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

Highlights Beijing's continued focus on reducing excess industrial capacity in the lead-up to the 19th National Congress of the Communist Party will keep iron ore and steel markets buoyant for the balance of the year. The trajectory of prices further out the curve will, however, depend greatly on how quickly China's reflationary policies wane next year. Energy: Overweight. U.S. gasoline inventories could fall by 7-10mm barrels in the first week following the storm (data to be reported today by the EIA), and another 5-10mm barrels (or more) over the next month, depending on how long it takes to restart all of the refineries knocked offline by Hurricane Harvey, according to estimates in BCA Research's Energy Sector Strategy. Current gasoline inventories sit about 20 million barrels above the 2011-2015 average, which, based on our calculations, could be completely evaporated within a month, materially changing the U.S. gasoline market and related crack spreads.1 Base Metals: Neutral. Following our analysis last month, we are recommending a tactical short Dec/17 COMEX copper position at tonight's close, expecting the market to correct in line with the fundamentals we highlighted.2 Precious Metals: Neutral. We remain long gold as a strategic portfolio hedge. The metal will be supported by low real interest rates and safe-haven demand. The position was recommended May 4, 2017, and is up 8.7%. Ags/Softs: Underweight. Another bumper crop is being priced into corn this year. Expectations for higher corn yields this year - ranging from 166.9 bushels/acre (bpa) to 169.2 bpa vs. 169.5 bpa expected by the USDA - will keep prices under pressure. We remain bearish.3 Feature In reaction to Chinese economic and environmental policies, iron ore and steel each rallied by ~78% in 2016. While steel continued its ascent in 2017 - gaining a further ~20% in the year-to-date (ytd), iron ore broke away from this trend and plummeted by more than 40% between mid-February and mid-June (Chart of the Week). Chart of the WeekSteel And Iron Ore Diverged Earlier This Year Although iron ore has since reversed its path and regained most of the loss, the divergence between steel and the ore from which it is produced comes down to a difference in fundamentals. Increased supplies of iron ore at a time of healthy inventories were bearish in H1. On the other hand, closures of both steel capacity as well as coal capacity kept the steel market tight. While China's supply-side policies have been the force behind the strength in both to date, Chinese demand - which accounts for ~50% of global iron ore and steel consumption, and steel production - will take center stage next year. The speed at which China's reflationary policies wane will determine the long-term trajectory of steel and iron ore markets. Granted while there are some early signs of a potential slowdown in China's economy, we do not expect this to hit metals generally in the near term. As Beijing continues its focus on reducing excess capacity in the steel sector, and as policymakers prepare for the 19th National Congress later this year, we expect steel and iron ore to remain buoyant in H2. China's Steel Production Paradox Eliminating Excess Steel Capacity At The Forefront Of Reform Agenda... The National Development and Reform Commission (NDRC) - China's top economic planning authority - has made clear that reducing overcapacity is at the forefront of its reform priorities. More concretely, Beijing aims to cut steel capacity by up to 100-150mm MT over the five-year period between 2016 and 2020. It has already made progress towards that end - shuttering a reported 65mm MT last year - and is on track to meet its targeted 50mm MT of steel capacity cuts by the end of 2017. Additionally, in January the central government announced its intention to eliminate all steel capacity from intermediate frequency furnaces (IFF) by the end of June 2017. So it is no surprise that steel has been performing so well. However, this narrative is inconsistent with Chinese data. ...Yet Chinese Production Is At All-Time Highs Steel production from China this year has been soaring, growing by more than 5% year-on-year (yoy) in the first seven months of 2017. In fact, latest production data from July came in at 74mm MT, marking a more than 10% yoy increase, and an all-time record high for monthly production (Chart 2). And since ~50% of global steel is produced in China, this has translated into strong global steel production figures in 2017. Production grew by 4.75% yoy in the first seven months of 2017, the most since 2011 and almost five times as much as the five-year average yoy increase for that period. In fact, the China Iron and Steel Association recently announced that the strength in steel prices does not reflect underlying fundamentals and is instead due to speculation and a misunderstanding of the market impact of China's policies. In an effort to deter speculation, China's commodity exchanges implemented several restrictions in August, including increasing margins on futures contracts and limiting positions (Chart 3).4 Chart 2Record Steel Production##BR##Amid Chinese Capacity Cuts Chart 3Pure Speculation Or Not?##BR##Beijing Cracking Down On Market Speculation It Comes Down To The Nature Of IFFs This paradox of record high production at a time of capacity closures comes down to the nature of IFF capacity that was shutdown. While for the most part, old, outdated and unproductive facilities were targeted for closure last year, the shift in focus towards IFFs had a different effect on the market in 2017. IFFs use scrap steel, rather than iron ore, as a raw material, which is melted through an induction furnace to produce low-quality steel. Because this steel fails to meet government specifications for high-quality steel, it is considered "illegal" and, although it is used to satisfy steel demand, it is not included in official production data. Thus, efforts to shut-down these producers are not evident in China's production figures. However, IFF steelmaking capacity is estimated to be 80-120mm MT a year, and accounts for ~10% of steel production capacity in China. In terms of output, this substandard steel accounts for almost 4% of Chinese production. Thus, traditional steelmaking facilities have been required to fill the supply void caused by IFF closures, raising the official production figures. Steel Exports Take A U-Turn As "Illegal" Capacity Is Shuttered Moreover, Chinese exports have reversed their trend and are on the decline. Steel exports registered a ~30% yoy fall in the first seven months of this year (Chart 4). This is further evidence that the capacity closures have had a real impact on actual steel production, and that domestic consumers have turned to steel that is typically exported, in order to fulfill their demand for the metal. Furthermore, as authorities crack down on IFFs, demand for scrap steel - the main raw material in IFFs - has declined. Amid waning demand, scrap steel prices fell by 9% in H1 before regaining almost 6% in July. This follows a ~70% rally last year (Chart 5). Chart 4Exports Are Down As##BR##Capacity Is Shutdown Chart 5Scrap Steel Rally Takes A Break##BR##As Demand From IFFs Eliminated Coking Coal Cost Push As part of its environmental protection plans, China's policymakers announced plans to replace 800mm MT of outdated coal mining capacity with 500mm MT of "advanced" capacity by 2020. Last year, coal-mining capacity closures exceeded the 250mm MT target, reversing the slump in coal prices and leading an almost 225% rally in coke futures. Coking coal, or metallurgical coal, is a key ingredient in the steelmaking process. Although coke dipped since its December high, it has rallied by 34% in the past two months. Thus, Chinese steel mills are now producing in an environment of higher input costs, which will translate to higher prices for the finished good. China's Capacity Closures Likely Peaked Given that China has set June 30, 2017 as the target for eliminating induction furnace-based steelmaking, we do not expect IFF shutdowns to continue impacting the steel market. Additionally, while excess steel capacity is conventionally estimated to be 325-350mm MT in China, the Peterson Institute for International Economics (PIIE) argues that this estimate does not account for the need for a certain amount of excess capacity. Instead, they cite 130mm MT as a more reasonable figure of Chinese excess steel capacity. According to PIIE estimates, this means that by the end of the year, China will have eliminated almost all of its excess capacity, and will be very close to the quantity of capacity closures it aims to achieve by 2020. Consequently, we do not expect shutdowns to continue driving up steel prices. However, plans to halve blast-furnace production at Northern China mills to reduce pollution during the winter will weigh on near term Chinese production and the steel market. Bottom Line: Chinese authorities are closing in on their targeted capacity shutdowns. We do not expect this reduction in capacity to continue impacting steel markets in the long term. Near-term supply dynamics will be driven by efforts to reduce winter pollution. IFF Closures Spur Demand For Iron Ore Chart 6Mid-Year China Inventories At Record High With the elimination of IFFs, which take in scrap steel as the main input, we expect greater demand for iron ore from traditional steel mills as they work toward filling the supply gap left by the loss of the so-called illegal steel. While steel prices have been on a consistent uptrend since 2016, iron ore - which usually moves in tandem with steel - diverged from its main demand market earlier this year, before resuming its rally in Q2. The deviation earlier this year was due to increased supplies from Australia and Brazil amid record levels of Chinese inventories (Chart 6). This has reversed, and iron ore has resumed its climb. Stronger demand for iron ore is consistent with import data, which shows that China has been hungry for Australian and Brazilian iron ore. However, since the average iron ore production cost in China - estimated at more than 60 USD/MT, or roughly three (3) times the cost of iron-ore production in Brazil and Australia - is greater than in other regions, many Chinese mines go offline during periods of low prices. By the same token, elevated prices tempt high-cost Chinese producers back online, increasing global supply. Bottom Line: Since the closure of induction furnaces has shored up demand for iron ore, pulling prices up with it, we do not anticipate further drops in prices. However, if prices remain elevated, increased production from China amid well stocked global markets will keep a tight lid on iron ore prices. Chinese Appetite Will Determine Long-Run Market Performance While steel and iron ore are currently well supported, their near term strength is in large part due to China's reflation policies which have revived demand. Given that it is a sensitive political year, we do not foresee downturns in the Chinese economy this year. Authorities will want to go into the 19th National Congress of the Communist Party in mid-October with solid economic data as a backdrop. However, waning Chinese growth would be a long-run negative for the markets (Chart 7). Specifically, official government data indicate: 1. There are early warning signs that the property market in China may be losing momentum. New floor space started, and new floor space completed contracted in July, while growth in floor space under construction and floor space sold have been easing. Furthermore, while total real estate investment has been growing at an average monthly rate of almost 9% yoy since the beginning of the year, July figures show a marked slowdown, at less than 5% yoy growth. We would not be surprised to see the property market winding down as China begins to tighten its real estate policies. 2. Chinese automobile production has slowed significantly from all-time highs recorded at the end of last year. The monthly average 4% yoy growth in the five months to July is a significant deceleration from the 10% yoy average witnessed during the same period last year. 3. However, infrastructure investment has been strong, recording its all-time high in June, and a 20% yoy increase in July. With the National Congress scheduled in October, we do not expect a slowdown in infrastructure spending this year. In addition, August manufacturing PMI data in China came in above expectations, and registered a slight increase from the previous month (Chart 8). The index has remained relatively stable since the beginning of the year, after gaining strength last year. Chart 7Despite Signs Of Fizzling,##BR##Slowdown Not Expected In 2017 Chart 8Accomodative Policies Will##BR##Keep Near Term Demand Solid Bottom Line: Although we expect China's appetite for steel will begin to wane as the economy unravels from its reflationary policies, steel demand will remain strong in 2017. Chinese authorities will want to ensure solid growth in the run-up to the National Congress scheduled for mid-October. Thus, the near-term focus will remain on supply, and the impact of its reforms on ferrous metals. Post-Harvey Rebuilding Will Spur Steel Demand Hurricane Harvey is expected to impact steel markets in three main ways: 30-35% of all U.S. steel imports come through Port Houston. However, the port resumed operations as of September 1 and there is no longer a threat posed on steel imports. The disruption in freight service resulting from Harvey is expected to temporarily push up trucking rates in the next few weeks. This will give U.S. steel firms, which have long been suffering from cheaper Chinese imports, an advantage and opportunity to fill the demand void which will be bullish for U.S. steel. Harvey will have a longer-run positive impact on steel markets through the demand that will be generated from the infrastructure rebuilding process. Still, increased demand for steel will be partially mitigated by a rise in scrap steel supply, in the aftermath of destruction. While it is still too early to measure the extent of damage and the impact of the rebuilding process on steel markets, estimates from the storm's damage run as high as USD 120 billion. Texas's governor estimated the damage to be much greater - between USD 150-180 billion. This compares to USD 110 billion from Hurricane Katrina, the most devastating storm to hit the U.S. prior to Harvey. Bottom Line: While it is still too early to determine the full extent of destruction, the infrastructure rebuilding phase will spur demand for steel. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Please see BCA Research's Energy Sector Strategy Weekly Report "Upgrading Refining Sector As Harvey Clears Out Inventories," published September 6, 2017 It is available at nrg.bcaresearch.com. 2 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Copper's Getting Out Ahead Of Fundamentals, Correction Likely," published August 24, 2017. It is available at ces.bcaresearch.com. 3 Please see "GRAINS - Corn lower as U.S. yield forecasts rise; soy, wheat climb," published by reuters.com on September 1, 2017. 4 Please see "Shanghai exchange urges steel investors to act rationally, hikes fees" published by reuters.com on August 11, 2017. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016

Underweight For most of this decade, U.S. airline pricing power and the price of jet fuel have moved in lockstep (second panel) i.e.: airlines have been able to pass through their primary input cost. However, this relationship has broken down since the end of 2016 as the industry has been locked in a price war between low cost carriers and the largely-restructured legacy airlines. The result has been a coincident fall in operating margins (bottom panel). The disruption to U.S. refining capacity and distribution of refined products from Hurricane Harvey seems likely to keep the price of jet fuel elevated and exacerbate the decline in near-term operating margins. Until recently, investors have shrugged off tumbling margins with expanding valuation multiples (bottom panel), though that appears to have turned early this summer; the S&P500 airlines index has been in freefall since. With higher costs a certainty in Q3, no relief from aggressive pricing and the longevity of higher jet fuel prices an unknown, it still doesn't pay to be long airlines. Stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5AIRL: LUV, ALK, AAL, UAL, DAL.

