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

Highlights The GOP's failure to repeal Obamacare could rev up the Republicans' motivation to move forward on tax cuts. Fed policymakers are taking financial stability seriously. Constructive conditions for consumer spending. Margin expansion continues in early Q2 earnings results. Feature Tax Cuts Still On The Table The Republicans' failure to pass their health care legislation is leading the markets to doubt the prospect for tax cuts. This may be premature but, contrary to conventional wisdom, it may actually increase the chances of tax cuts. Ironically, the inability to jettison Obamacare may turn out to be a blessing for President Trump and the Republican Party. According to the Congressional Budget Office, by 2026, 22 million fewer Americans would have health care if the legislation had been enacted compared with the status quo. The Senate bill also would have led to substantial cuts to Medicaid and deep reductions to insurance subsidies for poor and middle-class families, many of whom voted for Trump. The failure to repeal Obamacare could actually increase the motivation of Republicans to move forward on tax cuts anyway. The chances for broad tax reform have certainly diminished, since that will be just as difficult to get passed as healthcare reform. The GOP also wanted to use the roughly $200 billion in savings from healthcare reform to fund reduced tax rates. However, tax cuts are something that all Republicans can easily agree too, and they will need to show a legislative victory ahead of next year's mid-term elections. The difficulty will be how to pay for these cuts. We expect them to be "fully funded" in the sense that there will be offsetting spending cuts, but these will be back-loaded toward the end of the 10-year budget window, whereas the tax cuts will be front-loaded. This would generate a modest amount of fiscal stimulus over the next few years. Implications For The Fed Expansionary fiscal policy next year would generate difficulties for the FOMC. The June CPI report underscored that inflation is not a problem for now. Nonetheless, we highlighted in last week's report that pipeline inflationary pressures are gradually building. The unemployment rate is already below the Fed's estimate of the full employment level. Chart 1Inside The Fed's Forecasts... Moreover, unemployment will continue to fall unless productivity picks up soon. We backed out the productivity growth rate implied by the Fed's latest Summary of Economic Projections, given its assumption that real GDP growth will be roughly 2% over the next couple of years and that the unemployment rate will stabilize near the current level. This combination implies that productivity growth will accelerate from the average rate observed so far in this expansion (0.7%) to about 1%, which is consistent with monthly payrolls of 135,000. If we instead assume that productivity does not accelerate (and real GDP growth is 2%), then payrolls must jump to 160,000 and the unemployment rate would fall below 4% next year (Chart 1). The implication is that, unless real GDP growth slows, the unemployment rate is soon likely to reach lows not seen since 2000. The FOMC hawks would become even more worried that the Fed is taking too large a risk with inflation and financial stability (see below). Fiscal stimulus in 2018 would place the FOMC even further behind the curve. Policymakers would be forced to tighten aggressively to bump up the unemployment rate. The Fed would hope for a soft landing, but the more likely result is a recession in 2019. That said, it is too early for investors to position for a recession.1 Bonds rallied and the dollar weakened anew following the collapse of the Senate's healthcare bill on the view that hopes for fiscal stimulus are all but dead. We still believe that bond yields and the dollar have more upside potential, even in the absence of fresh fiscal stimulus. Last week's report2 highlighted that a global monetary policy recalibration is under way because central bankers have decided that "emergency" levels of monetary accommodation are no longer required. Moreover, the maximum level of policy divergence has not yet been reached between the Fed and other major central banks, which means that the dollar will have one last leg higher. The U.S. stock market has weathered the fiscal disappointment, seemingly moving out of sync with dollar and bond market action in the past several months. The equity market appears to have been given a "free pass" because earnings have been very supportive. The combination of robust earnings growth, steady real GDP growth near 2%, and low bond yields, all have been bullish for stocks. It will be tougher sledding when profit growth peaks. Fortunately, the earnings backdrop is still constructive at the moment (see below). A Third Mandate? Financial stability has become a third mandate for the Fed, and is one of the reasons the hawks want to keep tightening despite the fact that the FOMC has not yet met the inflation target. The topic has been mentioned by either Fed staff or FOMC members in 27 of the 39 meetings since September 2012. Fed Chair Yellen has elevated financial stability during her tenure, leading discussions or staff briefings in 19 of the 27 meetings she has presided over. The topic merited only passing mention in Fed deliberations prior to 2012. At the June meeting, Fed staff characterized the "financial vulnerabilities of the U.S. financial system" as moderate on balance.3 This assessment has not changed since the Fed began to offer opinions on the health of the financial system at its September 2013 meeting. However, the Fed does not provide a financial