous cycles (Chart 17). The big cyclical peaks in the spread typically occur when spreads are 50bps above the 200-day moving average, which is well above current levels. Chart 15Our New Model Suggests##BR##UST-Bund Spread Not Overstretched Chart 16Relative Data Surprises & UST##BR##Positioning May Limit Additional Spread Widening Chart 17UST-Bund Spread Momentum##BR##Not Yet At Stretched Extremes Our conclusion after looking at all these indicators is that the major cyclical peak in the Treasury-Bund spread is not yet on the immediate horizon, but is likely to unfold later this year - after one final move higher in Treasury yields versus Bunds. Bottom Line: A big cyclical turn in the Treasury-Bund spread is coming, but not before the ECB begins to seriously signal an end to its asset purchases and the Fed delivers a few more rate hikes. There will be better levels to move to a long Treasury/short Bund position by the summer. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "A Duration Checklist For U.S. Treasuries & German Bunds", dated February 15th 2017, available at gfis.bcaresearch.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Corporate Bonds & Inflation: The perception of accommodative monetary policy is the sole support for corporate bond performance. But this support will fade as inflationary pressures mount. Our first trigger to reduce exposure to corporate bonds will be when the 10-year TIPS breakeven inflation rate returns to a range between 2.4% and 2.5%. Corporate Debt & Buybacks: New tax legislation incentivizes firms to carry less debt in an optimal capital structure, but this is not likely to alter the current cyclical path of corporate sector re-leveraging. Share buybacks are also once again rising, an unambiguous negative for corporate balance sheet health. MBS: Absent a major monetary policy miscommunication that causes Treasury yields to spike dramatically, extension risk is not likely to be a significant driver of Agency MBS excess returns. We estimate that a monthly increase in yields exceeding 72 bps is required before extension risk becomes material. Feature Chart 1Watch This Space Inflation drives everything in the current environment. If the market comes to expect that inflation will return to the Fed's target, then Treasury yields have further upside. A relapse in inflation would likewise cause yields to fall. Elsewhere, with corporate balance sheets already in disrepair, accommodative monetary policy remains the sole support for spread product excess returns. Once inflation rises this support will also vanish, bringing an end to the credit cycle. With that in mind there is one chart we are tracking more closely than any other. It is the 10-year TIPS breakeven inflation rate and it has moved up significantly in recent months, from a mid-2017 low of 1.66% to its most recent reading of 2.11% (Chart 1). In last week's report we discussed why the 10-year breakeven rate will likely converge to a range between 2.4% and 2.5% before the end of the cycle, applying 29 bps to 39 bps of additional upward pressure to the nominal 10-year Treasury yield.1 This week, we focus on why this chart is so important for our spread product call. Specifically, we explain why a return of the 10-year TIPS breakeven rate to its fair value range between 2.4% and 2.5% will also likely trigger a reduction in our recommended allocation to corporate bonds. Trigger Warning: TIPS Breakevens & The Credit Cycle The range of 2.4% to 2.5% for the 10-year TIPS breakeven inflation rate represents where it has traded in prior periods when inflation is well anchored around the Fed's target. When it is below this range the assumption is that the Fed must respond dovishly whenever credit spreads widen or financial conditions tighten more generally.2 Why? Because when inflation is low the Fed needs the recovery to continue. It cannot allow tighter financial conditions to derail economic growth. Market participants know that this "Fed put" is in place and this makes it very difficult for spreads to gap meaningfully wider. For some context, let's consider the most recent period of significant spread widening between 2014 and 2016 (Chart 2). The initial catalyst for the sell-off was certainly the collapse in commodity prices and defaults in the energy sector, but why was the poor performance so broad based across the entire corporate bond universe? It is because the market assumed that the Fed would not respond dovishly to what was purely a commodity price shock. Notice that our 24-month Fed Funds Discounter, the number of rate hikes the market expects during the next two years, held steady at an elevated level throughout the entire period of spread widening (Chart 2, top panel). It was not until after the Fed capitulated in early 2016, and the discounter fell, that spreads started to recover. We therefore conclude that in order to see another significant sell-off in spread product we need to re-create the conditions that prevailed between 2014 and 2016. Specifically, we need a sense in the market that the Fed will not respond dovishly even if financial conditions tighten. The most likely catalyst for such a shift in market psychology is if inflation pressures are higher. The Fed would be less concerned about maintaining strong growth, and more concerned about containing inflation. Our sense is that a return to the range of 2.4% to 2.5% on the 10-year TIPS breakeven inflation rate will be the earliest signal of such a shift. Chart 2Wider Spreads Need A Hawkish Fed Chart 3Inflation Not Yet A Constraint The Empirical Evidence The link we have drawn between inflation and the end of the credit cycle is not pure theory. The historical record also shows that corporate bond excess returns are highest when inflationary pressures are lowest, and vice-versa. The readings from the Federal Reserve Bank of St. Louis' Price Pressures Measure (PPM) and from core PCE inflation have proven to be particularly useful in this regard (Chart 3).3 Table 1 shows that a level of 15% on the PPM has been a key threshold between positive and negative corporate bond excess returns. Monthly corporate bond excess returns have averaged +24 bps when the PPM is below 15%, but have averaged -5 bps when the PPM is between 15% and 30%. A PPM between 30% and 50% has historically been met with average monthly corporate bond excess returns of -17 bps. The PPM is currently at 7%, still supportive of our overweight allocation to corporate bonds. Table 2 repeats the exercise from Table 1, but this time for year-over-year core PCE inflation. The best periods for corporate bond performance have been when core PCE inflation is below 1.5%. In those periods monthly excess returns have averaged +25 bps. An inflation rate between 1.5% and 2% has led to more balanced corporate bond performance, with average monthly excess returns coming in at zero. Core PCE above 2% typically sends a negative signal for corporate bonds, with average monthly excess returns coming in at -13 bps when core PCE inflation is between 2% and 2.5%. Data released yesterday show that year-over-year core PCE inflation just ticked above 1.5% in December. It is therefore just starting to signal that the environment for corporate bond outperformance is becoming less favorable. Table 1Investment Grade Corporate Bond Excess Returns* Under Different Ranges ##br##Of Price Pressures Measure** (January 1990 To Present) Table 2Investment Grade Corporate Bond Excess Returns* Under Different Ranges##br## Of Year-Over-Year Core** PCE (December 1993 To Present) Bottom Line: The perception of accommodative monetary policy is the sole support for corporate bond performance. But this support will fade as inflationary pressures mount. Our first trigger to reduce exposure to corporate bonds will be when the 10-year TIPS breakeven inflation rate returns to a range between 2.4% and 2.5%. Corporate Debt, Buybacks & Tax Reform The preceding section takes for granted that corporate balance sheets are highly levered. Therefore, spreads will start to widen once inflationary pressures mount and monetary policy turns more restrictive. However, if firms suddenly started paying down debt and shoring up their balance sheets, then a significant enough improvement in corporate health could challenge our conclusions. On that note, the recently passed U.S. tax package does include a few incentives for firms to carry less debt in the capital structure: Lower corporate tax rates reduce the tax benefit from debt financing. Limiting the corporate interest tax deduction to 30% of earnings accomplishes the same thing. The ability to repatriate off-shore cash might also incentivize firms to pay off debt they had taken out to finance previous dividend and buyback programs. It is definitely conceivable that the first two provisions might incentivize less corporate debt issuance in the long run, but we doubt they will alter the cyclical picture. Chart 4 shows that the ratio of non-financial corporate debt to sales only tends to peak once the economy enters recession. In other words, firms in aggregate do not pay down debt unless prompted by slowing demand. As for repatriation, it is also possible that some firms might use repatriated cash to pay down debt, but we also doubt this effect will be large enough to alter the cyclical re-leveraging of the corporate sector. The temptation to use repatriated cash to boost share buybacks even further might be too great for firms to resist, and in fact we already see evidence of surging buyback announcements since the tax bill was introduced (Chart 5). Share buybacks obviously pose a significant risk to corporate bonds because they reduce the equity cushion in corporate capital structures. And in fact, aggregate share buybacks do tend to peak just prior to turns in the credit cycle. However, buyback activity is not a very reliable indicator of when the credit cycle is about to turn. Simply because it peaks at a different level in each cycle. Chart 4The History Of Corporate Leverage Chart 5Cue The Buyback Surge? The more reliable correlation is that periods when buybacks are declining have tended to coincide with periods of corporate bond underperformance (Chart 5, panel 2). This is most likely because tighter lending standards cause both corporate spreads to widen and buyback activity to decline, as banks make debt financing less available. This explains why the most recent decline in buyback activity did not coincide with corporate bond underperformance, because bank lending standards remained supportive and were not the driving force behind the reduction in buybacks (Chart 5, bottom panel). Bottom Line: New tax legislation incentivizes firms to carry less debt in an optimal capital structure, but this is not likely to alter the current cyclical path of corporate sector releveraging. Share buybacks are also once again rising, an unambiguous negative for corporate balance sheet health. Extension Risk In MBS Once the 10-year TIPS breakeven inflation rate reaches our trigger range of 2.4% to 2.5%, one of the beneficiaries of the reduction in our allocation to corporate bonds will likely be Agency MBS. These securities have become much more attractive relative to investment grade corporate bonds during the past year, as corporate bond option-adjusted spreads (OAS) narrowed and MBS OAS widened a tad (Chart 6). In fact, the OAS differential between a conventional 30-year Agency MBS and an investment grade corporate bond is only 19 bps away from its all-time high (Chart 6, panel 2). Chart 6An Attractive Option For De-Risking Last year's widening in MBS OAS is most likely due to the market pricing-in the run-off of the mortgages on the Fed's balance sheet. Now that the schedule for MBS run-off is well known, we think it is probably already reflected in current spreads. That