Highlights Even isolated North Korean attacks are unlikely to lead to a full-scale war; The USD sell-off will start to reverse once Trump makes Gary Cohn his official pick for Fed chairman; Europe is not a risk for investors ... even Italy is only a longer-term risk; France is reforming; stay long French industrials versus German. Feature Last week, in London, we were scheduled to give a talk on Sino-American tensions, East Asian geopolitical risks, and North Korea specifically. We submitted our topic of choice about a month ahead of the event, when tensions between Pyongyang and Washington were at their height. As tensions temporarily subsided following Supreme Leader Kim Jong-Un's decision to delay the planned missile launch towards Guam, several colleagues wondered if the topic was still a pertinent one. We stressed in our research that tensions would not dissipate and would continue to be market-relevant, if not critical for S&P 500.1 Unfortunately, we have been proven right. Forecasting geopolitics requires insight, multi-disciplinary methodology, and a treasure trove of empirical knowledge. But sometimes it also just comes down to using Google and looking at a calendar. For example, given the present context of heightened tensions, the annual U.S.-South Korean military exercises - Key Resolve, which occurs normally in the spring, and Ulchi-Freedom Guardian, which occurs in August - are obvious dates to monitor. They are provocations that North Korea has to respond to for both foreign and domestic audiences. Pyongyang has chosen to do so by firing an ICBM across Japan and testing a sixth nuclear device, allegedly a miniaturized hydrogen bomb. While both these actions qualitatively expand on previous acts (missile and nuclear tests), neither cross a threshold. We are still in the realm of "territorial threat display." President Trump and Supreme Leader Kim are angling their "swords," but have not dared to cross them yet. Nonetheless, our clients have pointed out that our "arch of diplomacy" approach leaves a lot to imagination. Therefore, the first insight from the road of this week is that we need to put our thinking cap on and imagine a scenario where tensions do blow over into open conflict. How do we imagine such a scenario occurring and why would it not devolve into full out war that forces the U.S. to attack the North Korean mainland? Is North Korea About To Become A Praying Mantis? We can imagine a scenario where North Korea commits an act that takes us beyond the nuanced thresholds set by recent history (Chart 1). For example, we have cited to clients that an attack against international shipping in the Yellow Sea or Sea of Japan by North Korean submarines would be an unprecedented act that the U.S. and Japan would likely retaliate against.2 We could see the U.S. following the script from 1988 Operation Praying Mantis in the Persian Gulf - the largest surface engagement by the U.S. Navy since the Second World War - when the U.S. sunk half of Iran's navy in retaliation for the mining of the guided missile frigate USS Samuel B. Roberts. In the case of North Korea, this would primarily mean taking out its approximately 20 Romeo-class submarines and an unknown number of domestically-produced - Yugoslav-designed - newly built submarines.3 Chart 1North Korean Provocations Rarely Affect Markets For Long Such an increase in tensions is not our baseline case, but we assign much higher probability to it than to an all-out war on the Korean Peninsula (which we still see as highly unlikely). How would the markets react to the sinking of North Korean submarines? How would Pyongyang react? The answer to the former (market's reaction) depends on the answer to the latter (what does Pyongyang do?). Our best guess is that Pyongyang would do nothing. In fact, we may never know that North Korean submarines were sunk. We would suspect that North Korean military strategists would chalk the subs as a loss and quietly move on to more missile tests. Leadership in Pyongyang is massively constrained by its quantifiable military inferiority. This part requires a bit of "order-of-battle" analysis, so bear with us for a few paragraphs. North Korea has around 6 million military personnel, about 25% of the total North Korean population, ready to fight. Which would be great if it were preparing to charge Verdun in WWI. Unfortunately for Pyongyang, it is arrayed against one of the most sophisticated defenses ever constructed by man. To burst through the Demilitarized Zone (DMZ), its mammoth ground forces would have at their disposal about 2000 T-55s (designed in the 1950s) and an unknown number of T-72s (designed in the 1970s). The former are obsolete, but the latter are solid main battle tanks that could do damage ... that is, in a world where war was not airborne. The problem is that North Korea would lose air superiority within hours of any serious engagement leaving its tanks and ground troops vulnerable to death-from-above. Since North Korean troops would have to enter about 20 miles into South Korea to threaten Seoul with occupation, they would have to exit the range of most of their air defenses. Choosing to turn on the most powerful of their systems - such as the KN-06 with a 150km range - would leave them vulnerable to the U.S. AGM-88 HARM missiles that sniff out active radar antenna or transmitters. To protect its invading forces, North Korea would have at its disposal only about 20-30 Mig-29s. Countering two dozen jets would be South Korea's combined 177 F-15 and F-16s, plus American forces that would vary in size depending how many aircraft carriers were deployed in the vicinity and whether U.S. forces in Japan were deployed to counter the attack. Given that a single American aircraft carrier holds up to 48 fighter jets, North Koreans would likely quickly find themselves fighting a losing battle. Once the North Korean fighter jets were destroyed, the South Korean air force would turn the invasion into a massacre. The reality is that North Korea's ground forces are just for show. Its tanks and fighter jets will never see battle. North Korea really only has two gears: P & N. The first is for "Provocation" and the second is for "Nuclear Armageddon." This is why we highly doubt that we will see our Praying Mantis scenario play out, or lead to full-scale war if it does. North Korea is constrained by its technological inferiority. It does not have the ability to conduct war across a full spectrum of engagement. Neither did Iran in 1988, which is why it never retaliated for the loss of its navy, put all its revolutionary zeal and chest-thumping aside, and sued the U.S. at the International Court of Justice instead.4 The U.S. has a range of limited military engagements, particularly at sea, that could hurt Pyongyang's ability to project what little power it has. Given our constraint-based methodology, which requires one to have some understanding of military affairs, we have a fairly high conviction view that North Korea will continue to toe-the-line of the expected and thus accepted provocations along the lines of the history surveyed in Chart 1. Going beyond that list would threaten to expose the paucity of North Korea's military capabilities. Bottom Line: We are still in for a wild ride with North Korea. As we expected, regional safe haven assets continue to perform well. We will hold on to our safe haven basket of Swiss bonds and gold, up 2.6% since August 16. Nonetheless, we expect North Korea to steer clear of provoking a war. Gary Cohn Will Collapse The USD! (But What If He Already Did?) Several fast-money clients - both in the U.S. and Asia - have a theory for why the greenback continues to suffer: Gary Cohn. The theory goes that Cohn is an ultra-dove whose job as the next Fed Chair will be to stay "behind the curve" and drive down the USD. This would accomplish President Trump's lofty nominal GDP growth goals despite legislative hurdles to his fiscal policy. It would also keep risk assets well bid and help begin rebalancing the U.S. trade deficit. What do we know of Mr. Cohn's views on monetary policy? Not much: He defended the Trump administration goal of a 3% GDP growth target, suggesting that he has a far more optimistic view of U.S. growth than the current Fed projection;5 He believes that monetary policy is "globalized," intoning at a conference in Florida quickly after the election that the Fed policy of raising rates before the rest of the world is ready to do the same would be a mistake;6 In a January 2016 Bloomberg TV interview, he said that both the U.S. and Chinese currencies were overvalued and would both have to devalue.7 People who know and have worked with Gary Cohn (including one colleague at BCA!) speak highly of his pragmatism, work ethic, and focus. Most agree that he would likely be dove-ish, but there is not a single person we have spoken to who thinks that he will be Trump's puppet. As such, his disconnected statements largely say nothing about his potential style of leadership. His most ultra-dovish, USD-slaying comment comes from January 2016, with DXY 6.9% down since then (Chart 2). Mission Accomplished Mr. Cohn? The real reason for the USD slide, aside from a persistently disappointing inflation print, has been a realization by the market that President Trump's bark has no bite. On a slew of measures, President Trump's initial bravado has dissipated into flabby rhetoric. Chart 3 shows the initial surge in optimism regarding growth, tax reform, infrastructure spending, Mexico's comeuppance, and bi-partisanship (measured as support among independents). Each data point has not only fallen back to pre-election levels, but appears to have now been desensitized to any news that would have excited it in the past. For example, NAFTA negotiations are off to a poor start, President Trump continues to bash the trade deal, and yet the peso has rallied since Trump's inauguration! Chart 2Mission Accomplished, Mr. Cohn? Chart 3Trump's Bark Has No Bite? The Fed itself has lost faith in the president. The number of FOMC members who see upside risks to inflation and GDP growth, not unrelated to fiscal policy, has fallen after a brief surge after the election (Chart 4). Chart 4The Fed Also Doubts Trump What chances are there for the White House and Congress to re-write the fiscal narrative over the final quarter of 2017? As we wrote last week, Hurricane Harvey will ensure that a debt ceiling breach and government shutdown are avoided. However, Congress is likely to spend September making one last attempt at Obamacare repeal and replace, thus largely wasting the month before returning to tax reform in earnest in the new fiscal year. We expect some form of tax legislation to take shape by the end of December. Will it be comprehensive tax reform? Unlikely. It will now almost certainly be merely a tax-cutting exercise, with some revenue offsets attached to it. With the Republicans in Congress now leading the tax reform effort, it is unlikely that the budget deficit hole will be as wide as President Trump would have wanted. The problem is that both Trump's July tax reform proposal and the House GOP August plan come short of revenue-neutrality by around $3-3.5 trillion (over the decade-long period) (Table 1). Given that such a massive increase in the deficit would be unacceptable to fiscal hawks (or Democrats) in the House, we would expect tax rates to be cut by a much more modest degree. Table 1By How Much Will Republican Tax Cuts Widen The Deficit? Table 1 gives a detailed survey of the preferences (Tax Cuts) and constraints (Revenue Offsets). It is difficult to see how all the constraints are overcome through the legislative process. This will force Republicans to modify their preferences on the scale of tax cuts. We would expect that a corporate tax cut from 35% to around 27-28% could be possible, along with a minimal middle-class tax cut. Anything beyond that would be overly complicated. Therein lies the paradox for Chair Cohn. The only way that he can be "behind the curve" is if the curve gets "in front of him." But why would it if any coming tax legislation has very little stimulative effect on the economy? Currently, the expected change in the Fed Funds Rate over the next two years stands at a measly 40 bps (Chart 5). That is just barely two rate hikes until September 2019. How can Mr. Cohn get the expectations any lower at this point? Bottom Line: The appointment of Gary Cohn will be a classic "sell the (USD on the) rumor, buy (the USD) on the news." We expect his appointment in late November or early December, if President Trump goes by the lead time from the past two nominations (Chart 6). That may be the time to pare back USD shorts for those investors who have been bearish on the greenback. Chart 5Hard To Drive Expectations##BR##Lower For Rate Hikes Chart 6How Long Does It Take To##BR##Confirm The Fed Chair? Europe Is Not A Risk Chart 7Europe's Economy Zooming Along One clear insight from our five weeks on the road this summer is that Europe is no longer on anyone's radar. We had hardly any questions regarding the upcoming German or Italian elections. And while most investors were somewhat pessimistic regarding French structural reforms, none expressed any interest in betting against them either. The obvious reason is that Europe's economy has genuinely recovered (Chart 7). Consumer and business confidence are holding up while the manufacturing PMI and industrial production remain strong. That said, uniformity of view among clients across several geographies makes us