stability grade at every meeting. In December 2013, Fed staff described financial conditions as moderate, but its next judgment (also moderate) was only in January 2016. Since then, Fed staff has provided an assessment of financial stability in half of the 12 subsequent meetings. Another indication that Fed policymakers are paying particular attention to financial market risk is that the issue has become a key part of the Monetary Policy Report (MPR).4 Before the onset of the GFC, financial stability warranted only a few paragraphs in the MPR, but since 2013 the report has included a special section on the topic. Chart 2FOMC Closely Monitoring Financial Stability The four primary areas that the Fed monitors to assess financial stability are: Vulnerabilities stemming from maturity and liquidity transformation in the financial sector (Chart 2, panel 1); Valuation pressures across a range of assets, including Treasury securities, equities, corporate bonds and commercial real estate (panel 2); Leverage in the household and business sectors (panel 5); and Regulatory burden (not shown). Some FOMC members are worried that if rates are not normalized soon, then valuation will become even more stretched in bond and equity markets, which could potentially lead to financial stability issues. This is a reason why a few of the central bankers want to hike rates even though inflation is still too low. This group believes it is better to tighten slowly, rather than wait and raises rates sharply in the future when financial valuations may be even more stretched. Nonetheless, others at the Fed are concerned that higher rates may trigger an equity correction, which if significant enough, would spark a slowdown in the U.S. economy via the wealth channel. In this case, greater financial instability would push the Fed to pause its rate hike regime prematurely. We intend to return to this scenario in a future Weekly Report. The monetary authority is also concerned by negative term premiums in the bond market. We expect only minimal impact on Treasury bond yields linked to the reduction in the Fed's balance sheet.5 That said, a big sell-off in bond prices that leads to a sudden correction in equity prices or a widening of credit spreads would tighten financial conditions, impact the real economy and prompt the Fed to rethink its path for the fed funds rate and its balance sheet. Bottom Line: The conditions that foster financial stability matter to the central bank almost as much as maintaining low and stable inflation, and full employment. The doves want to see inflation rise closer to the 2% target before tightening even more. The hawks worry that the relationship could be non-linear, which means that a further undershoot of unemployment below estimates of full employment could suddenly generate a surge in inflation. At a minimum, an undershoot could boost risks to financial stability by promoting excess risk-taking in the financial markets. Conditions Still Favor The Consumer June's reading on retail sales released in mid-July was disappointing, but the conditions that cultivated increased consumer spending are still in place. Core retail sales dipped by 0.1% month-over-month in June, and both the 3-month and 12-month rates of change have been on a downward trajectory since the start of the year (Chart 3, panel 1). Moreover, auto sales have stagnated near all-time highs in recent months, adding to the market's consumer concerns (panel 2). The only positive is that consumer spending looks better in real terms because inflation has moderated (panel 3). Nominal retail sales have softened, but inflation-adjusted spending is what feeds into the construction of GDP. Even so, conditions are in place for a rebound in spending in the coming months. Consumer confidence readings are still near cycle peaks; home values are elevated and rising; household net worth is at an all-time high and expanding rapidly, financial conditions are easy, and accelerating income growth is supported by the tightening labor market. When these economic circumstances prevailed in the past, consumer spending almost always sped up (Chart 4). Chart 3Soft Patch In Retail Sales##BR##And Inflation Continues Chart 4Conditions Conducive For##BR##Consumer Spending Bottom Line: The soft patch in consumer spending is lingering longer than expected, which challenges our view that U.S. economic growth will be stronger in the second half of the year relative to the first half average. Nevertheless, we anticipate that GDP growth will permit economic output to hit the Fed's low target for the year and keep the monetary authority on track to tighten policy at a faster pace than is discounted in the bond market. The resulting bond sell-off will not derail the equity bull run as long as profits remain supportive. Q2 Earnings Update: Margin Expansion Continues Chart 5Positive Earnings Surprises Continue The Q2 earnings reporting season is off to a strong start, with both EPS and sales running well ahead of consensus expectations as forecasted in our July 3 preview. Moreover, the counter trend rally in profit margins is still in place. Just under 20% of companies have reported results so far with 74% of companies beating consensus EPS projections, right at the long-term average of 70% (Chart 5). In addition, 74% have posted Q2 revenues that exceeded expectations. The surprise factor for Q2 stands at 5% for EPS and 1% for sales. We anticipate the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning early in 2018. Nonetheless, the initial results imply that Q2 will see another quarter of margin expansion. Average earnings growth (Q2 2017 versus Q2 2016) is strong at 9% with revenue growth at 5%. The