is, we think current MBS OAS present an attractive opportunity to shift some allocation out of corporate bonds and into MBS, in the context of de-risking a U.S. fixed income portfolio. As was stated above, we think it is still a bit too soon to take risk off the table, but that will change once inflationary pressures are more pronounced. Another reason why we view Agency MBS as attractive is that the risk of future spread widening appears to be low. Mortgage refinancings, the main driver of MBS spread widening, should stay low as long as we remain in a rising rate environment. Further, with so much burn-out already in existing mortgage pools, even a decline in mortgage rates is not likely to cause a surge in refi activity (Chart 6, bottom panel). This leaves duration extension as the main risk for excess MBS returns. The opposite of refinancing risk, extension risk in MBS comes from the fact that the duration of these negatively convex securities rises when yields rise, thus leading to greater losses in a rising rate environment. A typical positively convex bond will see its duration decline as yields rise, damping the negative impact of rising rates. How worried do we need to be about the impact of extension risk on excess MBS returns? To answer this question we performed a regression of monthly excess MBS returns (relative to duration-matched Treasury securities) on three factors: The monthly change in duration-equivalent Treasury yields. The squared monthly change in duration-equivalent Treasury yields. The monthly change in OAS. As is shown in Table 3, the first factor is positively related to MBS returns. This is because it proxies for refinancing risk. Lower yields lead to more refinancing and wider MBS spreads, while higher yields lead to less refinancing and tighter MBS spreads. The squared yield factor is included as a proxy for extension risk, and it enters the model with a negative coefficient. For example, a small increase in yields is positive for MBS returns since it leads to less refi activity, but a large increase in yields eventually becomes negative for returns once it causes MBS duration to extend. The change in OAS is also a significant driver of MBS returns, but is un-correlated with the change in yields and so operates independently from the factors that drive refinancing and extension risk. The main message from our excess return model is illustrated in Chart 7. If we assume that the OAS remains flat, then the relationship between monthly excess MBS returns (relative to Treasuries) and the monthly change in Treasury yields can be illustrated with the following quadratic equation: Table 3Model Of Monthly Excess (%) Returns For Conventional ##br##30-Year Agency MBS (2000 - Present) Chart 7Model Of Monthly Excess (%) Returns For Conventional ##br##30-Year Agency MBS (2000 - Present) The chart shows that, all else equal, a monthly change in the duration-matched Treasury yield between -35 bps and +72 bps is consistent with positive excess MBS returns relative to Treasuries. It is only when the monthly change in yields exceeds +72 bps on the upside, or -32 bps on the downside, that negative convexity starts to bite. As is shown in Chart 8, monthly changes in Treasury yields of this magnitude - especially spikes of more than 72 bps - are quite rare. Chart 8Extension Risk Rarely Bites Bottom Line: Absent a major monetary policy miscommunication that causes Treasury yields to spike dramatically, extension risk is not likely to be a significant driver of Agency MBS excess returns. We estimate that a monthly increase in yields exceeding 72 bps is required before extension risk becomes material. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "The Long And Short Of It", dated January 23, 2018, available at usbs.bcaresearch.com 2 Wider credit spreads, a stronger dollar, a rising VIX and falling equity prices all signal tighter financial conditions. 3 For further details on the Price Pressures Measure please see: https://research.stlouisfed.org/publications/economic-synopses/2015/11/06/introducing-the-st-louis-fed-price-pressures-measure/ Fixed Income Sector Performance Recommended Portfolio Specification

Neutral In yesterday’s Weekly Report, we outlined that the most cyclical parts of the S&P industrials index with high foreign sales content would benefit disproportionately from our stable-to-mildly sanguine EM/China view. While the broad machinery index fits the bill, the industrial machinery sub index less so, and we recommend monetizing gains of 4% since inception and moving to the sidelines while redeploying profits into the more cyclical S&P construction machinery & heavy truck index. One key determinant of the relative move of these indexes is the U.S. dollar. The greenback troughed in 2011 and since then the more “defensive”, less globally-exposed S&P industrials machinery index left their brethren in the dust (top panel). Now that the U.S. dollar has peaked, the catch up phase in the S&P construction machinery & heavy truck index that is already underway will likely gain momentum (bottom panel). Bottom Line: Book profits of 4% in the S&P industrial machinery index and downgrade to a benchmark allocation while staying overweight construction machinery; please see yesterday’s Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5INDM - ITW, IR, SWK, PH, FTV, DOV, PNR, XYL, SNA, FLS.

Highlights Portfolio Strategy A stable China, a depreciating U.S. dollar, rising commodity prices and sustained synchronized global growth signal that the industrials complex, especially the most cyclical part, remains on a solid footing. Deteriorating profit prospects warn that investors should refrain from paying a premium valuation for industrial machinery; take profits and move to the sidelines. Recent Changes S&P Industrial Machinery - Book profits of 4% and downgrade to neutral today. S&P Construction Machinery & Heavy Truck - Stop triggered last week, remove from the high-conviction list for a 10% gain. Small Caps / Large Caps - Downgrade alert in a recent Insight. Table 1 Feature The S&P 500 smashed through the 2,800 mark last week, as corporate profits continued to deliver, the U.S. dollar took a dive and global economic data releases held their own. Stars could not be more aligned for a euphoric blow off phase, with equity bourses the world over already registering annual-like returns in but a few short weeks. While stocks have more room to run, especially versus bonds, on a cyclical time frame, tactically the likelihood of a short-term healthy pullback is increasing. Last week we identified five indicators we are closely monitoring that are signaling an overstretched market.1 This week we update our Complacency-Anxiety Indicator that also catapulted to all-time highs and breached the one standard deviation above the historical mean mark (Chart 1). This confirms that a Q1 setback remains likely, and our strategy since December 18 has been to monetize gains in tactical trades and institute stops to the high flyers in our high-conviction call list. Were a 5-10% correction to materialize, we would "buy the dip" as we do not foresee a recession in the coming 9-12 months. While consumer price inflation is nowhere to be found, corporate selling prices are climbing at a brisk pace. The U.S. dollar debasement and related commodity reflex rebound, especially in oil prices, are the culprits, and the latter will likely assist even the CPI basket and morph into an inflationary impulse as we posited in late-November (please see the bottom two panels of Chart 1B). Already, inflation expectations are headed higher. Chart 2 updates our corporate sector pricing power proxy and our diffusion index. It also updates the business sector's overall wage inflation and associated diffusion index from the latest BLS employment report. The middle panel of Chart 2 shows the Atlanta Fed Wage Growth Tracker and that measure of wage inflation has converged down to the AHE reading, suffering a 100bps drop in the past year. Chart 1Complacency Reigns Chart 2Margin Expansion Phase Is Intact Corporate pricing power is upbeat at a time when wages are decelerating. Taken together, our margin proxy indicator suggests that the ongoing profit margin expansion phase has more upside (bottom panel, Chart 2). Table 2 shows our updated industry group pricing power gauges, which we calculate from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. Table 2 also highlights shorter-term pricing power trends and each industry's spread to overall inflation. Table 2Industry Group Pricing Power 78% of the industries we cover are lifting selling prices, and 45% are doing so at a faster clip than overall inflation. Importantly, inflation rates have increased since our late-September update. The outright deflating sectors dropped by two to 13 since our last update. Encouragingly, only 7 industries are experiencing a downtrend in selling price inflation, or 5 fewer than our most recent report. Impressively, deep cyclicals/commodity-related industries dominate the top ranks, occupying 8 out of the top 10 slots (top panel, Chart 3). A softening greenback and rising global end demand explain the commodity complex's sustained ability to increase prices. In contrast, tech, telecom and consumer discretionary sectors populate the bottom ranks of Table 2. Netting it out, accelerating corporate sector pricing power will continue to bolster top line growth in 2018. Tack on high operating leverage kicking into higher gear at this stage of the cycle and still muted wage inflation and profit margins and EPS growth will remain upbeat. With regard to cyclicals versus defensives, diverging pricing power (Chart 3) and wage growth trends (Chart 4) suggest that cyclicals continue to have the upper hand compared with defensives (Chart 5). Chart 3Deep Cyclicals... Chart 4...Have The Upper Hand... Chart 5...Vs. Defensives This week we update our view on a deep cyclical sector and modestly tweak our intra-sector positioning. Industrials And China We lifted the S&P industrials sector to an above benchmark allocation in early October via boosting the S&P construction machinery & heavy truck sub index to overweight.2 Synchronized global growth, a capex upcycle, firming capital goods final demand, and the U.S. dollar's fall coupled with the commodity price rebound all pointed to a bright outlook for U.S. capital goods producers. Currently, all these forces remain in play and continue to bolster industrials stocks' profit prospects. However, the emerging market (EM)/Chinese economic backdrop deserves closer scrutiny. Why? Because the most cyclical parts of the industrials complex are levered to the EM in general and China in particular. These high operating leverage businesses also drive relative profit and stock performance, signaling that China's economic growth might or ails determine the overall fortunes of U.S. capital goods producers. While Chinese economic data are currently a mixed bag and we take them with a big grain of salt, global high-frequency financial market data are emitting an unambiguously positive signal. First, BCA's FX strategist, Mathieu Savary, brought to our attention that the extremely economic-sensitive Canadian TSX Venture Exchange Index is in a V-shaped recovery.3 Highly speculative basic resources issues dominate this Index and help explain the tight positive correlation with Chinese output (top panel, Chart 6). Second, the ultimate economic-sensitive indicator, Dr. Copper, is also in a violent upswing, heralding that China will be, at least, stable in 2018 (middle panel, Chart 6). Third, high-beta Australian materials stocks have been in an upward trajectory since the early 2016 trough both versus the MSCI All-Country World Index and the broad Australian market, sniffing out improving Chinese-related commodity