nervous. On the future of the Euro Area, investors have swung wildly from morose to resigned that it is here to stay. Nonetheless, we generally agree with the consensus. Unlike at the beginning of this year, when we boldly claimed that European risks would turn out to be a "trophy red herring," we have no alpha to generate by disagreeing with the market.8 Here is why: German Election: We have a policy of not wasting our client's time by covering major geopolitical events that have no market-relevance. Germany is the world's fourth-largest economy and it will hold an election on September 24. However, we see no investment relevance in the election and therefore no reason to spend time covering it. Polls show that the center-left opposition Social Democratic Party (SPD) has arrested its decline and may force another Grand Coalition (Chart 8). The only moderately interesting question is whether Chancellor Angela Merkel's Christian Democratic Union (CDU) will be able to get its favored coalition ally, the Free Democratic Party (FDP), into government instead. The FDP has turned towards soft Euroskepticism since 2009. Its parliamentarians voted against several bills dealing with the Euro Area crisis during their 2009-2013 coalition with the CDU. That said, Chancellor Merkel has turned much more forcefully pro-Europe since the dark days of Greek bailouts and bond market rioting. The Chancellor can read the polls: Germans support the common currency at 81%, compared to 66% average between 2009-2013 (Chart 9). We expect the FDP to play along with the Europhile conversion by the CDU. Chart 8Another Grand Coalition? Chart 9Merkel Knows Germans Support The Euro If there is any significance to the calm ahead of the German election, it is that the country is at "peak normal." Its policymakers have dealt with a massive migration crisis, geopolitical crises to the East, terrorist attacks, and severe political and economic stresses in its sphere of influence, all with a near-complete absence of internal drama. This looks like either "as good as it gets," or the start of a new Golden Age in Europe, with Berlin in the lead. It is probably neither, but given European asset prices, and gearing to the growing global economy, we would remain overweight Euro Area equities going forward. Italian Election: Polls remain too-close-to-call in the upcoming Italian election, with Euroskeptic parties continuing to poll well (Chart 10). However, we are not sure one can truly call these parties Euroskeptic anymore. Despite a high level of Euroskeptic sentiment in the country (Chart 11), its Euroskeptic parties have been scared off by the failures of peers in Austria, the Netherlands, and France. Chart 10Italy: Euroskeptic Parties Poll Well... Chart 11...Reflecting Broader Euroskepticism Luigi Di Maio, leader of the anti-establishment Five Star Movement (M5S) in the Italian Chamber of Deputies, and Matteo Salvini, head of the right-wing, populist Lega Nord, both reversed positions on the euro this month. Di Maio will be 5SM candidate for prime minister in the upcoming elections - which must be held by May and will likely take place in February or March. He reiterated a position, which 5SM hinted at in the past, that leaving the Euro Area would only be the "last resort" if Brussels refused to relax strict budget rules. Meanwhile, the firebrand, populist, Salvini hid behind Italy's constitution, claiming that a referendum on the euro would be illegal. In the short term, this means that the election in 2018 is no longer a risk. In the long term, it does not change the fact that Italy is ripe for a bout of Euroskeptic crisis at some later stage. Migration Crisis: Bad news for right-wing populists everywhere: the migration crisis is over and in quite a dramatic fashion. This is an empirical fact (Chart 12). Europe's enforcement efforts and collaboration with Libyan authorities (such as they are) have now forced even the humanitarian agencies to abandon the Mediterranean route. One of the largest such agencies - the Migrant Offshore Aid Station (MOAS) - recently announced that it was packing its mothership, the Phoenix, for Myanmar. The group is the fourth to stop patrols for migrants. Medecins sans Frontieres, Save the Children, and Germany's Sea Eye all cited hostile actions taken by Libyan authorities towards their vessels as the main reason to stop rescuing migrants in Libyan waters. Chart 12The 'Migration Crisis' Is Definitively Over To be clear, what is happening in the Mediterranean is a result of European enforcement efforts, not any sudden awakening of Libyan capacity or sovereignty. The European Union and Italy are training and funding the Libyan Coast Guard, which has started to intercept humanitarian vessels, threaten them with force (often right in front of the Italian Navy!), and force them to return migrants to Libya, where they are subjected to extremely cruel internment. Prior to this development, human smugglers would launch barely seaworthy "crafts" towards humanitarian ships waiting literally yards away in Libyan waters to "rescue" the "migrants" to Europe. As such, humanitarian agencies were aiding and abetting human smuggling, by making it a lucrative enterprise with no downside risk for the smugglers. We expect the step-up in enforcement in Libyan waters to severely impair the cost-benefit calculus of attempting a Mediterranean crossing for a would-be migrant. Instead of a welcoming NGO vessel many will find themselves in Libyan Internment camps. Word will spread fast and the migration crisis will abate further. We have now come full circle on the migration crisis, which we predicted back in September 2015 would end precisely in such an illiberal fashion.9 Europe has a vicious streak ... who knew? Structural Reforms In France: In February, we penned a bullish report on France, arguing with high conviction that Marine Le Pen would lose and that structural reforms would follow.10 What is the status of the latter forecast? Despite a decline in President Emmanuel Macron's popularity (Chart 13), he is expending his political capital early in his term. He understands our "J-curve of Structural Reform" (Diagram 1). Policymakers who understand how the reform J-curve works know that they have to spend their political capital while they have it, at the beginning of their term, in order to reap the benefits, if there are any, while they are still in power. Chart 13Macron's Popularity Slips Diagram 1The J-Curve Of Structural Reform How do Macron's reforms compare with previous efforts? Generally speaking, Macron's reforms (Table 2) compare favorably with both the 2012 Mariano Rajoy reforms in Spain and the 2003 Hartz reforms in Germany. The Hartz reforms were instrumental in expanding temporary work contracts and restructured generous unemployment benefits. Similarly, the Rajoy reforms in Spain clarified economic grounds for dismissal and created more flexible "entrepreneur contracts." Macron's reforms fit these efforts, especially the proposals to put in place "project contracts" - an open-ended contract lasting for the duration of a project - and to establish a floor and a ceiling for allowances in cases of unfair terminations, and make termination for economic reasons easier. Table 2French Labor Reforms: The Key Bits The two criticisms of the reform efforts we most often hear are that France has not had a crisis to spur reforms and that unions will launch vicious protests. The first criticism is dubious, given that France is itself emerging from the low-growth doldrums of the post-Great Financial Crisis. It is simply false to say that France has had no crisis. The French public is acutely aware that its real per-capita GDP growth has been closer to Greek levels than German ones over the last two decades (Chart 14) and that it has lost competitiveness in the global marketplace (Chart 15). One cannot have a conversation with a French friend, colleague, or client without wanting to order a strong drink!11 Chart 14France's Lost Millennium Chart 15France's Lost Competitiveness Besides, what monumental crisis was it that propelled Germany into reforms in the early 2000s? A vicious recession? A massive bank crisis? It was neither. Germany was simply weighed down for a decade by fiscal transfers to East Germany and sensing that its export-oriented industry was facing a massive challenge from the Asian move up the value chain. It was this acute sense of competitive pressure, of falling behind, that spurred Germany to reform. With France, the acute sense of falling behind Germany (Chart 16) is at the heart of today's effort. Chart 16German Competition Puts A Fire Under France The second criticism, that the unions will hold protests, misjudges the political capital arrayed behind Macron. Despite his sagging popularity, 85.9% of the seats in the National Assembly are of pro-reform orientation (Diagram 2). The second-largest party in the parliament is Les Republicains, an even more zealously pro-reform group. This is a unique situation in French history and will allow the government to ignore protests on the street. Diagram 2The Balance Of Power In France's National Assembly In fact, two of the largest unions in France - Force Ouvrière and CFDT - have both said they would not protest the labor reforms. This leaves only the more militant CGT to protest, along with the left-wing presidential candidate Jean-Luc Mélenchon. The reason investors will still fret about protests this month is because CGT retains a strong representation in heavy industry and infrastructure sectors like energy and railways. As such, their industrial action could grind the country to a halt. We suspect that a repeat of the 1995 general strike or the 2010 French pension reform unrest - both of which CGT spearheaded - will be the final nail in the coffin of "Old France." Unlike those previous reform efforts, President Macron's effort has been clearly signaled ahead of the election and thus retains considerable democratic legitimacy. As such, any repeat of the 1995 or especially 2010 unrest would delegitimize the unions and give President Macron even more political capital. Bottom Line: We agree with the now conventional view that all is well in Europe. Stability ahead of the German election reminds investors of what a healthy country is supposed to look like. Italian election risks have dissipated. And our French structural reforms call remains on track. This gives us an opportunity to do some house-cleaning regarding our calls. First, we are closing our long French 10-year bond / short Italian 10-year bond trade for a gain of only 1 bps. Second, we are closing our overweight Euro Area equities relative to U.S. equities call for a gain of 7.88%. Given our euro-bullishness, we never recommended that this call be currency hedged. We are now reinstating it with a currency hedge. We are also closing our long German 10-Year CPI Swap for a gain of 45.5 bps. We will stick with our long French industrial equities / short German industrials, which is currently up 9.25%. This is a way we have chosen to articulate our bullish view on the reforms, although clients with greater sophistication in European sectors could come up with a more direct way to articulate the view. Separately, we are also booking profits on our long China volatility trade (CBOE China ETF Volatility Index) for a gain of 16.82%. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?" dated August 16, 2017, available at gps.bcaresearch.com. 2 A North Korean submarine sank the South Korean corvette Cheonan in 2010, but that was still within the norm of behavior for the two countries that are still effectively at war and have contested maritime borders. 3 Romeo-class submarines are nearly 70 years old. As much as we harken back to Yugoslav engineering with pride at BCA's Geopolitical Strategy, Belgrade was never much of a naval power. Nonetheless, diesel-powered submarines are quite proficient in staying undetected and could present a problem for the U.S. Navy. At least until they had to resurface or get back to base, where nuclear-powered U.S. Virginia-class attack-subs would lie in wait for them. 4 Tehran won the court case in 2003! And the ICJ forced the U.S. to compensate Iran for its lost ships or else face invasion by the United Nations army. (We are just kidding obviously. Iran did win, but it got nothing.) Please see Pieter H.F. Bekker, "The World Court Finds that U.S. Attacks on Iranian Oil Platforms in 1987-1988 Were Not Justifiable as Self-Defense, but the United States Did Not Violate the Applicable Treaty with Iran," American Society of International Law Volume 8, Issue 25, dated November 11, 2003, available at: asil.org. 5 Please see CNBC, "Tax reform is coming in September, Trump economic advisor Gary Cohn says," dated June 29, 2017, available at cnbc.com. 6 Please see Wall Street Journal, "How Donald Trump's New Top Economic Adviser Views the World," dated December 14, 2016, available at wjs.com. 7 Please see Business Insider, "Trump and his top economic adviser have had completely different views on China," dated January 3, 2017, available at businessinsider.com. 8 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Special Report, "The Great Migration - Europe, Refugees, And Investment Implications," dated September 23, 2015, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy and Foreign Exchange Strategy Special Report, "The French Revolution," dated February 3, 2017, available at gps.bcaresearch.com. 11 Thankfully for France, the choice would still be French wine!