BCA Earnings model predicts EPS growth to hit roughly 18% later this year on a 4-quarter moving total basis, before moderating in 2018 (Chart 6). Measured on this basis, S&P 500 EPS growth so far in Q2 is 18%, compared with 12% in Q1. The strength in earnings and revenue is broad based (Table 1). Earnings per share are up in Q2 2017 versus Q2 2016 in 10 of 11 sectors; the lone exception is the utilities sector. EPS results are particularly strong in energy, technology and financials. Energy revenues surged by 15% in Q2 versus a year ago. Sales gains in technology (7%), materials (6%), utilities (5%), and real estate (5%), are notable. The upward trajectory of EPS estimates for 2017 and 2018 (Chart 7) since the start of 2017 is encouraging. We will provide an update on the Q2 earnings season in the August 7 Weekly Report. Chart 6Strong EPS##BR##Growth Ahead Table 1S&P 500:##BR##Q2 2017 Results* Chart 7Estimates For '17 & '18 Have Moved##BR##Higher Since Start Of The Year Bottom Line: EPS growth will continue to accelerate through the end of 2017 and into early 2018, aided by a period of margin expansion and decent top-line growth. The elevated level of ISM sets the stage for EPS growth to gather speed in the second half of 2017. Firm readings on ISM are an indication that our bullish profit story for 2017 is still intact. Stay overweight stocks versus bonds. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see BCA's U.S. Investment Strategy Weekly Report "Waiting For The Turn", dated June 26, 2017. Available at usis.bcaresearch.com. 2 Please see BCA's U.S. Investment Strategy Weekly Report "Global Monetary Policy Recalibration", dated July 17, 2017. Available at usis.bcaresearch.com. 3 https://www.federalreserve.gov/monetarypolicy/fomcminutes20170614.htm 4 https://www.federalreserve.gov/monetarypolicy/files/20170707_mprfullreport.pdf 5 Please see BCA's U.S. Bond Strategy Weekly Report "Two Challenges For U.S. Policymakers", dated May 23, 2017. Available at usbs.bcaresearch.com.

Highlights The Fed is behind the curve in raising rates, as is the Bank of Canada, the Reserve Bank of Australia, the Reserve Bank of New Zealand, and the Swedish Riksbank. In contrast, the Bank of Japan, the ECB, and the Swiss National Bank have little need to tighten monetary policy. Accordingly, investors should favor USD, CAD, SEK, NZD, and to a lesser extent, AUD. EUR, CHF, and JPY will weaken. GBP will trade sideways. Short-term momentum could push EUR/USD to 1.18, but the euro will ultimately reach parity against the dollar next year, as the Fed is forced to accelerate the pace of rate hikes. Stay structurally long DXY. Go long SEK/CHF. We are closing our longstanding overweight positions in Australian and New Zealand government bonds for a handsome profit. Remain overweight global equities for now, but be prepared to turn bearish in the second half of 2018. Feature The Fed: It's Time To Get A Bit More Hawkish In our December 2015 report "The Fed Makes An Unforced Error," we made the case that the Federal Reserve would regret its decision to tighten monetary policy.1 Subsequent events validated this view: U.S. growth sagged in the first half of 2016, leading to a sharp flattening in the yield curve. It would be another 12 months before the Fed raised rates again. As bond prices and the economic data evolved over the course of 2016, our recommendations changed accordingly. On July 5th, we published a note entitled "The End Of The 35-Year Bond Bull Market" arguing that it was time to take profits on long duration positions.2 As luck would have it, this was the exact same date that the 10-year Treasury yield hit a record closing low of 1.37%. Fast forward to the present and investors are once again debating the next steps that central banks are likely to take. However, unlike in 2015, a strong case can be made that the Fed is now behind the curve in raising rates, rather than ahead of it. There are three reasons for this: There is less slack now than in 2015. The unemployment rate stands at 4.4%, down from 5% in December 2015. The broader U-6 unemployment rate has fallen even more, from 9.9% to 8.6%. Other measures of labor market slack are also closing in on their past business-cycle lows (Table 1). Table 1Comparing Current Labor Market Slack With Past Cycles The neutral interest rate has likely risen somewhat over the past 18 months (Chart 1). Household debt has continued to decline as a share of disposable income. The share of national income going to labor has increased. Wage growth among lower-income workers who tend to spend most of their paychecks has accelerated. All this should give consumers the wherewithal to spend more, warranting higher interest rates. Bank balance sheets have also continued to improve, as evidenced by the recent stress test results. In addition, fiscal policy has eased modestly and could ease even more if Congress is able to pass legislation cutting taxes later this year or in early 2018. Financial conditions have eased significantly since the start of the year, which should boost growth in the second half of this year (Chart 2). This is in sharp contrast to 2015, a year when financial conditions tightened sharply. Easier financial conditions are boosting credit growth. The annualized 3-month change in bank credit has accelerated from 1.1% in April to 4.2% at present. (Chart 3). Chart 1Households Have The Wherewithal To Spend More Chart 2Financial Conditions Have Eased Chart 3Credit Growth Has Picked Up The prospect of stronger growth over the next few quarters implies that the unemployment rate is likely to fall below 4% early next year, possibly breaking through the 2000 low of 3.8%. If that were to happen, the