demand (bottom panel, Chart 6). Similarly, upbeat non-Chinese economic data suggest that China's economic prospects are far from faltering. Australia's close economic ties with China signal that taking a pulse of the Australian economic juggernaut reveals the state of China's economic affairs. Down Under employment growth has been brisk of late, with annual job creation running at a 3.3% clip, a rate last hit in the mid-2000s when China's economy was roaring and the commodity super-cycle was in full swing (second panel, Chart 7). Australian CEO confidence as well as consumer confidence are pushing decade highs, and the manufacturing PMI survey recently shot to a 16 year high (third panel, Chart 7). Chart 6China Is##BR##Alright Chart 7Australian Indicators Confirm:##BR## China Is Stable All of this suggests that China will likely remain stable in 2018, barring a policy mistake a la the August 11, 2015 currency devaluation. The upshot is that industrials EPS and equities have more room to run. On that front, both our Cyclical Macro Indicator and our profit growth model corroborate that the path of least resistance for relative share prices is higher (Chart 8). U.S. dollar debasing is synonymous with capital goods producers' top line growth acceleration, as a large part of total revenues are sourced from abroad. The near 20 percentage point fall in the trade-weighted U.S. dollar since 2015 suggests that more global market share gains are in store for U.S. industrials (Chart 9). Global growth is also joined at the hip with the greenback's depreciation. Synchronized global growth along with our derivative coordinated global capex growth 2018 theme, will likely serve as catalysts for a sustained breakout in relative share prices (Chart 10). Chart 8EPS Model And CMI Flash Green Chart 9Industrials Love A Cheap Greenback Chart 10Levered To Global Growth Adding it up, a stable China is music to the ears of industrials executives. Tack on a depreciating U.S. dollar, rising commodity prices and sustained synchronized global growth and the most cyclical parts of the industrials complex will continue to lead the pack. Bottom Line: Stay overweight the S&P industrials index, but selectivity is warranted. Take Profits In Industrial Machinery We outlined above that the most cyclical parts of the S&P industrials index with high foreign sales content would benefit disproportionately from our stable-to-mildly sanguine EM/China view. While the broad machinery index fits the bill, the industrial machinery sub index less so, and we recommend monetizing gains of 4% since inception and moving to the sidelines. Chart 11 shows the relative performance of the two key drivers of the S&P machinery index: industrial machinery and construction machinery & heavy truck sub-indexes. While these indexes moved hand-in-hand since the mid-1990s, early this decade this tight positive correlation fell apart. One key determinant of the relative move of these indexes is the U.S. dollar. The greenback troughed in 2011 and since then the more "defensive", less globally-exposed S&P industrials machinery index left their brethren in the dust (bottom panel, Chart 11). Now that the U.S. dollar has peaked, the catch up phase in the S&P construction machinery & heavy truck index that is already underway will likely gain momentum (top panel, Chart 11). Beyond the depreciating currency, at the margin, softening S&P industrial machinery operating metrics argue for pruning exposure in this index. Both the Empire and Philly Fed new orders surveys have petered out, suggesting that industry new order growth will likely continue to lose steam (middle panel, Chart 12). In fact, a weak industrial machinery new orders-to-inventories ratio is also warning that sell-side analysts' relative profits forecasts are too optimistic (bottom panel, Chart 12). Chart 11Catch Up Phase Chart 12Waning End-Demand Drilling deeper into industry operating metrics is revealing. While shipments have held their own and moved mostly sideways similar to new orders, inventory accumulation is worrying. Industry inventories have risen by over 30% during the past three years (Chart 13). Simultaneously, industrial machinery backlogs have drifted steadily lower. Given the supply build up, any hiccup in demand, even a minor one, could prove very deflationary and heavily weigh on industry profitability. With regard to valuations, Chart 14 shows that both on a relative trailing price-to-sales and relative forward price-to-earnings ratio basis, the index is trading one standard deviation above the historical mean. The moderating industry demand backdrop suggests that relative valuations are expensive. Chart 13Inventory Liquidation Risk Chart 14Why Pay A Premium? Adding it all up, deteriorating profit prospects warn that investors should refrain from paying a premium valuation for the S&P industrial machinery index. Bottom Line: Book profits of 4% in the S&P industrial machinery index and downgrade to a benchmark allocation. We also recommend redeploying profits from our downgrade in the S&P industrial machinery index to their more cyclical machinery siblings the S&P construction machinery & heavy truck index, thus sustaining the overall overweight exposure in the broad S&P industrials sector. Housekeeping Last week we instituted a risk management tool for our 2018 high-conviction list: setting a stop once a call has cleared the 10% return mark.4 This past week, the S&P construction machinery & heavy truck index hit the trailing stop at the 10% mark, and thus we are booking gains and removing this index from the high-conviction list. While our confidence is not as high as in late-November given the parabolic move in this index and rising chance of a tactical overall equity market pullback, from a cyclical perspective we continue to recommend a core overweight in this industrials sector powerhouse. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Too Good To Be True?" dated January 22, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Earnings Take Center Stage," dated October 2, 2017, available at uses.bcaresearch.com. 3 Please see BCA Foreign Exchange Strategy Weekly Report, "Health Care Or Not, Risks Remain," dated March 24, 2017, available at fes.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Weekly Report, "Too Good To Be True?" dated January 22, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth. Stay neutral small over large caps (downgrade alert).

Highlights Q4 earnings are beating raised expectations, and the bar for 2018 EPS is even higher. Housing, capex and a nudge from government spending are set to boost GDP in 2018. BCA's consumer spending model shows that economic factors, not sentiment or political affiliation, are the main drivers of household consumption. Feature Risk assets continued their early 2018 surge last week, supported by better than expected Q4 corporate earnings results, solid economic growth and a weaker dollar. The headline 2.6% gain in Q4 GDP understated the strength in the U.S. economy as 2017 ended (Chart 1). Real final sales to domestic purchasers rose 4.3% in Q4, the fastest clip in nearly four years. Moreover, the economy is poised to grow well above its long term potential in the first half of 2018, aided by surging capex, the lagged effect of easy financial conditions and the tax bill. Faster growth will push down the unemployment rate and lead to higher inflation by year end. Q4 corporate earnings are beating raised expectations. However, managements have raised the bar for 2018 results, which may lead to disappointment later this year. Investors have correctly ignored the elevated level of political polarization in Washington and focused on the fundamentals. The final section of this week's bulletin suggests that despite a widening gap in consumer sentiment between political parties, economic fundamentals, not political affiliation, drives consumer behavior. Chart 1GDP Growth Remains Below Average, But Above Fed's Long Run Target Raising The Bar The Q4 earnings reporting season is off to a strong start, with both EPS and revenue growth ahead of consensus expectations at the start of January. Moreover, the counter-trend rally in margins remains in place. We previewed the Q4 2017 S&P 500 earnings season earlier this month.1 Table 1S&P 500: Q4 2017 Results* Just under 30% of companies have reported results thus far, with 80% beating consensus EPS projections, well above the long term average of 69%. Furthermore, 82% have posted Q4 revenues that topped expectations, which exceeded the long-term average of 56%. The surprise factor for Q4 stands at 5% for EPS and 1% for sales. Both readings are right at the average surprise in the past five years. The surprise figures are even more impressive given that analysts' views of Q4 results increased between the start of Q4 2017 and the start of Q4 reporting season. Analysts' estimates typically move lower as the quarter unfolds, in effect lowering the bar for results. We anticipate the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning in mid-2018. Nonetheless, initial results imply that Q4 will be another quarter of margin expansion. Average earnings growth (Q4 2017 versus Q4 2016) is solid at 13% with revenue growth at 7%. However, on a four quarter basis, U.S. margins fell slightly in the fourth quarter, but remain at a high level on the back of decent corporate pricing power. A pick-up in productivity growth into year-end helped as well. Strength in earnings and revenues are broadly based (Table 1). Earnings per share increased in Q4 2017 versus Q4 2016 in 9 of the 11 sectors. EPS results are particularly stout in energy (140%), materials (28%), technology (18%) and financials (15%). The energy, materials and technology sectors likewise experienced significant sales gains (21%, 11%, and 11% respectively). The 5% year-over-year increase in financial sector earnings follows the 7% drop in Q3, owing to the impact of Hurricanes Harvey and Irma on the insurance and reinsurance industries. Excluding energy, S&P 500 profits in Q4 2017 versus Q4 2016 are a still-robust 11%. Upbeat managements have raised the bar significantly for 2018 results in the past few months (Chart 2). On October 1, 2017, before the GOP introduced the bill, the bottom-up estimate for 2018 S&P 500 EPS growth stood at 11%. As of January 26, 2018, the estimate is 17%. Moreover, the upward revisions are widespread. 2018 EPS growth rate estimates in 9 of 11 sectors are higher today than at the start of October (Table 2). 