Highlights Chart 1"Trump Trade" Progress Report One of our seven investment themes for 2017, published in a Special Report last December, is that the combination of strong U.S. growth and accommodative Fed policy creates a cyclical sweet spot in which risk assets will outperform. After last week's GDP revisions we now know that real growth averaged 2.1% in the first half of the year, solidly above the Fed's 1.8% estimate of trend. Meanwhile, weak inflation has caused markets to discount an exceptionally shallow path for Fed rate hikes - only 19 bps of rate hikes are priced for the next 12 months. This divergence between growth and inflation is reflected in Treasury yields. The real 10-year yield is 24 bps above its pre-election level, while the compensation for inflation protection is only 5 bps higher (Chart 1). Not surprisingly, the cyclical sweet spot has led corporate bonds to outperform duration-matched Treasuries by 296 bps since the election. The persistence of the cyclical sweet spot leads us to believe that last month's politically-driven spread widening should be seen as an opportunity to increase exposure to corporate bonds. Remain at below-benchmark duration and overweight spread product in U.S. fixed income portfolios. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 62 basis points in August, dragging year-to-date excess returns down to 146 bps. The average index option-adjusted spread widened 8 bps on the month to reach 110 bps. In last week's report,1 we demonstrated that to properly assess corporate bond valuations it is not sufficient to simply look at the average index spread. We need to adjust for the fact that both the average credit rating and duration of the index change over time. We also need to consider corporate spreads relative to other similar stages of the economic cycle, not relative to long-run averages. In this respect, considering the breakeven spread2 for each credit tier relative to where it traded in the early stages of prior Fed tightening cycles gives us the best sense of the value proposition in corporate bonds. At present, this analysis shows that while Aaa corporate spreads are expensive, the other investment grade credit tiers all appear fairly valued (Chart 2). Corporate profit data for the second quarter was released last week and showed a big jump in our measure of EBITD (panel 4). This makes it extremely likely that net corporate leverage declined in Q2. All else equal, this lengthens the window for corporate bond outperformance Table 3.3 Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 67 basis points in August, dragging year-to-date excess returns down to 378 bps. The index option adjusted spread widened 26 bps to end the month at 378 bps, 55 bps above the mid-2014 cycle low. Back in March4 we tested a strategy of buying the High-Yield index relative to Treasuries whenever spreads widened by more than 20 bps in a single month, and then holding the trade for a period of one, two or three months. We found that this "buy the dips" strategy works very well when inflationary pressures are low, but performs poorly when inflation is high and rising. When inflation is low the Fed needs to support the recovery by adopting a more dovish posture whenever financial conditions tighten. With the St. Louis Fed Price Pressures Measure5 at only 6% (Chart 3), we expect a "buy the dips" strategy will continue to work for some time. In terms of valuation, our estimated default-adjusted spread stands at 245 bps. Historically, this level is consistent with excess returns of just under 3% versus duration-matched Treasuries over the subsequent 12 months. Our estimated default-adjusted spread is based on an expected default rate of 2.6%, and an expected recovery rate of 49%. MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 12 basis points in August, dragging year-to-date excess returns down to -9 bps. The conventional 30-year MBS yield fell 13 bps in August, driven by an 18 bps decline in the rate component. This was partially offset by a 4 bps increase in the compensation for prepayment risk (option cost) and a 1 bp widening of the option-adjusted spread (OAS). The Fed is likely to announce the run-off of its balance sheet when it meets later this month. For its part, the market has been pricing-in this eventuality for most of the year, leading to a significant widening in MBS OAS. More recently, the option cost component of MBS spreads has joined in, widening alongside falling mortgage rates and expectations of rising prepayments (Chart 4). In this sense, the Fed's commitment to proceed with balance sheet normalization no matter the outlook for the future pace of rate hikes is doubly negative for MBS spreads. OAS are biased wider as Fed buying exits the market, while low rates encourage faster prepayments and a higher option cost component of spreads. Going forward, the option cost component of spreads will decline as mortgage rates cease their downtrend, but OAS still appear too tight relative to trends in net issuance. Despite robust issuance so far this year and the Fed backing away as a buyer, the conventional 30-year MBS OAS remains well below its pre-crisis mean (panel 2). While MBS are starting to look more attractive, especially relative to Aaa credit (panel 3), we think it is still too soon to buy. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 5 basis points in August, bringing year-to-date excess returns up to 154 bps. The Foreign Agency and Local Authority sectors drove the index outperformance in August. Both beat the duration-matched Treasury benchmark by 12 bps. Sovereigns outperformed the benchmark by 3 bps, Supranationals outperformed by 1 bp, and Domestic Agency bonds underperformed by 2 bps. We took a detailed look at the Sovereign index in a recent report,6 both at the aggregate and individual country levels. At the aggregate level, the two main factors we consider when deciding whether to add USD-denominated sovereigns to our portfolio at the expense of domestic U.S. credit are relative valuation and the outlook for the U.S. dollar (Chart 5). At present, relative valuation is skewed heavily in favor of domestic U.S. credit (panel 2). Added to that, given downbeat Fed rate hike expectations, we view further dollar weakness as unlikely on a 6-12 month horizon. Taken together, we continue to favor U.S. credit over USD-denominated Sovereign debt. At the country level, we identified several countries where USD-backed debt appears attractive. We found that Finland, Mexico and Colombia all offer attractive spreads. However, the spread pick-up available in Mexican and Colombian debt is compensation for heightened exchange rate volatility. Finnish debt appears the most attractive on a risk/reward basis. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 40 basis points in August (before adjusting for the tax advantage). Munis have outperformed the Treasury benchmark by 144 bps, year-to-date. The average Municipal / Treasury (M/T) yield ratio held flat in August, and it remains extremely tight relative to its post-crisis trading range (Chart 6). The M/T yield ratio remains very low despite the fact that state & local government net borrowing continues to rise. Net borrowing increased to $209 billion in Q2, the highest level since the second quarter of last year. Further, the Trump administration appears to be finally tackling the issue of tax reform. While comprehensive tax reform is probably too ambitious, some form of corporate and personal tax cuts seems likely, probably in the first half of next year. Lower tax rates are obviously a negative for municipal bonds, but some of the negative impact could be offset if current tax deductions (such as the deduction of state & local income tax) are removed. All else equal, fewer available tax deductions elsewhere makes the tax exemption of municipal bonds look more attractive. Of course, the municipal bond tax exemption itself could also be threatened, but at least so far this appears less likely. The bottom line is that current M/T yield ratios are far too low given the looming risks of rising state & local government borrowing and looming federal tax cuts. Remain underweight. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bull flattened in August. The 2/10 slope flattened 17 bps and the 5/30 slope flattened 2 bps. The market moved to discount an even shallower path for Fed rate hikes in August. At the end of July the market had expected 27 bps of rate hikes during the next 12 months, and that number has now fallen to 19 bps (Chart 7). Consequently, our recommendation to short the July 2018 fed funds futures contract has suffered. The position is now 17 bps in the red, but we continue to believe that the market's expected rate hike path is too benign. From current levels, a position short the July 2018 fed funds futures contract will return 35 bps if there are two hikes between now and next July and 61 bps if there are 3 hikes. We also continue to recommend a position long the 5-year bullet versus a duration-matched 2/10 barbell on the view that the Treasury curve will steepen as inflation and TIPS breakevens move higher. This position has earned 28 bps since initiation last December, but valuation is starting to look less attractive. Our butterfly spread model7 suggests that the 5-year bullet is now slightly expensive compared to the 2/10 barbell (panel 3). Or put differently, that the 2/10 Treasury slope will have to steepen by more than 20 bps during the next 6 months for our trade to earn a positive return. TIPS: Overweight Chart 8TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 36 basis points in August, dragging year-to-date excess returns down to -169 bps. The 10-year TIPS breakeven inflation rate fell 6 bps on the month and, at 1.76%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. Despite robust growth, extremely weak realized inflation has caused breakevens to tighten this year. Last week's July PCE release was yet another disappointment. The year-over-year core inflation rate fell from 1.51% to 1.41% and the year-over-year trimmed mean rate fell from 1.68% to 1.64% (Chart 8). However, measures of pipeline inflation pressure such as the supplier deliveries and prices paid components of the ISM Manufacturing survey point towards higher inflation. The supplier deliveries component increased from 55.4 to 57.1 in August (panel 4) while the prices paid component held firm at an elevated 62 (panel 3). Adding it all up, and incorporating the fact that employment growth should stay strong enough to maintain downward pressure on the unemployment rate, we think it is very likely that core inflation will soon reverse course and resume the steady uptrend that began in early 2015. TIPS breakevens will widen alongside. At present, our TIPS Financial model suggests that breakevens are trading in line with other financial market instruments (panel 2). In other words, there is no apparent mis-valuation in breakevens relative to other financial markets, and higher realized inflation is likely required before breakevens move sustainably wider. ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 11 basis points in August, bringing year-to-date excess returns up to 71 bps. Aaa-rated ABS outperformed the benchmark by 10 bps in August, bringing year-to-date excess returns up to 63 bps. Meanwhile, non-Aaa ABS outperformed by 26 bps in August, bringing year-to-date excess returns up to 147 bps. Credit card ABS outperformed the Treasury benchmark by 10 bps in August, bringing year-to-date excess returns up to 69 bps. Auto loan ABS outperformed by 12 bps, bringing year-to-date excess returns up to 71 bps. The index option-adjusted spread for Aaa-rated ABS tightened 4 bps on the month, and remains well below its average pre-crisis level (Chart 9). At 36 bps, the option-adjusted spread for Aaa-rated ABS is now the same as the option-adjusted spread for conventional 30-year Agency MBS. Meanwhile, lending standards are now tightening for both auto loans and credit cards. Further, the New York Fed's Household Debt and Credit Report for the second quarter revealed that "flows of credit card balances into both early and serious delinquencies climbed for the third straight quarter - a trend not seen since 2009."8 While overall credit card charge-offs in ABS collateral pools remain low (panel 4), it is clear that the cyclical winds are shifting against consumer ABS. If the trends of tightening lending standards and rising delinquencies continue, then it will soon be time to reduce consumer ABS exposure, possibly shifting into Agency MBS. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 19 basis points in August, bringing year-to-date excess returns up to 116 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 2 bps on the month, and is approaching one standard deviation below its average pre-crisis level (Chart 10). The combination of tightening lending standards and weaker demand for commercial real estate (CRE) loans (as evidenced by the Fed's Senior Loan Officer Survey) suggests that credit concerns are starting to mount in the CRE space. Meanwhile, CMBS delinquency rates have leveled-off during the past few months and remain much lower in the multi-family space (panel 5). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 14 basis points in August, bringing year-to-date excess returns up to 79 bps. The average index option-adjusted spread for the Agency CMBS index held flat at 48 bps on the month. This compares favorably to the 36 bps offered by both Aaa-rated consumer ABS and conventional 30-year Agency MBS. Not only does the Agency CMBS sector continue to offer an attractive spread relative to both consumer ABS and Agency MBS, but its agency guarantee and concentration in the multi-family space (where delinquencies are still low) makes it look particularly attractive. Treasury Valuation Chart 11Treasury Fair Value Models The current reading from our 2-factor Treasury model (which is based on Global PMI and dollar sentiment) places fair value for the 10-year Treasury yield at 2.67% (Chart 11). Our 3-factor version of the model (not shown), which also includes the Global Economic Policy Uncertainty Index, places fair value at 2.68%. The Global Manufacturing PMI rose to 53.1 in August, from 52.7 in July, reaching a 75-month high (panel 3). Meanwhile, bullish sentiment toward the U.S. dollar continues to plunge (bottom panel). Taken together, these two factors suggest that not only is global growth accelerating but that the global economic recovery is increasingly broad based. This is an extremely bond-bearish development. A broad based global recovery means that when U.S. data finally start surprising positively, it is less likely that any increase in Treasury yields will be met with an influx of foreign demand. For further details on our Treasury models please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 11, 2016, available at usbs.bcaresearch.com At the time of publication the 10-year Treasury yield was 2.16%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Policy Reflections", dated August 29, 2017, available at usbs.bcaresearch.com 2 The 12-month breakeven spread is the basis point widening required over a 12-month period before a corporate bond delivers losses relative to a duration-matched Treasury security. We assume no impact from convexity and calculate the breakeven spread as OAS divided by duration. 3 Please see U.S. Bond Strategy Weekly Report, "Low Inflation And Rising Debt", dated June 13, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Keep Buying Dips", dated March 28, 2017, available at usbs.bcaresearch.com 5 The Price Pressures Measure is a composite indicator which shows the percent chance that PCE inflation will exceed 2.5% during the next 12 months. 6 Please see U.S. Bond Strategy Weekly Report, "The Upside Of A Weaker Dollar", dated August 15, 2017, available at usbs.bcaresearch.com 7 For further details on our models please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com 8 https://www.newyorkfed.org/microeconomics/hhdc Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Informe especial

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

Highlights Some caution warranted here. Hurricane Harvey's impact on the economy and markets. Tensions in North Korea will linger. NIPA and S&P now telling same story on profits, margins. Is the August employment report enough for the Fed? Feature The impact of Hurricane Harvey will ripple through the economic data in the coming months, but will not impact the overall trajectory of the economy or the Fed. However, elevated equity valuations, escalating tensions in North Korea, a widening disconnect between the bond market and the Fed and profit growth that is poised to peak in the second half of the year warrants careful attention from investors. Nonetheless, we remain slightly overweight stocks and favor stocks over bonds. Caution On Risk Assets We recommend that clients be prudent, paring back any overweight positions and holding some safe-haven assets within diversified portfolios. BCA research has demonstrated that U.S. Treasuries, Swiss bonds and JGBs were the best performers during a crisis (Chart 1). The same is true for the Swiss franc and the Japanese yen, such that the currency exposure should not be hedged in these cases. The dollar is more nuanced. It tends to perform well during financial crises, but not in geopolitical crises or recessions. Chart 1Gold Loves Geopolitical Crises Gold tends to perform well in geopolitical events, although not in recessions or financial crunches. Our base case projects stocks outperforming cash and bonds over the next 6-12 months. BCA's dollar and duration positions have disappointed so far this year. Much hinges on U.S. inflation. Investors appear to have adopted the stance that structural headwinds to inflation will forever dominate the cyclical pressures. Therefore, the bond market is totally unprepared for any upside shocks on the inflation landscape. Admittedly, a rise in bond yields may not be imminent, but the risks appear to be predominantly to the upside. Harvey's Lingering Aftermath History shows that natural disasters such as Hurricane Harvey have a temporary effect on the U.S. economy, the financial markets and the Fed. Ultimately, the macro environment in place before the storm will reassert itself. Nonetheless, it may be a few months before investors determine the long-term impact of the record rainfall and flooding in Houston. Chart 2 shows the ranking of Harvey's preliminary damage estimate of $30B versus other storms of similar magnitude. We are still several weeks away from the peak of the Atlantic hurricane season (mid-September) and two of the most destructive storms in the past 25 years made landfall in mid-to-late October (Wilma and Sandy). Chart 2Economic Impact From Major Hurricanes Chart 3 shows the performance of key economic, inflation and financial market indicators in the past two years and also around five major hurricanes since 1992. Most of the activity-related economic statistics are volatile in the aftermath of the storms and then they recover. The Citi economic surprise index initially moves higher after a storm, and then fades (Chart 3A). There are big swings in housing starts and industrial production and employment growth slows. Inflation tends to climb post-landfall (Chart 3B). In prior episodes, core PCE and core CPI have accelerated along with gasoline prices. Consumer confidence dips initially, but then recovers. Wages are volatile, but tend to accelerate after several months. Chart 3C shows that stocks drift lower for several months following hurricanes and subsequently recoup the losses. The stock-to-bond ratio also moved lower, but regains its pre-storm heights about two months later. Treasury yields fall after storms, but we note that yields have been in a secular decline for 25 years. Chart 3AMajor Hurricane Impact##BR##On Activity Data Chart 3BMajor Hurricane Impact On##BR##Sentiment And Inflation Data Chart 3CMajor Hurricane Impact On##BR##Financial Markets & The Fed Hurricane Harvey will not shake the Fed. Nonetheless, the central bank will acknowledge the disaster in the FOMC statement, the FOMC minutes, and/or in Fed Chair Janet Yellen's news conference. We are unchanged in our view that policymakers will begin to pare its balance sheet later this month and bump up rates again in December, assuming that core inflation shows some signs of strength between now and then. History shows (Chart 3C) that, on average, the Fed funds rate tends to move higher in the months after storms hit, but the primary message is that the Fed just continues to do whatever it was doing before the storm. The Fed cut rates in the aftermath of Hurricane Andrew in 1992 in what turned out to be the final rate reduction of the cycle that began in 1989. Ivan hit in September 2004, but the monetary authority raised rates in the final three FOMC meetings of 2004, including at the meeting only a week after the hurricane made landfall. Similarly, the Fed clung to its rate hike regime after Wilma in October 2005. In 2008, Ike arrived in Texas two days before Lehman Brothers collapsed in mid-September. The Fed, which had been cutting rates since September 2007, lowered rates in the final months of 2008. The Fed announced QE3 in late summer 2012 and continued with the program after Sandy came ashore at the end of October 2012. Harvey will be a game changer in some respects: the devastation reduces the odds of a government shutdown or of failing to increase the debt ceiling. We have maintained that there were extremely low odds that the debt ceiling would not be raised. We stated that there was a 25% chance of a government shutdown between October 1, when the current funding expires, and sometime in mid-October when the debt ceiling will hit according to the Congressional Budget Office. However, it would be unfathomable to shut down the government and force the Federal Emergency Management Agency (FEMA) to cease operations. The resulting outrage would damage the Republicans, especially in Texas. Bottom Line: Harvey may have a near-term impact on the economy, but the Fed will stick to its plan. The catastrophe makes it increasingly likely that the debt ceiling will be raised and a resolution will be passed to keep the government operating into the new fiscal year. Thus, equity investors can safely ignore these two risks, and focus on the key risk in the outlook: North Korea. North Korea Could Linger Over Markets BCA believes that the probability of a war on the Korean Peninsula is very low,1 but it may take a while before the uncertainty in Northeast Asia is resolved. Between now (escalating tensions) and then (a negotiated settlement), there will be more provocations and market volatility. There are long-standing constraints to war. The first is a potentially high death toll: Pyongyang can inflict massive civilian casualties in Seoul with a conventional artillery barrage. Furthermore, U.S. troops, and Japanese forces and civilians, would also suffer. Secondly, China is unlikely to remain neutral. Strategically, China will not tolerate a U.S. presence on its border with North Korea. Nevertheless, Washington must establish a credible threat of military action if it is to convince Pyongyang that negotiations offer a superior outcome. It is unclear how long it will take Trump to convince North Korea that the threat of a U.S. preemptive strike is credible. Chart 4 shows the arc of diplomacy2 that the U.S. took with Iran between 2010 and 2014. From an investor perspective, it will be difficult to gauge whether the brinkmanship and military posturing are part of this territorial threat display or evidence of real preparations for an actual attack. More market volatility may occur, but for the time being, we do not think that the tensions in the Korean peninsula will end the bull market in global equities. Positions in traditional safe-haven assets, such as gold, U.S. Treasuries, Swiss francs and (perhaps) Japanese yen, should be considered as hedges against increased market swings. Chart 4Arc Of Diplomacy: Tensions Ramp Up As Nuclear Negotiations Begin Update: Equity Valuations, Sentiment And Technicals U.S. equity valuations are stretched, but elevated valuations alone are not enough to prompt a sell-off in stocks. The BCA valuation indicator is in overvalued territory, where it has been since late 2013. History shows3 that stocks can stay overvalued for extended periods, even when the Fed is raising rates, but policy is still accommodative as it is today. BCA's composite valuation indicator is still shy of the +1 standard deviation level that defines extremely over-valued (Chart 5). However, this is due to the components that compare equity prices with bond yields. The other three elements of the equity indicator, which are unrelated to bond yields, suggest that stock valuation is stretched (Chart 5 panels 2, 3 and 4). That said, equities are attractively priced relative to competing assets, such as corporate bonds and Treasuries (Chart 6). Chart 5U.S. Equities##BR##Are Overvalued... Chart 6...But Look Less Expensive##BR##Relative To Competing Assets Valuation is not a reliable tool to time market turning points and, absent a significant deterioration in the economic, profit and margin environment, we do not forecast a sustained pullback in stocks. Looking beyond BCA's tactical 6-12 month window, above-average market multiples alone imply below-average returns for stocks across a strategic time horizon. Chart 7No Strong Signal From##BR##Sentiment Or Technicals BCA's technical and sentiment indicators are not at extremes (Chart 7). The BCA technical indicator, while above zero, is not at a level that in the past has triggered a stock pullback. Similarly, the BCA investor sentiment composite index, while at the top end of its bull market range, is not at an extreme. Moreover, only 50% of the stocks in the NYSE composite are above their 10-week moving average, a level which has not been previously associated with major equity sell-offs. Bottom Line: The solid earnings backdrop remains in place for U.S. stocks as measured by either the S&P or the national accounts. We anticipate that profit growth has peaked according to S&P 500 data on a 4-quarter moving total basis due to tough comparisons although it will slip only modestly in the second half of the year. Next year will see EPS growth drop back into the mid-single digit range. The consensus estimate for 2018 EPS growth is 11%. While valuations are elevated, neither sentiment nor technical indicators are flashing red. We recommend stocks over bonds in the next 6-12 months, but acknowledge that risks to BCA's stance are climbing. A Reconnection In Q2 The Q2 data show that the NIPA and S&P earnings measures have reconnected. In our July 3, 2017 Weekly Report "Summer Stress Out"4 we highlighted the apparent disconnect between the S&P and