unemployment rate would end up being nearly a full percentage point below the Fed's estimate of NAIRU. It is possible, of course, that the true value of NAIRU is lower than official estimates suggest. Older workers change jobs less frequently, and so an aging workforce tends to produce less frictional unemployment. The internet has also improved the ability of companies to fill vacancies with suitable workers. On the flipside, declining geographical mobility and falling demand for low-skilled labor may have raised structural unemployment. On balance, we are skeptical that the current estimate of NAIRU of 4.7% - already one percentage point below its post-1960 average (Chart 4) - is significantly overstated. A tighter U.S. labor market will put upward pressure on wages. While recent wage data has been on the soft side, our wage tracker is still growing twice as fast as in 2010 (Chart 5). Indeed, for all the talk about how wage growth is "inexplicably" slow, real wages have been rising more quickly than productivity for three straight years now - the longest stretch since the late 1990s (Chart 6). Chart 4NAIRU Is Low By Historic Standards Chart 5A Stronger Labor Market Will Lead To Faster Wage Growth Chart 6Real Wages Now Increasing Faster Than Productivity Inflation: A Lagging Indicator When will accelerating wage growth translate into sharply higher price inflation? Probably not this year. Historically, inflation has been the mother-of-all lagging indicators. Core inflation peaked at 2.5% in August 2008, eight months after the start of the recession. In fact, core inflation has topped out in every single business cycle over the past 40 years only after the expansion has ended and the recession begun (Chart 7). Likewise, core inflation typically bottoms several years after the economic recovery is underway. This suggests that inflation could stay subdued for the next 12 months as the labor market slowly overheats, before moving higher in the second half of 2018. Chart 7Inflation Is A Lagging Indicator If the Fed drags its feet in raising interest rates, it will be difficult to achieve a soft landing. Stabilizing the economy is akin to landing a plane: You don't just need to know the speed at which you have to hit the runway, you also have to time your descent in order to touch the ground at precisely the right speed. Even if the Fed knew where the neutral interest rate stood (which it doesn't), tightening monetary policy too late could end up pushing the unemployment rate to such a low level that it has nowhere to go but up. And as we have shown before, once the unemployment rate starts rising, it generally keeps rising, owing to the presence of numerous negative feedback loops.3 The Fed has arguably already fallen into the trap of waiting too long. If so, gradual rate hikes this year will give way to more aggressive hikes late next year, setting the stage for a recession in 2019. The Bank Of Canada Turns Hawkish On the other side of the 45th parallel, the Bank of Canada raised rates last week and signaled that further hikes lie in store. The BoC revised up its GDP growth forecasts for 2017 and 2018. It also indicated that the output gap would close later this year, rather than next year as it had earlier projected. The Bank of Canada's newfound optimism was bolstered by the most recent Business Outlook Survey, which pointed to accelerating growth, dwindling spare industrial capacity, and an increasingly tight labor market (Chart 8). The moose in the living room is the Canadian housing market (Chart 9). Central bankers are generally reluctant to use the blunt tool of tighter monetary policy to target excessive property prices. However, when stricter macroprudential regulations fail to do the job, the standard prescription is to tighten monetary policy slowly but early. The Bank of Canada has done the former but not the latter. Consequently, as my colleague Jonathan LaBerge argued in last week's Special Report, the coming housing bust is likely to be a nasty affair.4 This will be the price the Bank of Canada pays for being behind the curve. Chart 8Canadian Growth Picture Is Upbeat Chart 9Housing Bubbles Abound For now, we remain long the Canadian dollar in our currency recommendations. We are expressing this view by being long CAD/EUR, a trade that has gained 3.5% in the nine weeks since we initiated it. We also recommend being underweight Canadian government bonds within a global fixed-income portfolio. It is important to stress, however, that these are 12-month views. Most Canadian mortgages are floating rate. Higher borrowing costs will likely trigger a housing bust late next year or in 2019, forcing the Bank of Canada to slow or even reverse the pace of rate hikes. The RBA And RBNZ ... Behind The Curve Too Australia and New Zealand have also been grappling with dangerously overvalued housing markets, and just as in Canada, the RBA and RBNZ have been behind the curve in responding to the brewing excesses. That is starting to change. The Reserve Bank of Australia struck a hawkish tone in the July 4 meeting minutes released this week, sending the Aussie dollar to a 26-month high against the greenback. The RBA highlighted the improvement in business conditions and a tightening labor market. It also indicated that the "neutral cash rate" was 3.5%, two points higher than the rate of 1.5%. Australia's terms of trade have been recovering of late and this should support the economy as well as the Aussie dollar (Chart 10). The RBNZ is even further behind the curve than the RBA (Chart 11). Nominal GDP is growing at over 6% and retail sales are expanding at nearly 8%. Population growth has risen sharply in recent years due to increased