2018 consensus projections increased the most for Telecom, Financials, Energy, and Consumer Discretionary. Analysts have cut their view of 2018 results for the Utilities and Real Estate sectors since the bill was introduced. Our U.S. Equity Strategy service introduced profit models for all 11 S&P 500 sectors earlier this month.2 Chart 2Buybacks, Surging Capex Raising The Bar For 2018 EPS Growth Table 2Estimated Earnings Growth For 2018 The Tax Cut and Jobs Act of 2017 is behind most of this ebullience, but improving global growth, a steeper yield curve and higher energy prices are also responsible. The tax bill lowered the corporate tax rate for 2018 and the repatriation holiday provides firms with excess cash. As we noted in last week's report,3 companies are likely to return almost all of that cash to shareholders via increased buybacks. Moreover, a few firms are marking up 2018 estimates in anticipation of a surge in capital spending, as managements pull ahead new investment into 2018 from later years to benefit from the bill. Chart 3Profit Growth Will Peak In 2018 Analysts expect EPS growth to slow significantly in 2019 from the anticipated 2018 clip, which matches BCA's view. However, unlike estimates for 2017 and 2018, we anticipate that EPS estimates for 2019 will move lower throughout 2018 and 2019, ahead of a recession in late 2019.4 Bottom Line: The BCA earnings model shows that S&P 500 EPS growth is peaking on a four-quarter moving total basis, and should begin to decelerate in 2H 2018 to a level commensurate with 3 ½-4% nominal GDP growth (Chart 3). After-tax earnings growth will be higher than this, however, due to the recently passed tax cuts. Margins will crest in mid-2018, but BCA believes that the earnings backdrop will remain a tailwind for the equity market. The Tax Cut and Job Act raised expectations for 2018 in most sectors, and it remains to be seen whether managements can match the lofty projections, especially in the second half of the year. BCA expects growth outside the U.S. to remain robust, an additional support for EPS growth in the coming quarters. Further weakness in the dollar, counter to our call for a 5% gain in the DXY, would also provide a modest boost to S&P 500 results in 2018. Strong domestic economic activity will also boost profits this year. Setting The Stage For 2018 Q4 GDP posted a 2.6% gain, failing to match (raised) expectations of a 2.9% increase (Chart 1 again). At 2.5%, the year-over-year change in GDP exceeded the FOMC's forecast for 2017 GDP (2.1%) at the start of 2017. Moreover, the 2.5% year-over-year reading in Q4 is well above the Fed's estimate of potential GDP (1.8%). The implication for investors is that because U.S. economic growth is faster than its long-term potential, the labor market is tightening and inflation is poised to move higher. Accordingly, market odds for a Fed hike in March are over 90%, and investors expect almost three additional hikes in the next 12 months (Chart 4). The FOMC expects to raise rates three times this year. BCA's stance is that the Fed will raise rates 4 times. Chart 4The FOMC And The Market Are Closely Aligned On Rate Hikes In 2018 BCA's view is that U.S. economic growth is set to accelerate in the first half of 2018 aided by the tax cut, strong global growth and the lagged effect of easier financial conditions. The direct effect of the tax cuts will likely boost U.S. real GDP growth in 2018 by 0.2 to 0.3 percentage points. It could be more, depending on the impact on animal spirits in the business sector and any fresh infrastructure spending. Full expensing of capital goods and changes to the budget sequesters would add another 0.2 percentage points. Global growth estimates are still on the upswing, which will provide U.S. capex a boost (Charts 5 and 6). Moreover, financial conditions have eased since the Fed's initial hike of the cycle (Chart 7). Financial lead GDP growth by 6 to 9 months, suggesting that real GDP growth in the U.S. will remain at or above 3% for at least the first half of 2018 (Chart 8). The New York Fed's Nowcast for Q1 2018 stands at 3.1%, while the Atlanta Fed's GDP Now reading for Q1 is 3.4% (Chart 9). Chart 5Global Growth Expectations##BR##Are Accelerating Chart 6Capex Poised##BR##For Liftoff Chart 7Financial Conditions Have Eased Since##BR##The Fed's First Rate Hike Of The Cycle Chart 8Easier Financial Conditions##BR##Will Boost U.S. Growth Chart 9Solid GDP Growth##BR##Expected In Q1 Residential investment, which surged in Q4 as communities in Texas and Florida began to rebuild after the storms, will add to growth in 2018. Inventories of new and existing homes are close to all-time lows (Chart 10). Housing affordability remains well above average, and will remain supportive of housing investment even if rates rise by 100 bps (Chart 11). Bank managements are upbeat about credit quality and loan growth,5 although the recent soundings from the Fed's Senior Loan Officers survey shows that mortgage demand has ebbed in recent quarters. However, banks' lending standards for home loans remain relatively loose (Chart 12). Moreover, household formation recovered in the past few years alongside the labor market, providing additional support for housing. Risks to housing include the impact of the limits to mortgage interest and state and local taxes imposed by the Tax Cut and Jobs Act of 2017. Chart 10Solid Housing##BR##Fundamentals In Place Chart 11Housing Affordability Under##BR##Various Rate Assumptions Chart 12Mortgage Spigot##BR##Open For Homebuyers Bottom Line: U.S. economic growth is poised to string together the longest period of above-potential GDP growth since early in the recovery. The odds of a recession in 2018 are very low (Chart 13). Housing, capital spending and a modest lift from government spending will lift GDP, pushing the output gap further into positive territory (Chart 14). The added support to the economy from the tax bill makes it more likely that the economy will overheat, and lead to higher inflation and faster rate hikes than the market, or the Fed, expects. Stay underweight duration and overweight stocks versus bonds for now, although we plan to take some risk off the table later in the year. Despite record levels of political polarization, the U.S. consumer will provide support for the economy in 2018 as well. Chart 13Odds Of A Recession Are Low Chart 14U.S. Economy Growing Faster Than Potential Tribal Economics Chart 15Income Inequality Fosters Polarization Many of our clients have been asking: "Why is consumer confidence so high if Americans are so angry?" BCA's view is that Americans' anger is based to some extent on "economic discontent",6 driven largely by political orientation. However, economy-wide, the negative attitude based on party affinity is more than offset by a higher level of optimism based on economic fundamentals. Moreover, the dissatisfaction among households may be about structural issues that have long-term implications, like income inequality, which fosters or nurtures polarization and where the latter continues to grow. The polarization in the cultural realm has been mirrored in the political arena. According to political scientists Keith Poole and Howard Rosenthal, polarization in Congress is currently at its highest level since World War II (Chart 15). Furthermore, BCA's Geopolitical Strategy service stance is that the long-term implications of polarization are here to stay as income inequality remains the most significant driver, among five main factors, that explain the polarization in the U.S. today.7 & 8 The election of President Trump in November 2016 ushered in a period of significant polarization and partisan conflict. Compared with other administrations, Trump effected the most change in economic expectations9 (Table 3). Moreover, even a year later, the partisan gap (Republicans minus Democrats) has widened further; Republicans are most optimistic and Democrats are most pessimistic (Chart 16). Table 3Change In Economic Assessments##BR##Pre And Post Elections Chart 16Partisan Gap Is Widest##BR##And Persistent, For Now To further understand the divergence between the elevated consumer sentiment readings and households' high level of anger, it is useful to look through the lens of the stages of "economic discontent".10 The framework pioneered by the University of Michigan identifies five typical stages of a collapse in economic confidence (Table 4). The study acknowledges that consumers are rational individuals. As such, households tend to shape their economic expectations on cyclical fundamental drivers of the economy, rather than political affiliation (Chart 17). The implication is that as long as consumers remain satisfied with the performance of the three cyclical drivers, readings on consumer sentiment will hold up, as the positive views on fundamentals outweigh any resentment they may have about long-term issues like income inequality. Finally, it is clear that households have not lost all hope (stage four), where economic discontent turns into political discontent. Consumers are very far away from total despair, not seen since the 1930s! Nonetheless, BCA's view is that with recession likely by late 2019/early 2020, the U.S. will see a revolt of some kind by the 2020 election.11 Table 4Five Stages Of##BR##Economic Discontent Chart 17Expectations For Cyclical##BR##Fundamental Drivers Are Solid Consumers have hope that their economic expectations will be met by the Trump administration's policies as the economy continues to deliver strong job growth/job security and tame inflation, preserving households' purchasing power. BCA's consumer spending model shows that economic factors, not sentiment, are the main drivers of household consumption (Chart 18). Several academic studies support this view. Researchers at Princeton University and the National Bureau of Economic Research find that political polarization's impact on consumer spending is trivial.12 Furthermore, a recent study by the Federal Reserve Bank of New York,13 also finds that the election of President Trump had negligible partisan impact on consumer spending patterns. Economists at the NY Fed show that consumers' expectations in surveys may include "true beliefs" based on economic factors and "some noise". They conclude that if the partisan gap does not cause economic decisions to vary significantly, then macroeconomists and policymakers should downplay the impact of consumers' political views on spending patterns. Chart 18Consumption Has##BR##Room To Grow Chart 19Lower-Lows In The Personal##BR##Savings Rate Unlikely Bottom Line: BCA expects consumer spending to grow by at least 2% in 2018. Consumption is well supported by record high household net worth, and accelerating wages. On the other hand, employment growth will slow later this year and we should not assume that the personal saving rate will keep falling given that it has hit a recovery low of 3.1% (Chart 19). John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com 1 Please see BCA Research's U.S. Investment Strategy Weekly Report, "A Smooth Transition" published January 15, 2018. Available at usis.bcaresearch.com. 2 Please see BCA Research's U.S. Equity Strategy Weekly Report, "White Paper: Introducing Our U.S. Equity Sector Earnings Models" published January 16, 2018. Available at uses.bcaresearch.com. 3 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Variations On A Theme" published January 22, 2018. Available at usis.bcaresearch.com. 4 Please see BCA Research's Global Investment Strategy Weekly Report, "Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear," October 4, 2017. Available at gis.bcaresearch.com. 5 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Variations On A Theme", published January 22,2018. Available at usis.bcaresearch.com. 6 "Economic Discontent: Causes and Consequences", Richard Curtin, Director, Survey of Consumers, University of Michigan, November 12, 2008. 7 Please see BCA Research's Global Investment Strategy Special Report, "The Future Of Western Democracy: Back To Blood", dated November 18, 2016. Available at gis.bcaresearch.com. 8 Please see BCA Research's Geopolitical Strategy Special Report, "U.S. Election: Outcomes And Investment Implications", dated November 9, 2016. Available at gps.bcaresearch.com. 9 "Consumer Expectations: Politics Trumps Economics", Richard Curtin, University of Michigan, June 1, 2017. 10 "Economic Discontent: Causes and Consequences", Richard Curtin, Director, Survey of Consumers, University of Michigan, November 12, 2008. 11 Please see BCA Research's Geopolitical Strategy Special Report "Populism Blues: How And Why Social Instability Is Coming To America" June 9, 2017. Available at gps.bcaresearch.com. 12 "Partisan Bias, Economic Expectations, and Household Spending", Atif Mian, Amir Sufi and Nasim Koshkhou, Stanford University, University of Chicago Booth of Business, NBER and Argus Information and Advisory Services, July 2017. 13 "Political Polarization In Consumer Expectations", Olivier Armantier, John J. Conlon and Wilbert van der Klaauw, Federal Reserve Bank of New York, December 15, 2017.