NIPA, sales earnings and margin data through Q1 2017. The release of the Q2 corporate profits data in the national accounts and the end the Q2 S&P 500 reporting season allow us to provide an update. The year-over-year reading on the NIPA earnings measure ticked up in Q2 while the S&P-based metric ticked down. That said, while there are marked differences in annual growth rates between the two measures, the levels were close to the same point in the second quarter of 2017 (Chart 8, bottom panel). Chart 9 shows that a wide difference persists between corporate sales measured by S&P and the national accounts. Margins calculated on the S&P basis climbed in Q2 while NIPA margins held steady. Even so, a modest gap still remains between NIPA margins at 15.2% and S&P margins at 13.2%. Most of the divergence is related to the denominator of the calculation. The NIPA denominator is corporate sector Gross Domestic Product (GDP). This is a value-added concept that is different from sales. It is not clear why, but GDP has grown much faster than sales since the end of 2014. Chart 8S&P And NIPA##BR##Profit Comparison Chart 9Denominator Explains##BR##S&P/NIPA Margin Divergence We believe that the S&P statistics are painting a more accurate picture because sales are easier to measure while value-added is more complicated. The slow growth of sales is not a bullish point for stocks. Nonetheless, it does not appear that financial engineering has distorted bottom-up company data to such an extent that the S&P readings are falsely signaling strong profit growth. We expect the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning early in 2018. Nonetheless, the profit backdrop is positive for stocks for now. Is The August Jobs Report Enough For The Fed? Chart 10Labor Market Conditions##BR##Favor Risk Assets U.S. payrolls expanded by 156,000 in August. Relative to the underlying growth rate in the labor force, this is still a healthy pace of jobs growth. Nevertheless, it fell short of expectations for a 180,000 increase and the prior two months saw a cumulative downward revision of 41,000. The August data were not impacted by Hurricane Harvey. Aggregate hours worked, a measure of total labor inputs based on changes in employment and the workweek, fell by 0.2% m/m. That said, aggregate hours worked are up 1.3% at a quarterly annualized rate thus far in Q3. This is consistent with GDP growth of a bit over 2%, which has been the trend in the current economic expansion. Meanwhile, wage gains remain muted. Average hourly earnings rose just 0.1% m/m. Annual wage inflation has been steady at 2.5% for several months now (Chart 10, bottom panel). If productivity is expanding modestly around 1%, the current pace of wage gains would suggest that unit labor costs are growing around 1.5%. This will make it difficult for general price inflation to accelerate to the Fed 2% target. Nonetheless, the reacceleration in the 3-month change in average hourly earnings from 1.9% in January 2017 to 2.6% in August supports the Fed's view on inflation. Finally, the unemployment rate ticked up to 4.4% from 4.3%. This was because the separate household survey showed a 74,000 drop in employment. The participation rate held steady at 62.9% in August. Bottom Line: While falling short of expectations in August, U.S. employment growth remains solid and job gains are continuing at a pace consistent with the 2% GDP growth rate of recent years. However, muted wage gains mean that progress to the Fed's 2% inflation target is looking suspect. We anticipate that the Fed will announce the process of running down its balance sheet at the September FOMC meeting. Rate hikes are on hold at least until the December FOMC meeting, and even then only if core inflation shows some signs of strength in the next few months. U.S. risk assets should continue to benefit from moderate growth, low inflation and a "go slow" approach by the Fed. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA's Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?", August 16, 2017. It is available at gps.bcaresearch.com. 2 Please see BCA's Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets? ,"May 24, 2017, available at gps.bcaresearch.com. 3 Please see BCA's U.S. Investment Strategy Weekly Report, "Sizing Up The Second Half", July 10, 2017, available at usis.bcaresearch.com. 4 Please see BCA's U.S. Investment Strategy Weekly Report, "Summer Stress Out", July 3, 2017, available at usis.bcaresearch.com.

Feature Dear Client, In addition to this abbreviated Weekly Report, I am sending you a Special Report written by Mark McClellan, Managing Editor of the monthly Bank Credit Analyst. Mark makes a compelling case that the deflationary effects of the "Amazon economy" are overstated. I trust you will find his report very informative. Best regards, Peter Berezin, Chief Global Strategist Global Investment Strategy Chart 1September Is Generally ##br##Not A Good Time Of Year For Stocks My colleagues and I convened a meeting earlier this week to discuss whether to abandon our long-standing cyclically bullish view towards risk assets. Several of them felt it was time to turn more cautious. I am sympathetic to their concerns: Valuations are stretched, volatility is low, and geopolitical risks (most notably North Korea) are on the rise. Profit growth is likely to decelerate later this year, as the easy comps stemming from the depressed level of earnings in the first half of 2016 vanish. Meanwhile, stocks are entering the volatile early autumn months, a period which has historically seen poor returns (Chart 1). Nevertheless, at times like these, it is useful to fall back on our time-tested indicators. Bear markets have almost always coincided with economic recessions, with the latter usually causing the former (Chart 2). None of our recession-timing signals are flashing red: To cite just a few examples, ISM manufacturing new orders are strong, initial unemployment claims are low, core capital goods orders are accelerating, and the yield curve is not in any immediate risk of inverting (Chart 3). Chart 2Recessions And Bear Markets Usually Overlap Chart 3No Warnings Of Recession Here U.S. financial conditions have eased sharply this year, which should support growth over the next few quarters (Chart 4). A recent IMF report highlighted that easier U.S. financial conditions tend to generate positive spillovers onto other countries.1 The fact that all 45 countries monitored by the OECD are on track to grow this year - the first time this has happened since 2007 - is a testament to the strong fundamentals underpinning the global economy. Chart 4Easing Financial Conditions Bode Well For Growth The Fed's Dot Problem In this light, the Fed's projection that the unemployment rate will end this year at 4.3% and only fall to 4.2% by end-2018 no longer looks credible. If U.S. GDP growth remains above trend, as we expect, the unemployment rate could fall below its 2000 low of 3.8% by next summer. That will be enough to prompt investors to price in a few more rate hikes. Considering that the market expects just 22 basis points in hikes through to end-2018, this is not a high bar to clear. A bit more fiscal stimulus would add to the pressure to tighten monetary policy. While any meaningful progress on tax reform will be difficult to achieve, the odds are good that Congress will agree to cut statutory corporate and personal tax rates, with the latter focusing mainly on middle-income earners. Failure to raise the debt ceiling or extend federal spending authority beyond the current budget window could scuttle the benefits from lower tax rates. Fortunately, the risks of such an outcome have receded. If there is a silver lining from Hurricane Harvey, it is that the disaster could at least temporarily overcome the political impasse in Washington. Congress will need to appropriate additional disaster relief funds over the coming weeks. Politicians who are seen as creating roadblocks to such funding will face the electorate's wrath. The odds of an infrastructure bill passing through Congress have also risen. All recoveries eventually run out of steam, but this one can last at least until the second half of 2019, which will make it the longest U.S. expansion on record. As we discussed several weeks ago, the next recession is likely to be triggered by the Fed scrambling to hike rates in response to rising inflation.2 This is not an immediate concern, given that it usually takes a while for an overheated economy to generate inflation - especially since the U.S. currently can satisfy rising domestic demand with higher imports. However, the risks of overheating will increase as unemployment falls further and excess capacity elsewhere in the world is absorbed. Draghi After Jackson Hole Chart 5A Stronger Euro Is Deflationary Textbook economic theory states that a shift in consumption towards imported goods requires a real appreciation of the currency. The dollar, of course, has done exactly the opposite of that, depreciating by 6.6% in trade-weighted terms since the start of the year. The euro, in particular, has gained significant ground against the greenback, rising above $1.20 at one point this week. Mario Draghi's failure to express concerns about the resurgent euro during his Jackson Hole address was construed by many market participants as a green light for further currency strength. We are skeptical of this "saying nothing means you are saying something" interpretation. Draghi wanted to acknowledge (and partly take credit for) the recovery across the euro area, but he is cognizant of the problems posed by a stronger euro. The ECB's June forecast showed inflation rising to only 1.6% in 2019. In the period since those forecasts were compiled, the trade-weighted euro has appreciated by 3.9%, bringing the year-to-date gain to 6.2% (Chart 5). ECB staff calculations, which Draghi has approvingly quoted, show that a 10% appreciation in the euro would reduce inflation by 0.2 percentage points in the first year and 0.6-to-0.8 points in the subsequent two years.3 Better-than-expected growth since the June forecasts will offset some of the deflationary impact from the stronger euro, but probably not by much, given that the Phillips curve is quite flat at high-to-moderate levels of spare capacity. With labor market slack across the euro area still 3.2 percentage points higher today than in 2008 (and 6.7 points higher outside of Germany), it will be a while before stronger growth generates markedly higher inflation. We expect the ECB to reduce its 2018/2019 inflation forecast by 0.1-to-0.2 percentage points next week. It would be awkward for the central bank to play up the prospect of monetary policy normalization while it is simultaneously trimming its inflation projections. This suggests that the ECB's communications could turn more dovish, thereby limiting further upside for the euro. EUR/USD is currently trading near the top of the $1.10-to-$1.20 range that we foresee lasting for the next 10 months. Thus, our expectation is that the euro will weaken over the next few months, ending the year near $1.15, and potentially moving back towards its 2017 lows in the second half of next year, as an overheated U.S. economy forces the Fed to pick up the pace of rate hikes. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see "Getting The Policy Mix Right," IMF Global Financial Stability Report, (Chapter 3), (April 2017). 2 Please see Global Investment Strategy Weekly Report, "From Slow Burn Recovery to Retro-Recession?" dated August 18, 2017. 3 Please see European Central Bank, "March 2017 ECB Staff Macroeconomic Projections For The Euro Area." APPENDIX 1 Tactical Global Asset Allocation Monthly Update To complement our analysis, we use a variety of time-tested models to assess the global investment outlook. At present, these models favor global equities over bonds over a three-month horizon (Appendix Table 1). Appendix Table 1BCA's Tactical Global Asset Allocation Recommendations* Our business cycle equity indicators remain in bullish territory, as reflected in strong global growth and rising corporate earnings. Our monetary and financial indicators are also generally supportive. In contrast, our sentiment readings are sending mixed signals. On the one hand, implied equity volatility remains low and institutional exposure to stocks is quite high. On the other hand, surveys of retail investors show a healthy skepticism towards the bull market, which is a positive contrarian indicator. As has been the case for some time, our valuation measures are signaling that stocks are expensive, but these are typically useful only over horizons beyond one or two years. As we flagged last month, stocks tend to do poorly in August and September, which may hurt returns over the next few weeks. The stronger euro will negatively impact earnings in the euro area. This has caused our models to suggest a slight downgrade to European equities. However, we are inclined to fade this signal, given our expectation that the euro will give up some of its recent gains. Japanese stocks continue to score well on our metrics, buoyed by strengthening corporate profits and attractive valuations. Emerging market equities are fairly valued, although China still appears cheap. The rally in U.S. Treasurys has caused the gap between the 10-year yield and our model's fair value estimate to widen to around 50 basis points, the highest since last September. European and Japanese bonds also look somewhat overvalued, although the latter will continue to receive support from the BoJ's yield curve targeting operations. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Informe especial