immigration, leading to greater demand for housing. The government has increased infrastructure spending and cut taxes. The unemployment rate has fallen back to an 8-year low of 4.9%, while the terms of trade is approaching record-high levels. Chart 10RBA Behind The Curve... Chart 11... And RBNZ Too? With all this in mind, we are closing our longstanding overweight positions in Australian and New Zealand government bonds for gains of 59.5% and 74.2%, respectively.5 Riksbank: End Of NIRP? The Swedish repo rate stands at -0.5%, despite the fact that the output gap has moved into positive territory (Chart 12). Inflation is still slightly below target, but is moving higher. The Riksbank is taking notice of the changing economic environment. The central bank backed away from its easing bias at its most recent policy meeting. The facts on the ground support this decision. Sweden's GDP is now 0.7% above potential and the economy continues to strengthen. The Riksbank's resource utilization indicator points to a sharp acceleration in Swedish inflation in the coming quarters. Nonfinancial private credit has reached 237% of GDP, up from 106% in 2000. If the Riksbank falls too far behind the curve, it will be forced to jack up rates very aggressively down the road, reviving the specter of the debt crisis of the early 1990s. The ECB, SNB, And BoJ: Take It Easy Whereas a strong case can be made that the central banks discussed above are behind the curve in normalizing monetary policy, the same cannot be said for the ECB, Swiss National Bank, or Bank of Japan. Labor market slack across the euro area as a whole is still 3.2 percentage points higher than in 2008 and 6.7 points higher outside of Germany (Chart 13). Moreover, as we discussed two weeks ago, the neutral rate in the euro area remains very depressed.6 Thus, even if the euro area economy were close to full employment, the ECB would still not have much scope to raise rates. Chart 12NIRP In Sweden: R.I.P. Chart 13Euro Area: Labor Market Slack Still High Outside Of Germany In this light, investors have gotten too optimistic about the ability of the ECB to tighten monetary policy. While the ECB will further taper asset purchases as early as this autumn, sustained rate hikes are still a few years away. Mario Draghi explicitly said during his press conference yesterday that "the last thing that the governing council may want is actually an unwanted tightening of the financing conditions." This is in sharp contrast to the Fed, which is trying to tighten financial conditions by raising rates. Swiss monetary conditions are far from accommodative, despite a policy rate that remains buried in negative territory (Chart 14). Core inflation is close to zero and wage growth is anemic. An overvalued currency has offset the benefits from lower interest rates. Given the SNB's policy of intervening in the currency markets to keep EUR/CHF within a reasonably tight range, the recent appreciation of the euro will further add to the deflationary pressures weighing on the Swiss economy. Investors should position for a weaker franc (and euro) in the months ahead. Go long SEK/CHF (Chart 15). Chart 14The Swiss Economy Still Needs Low Rates Chart 15Long SEK/CHF Similar to the ECB and the SNB, the Bank of Japan is in no position to tighten monetary policy. Core inflation has fallen back to zero and medium-to-long-term inflation expectations have dipped so far this year (Chart 16). The annual shunto wage negotiations this summer produced little in the way of salary hikes. And even if inflation were to rise, the government would likely want to tighten fiscal policy before contemplating removing the monetary punch bowl. The Bank Of England: A Tough Call If one didn't know what transpired last June, the case for tighter monetary policy in the U.K. would be fairly straightforward. The unemployment rate is at a 9-year low and inflation is well above target. The trade-weighted pound has weakened by 21% since November 2015, which in most cases, would translate into stronger growth in the years ahead. Reflecting these points, our Central Bank Monitors show that the U.K. is more in need of tighter money than any other major developed economy (Chart 17). Chart 16BoJ: In No Position To Tighten Chart 17The Message From Our Central Bank Monitors Brexit negotiations are likely to cast a pall over the economy, however. The EU will be forced to take a tough line with the U.K., for fear that the Brexit vote could prompt other countries to follow's Britain's lead. BCA's geopolitical strategists ultimately expect a "hard Brexit" to be averted, but things may need to be brought to the precipice before that happens. The pound is cheap and so we do not expect it to weaken significantly from current levels. Nevertheless, the upside for both sterling and gilt yields will remain constrained until political uncertainty abates. Investment Conclusions As a rule of thumb, investors should favor currencies in economies whose central banks are behind the curve. Such central banks are likely to find themselves in a position where they have to scramble to tighten monetary policy. We noted on July 7th that short-term momentum favors the euro and that we would not be surprised if EUR/USD reaches 1.18 over the coming weeks. Looking further ahead, the appreciation of the euro in the first half of this year will weigh on growth in the remainder of 2017 and into early 2018. This will force the ECB to cool its heels. In contrast, U.S. growth should accelerate. Against the backdrop of diminished spare capacity, this will prompt the Fed to turn more hawkish. We expect EUR/USD to fall to 1.05 by year-end, and reach parity next year as the Fed ramps up the pace