Highlights EUR/USD is in a blow off phase. Treasury secretary Mnuchin's comments added fuel to a fire already lit by worries of twin deficits and the inherent responsivity of the dollar to momentum. It is dangerous to short EUR/USD when momentum is so strong; while we expect EUR/USD to correct over the next three months, it is safer to short the euro against the yen. The rebound in Australia's national income will peter off, this will hurt inflows into the country. The RBA will not surprise markets to the upside in 2018. Most of the drivers of AUD/USD point south. Stay short the AUD against the CAD and NZD, shorting AUD/JPY is attractive. Feature By somewhat abandoning the "strong dollar policy" in Davos, U.S. Treasury Secretary Steve Mnuchin sent the dollar in yet another tailspin this week.1 The weakness was further compounded by the seeming lack of concern vis-à-vis the euro's strength expressed by European Central Bank President Mario Draghi during the European Central Bank's press conference in Frankfurt yesterday. Mnuchin's comments rightfully worried investors, as they echoed President Trump's own rhetoric from a year ago that a strong dollar was negative for the U.S. economy, at least in terms of trade competitiveness. However, it is important to remember that words are only words, and for these utterances to have any durable impact, they need to be backed by policy instruments. The 1985 Plaza Accord was able to drive down the dollar not just because finance ministers said that the greenback was too strong, but also because the Federal Reserve cut interest rates in half between July 1984 and October 1986. This drove 2-year yield differentials between the U.S. and Japan, the U.K., and Germany down by 454 bps, 630 bps and 407 bps, respectively. Compounding this punch, the USD was trading at prodigiously expensive levels in early 1985. Today, the Fed is not cutting interest rates, it is raising them. In fact, BCA expects at least three rate hikes this year. The current weakness in the dollar is also easing U.S. financial conditions further, which is giving more ammunition for the Fed to tighten policy. Meanwhile, President Draghi reiterated that the ECB was very unlikely to increase rates in 2018; thus rate differentials between the U.S. and the euro area are widening, not narrowing. There is also the nagging question of the twin deficit in the U.S. The Trump stimulus package is expected to increase the fiscal deficit, and also feed through to a higher current account deficit. We have sympathy for this view. While such a twin deficit was associated with a weakening USD at the beginning of the millennium, in the first half of the 1980s it was not. Thus a twin deficit is no guarantee of a weaker dollar. The behavior of the Fed is likely to once again dominate. In the early days of the millennium, the Greenspan Fed was easing policy aggressively. In the early 1980s, while the Fed was cutting rates, it was cutting rates at a slower pace than had been anticipated because it realized that President Ronald Reagan's tax cuts and increased military spending were inflationary. Volcker wanted to make sure inflation expectations would stay well anchored, and not spike up. It thus seems that once again, the behavior of U.S. inflation is paramount. If U.S. inflation picks up as we expect (Chart I-1), the dollar is likely to appreciate as the Fed will hike. If U.S. inflation stays moribund, the twin deficit will likely tank the dollar. What to do practically? We have posited that the expected terminal rate spread between the euro area and the U.S. has been the interest rate spread driving EUR/USD rate over the past 12 months. Yet, even by this metric, the move in the euro to 1.25 is out of bound, as the euro has completely diverged from the recent trends in terminal rate differentials (Chart I-2). This suggests the euro is vulnerable at current levels. Chart I-1U.S. Inflation Will Pick Up Chart I-2Mind The Gap! It is also important to remark that the dollar's weakness is generalized. Moreover, the dollar is oversold and likely to experience a rebound (Chart I-3). However, timing this rebound is a made harder by the nature of the greenback. As we highlighted in a Special Report in December, the U.S. dollar is one of the two currencies exhibiting the strongest response to momentum factors.2 This is because the dollar is a very important macro variable, which is both responsive to global growth but also a key input to global growth. As global growth strengthens, this tends to weigh on the USD, but the USD's weakness tends to also boost global growth, as it eases global financial conditions. This creates a strong feedback loop that favors momentum trades in the USD. Chart I-3The Time To Bet On A Rebound Is High The greenback is currently entangled in such dynamics. Global growth improved after China massively stimulated its economy in 2015 and early 2016, which hurt the dollar. The weakness in the dollar is now helping global growth, which further hurts the dollar. It is thus a mugs game trying to time a reversal in the USD. As a result, even if we think EUR/USD is likely to experience a sharp correction in the coming weeks, we prefer shorting EUR/JPY. EUR/JPY is expensive, and positioning is just as extreme. However, by shorting the euro against the yen, we are not as exposed to the dollar cycle, and if global growth were to weaken in response to increasing tightening in Chinese policy, the yen would benefit in this environment. As such, the risk-reward ratio for this trade is higher. Bottom Line: Mnuchin comments on the USD were only an excuse for the dollar to sell off. The true culprit for the dollar's weakness is the greenback's own extreme sensitivity to momentum. As a result, timing a dollar reversal is nearly impossible. Only once the dollar begins to turn around can we begin betting on a tactical USD rally, even if it dooms us to miss the early parts of the move. Shorting EUR/JPY continues to offer a more attractive risk-reward tradeoff than shorting EUR/USD. Feature: Hard Times Ahead For The AUD The Australian dollar has rallied by a stunning 18.3% since its February 2016 trough. Improvement in global trade, surging Chinese stimulus, the resurgence in commodity prices, the rally in EM stocks, and the fall in the U.S. dollar have all aligned to transform the AUD into a high flyer. Not only have these factors encouraged risk-taking, creating an environment that is helping high-beta Australian assets perform well, they also have had a direct positive outcome on the Australian balance of payments, thus creating real improvements in the AUD's fundamentals as well. With AUD/USD now back above the key 0.80 threshold, it is important for investors to ask themselves: Can the AUD continue on its upward trajectory or is it time to bet against it? While the short-term outlook remains clouded by the USD's downward momentum, the AUD is likely to weaken on a cyclical basis. Playing AUD weakness against the NZD, CAD, and JPY seems like safer bets at the current juncture. Australian Economic Developments Australia's real GDP growth has slowed from 2.8% in Q3 2016 to 2.2% in Q3 2017, and currently stands below the lows recorded in 2015. However, this hides some very significant improvements, as nominal GDP growth has surged - from 1.4% in Q3 2015 to 6.5% in Q3 2017 (Chart I-4). Consumption has not been the crucial source of variations in Australia's economic activity. Instead, the source of change has emanated from net exports, which have moved from slicing off nearly 2% to GDP growth in late 2015 to adding more than 3% in the most recent quarter. The fluctuations in Australian growth have in large part reflected the dynamics in commodities prices. Australia has undergone massive fluctuations in its terms-of-trade as iron ore, copper and coal prices experienced a bust, followed by a subsequent boom that has pushed base metals prices up by 76% since their nadir. These movements in commodity prices not only explain past gross domestic product performance, they also explain the swings in both national income and corporate profits (Chart I-5). Chart I-4Australian Growth Decomposition Chart I-5The Positive Shock: Commodities In response to the improvement in national income and profits since the winter of 2016, the basic balance of Australia has surged from a deficit of 3% of GDP to a surplus of 3% (Chart I-6). While higher commodities prices contributed to higher exports, lifting the current account, portfolio flows moved up by more than 4% of GDP. This was simply because the surge in Australian corporate profits also made investing in Australia much more attractive for investors around the world. This combination caused a lot of investors to buy Australian dollars in the process, generating a severe upward bias in favor of the AUD. But how these trends are likely to evolve remains uncertain. To begin with, the rate of change of the Reserve Bank of Australia's commodity index has already rolled over, plunging from a high of 47% six months ago to -1% today. The historical lead times of this variable on GDP, GNI and profits suggests that each of these three variables are set to decelerate meaningfully in the coming quarters. This could weigh on inflows into Australia. China too plays a key role. Exports to China were subtracting 0.5% from Australia's growth as of the end of 2016 and are now adding 1.5%. Swings in Chinese activity could amplify the impact of the rollover in commodities price inflation. In fact, the slowing Li Keqiang index already paints this exact picture (Chart I-7). The growth rate of railway freight, one of the index's components, has already collapsed from 20% in August 2017 to 1%, and iron ore stockpiles in Chinese ports are hitting record highs. The tightening of the monetary and fiscal screws in China are therefore likely to exert a negative impact on Australia's national income, and thus on inflows that have been so important in supporting the AUD. Chart I-6From Income Shock To ##br##Balance Of Payment Shock Chart I-7China's Boost Is Dissipating ##br##The Boost To Trade Is Dissipating But what about real economic activity? Here again, the picture does not shine particularly bright. Fiscal policy has been a drag on GDP since 2011, and 2018 will be no exception, as the fiscal thrust will be -0.3% of potential GDP (Chart I-8). A potential rollover in aggregate profits could limit corporate capex in 2018. Mining projects in Australia are expected to continue to decline as a share of GDP in 2018, thus mining capex will remain a drag on growth (Chart I-9). Moreover, imports