Dear Client, In addition to this Special Report written by my colleague Mark McClellan, we are sending you an abbreviated weekly report, which includes the Tactical Global Asset Allocation Monthly Update. Best regards, Peter Berezin, Chief Global Strategist Global Investment Strategy Highlights A "culture of profound cost reduction" has gripped the business sector since the GFC according to one school of thought, permanently changing the relationship between labor market slack and wages or inflation. If true, it could mean that central banks are almost powerless to reach their inflation targets. Amazon, Airbnb, Uber, robotics, contract workers, artificial intelligence, horizontal drilling and driverless cars are just a few examples of companies and technologies that are cutting costs and depressing prices and wages. In the first of our series on inflation, we will focus on the rise of e-commerce and the related "Amazonification" of the economy. In theory, positive supply shocks should not have more than a temporary impact on inflation if the price level is indeed a monetary phenomenon in the long term. But a series of positive supply shocks could make it appear for quite a while that low inflation is structural in nature. We are keeping an open mind and reserving judgement on the disinflationary impact of robotics, artificial intelligence and the gig economy until we do more research. But in terms of the impact of e-commerce, it is difficult to find supportive evidence at the macro level. The admittedly inadequate measures of online prices available today do not suggest that e-commerce sales are depressing the overall inflation rate by more than 0.1 or 0.2 percentage points. Moreover, it does not appear that the disinflationary impact of competition in the retail sector has intensified over the years. Today's creative destruction in retail may be no more deflationary than the shift to 'big box' stores in the 1990s. Perhaps lower online prices are forcing traditional retailers match the e-commerce vendors, allowing for a larger disinflationary effect than we estimate. However, the fact that retail margins are near secular highs outside of department stores argues against this thesis. The sectors potentially affected by e-commerce make up a small part of the CPI index. The deceleration of inflation since the GFC has been in areas unaffected by online sales. High profit margins for the overall corporate sector and depressed productivity growth also argue against the idea that e-commerce represents a large positive macro supply shock. Perhaps the main way that e-commerce is affecting the macro economy and financial markets is not through inflation, but via the reduction in the economy's capital spending requirement. This would reduce the equilibrium level of interest rates, since the Fed has to stimulate other parts of the economy to offset the loss of demand in capital spending in the retail sector. Feature Anecdotal evidence is all around us. The global economy is evolving and it seems that all of the major changes are deflationary. Amazon, Airbnb, Uber, robotics, contract workers, artificial intelligence, horizontal drilling and driverless cars are just a few examples of companies and technologies that are cutting costs and depressing prices and wages. Central banks in the major advanced economies are having difficulty meeting their inflation targets, even in the U.S. where the labor market is tight by historical standards. Based on the depressed level of bond yields, it appears that the majority of investors believe that inflation headwinds will remain formidable for a long time. One school of thought is that low inflation reflects a lack of demand growth in the post-Great Financial Crisis (GFC) period. Another school points to the supply side of the economy. A recent report by Prudential Financial highlights "...obvious examples of ... new business models and new organizational structures, whereby higher-cost traditional methods of production, transportation, and distribution are displaced by more nontraditional cost-effective ways of conducting business." 1 A "culture of profound cost reduction" has gripped the business sector since the GFC according to this school, permanently changing the relationship between labor market slack and wages or inflation (i.e., the Phillips Curve). Employees are less aggressive in their wage demands in a world where robots are threatening humans in a broadening array of industrial categories. Many feel lucky just to have a job. In a highly sensationalized article called "How The Internet Economy Killed Inflation," Forbes argued that "the internet has reduced many of the traditional barriers to entry that protect companies from competition and created a race to the bottom for prices in a number of categories." Forbes believes that new technologies are placing downward pressure on inflation by depressing wages, increasing productivity and encouraging competition. There are many factors that have the potential to weigh on prices, but analysts are mainly focusing on e-commerce, robotics, artificial intelligence, and the gig economy. In the first of our series on inflation, we will focus on the rise of e-commerce and the related "Amazonification" of the economy. The latter refers to the advent of new business models that cut out layers of middlemen between producers and consumers. Amazonification E-commerce has grown at a compound annual rate of more than 9% over the past 15 years, and now accounts for about 8½% of total U.S. retail sales (Chart 1). Amazon has been leading the charge, accounting for 43% of all online sales in 2016 (Chart 2). Amazon's business model not only cuts costs by eliminating middlemen and (until recently) avoiding expensive showrooms, but it also provides a platform for improved price discovery on an extremely broad array of goods. In 2013, Amazon carried 230 million items for sale in the United States, nearly 30 times the number sold by Walmart, one of the largest retailers in the world. Chart 1E-Commerce: Steady Increase In Market Share Chart 2Amazon Dominates With the use of a smartphone, consumers can check the price of an item on Amazon while shopping in a physical store. Studies show that it does not require a large price gap for shoppers to buy online rather than in-store. Amazon appears to be impacting other retailers' ability to pass though cost increases, leading to a rash of retail outlet closings. Sears alone announced the closure of 300 retail outlets this year. The devastation that Amazon inflicted on the book industry is well known. It is no wonder then, that Amazon's purchase of Whole Foods Market, a grocery chain, sent shivers down the spines of CEOs not only in the food industry, but in the broader retail industry as well. What would prevent Amazon from applying its model to furniture and appliances, electronics or drugstores? It seems that no retail space is safe. A Little Theory Before we turn to the evidence, let's review the macro theory related to positive supply shocks. The internet could be lowering prices by moving product markets toward the "perfect competition" model. The internet trims search costs, improves price transparency and reduces barriers to entry. The internet also allows for shorter supply chains, as layers of wholesalers and other intermediaries are removed and e-commerce companies allow more direct contact between consumers and producers. Fewer inventories and a smaller "brick and mortar" infrastructure take additional costs out of the system. Economic theory suggests that the result of this positive supply shock will be greater product market competition, increased productivity and reduced profitability. In the long run, workers should benefit from the productivity boost via real wage gains (even if nominal wage growth is lackluster). Workers may lower their reservation wage if they feel that increased competitive pressures or technology threaten their jobs. The internet is also likely to improve job matching between the unemployed and available vacancies, which should lead to a fall in the full-employment level of unemployment (NAIRU). Nonetheless, the internet should not have a permanent impact on inflation. The lower level of NAIRU and the direct effects of the internet on consumer prices discussed above allow inflation to fall below the central bank's target. The bank responds by lowering interest rates, stimulating demand and thereby driving unemployment down to the new lower level of NAIRU. Over time, inflation will drift back up toward target. In other words, a greater degree of the competition should boost the supply side of the economy and lower NAIRU, but it should not result in a permanently lower rate of inflation if inflation is indeed a monetary phenomenon and central banks strive to meet their targets. Still, one could imagine a series of supply shocks that are spread out over time, with each having a temporary negative impact on prices such that it appears for a while that inflation has been permanently depressed. This could be an accurate description of the current situation in the U.S. and some of the other major countries. We have sympathy for the view that the internet and new business models are increasing competition, cutting costs and thereby limiting price increases in some areas. But is there any hard evidence? Is the competitive effect that large, and is it any more intense than in the past? There are a number of reasons to be skeptical because most of the evidence does not support Forbes' claim that the internet has killed inflation. 1. E-commerce affects only a small part of the Consumer Price Index As mentioned above, online shopping for goods represents 8.5% of total retail sales in the U.S. E-commerce is concentrated in four kinds of businesses (Table 1): Furniture & Home Furnishings (7% of total retail sales), Electronics & Appliances (20%), Health & Personal Care (15%), and Clothing (10%). Since goods make up 40% of the CPI, then 3.2% (8% times 40%) is a ballpark estimate for the size of goods e-commerce in the CPI. Table 1E-Commerce Market Share Of Goods Sector Table 2 shows the relative size of e-commerce in the service sector. The analysis is complicated by the fact that the data on services includes B-to-B sales in addition to B-to-C.2 However, e-commerce represents almost 4% of total sales for the service categories tracked by the BLS. Services make up 60% of the CPI, but the size drops to 26% if we exclude shelter (which is probably not affected by online shopping). Thus, e-commerce in the service sector likely affects 1% (3.9% times 26%) of the CPI. Table 2E-Commerce Market Share Of Service Sector Adding goods and services, online shopping affects about 4.2% of the CPI index at most. The bottom line is that the relatively small size of e-commerce at the consumer level limits any estimate of the impact of online sales on the broad inflation rate. 2. Most of the deceleration in inflation since 2007 has been in areas unaffected by e-commerce Table 3 compares the average contribution to annual average CPI inflation during 2000-2007 with that of 2007-2016. Average annual inflation fell from 2.9% in the seven years before the Great Recession to 1.8% after, for a total decline of just over 1 percentage point. The deceleration is almost fully explained by Energy, Food and Owners' Equivalent Rent. The bottom part of Table 3 highlights that the sectors with the greatest exposure to e-commerce had a negligible impact on the inflation slowdown. Table 3Comparison Of Pre- And Post-Lehman Inflation Rates 3. The cost advantages for online sellers are overstated Bain & Company, a U.S. consultancy, argues that e-commerce will not grow in importance indefinitely and come to dominate consumer spending.3 E-commerce sales are already slowing. Market share is following a classic S-shaped curve that, Bain estimates, will top out at under 30% by 2030. First, not everyone wants to buy everything online. Products that are well known to consumers and purchased on a regular basis are well suited to online shopping. But for many other products, consumers need to see and feel the product in person before making a purchase. Second, the cost savings of online selling versus traditional brick and mortar stores is not as great as many believe. Bain claims that many e-commerce businesses struggle to make a profit. The information technology, distribution centers, shipping, and returns processing required by e-commerce companies can cost as much as running physical stores in some cases. E-tailers often cannot ship directly from manufacturers to consumers; they need large and expensive fulfillment centers and a very generous returns policy. Moreover, online and offline sales models are becoming blurred. Retailers with physical stores are growing their e-commerce operations, while previously pure e-commerce plays are adding stores or negotiating space in other retailers' stores. Even Amazon now has storefronts. The shift toward an "multichannel" selling model underscores that there are benefits to traditional brick-and-mortar stores that will ensure that they will not completely disappear. 