of rate hikes. The market is betting that the Fed will deliver fewer rate hikes than implied by the 'dots'. Our hunch is that the Fed will deliver more hikes than what its forecast suggests, especially starting early next year when inflation is liable to accelerate. Bullish sentiment towards the dollar has collapsed. Investors should turn contrarian and position for a stronger greenback over the next 12 months. In addition to the dollar, we like the Swedish krona, Canadian dollar, and New Zealand dollar. The Aussie dollar should also perform reasonably well, provided that the Chinese economy continues to hold up, as we expect it will. The Japanese yen remains our least favorite currency. Despite the dollar selloff, USD/JPY has managed to gain 3% since mid-April. As the Fed and a number of other central banks raise rates, the spread in yields between foreign government bonds and JGBs will widen. This will push down the yen, helping Japanese stocks in the process. As far as overall risk sentiment is concerned, another rule of thumb says that stocks rarely fall on a sustained basis outside of recessions (Chart 18). We do not expect a recession in the U.S. or elsewhere until 2019. This implies that investors should maintain an overweight position in global equities for now, favoring cyclical sectors over defensive ones. Chart 18Stocks Rarely Fall On A Sustained Basis Outside Of Recessions Peter Berezin, Global Chief Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "The Fed Makes An Unforced Error," dated December 18, 2015, available at gis.bcaresearch.com. 2 Please see Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gis.bcaresearch.com 3 Please see Global Investment Strategy Weekly Report, "When Doves Cry," dated June 9, 2017, available at gis.bcaresearch.com. 4 Please see Global Investment Strategy Special Report, "Canada: A (Probably) Happy Moment In An Otherwise Sad Story," dated July 14, 2017, available at gis.bcaresearch.com. 5 Calculated as the total excess return on the 10-year bond index relative to global government benchmark since inception in 2009, foreign-currency hedged since 2014. The 10-year yield for New Zealand government bonds has dropped from 4.28% at the time of inception to 2.94% today. The 10-year yield for Australian government bonds has fallen from 4.10% to 2.74% over this period. 6 Please see Global Investment Strategy Weekly Report, "Draghi's Dilemma," dated July 7, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

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

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

Highlights Reduced demand in oil-exporting countries and higher supplies from distressed states is whittling down the amount of oil being removed from the market this year, based on our latest supply-demand balances. As a result, even though OECD inventories will be drawn down to their five-year average levels by year end, this average will be a higher end-point than we projected last month. The Kingdom of Saudi Arabia (KSA) continues to reassure markets through anonymous media leaks it will cut production further to accommodate higher Libyan and Nigerian production. This is not unexpected, but it still is speculative. Ecuador's opting out of OPEC 2.0's production cuts raises the odds other financially distressed non-Gulf producers also will head for the exits. Energy: Overweight. Crude oil prices remain supported by actual production cuts, and the promise of further reductions by KSA and possibly other OPEC 2.0 members. Base Metals: Neutral. Labor and management at the Zaldívar copper mine in Chile are negotiating, according to Metal Bulletin. Separately, a three-year deal was agreed at the Centinela copper mine in Chile last week. Precious Metals: Neutral. Gold rallied on the back of lower inflation readings in the U.S., which suggested the Fed will back off aggressively pursuing its rates normalization policy. This would leave real rates low. Our strategic long portfolio hedge is up 1.0% since it was initiated May 4, 2017. Ags/Softs: Underweight. We maintain our bearish view on grains. Fears that extreme heat in the U.S. Midwest and Plains will not be sufficient to counter the still-high ending-stocks expectations published in the USDA's WASDE last week. Feature Higher oil production is seeping into global balances. Lower prices, which are stimulating demand in oil-importing markets, are reducing incomes and demand in oil-exporting provinces. As a result, the rate at which inventories will draw this year is slowing. Our latest supply - demand balances shown in Table 1 indicate the net 900k b/d physical deficit we expected for 2017 has been whittled down to just under 500k b/d, as a result of production increases in Libya and Nigeria, and slower demand growth in oil exporters generally (Chart of the Week). Table 1BCA Global Oil Supply -##BR##Demand Balances (mm b/d) Chart of the WeekHigher Production And Lower Demand Reduce##BR##Physical Deficits Versus Last Month's Projections Ecuador, a small-ish OPEC member producing about 550k b/d, opted out of the Agreement negotiated by KSA and Russia to remove some 1.8mm b/d of production from the markets. This indicates weaker states that are party to the OPEC 2.0 Agreement are finding it impossible to maintain compliance with the cuts they've obliged themselves to undertake in the face of lower oil prices. As a result, they are compelled to increase production in an attempt to recover lost revenue (R), by increasing their quantity (Q) sold when prices (P) are weak, so as to maximize P*Q = R while they can. This only works if they are alone in increasing production while others - notably KSA, other Gulf states and Russia - restrict