of capital goods have been a leading indicator of Australian capex, and they too have rolled over after a recent surge, suggesting that non-mining capex growth will also experience limited upside. The Australian consumer is also unlikely to come and save the day. To begin with, the savings rate has additional upside. As net worth has increased, Australian households have curtailed their savings rate to 3% of disposable income (Chart I-10). Moreover, debt levels have increased significantly, rising to an eye-opening 200% of income. The problem is that Australian housing is now much overvalued (Chart I-11). While this does not guarantee a fall in house prices, it is highly unlikely that net worth will continue to increase at its heady pace. Thus, with high debt loads and a limited wealth effect, the probability is high that the savings rate will increase. Chart I-8Fiscal Policy: Still Contractionary ##br## Fiscal Policy Is Still A Drag Chart I-9Mining Capex##br## Still Falling Chart I-10Households Savings ##br##Rate Should Rise Put together, the Australian economy is unlikely to accelerate this year. As Chart I-12 illustrates, business confidence has been weakening throughout the year, new orders are at high levels but are rolling over, and real consumer spending has not been able to gain any traction - despite job growth reaching a 3.8% annual pace. Job growth is unlikely to accelerate from such high levels, limiting the potential for household income growth to undo the damage of a rising savings rate. Chart I-11House Price Gains Will Slow Chart I-12No Boost To Real GDP Growth Bottom Line: The Australian dollar has benefitted from a major nominal improvement in the economy. As terms of trade rebounded, so did nominal GDP, national income and profits. This caused a surge in inflows into the country. However, the best of the positive terms-of-trade shock is ebbing, and the slowdown in Chinese industrial activity also points to weakening national income growth. In terms of real activity, the Australian fiscal drag continues unabated, capex will not accelerate, and households are likely to increase their savings rate, which will weigh on consumption. While Australia is not on the verge of recession, it will not experience much of a boom either. But How Fast Can The RBA Hike Anyway? Chart I-13The RBA Is Limited By Economic Slack The RBA is also still facing a tough environment. On one hand, job creation was very robust in Australia last year, and core CPI has accelerated. However, wage growth remains depressed at 2%. Even more disturbing is the fact that Australian wages have decoupled from a reliable driver: exports to China (Chart I-13). This underscores the extremely large degree of slack present in the Australian labor market. As the middle panel of Chart I-13 displays, the underemployment rate remains near twenty five-year highs and is congruent with the current level of wage growth. Moreover, Australia's output gap is still -2% of GDP and is not expected to close until after 2020. Thus, the underemployment rate will continue to act as an anchor on policy (Chart I-13, bottom panel). The strength in the AUD since 2016 will play into these dynamics. The lack of traction on wages is likely to be compounded by the tightening in monetary conditions resulting from an expensive AUD. As such, we would expect core CPI to weaken again in the coming quarters, which will comfort the RBA that its dovish stance remains appropriate. Finally, the high indebtedness of Australian households along with the fact that house price appreciation has slowed also suggests that household balance sheets are not capable of withstanding much of an increase in interest rates right now. The RBA is unlikely to toy with such a deflationary risk while the output gap is still negative and labor utilization is so low. The market is currently pricing in 40 basis points of hikes in 2018. A hike in 2018 is possible, as the global economy has healed from its deflationary nadir of 2016, but the economic backdrop of Australia will not let the RBA test the waters more than once this year. We thus anticipate that the RBA will continue to lag the Bank of Canada and the Federal Reserve - two central banks we expect to raise rates three times in 2018. The RBA will also most likely lag behind the RBNZ. Bottom Line: The Australian economy is replete with excess capacity, which is limiting the ability of the RBA to push up its policy rate. Moreover, the elevated indebtedness of Australian households suggests the RBA is loath to generate a deflationary shock while the output gap is already negative. The RBA will therefore lag the Fed, the BoC and the RBNZ. Implications For The AUD AUD/USD is currently trading at a 15% premium to its purchasing power parity equilibrium versus the U.S. dollar, making it one of the rare currencies expensive against the still-pricey greenback (Chart I-14, top panel). Moreover, Australia's real effective exchange rate also trades above its long-term average (Chart I-14, bottom panel). While the AUD is not wildly expensive, its current premium to fair value does suggest it would not be immune to adverse cyclical dynamics. What do the cyclical drivers currently say about the AUD? As we have highlighted, Australian national income and profit growth are likely to decelerate sharply in 2018, which is likely to undo some of the improvement that has materialized in the basic balance and thus remove one of the key supports that has underpinned the AUD. In this optic, the fact that the AUD has been able to strengthen despite a significant deceleration in Australian exports of iron ore to China raises a yellow flag against the AUD's strength (Chart I-15). Chart I-14No Valuation Cushion In AUD Chart I-15AUD Disconnect However, when investors expect strong growth from EM economies, the AUD does well. Thus, if the outlook for EM growth remains healthy, current weaknesses in commodities shipments can be safely ignored. Under this framework, the recent sharp upgrade by global investors of long-term earnings growth of EM equities sheds light on the AUD's strength, despite slowing iron ore exports (Chart I-16). Yet, this growth expectation is now the highest on record. This suggests the expectation hurdles in EM are very elevated. Even if EM growth does not crater, any disappointment could leave the AUD in a vulnerable position. The rollover in the annual performance of EM/JPY carry trades point to a growing risk of such disappointments.3 Financial markets are also sending interesting signals. Australian equities are underperforming global indices in local currency terms, suggesting the growth outlook for Australia is weakening relative to the rest of the world. These developments are true even when financial stocks are removed from the equation. Moreover, AUD/USD has historically traded in line with the relative performance between Australian and U.S. equities. Not only is the AUD currently quite above the level implied by the relative stock performance, but also the underperformance of Aussie stocks is deepening. This is another poor omen for AUD/USD (Chart I-17). Chart I-16Investors Love EM, ##br##This Helps The Aussie Chart I-17Listen To Equities If stocks are sending a message regarding the path of the Australian economy vis-à-vis the U.S., and thus about the outlook for AUD/USD, so are various key drivers of policy. First, AUD/USD normally broadly tracks the gap in the five-year moving average of nominal GDP growth between Australia and the U.S. This growth differential is moving in the opposite direction of AUD/USD, and based on the IMF's forecast, it is only expected to widen. AUD/USD has also been responsive to the relative utilization of labor, as measured by the spreads between the U.S.'s U-6 unemployment rate and Australia's labor underemployment measure (Chart I-18). Currently, this spread is not ratifying the rally in AUD/USD - and is pointing toward a much more hawkish Fed than RBA. This too paints a somber picture for the Aussie. This picture is echoed by the trend in Australia's employment-to-population ratio for prime age workers relative to the U.S. Again, Australia's large labor market excess supply points to a weaker AUD (Chart I-19, top panel). What's more, Australia's employment-to-population ratio is set to fall further vis-à-vis the U.S. This relative labor utilization measure has tracked the share of investment as a percent of Chinese GDP. This is because the investment-heavy period of development that China has undergone over the past 30 years has been very commodities intensive, forcing full labor utilization in Australia. However, based on the IMF's forecast, the role of investment in the Chinese economy is set to decline further (Chart I-19, bottom panel). Chart I-18Labor Market Slack Points To Weak AUD Chart I-19Labor Market And China Additionally, Xi Jinping's reforms are about decreasing pollution and leverage while increasing the role of consumption and services in the economy. This points to a risk of an even greater fall in the share of capex in China's economy. This would deepen the decline in labor utilization in Australia relative to the U.S., and thus increase downside risk for the AUD. Another risk emanates from U.S. financial markets themselves. The AUD tends to perform well when volatility in financial markets is on the decline, or at very low levels. This describes the current state of financial markets. On the other hand, a higher VIX is associated with a declining AUD. The VIX's current low level is not enough to flash an imminent sell signal, but the risk of a spike in risk aversion increases significantly if the spot VIX is low and the VIX futures curve is "too flat." Since there is a strong inverse relationship between the VIX futures curve slope and the spot VIX, the curve is "too flat" when its steepness is below the degree implied by the line of best fit linking the slope to spot VIX. As Chart I-20 shows, when the slope of the VIX is below this implied fair value, the subsequent 12 months of returns in the AUD/USD have been negative 84% of the time. The current reading in this relationship suggests that the AUD could depreciate by a large amount over the coming year. Chart I-20Flat VIX Term Structure = Lower AUD In 12 Months Bottom Line: Australia's national income growth is set to decline, and the RBA is unlikely to increase rates more than is currently priced into the curve. Moreover, the Australian dollar is trading on the expensive side. These factors point to vulnerability for the AUD. Moreover, key variables are suggesting this vulnerability could