4. E-commerce is not the first revolution in the retail sector The retail sector has changed significantly over the decades and it is not clear that the disinflationary effect of the latest revolution, e-commerce, is any more intense than in the past. Economists at Goldman Sachs point out that the growth of Amazon's market share in recent years still lags that of Walmart and other "big box" stores in the 1990s (Chart 3).4 This fact suggests that "Amazonification" may not be as disinflationary as the previous big-box revolution. 5. Weak productivity growth and high profit margins are inconsistent with a large supply-side benefit from e-commerce As discussed above, economic theory suggests that a positive supply shock that cuts costs and boosts competition should trim profit margins and lift productivity. The problem is that the margins and productivity have moved in the opposite direction that economic theory would suggest (Chart 4). Chart 3Comparison Of Pre- And Post-Lehman Inflation Rates Chart 4Incompatible With A Supply Shock By definition, productivity rises when firms can produce the same output with fewer or cheaper inputs. However, it is well documented that productivity growth has been in a downtrend since the 1990s, and has been dismally low since the Great Recession. A Special Report from BCA's Global Investment Strategy 5 service makes a convincing case that mismeasurement is not behind the low productivity figures. In fact, in many industries it appears that productivity is over-estimated. If e-commerce is big enough to "move the dial" on overall inflation, it should be big enough to see in the aggregate productivity figures. Chart 5Retail Margin Squeeze Only In Department Stores One would also expect to see a margin squeeze across industries if e-commerce is indeed generating a lot of deflationary competitive pressure. Despite dismally depressed productivity, however, corporate profit margins are at the high end of the historical range across most of the sectors of the S&P 500. This is the case even in the retailing sector outside of department stores (Chart 5). These facts argue against the idea that the internet has moved the economy further toward a disinflationary "perfect competition" model. 6. Online price setting is characterized by frictions comparable to traditional retail We would expect to observe a low price dispersion across online vendors since the internet has apparently lowered the cost of monitoring competitors' prices and the cost of searching for the lowest price. We would also expect to see fairly synchronized price adjustments; if one vendor adjusts its price due to changing market conditions, then the rest should quickly follow to avoid suffering a massive loss of market share. However, a recent study of price-setting practices in the U.S. and U.K. found that this is not the case.6 The dataset covered a broad spectrum of consumer goods and sellers over a two-year period, comparing online with offline prices. The researchers found that market pricing "frictions" are surprisingly elevated in the online world. Price dispersion is high in absolute terms and on par with offline pricing. Academics for years have puzzled over high price rigidities and dispersion in retail stores in the context of an apparently stiff competitive environment, and it appears that online pricing is not much better. The study did not cover a long enough period to see if frictions were even worse in the past. Nonetheless, the evidence available suggests that the lower cost of monitoring prices afforded by the internet has not led to significant price convergence across sellers online or offline. Another study compared online and offline prices for multichannel retailers, using the massive database provided by the Billion Prices Project at MIT.7 The database covers prices across 10 countries. The study found that retailers charged the same price online as in-store in 72% of cases. The average discount was 4% for those cases in which there was a markdown online. If the observations with identical prices are included, the average online/offline price difference was just 1%. 7. Some measures of online prices have grown at about the same pace as the CPI index The U.S. Bureau of Labor Statistics does include online sales when constructing the Consumer Price Index. It even includes peer-to-peer sales by companies such as Airbnb and Uber. However, the BLS admits that its sample lags the popularity of such services by a few years. Moreover, while the BLS is trying to capture the rising proportion of sales done via e-commerce, "outlet bias" means that the CPI does not capture the price effect in cases where consumers are finding cheaper prices online. This is because the BLS weights the growth rate of online and offline prices, not the price levels. While there may be level differences, there is no reason to believe that the inflation rates for similar goods sold online and offline differ significantly. If the inflation rates are close, then the growing share of online sales will not affect overall inflation based on the BLS methodology. The BLS argues that any bias in the CPI due to outlet bias is mitigated to the extent that physical stores offer a higher level of service. Thus, price differences may not be that great after quality-adjustment. All this suggests that the actual consumer price inflation rate could be somewhat lower than the official rate. Nonetheless, it does not necessarily mean that inflation, properly measured, is being depressed by e-commerce to a meaningful extent. Indeed, Chart 6 highlights that the U.S. component of the Billion Prices Index rose at a faster pace than the overall CPI between 2009 and 2014. The Online Price Index fell in absolute and relative terms from 2014 to mid-2016, but rose sharply toward the end of 2016. Applying our guesstimate of the weight of e-commerce in the CPI (3.2% for goods), online price inflation added to overall annual CPI inflation by about 0.3 percentage points in 2016 (bottom panel of Chart 6). There is more deflation evident in the BLS' index of prices for Electronic Shopping and Mail Order Houses (Chart 7). Online prices fell relative to the overall CPI for most of the time since the early 1990s, with the relative price decline accelerating since the GFC. However, our estimate of the contribution to overall annual CPI inflation is only about -0.15 percentage points in June 2017, and has never been more than -0.3 percentage points. This could be an underestimate because it does not include the impact of services, although the service e-commerce share of the CPI is very small. Chart 6Online Price Index Chart 7Electronic Shopping Price Index Another way to approach this question is to focus on the parts of the CPI that are most exposed to e-commerce. It is impossible to separate the effect of e-commerce on inflation from other drivers of productivity. Nonetheless, if online shopping is having a significant deflationary impact on overall inflation, we should see large and persistent negative contributions from these parts of the CPI. We combined the components of the CPI that most closely matched the sectors that have high e-commerce exposure according to the BLS' annual Retail Survey (Chart 8). The sectors in our aggregate e-commerce price proxy include hotels/motels, taxicabs, books & magazines, clothing, computer hardware, drugs, health & beauty aids, electronics & appliances, alcoholic beverages, furniture & home furnishings, sporting goods, air transportation, travel arrangement and reservation services, educational services and other merchandise. The sectors are weighted based on their respective weights in the CPI. Our e-commerce price proxy has generally fallen relative to the overall CPI index since 2000. However, while the average contribution of these sectors to the overall annual CPI inflation rate has fallen in the post GFC period relative to the 2000-2007 period, the average difference is only 0.2 percentage points. The contribution has hovered around the zero mark for the past 2½ years. Surprisingly, price indexes have increased by more than the overall CPI since 2000 in some sectors where one would have expected to see significant relative price deflation, such as taxis, hotels, travel arrangement and even books. One could argue that significant measurement error must be a factor. How could the price of books have gone up faster than the CPI? Sectors displaying the most relative price declines are clothing, computers, electronics, furniture, sporting goods, air travel and other goods. We recalculated our e-commerce proxy using only these deflating sectors, but we boosted their weights such that the overall weight of the proxy in the CPI is kept the same as our full e-commerce proxy discussed above. In other words, this approach implicitly assumes that the excluded sectors (taxis, books, hotels and travel arrangement) actually deflated at the average pace of the sectors that remain in the index. Our adjusted e-commerce proxy suggests that online pricing reduced overall CPI inflation by about 0.1-to-0.2 percentage points in recent years (Chart 9). This contribution is below the long-term average of the series, but the drag was even greater several times in the past. Chart 8BCA E-Commerce Proxy Price Index Chart 9BCA E-Commerce Adjusted Proxy Price Index Admittedly, data limitations mean that all of the above estimates of the impact of e-commerce are ballpark figures. Conclusions We are keeping an open mind and reserving judgement on the disinflationary impact of robotics, artificial intelligence and the gig economy until we do more research. But in terms of the impact of e-commerce, it is difficult to find supportive evidence. The available data are admittedly far from ideal for confirming or disproving the "Amazonification" thesis. Perhaps better measures of e-commerce pricing will emerge in the future. Nonetheless, the measures available today do not suggest that online sales are depressing the overall inflation rate by more than 0.1 or 0.2 percentage points, and it does not appear that the disinflationary impact has intensified by much. One could argue that lower online prices are forcing traditional retailers to match the e-commerce vendors, allowing for a larger disinflationary effect than we estimate. Nonetheless, if this were the case, then we would expect to see significant margin compression in the retail sector. The sectors potentially affected by e-commerce make up a small part of the CPI index. The deceleration of inflation since the GFC has been in areas unaffected by online sales. High corporate profit margins and depressed productivity growth also argue against the idea that e-commerce represents a large positive macro supply shock. Finally, today's creative destruction in retail may be no more deflationary than the shift to 'big box' stores in the 1990s. Perhaps the main way that e-commerce is affecting the macro economy and financial markets is not through inflation, but via the reduction in the economy's capital spending requirement. Rising online activity means that we need fewer shopping malls and big box outlets to support a given level of consumer spending. This would reduce the equilibrium level of interest rates, since the Fed has to stimulate other parts of the economy to offset the loss of demand in capital spending in the retail sector. To the extent that central banks were slow to recognize that equilibrium rates had fallen to extremely low levels, then policy was behind the curve and this might have contributed to the current low inflation environment. Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Robert F. DeLucia, "Economic Perspective: A Nontraditional Analysis of Inflation," Prudential Capital Group (August 21, 2017). 2 Business to business, and business to consumer. 3 Aaron Cheris, Darrell Rigby and Suzanne Tager, "The Power Of Omnichannel Stores," Bain & Company Insights: Retail Holiday Newsletter 2016-2017 (December 19, 2016) 4 "US Daily: The Internet and Inflation: How Big is the Amazon Effect?" Goldman Sachs Economic Research (August 2, 2017). 5 Please see Global Investment Strategy Weekly Report, "Weak Productivity Growth: Don't Blame the Statisticians," dated March 25, 2016, available at gis.bcaresearch.com 6 Yuriy Gorodnichenko, Viacheslav Sheremirov, and Oleksandr Talavera, "Price Setting In Online Markets: Does IT Click?" Journal of the European Economic Association (July 2016). 7 Alberto Cavallo, "Are Online and Offline Prices Similar? Evidence from Large Multi-Channel Retailers," NBER Working Paper No. 22142 (March 2016).

Neutral When we upgraded the unloved telecom services index to neutral last month, we noted that a point would eventually be reached when selling prices would no longer contract. Yesterday's personal consumption expenditure data indicates the inflection point may have been reached as U.S. consumer spending on telecom services has surged faster than at any point in the past decade (second panel). Positive consumption data is not yet reflected in EPS growth estimates, where the telecom services index remains the GICS 1 industry laggard of the S&P 500 (third panel). Nor is it reflected in industry valuation multiples, which look to have bottomed on very weak earnings (bottom panel). It is too early to for us assess the durability of the growth in consumer telecom outlays and hence to become more constructive on telecom earnings growth relative to the S&P500. However, we are gaining confidence at least that the slide has been arrested. We reiterate our neutral call. The ticker symbols for the stocks in this index are: T, VZ, LVLT, CTL.