output to revive prices. Otherwise, if all the distressed states in the OPEC 2.0 coalition took the same action, markets would be flooded with oil. This was demonstrated in the mid-1980s during KSA's netback-pricing regime, when the Kingdom priced its oil as a function of prices received by refiners. This collapsed prices, and, eventually, reined in free-riding on KSA's production cuts.1 While few of these states, mostly outside the Gulf, are capable of significantly increasing production, at the margin, they can have an impact. Production Increases In OPEC, U.S. Partly Counter OPEC 2.0's Best Efforts Year-to-date to June, Iran and Libya have added 110k and 140k b/d of production to the market vs. their respective Oct/16 benchmark levels of 3.7mm and 550k b/d against which the OPEC 2.0 deal is being assessed. June production for these states was up 120k and 300k b/d for Iran and Libya, respectively, vs. October levels, while Nigeria's output was up 90k b/d (Chart 2). Libya and Nigeria are not parties to the OPEC 2.0 deal. Nonetheless, these states together with Iran added close to 500k b/d vs. their Oct/16 output levels in June, without an offsetting decline from members of the OPEC 2.0 coalition. Gulf OPEC ex Iran production is down some 850k b/d on average at 24.6mm b/d in 1H17 vs. Oct/16 levels, while non-Gulf OPEC production is down 215k b/d at 7.5mm b/d. We still see OPEC 2.0's production significantly below the EIA's estimate to March 2018 (Chart 3), which drives our view of inventory behavior. U.S. production also was higher in 1H17, as WTI prices rallied in response to the OPEC 2.0 production-cutting deal (Chart 4). For 1H17, U.S. crude oil production was up 230k b/d vs. 4Q16 levels, at 9.04mm b/d, led by higher shale-oil output. Chart 2Almost 500k b/d Added To Oct/16 Output##BR##By Iran, Libya, And Nigeria In June Chart 3OPEC 2.0 Cuts Drive##BR##Inventory Draws Chart 4U.S. Crude Production##BR##Grows In 1H17 Slower Demand Growth Reduces Storage Draw On the demand side, we've lowered our estimate of demand growth this year to close to 1.37mm b/d, down nearly 110k b/d vs. our earlier May estimate. This results from lower consumption in oil exporting states. The combination of stronger supply growth and weaker demand growth reduces our estimated physical deficit for this year to 470k b/d from close to 900k b/d in our May balances estimates. These revised supply - demand estimates still produce enough of a physical deficit to allow storage to fall to five-year average levels (Chart 5). However, with the drawdowns prolonged by slower supply losses and reduced demand, inventories are now projected to remain above 2.8 billion bbls versus our earlier estimate of inventories declining to ~2.75 billion barrels by end-2017 or early 2018. Chart 5OECD Storage Draws To Five-Year Average Levels, But Higher Supply And Lower Demand Keep This Level Higher Chart 5OECD Storage Draws To Five-Year Average Levels, But Higher Supply And Lower Demand Keep This Level Higher Net, at the end of this drawdown, storage will be higher than expected, even if it does make it to five-year average levels. This will leave less room for OPEC 2.0 members to implement a strategy to backwardate the forward WTI curve so as to slow the rate at which shale-oil rigs return to the field, which we've discussed in previous research.2 More Cuts Required By OPEC 2.0 Going into its St. Petersburg meetings next week, there are clearly defined issues to be addressed by OPEC 2.0. The foregoing suggests additional cuts will be needed to empty storage sufficiently by yearend for OPEC 2.0 to be able to move to the next phase of its plan to regain some influence over the evolution of oil prices, particularly the U.S. benchmark WTI price, which drives hedging and profitability of U.S. shale producers. Over the short term, this effort likely will be clearly supported by KSA's stated intention to reduce exports to the U.S. market (Chart 6). All else equal, this will result in sharper draws in the high-frequency U.S. weekly inventory data, by augmenting reduced shipments to the U.S. from OPEC overall (Chart 7). Chart 6KSA's To Reduce##BR##Exports To The U.S. Chart 7OPEC Exports To The U.S. To Fall Further##BR##When KSA Reduces Shipments More substantive price-support and inventory-draining measures, as noted at the top of this article, will have to involve further production cuts by OPEC 2.0. KSA again is signaling it is open to additional production cuts, in order to normalize oil inventories.3 We have no doubt the Kingdom's Gulf allies - particularly Kuwait and the UAE - will support KSA in this effort. We also expect Russia to be supportive of this effort. The size of the cuts likely will exceed 500k b/d, so as to offset the production gains of Libya and Nigeria. Iran's higher production discussed herein, and Iraq's recent assertiveness in claiming "the right" to increase its production given the size of its reserves, suggests a short and a long game for the leadership of OPEC 2.0. In the short-term, Iran, Iraq, Libya and Nigeria will be constrained by lack of funds to significantly increase production. Thus, OPEC 2.0 - mostly KSA and its allies - can cut production without triggering an immediate response from these states, which will allow storage to resume drawing at a faster rate. For OPEC 2.0 to have a meaningful effect on U.S. shale production, the stronger storage draws in the near term would have to be accompanied by forward guidance from KSA, Russia and their allies that production will be increased in the medium term - 6 months or so out - so that continued demand growth can be accommodated by higher supplies. This would require storage and production flexibility by