materialize into actual weakness: investors are pricing in too much growth in the EM space, Australian equities point to growth underperformance, labor market utilization measures suggest relative policy will hurt the AUD, China's long-term policy tilt is becoming increasingly AUD-negative, and any spike in asset volatility would hurt the Aussie. Strategy Considerations The arguments highlighted above all point to a weakening AUD. However, the picture is never that clear-cut. In fact, there is one major risk to our view: commodities prices and the USD itself. As Chart I-21 illustrates, commodities prices have a stronger inverse relationship with the USD than they have a positive link to Chinese economic conditions. Thus, if the greenback were to weaken further, the AUD could delay its moment of reckoning even further. This suggests that playing AUD weakness on its crosses, while potentially less rewarding, is a safer strategy. Our long-term valuation models continue to highlight the positive risk/reward tradeoff to shorting AUD/NZD: Not only is the New Zealand economy less exposed to shifting away from investment in the Chinese economy, AUD/NZD is trading at valuation levels that are historically followed by periods of pronounced weakness (Chart I-22). Moreover, the Kiwi economy is displaying a much higher level of resource utilization than Australia, suggesting there is more scope for the RBNZ to increase rates than there is for the RBA. Chart I-21Risk To The View: The Weak USD Chart I-22Improve Your Reward To Risk: Short AUD/NZD The same can be said about AUD/CAD. AUD/CAD also trades at a significant premium to its fair value. As we argued two weeks ago, like New Zealand, labor and capacity utilization in Canada are both very tight, thus we foresee three BoC rate hikes this year, which is at least two more than we anticipate in Australia. Additionally, our commodity strategists continue to like energy more than they like metals. Thus, terms-of-trade dynamics will play in favor of the CAD. That being said, this trade is much more correlated with the movements in AUD/USD than the AUD/NZD bet is. Shorting AUD/JPY is also an attractive trade right now. AUD/JPY is trading at a 30% premium to purchasing power parity, and the risk represented by a potential removal of over-exuberance currently evident in the pricing of growth in EM markets would likely be amplified in this cross. Additionally, as we highlighted two weeks ago, the risk of a tactical rally in the JPY is growing significantly. Bottom Line: The outlook is negative for AUD/USD, but if the USD's bear market can gather force from current levels, this would dampen the attractiveness of shorting the Aussie. While potentially less profitable but also considerably less risky, shorting AUD/NZD and AUD/CAD remain attractive expressions of our negative AUD bias. We also like going short AUD/JPY as it plays both on our positive tactical view on the JPY and on the risks of a slowdown in EM earnings growth expectations. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Even if he somewhat retracted his comments later during the day. 2 Please see Foreign Exchange Strategy Special Report, titled "Riding The Wave: Momentum Strategies In Foreign Exchange Markets," dated December 8, 2017, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, titled "Canaries In The Coal Mine Alert: EM/JPY Carry Trades," dated December 1, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was mixed: The Chicago Fed National Activity Index underperformed expectations of 0.44, coming in at 0.27; The Richmond Fed Manufacturing Index came in at 14, well below the expected 19; Manufacturing PMI came in at 55.5, above the consensus of 55; Existing Home Sales contracted by 3.6% on a monthly pace; New Home Sales contracted by 9.3% on a monthly pace; Continuing jobless claims underperformed at 1.937 million, while initial jobless claims outperformed expectations at 233,000. The greenback has experienced notable downside this week owing to a slew of disappointing data and significant technical breakdowns. Treasury Secretary Steven Mnuchin's comments concerning a weaker dollar being beneficial for growth only added fuel to the fire. We have a neutral view on the greenback against the euro as emerging inflation in the U.S. later in the year should help alleviate some of the gains in the euro. Report Links: A Cold Snap Doesn't Make A Winter - January 5, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 European data this week was stellar: German Current Situations and Economic Sentiment ZEW Surveys came in at 95.2 and 20.14, outperforming the expected 89.8 and 17.8; Overall euro area Economic Sentiment ZEW Survey came in at 31.8, outperforming the expected 29.7; European consumer confidence also beat expectations of 0.6, coming in at 1.3; German IFO Business Climate and Current Assessment outperformed expectations, while the Expectations survey underperformed; German Gfk Consumer Confidence came in at 11, also surpassing expectations of 10.8. Mario Draghi affirmed his positive outlook on European growth and inflation. However, we believe that the most recent move to 1.25 is unsustainable as the euro continues to decouple from relative terminal rates. We believe that signs of weakening global growth should translate into a weaker euro in the short term. Report Links: The Unstoppable Euro - January 19, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 A Cold Snap Doesn't Make A Winter - January 5, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Even if they decelerated relative to the previous month, imports yearly growth surprised to the upside, coming in at 14.9%. Moreover, the Nikkei Manufacturing PMI also outperformed expectations, coming in at 54.4. The All Industry Activity Index month-on-month growth also outperformed, coming in at 1%. However, exports yearly growth, surprised to the downside, coming in at 9.3%. The Bank of Japan left the reference rate unchanged at -0.1%. In their Outlook for Economic Activity and Prices, the BoJ stated that it expects inflation to reach the 2% target by 2019. Moreover, the committee highlighted that the output gap will move further into positive territory in 2018 and 2019. Overall, we expect for the yen to appreciate in coming months, particularly against the Euro, given that financial conditions have tightened much more in Europe than in Japan. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Retail sales and retail sales ex-fuel yearly growth both underperformed expectations, coming in at 1.4% and 1.3% respectively. Both of these measures also declined relatively to last month. Moreover, the claimant count change surprised negatively, coming in at 8.6 thousand. However, average earnings excluding bonus yearly growth outperformed expectations, coming in at 2.4%. This number also increased from 2.3% last month. GBP/USD has surged by almost 4% this week, partly due to the fall in the dollar. However the pound has also rallied against the euro, with EUR/GBP falling by almost 2%. Overall, the ability for the BoE to raise rates relative to other central banks will be limited, as the strengthening currency should create a drag on inflation and the economy displays underlying weaknesses. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The Australian dollar has benefitted from last year's stellar growth period, now above the crucial 0.80 level. Slowing Chinese industrial activity and a domestic fiscal drag will handicap Australian growth this year. We believe the AUD is expensive amongst various metrics and the RBA is unlikely to hike any time soon given the negative output gap. Additionally, substantial labor market slack remains as the concentration of employment has been in part-time growth. We believe markets are overpricing hikes at 40 bps, and the AUD will suffer once this becomes priced in. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data In New Zealand has been mixed: The ANZ Activity Outlook was unchanged from last month, coming in at 15.6%. However, headline inflation surprised to the downside, coming in at 1.6%. It also declined significantly from last month's 1.9% value. Intraday, the kiwi fell by almost 1.5% following the weak inflation number. However even amid this drop NZD/USD has rallied by almost 1% this week, as the dollar has weakened to its lowest level in 3 years. Overall, we are positive on this cross relatively to the AUD, given that Australia is more sensitive to a slowdown in China than New Zealand. However, the New Zealand dollar will likely have downside against the yen. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Data out of Canada was mixed: Wholesale sales monthly growth missed expectations of 1%, coming in at 0.7%; Headline retail sales missed expectations of 0.7%, coming in only at 0.2% on a monthly basis; Core retail sales (ex. Autos) outperformed the expected 0.8% greatly, coming in at 1.6% month-on-month; We remain bullish on CAD as strong employment and higher wages will augur well for inflation this year. Higher oil prices will continue to power the Canadian economy and help close the output gap in line with expectations. The Bank will therefore continue to tighten policy. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 EUR/CHF has fallen this week by almost 0.5% even as the euro has rallied. Nevertheless, as long as the SNB continues with its ultra-dovish monetary stance, upside for the franc is limited, as the Swiss National Bank will continue to intervene in the currency markets. Indeed, on Monday SNB president Thomas Jordan once again reiterated that he believed that the franc was "Highly Valued". As of now, while inflation is slowly picking up, wage growth and house price growth are too anemic for the SNB to have a significant change in their monetary stance. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK has depreciated by 2.2% this week, as it has been struck by a double whammy of higher oil prices and a very weak dollar. Meanwhile, on Wednesday, the Norges Bank decided to keep its key interest rate unchanged at 0.25%. The bank decided that monetary policy should stay accommodative for the foreseeable future, as inflation is likely to stay under target. Furthermore they stated that inflation, the economy, and the currency were evolving according to their December 2017 expectations. Overall, we expect the krone to appreciate relative to the Canadian dollar, as the BoC is fully priced this year, while the Norwegian interest rates could still have some upside amid rising oil prices. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Data out of Sweden was mixed: Consumer confidence decreased to 107.2 from 107.7, under expectations of 107.4; The unemployment rate increased to 6% from 5.8%, but beat expectations of 6.1%; Producer prices increased in December at a 1.6% monthly pace, and a 2.3% yearly pace. The SEK has appreciated noticeably given the recent hawkish comments by Riksbank officials about the policy path. While the consensus does seem to be changing in the Bank, we remain cautious given Ingves' dovish leanings. SEK could weaken against EUR for the rest of the year given Europe's stellar growth momentum. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Xs And The Currency Market - November 24, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Dear Client, In addition to this abbreviated Weekly Report, I am sending you a Special Report co-authored by Mark McClellan, Managing Editor of the monthly Bank Credit Analyst, and Brian Piccioni of Technology Sector Strategy. Mark and Brian argue that the deflationary impact of robot automation will not prevent inflation from rising as the labor market tightens. I hope you will find their report interesting and informative. Best regards, Peter Berezin, Chief Global Strategist Global Investment Strategy Highlights Our cyclically overweight stance on global equities/underweight stance on bonds is working. Stick with it. U.S. Treasury Secretary Mnuchin's comments about the dollar are unlikely to have any lasting effects. EUR/USD has decoupled from terminal rate expectations since the start of this year. Tactical trade recommendation: Go short EUR/USD while simultaneously going long 30-year U.S. Treasurys/short 30-year German bunds. Feature Global Equities Enter A Blow-Off Phase Valuations do not matter on the way up, but they sure do matter on the way down. Once the market reaches that Wile E. Coyote moment - the one where the poor sap runs off the cliff, pauses in mid-air, looks down, and sees the ground below - all hell will break loose. On every valuation measure, U.S. stocks, and increasingly global stocks, have become very expensive (Chart 1). Chart 1AU.S. Stocks Are Expensive... Chart 1B...While Global Stocks Are Getting There That moment, however, is unlikely to arrive until the global economy and earnings growth begin to stall out. As we have argued in past reports, this probably will not happen until late next year. Historically, it has not paid to get defensive until six months before the start of a recession (Table 1). This suggests that stocks could continue to rally right through 2018. Beep beep. Table 1Too Soon To Get Out Granted, the timing of our recession call could turn out to be wrong, which is why we are watching a wide number of leading variables for signs that a slowdown is around the corner (Chart 2). In the U.S., these include credit spreads, the slope of the yield curve, financial conditions, business and consumer confidence, ISM new orders minus inventories, building permits, core capital goods orders, and initial unemployment claims. We have consolidated these variables and dozens of others into our MacroQuant model. The model is still pointing to a reasonably rosy cyclical outlook for stocks (Chart 3). Chart 2Leading Cyclical Data Still Strong Chart 3Cyclical Outlook For Stocks Is Still Rosy The Dollar Takes A Pounding While our cyclical bullish view on stocks and bearish view on bonds has paid off this year, our expectation that the dollar would recoup some of last year's losses has not worked out. Time will tell if December 2016 marked the beginning of a secular dollar bear market. The dollar tends to suffer when global growth accelerates. This happened last year. The dollar also tends to weaken when the composition of growth shifts away from the United States. That also happened in 2017. The remainder of this year could be different. We expect global growth to remain solidly above-trend in 2018, but ease from the torrid pace of 2017. This is already being foreshadowed by the decline in our Global LEI diffusion index to below 50%, a slowdown in Korean and Taiwanese exports, a deceleration in the Chinese Li Keqiang Index, and the loss of momentum in EM carry trades (Chart 4). Meanwhile, the composition of global growth should shift back in favor of the U.S. The fact that the U.S. Economic Surprise index has recovered in recent months relative to other economies suggests that this reversal of fortunes is already underway (Chart 5). The end result for asset markets could be slightly reminiscent of the late 1990s, a period when both equities and the dollar rallied. Chart 4Global Growth Will Remain Above-Trend ##br##But Ease From Blistering Pace Chart 5Composition Of Global Growth Will Shift ##br##Back In Favor Of The U.S. Talk Is Cheap Chart 6Trade-Weighted Dollar No Longer Pricey We do not put much weight on the remarks concerning the dollar made by Treasury Secretary Steven Mnuchin at Davos this week. While Mnuchin did say that "obviously a weaker dollar is good for us as it relates to trade and opportunities," he added that "longer term, the strength of the dollar is a reflection of the strength of the U.S. economy and the fact that it is and it continues to be the primary currency in terms of the reserve currency." More importantly, history suggests that verbal interventions in currency markets are only effective beyond the near term when backed by a supporting change in monetary policy. Many people remember the success that then-Treasury Secretary James Baker had in driving down the dollar following the Plaza Accord in 1985, but what is often forgotten is that the Federal Reserve steadily cut rates from 11.8% in July 1984 to 5.8% in October 1986. As a result, the 2-year interest rate differential fell by 454 bps against Japan, 630 bps against the U.K., and 407 bps against Germany over this period. It is also worth noting that the Fed's real broad trade-weighted dollar index is now 27% below its 1985 peak and 3% below its long-term average (Chart 6). This makes any effort to talk down the dollar all the more difficult. ECB Sending Mixed Messages About The Euro Chart 7Market Has Brought Forward ECB Rate Hikes ECB officials continue to send mixed messages about the resurgent euro. Earlier this month, ECB Vice President Vitor Constâncio and Bank of France Governor François Villeroy both expressed concern about the euro's strength, as did Ewald Nowotny, the fairly hawkish President of Austria's central bank. In contrast, Mario Draghi refused to wade into the debate during yesterday's press conference. The lack of angst in his tone sent the euro higher. Draghi's reluctance to say anything concrete about the euro was partly motivated by the desire to avoid the sort of "beggar thy neighbor" criticism that greeted Mnuchin's remarks. Like other central banks, the ECB gives a lot of weight to financial conditions in setting monetary policy. A stronger currency has tightened euro area financial conditions. This is something that must concern the ECB, at least behind closed doors. Ultimately, any effort by the ECB to knock down the euro will only work if it convinces the market to soften its expectations about the future pace of rate hikes. The likelihood of such an outcome is certainly higher now than it was in 2016. Our "months to hike" measure for the ECB has plummeted from over 60 months in mid-2016 to 19 today (Chart 7). Given that the ECB has made it clear that it intends to delay raising rates for some time after asset purchases end later this year, it is hard to see the central bank hiking rates before the summer of 2019. That is not far from where market pricing now stands. In contrast, if euro area growth were to surprise meaningfully on the downside or if core inflation in the peripheral economies continues to fall - it is already close to zero in Italy - the ECB could be forced to bide its time longer than the market currently expects. A Safer Way To Short EUR/USD Chart 8EUR/USD And Rate Decoupling ##br##Will Not Last Long Still, the euro has a lot going for it. Unlike the U.S., the euro area is running a current account surplus. This means the region does not need to attract foreign capital for there to be excess demand for euros. All it needs to do is keep net capital outflows roughly below 3% of GDP. The ability of the euro area to retain and attract fresh capital has become easier as political risk has ebbed and the ECB's pledge to do "whatever it takes" to preserve the euro has solidified. The euro's share of global central bank reserves currently stands at 20%, well below the 60% share enjoyed by the U.S. dollar. If capital continues to gravitate towards the region, the euro could strengthen further. All this makes shorting the euro a risky bet. With that in mind, investors should consider hedging short EUR/USD positions by wagering that the terminal rate spread between the euro area and the U.S. will narrow. Chart 8 shows that the spread in expected policy rates ten years out has decoupled from EUR/USD since the start of the year. The same is true for the 30-year spread between Treasurys and bunds - another good proxy for the terminal rate spread. While spreads have widened in favor of the dollar, the greenback has nonetheless plunged. Such decoupling rarely lasts long, which makes this a highly attractive trade. With that in mind, we are going short EUR/USD as a tactical trade while hedging the risk of a stronger euro by going long 30-year Treasurys/short 30-year bunds (a bet on further spread compression). Given that the first leg of the trade is more volatile than the second, we are scaling up the latter by a factor of 1.5. We will aim to close the trade for a gain of 5% (EUR/USD of about 1.18), assuming no change in the current spread of 160 bps. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Underweight United Airlines spooked the market this week when they announced their plans to grow capacity by 4-6% per year until 2020; the stock fell by 11% that day and took the S&P airlines index down with it. Capacity additions of this magnitude force competitors to choose between matching or ceding market share. Either choice bodes poorly for airfare pricing, probably unwisely considering how consumer spending on airfares has already fallen off a cliff (second panel). Meanwhile, input prices have shot upward and have diverged sharply from airlines’ ability to pass through fuel costs (third panel). This means a reversal of the downward trend in margins remains well beyond the horizon (bottom panel). Investors should avoid the turbulence; stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, AAL, UAL, ALK.