OPEC 2.0's leaders. Should all of this fall in place, we would expect a backwardation to develop toward yearend, which would be the first step in a longer-term strategy by OPEC 2.0 to slow the rate at which horizontal rigs return to drilling in the shale fields. Bottom Line: Higher oil production from Libya, Iran and Nigeria, coupled with a slight downgrade in demand growth, will reduce the physical deficit we expected this year. This will, all else equal, reduce the rate at which OECD storage draws, and raise the level of five-year average inventory levels by yearend. We do not believe this is a favorable outcome for OPEC 2.0, particularly KSA and Russia, if they are intent on regaining some influence over the evolution of oil prices. For this reason, we believe KSA and its Gulf Arab allies will reduce production further to put the inventory draws back on track. We remain long low-risk calls spreads in Dec/17 WTI and Brent - long $50/bbl strikes vs. short $55/bbl strikes - and will look for opportunities to gain upside exposure once we get clear signaling from OPEC 2.0 leadership. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see BCA's Commodity & Energy Strategy Weekly Report "Sideshow In Vienna," published October 23, 2014, for a review of netback pricing by KSA. It is available at ces.bcaresearch.com. 2 Please see BCA Research's Commodity & Energy Strategy Weekly Reports of April 6, 2017, entitled "The Game's Afoot In Oil, But Which One," and March 30, 2017, entitled "KSA's, Russia's End Game: Contain U.S. Shale Oil" for a discussion of this strategy. Both are available at ces.bcaresearch.com. 3 Please see "Saudi Arabia still aims to reduce supply; weighs Nigerian, Libyan barrels," published by reuters.com on July 18, 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

Highlights To change our EM strategy, we would need to change our view on China and accept that China's credit bubble - especially in combination with the ongoing policy tightening - does not constitute a material risk to mainland growth in the foreseeable future. We are simply not ready to make this call. It is a matter of time until mainland's growth relapses and China-related plays (including commodities and EM) enter a bear market. Even though the headline growth numbers out of China have so far remained solid, their second derivatives - change in growth rate - have turned negative. Asian export growth has already rolled over, and a slowdown will become pronounced in the months ahead. This will likely halt and reverse the EM rally. Having taken into consideration various factors, we believe it would be wrong to change our strategy at the moment. Feature The U.S. dollar has tumbled and EM risk asset prices have spiked following last week's testimony by Federal Reserve Chair Janet Yellen to Congress. This week we review what has gone wrong with respect to our view, as well as weigh the pros and cons of altering strategy at this point. Our bearish view on EM has been contingent on two pillars: Our downbeat view on EM over the past year has rested on higher U.S. bond yields pushing up the U.S. dollar. This view played out in the second half of last year but has been wrong since early this year. We have continuously argued that EM risk assets are vulnerable due to China's growth relapse amid ongoing liquidity tightening and the lingering credit bubble. Even though the headline growth numbers out of China have so far remained solid, their second derivatives - change in growth rate - have turned negative (more details are provided in the section below). We maintain that our theme of slower mainland growth still has high odds of playing out later this year. We expect meaningfully weak data (on a first-, not second-derivative basis) out of China before year end. If equity markets are forward-looking, they should start pricing in such a scenario now. What has surprised us is the fact that EM investors have utterly and altogether ignored political woes in a number of EM countries, lower commodities prices and lingering structural and cyclical problems in many developing economies, as well as China's tightening amid the credit excesses. Instead, EM investors have singularly focused on downward surprises in U.S. inflation - even ignoring strong employment data in America. Remarkably, EM share prices historically plunged when U.S. inflation and inflation expectations dropped (Chart I-1). Hence, the year-to-date negative correlation between EM stocks and U.S. inflation is out of sync with the historical relationship. We review some other inconsistencies and contradictions below. Chart I-1U.S. Inflation And EM Stocks Were Historically Positively Correlated, But Not This Year Inconsistencies In Prevalent Narrative The purpose of this section is not to justify our investment strategy, which has been wrong-footed, but to elaborate on financial markets' nuances that have been much less clear-cut than popular financial market narratives imply. The reality is much more complicated than the following prevalent among investors narrative: low U.S. inflation entails little tightening by the Fed, resulting in a weak U.S. dollar and an EM rally. There are some contradictions in this story: If U.S. household consumption growth in nominal terms is as weak as portrayed by the latest retail sales and inflation readings (Chart I-2), how can U.S. corporate earnings continue to grow at a double-digit rate, as most investors currently expect? The only way this can happen is if productivity growth is really strong and profit margins continue to expand. Productivity is a black box that no one can measure accurately in real time. If underlying productivity growth is indeed robust, the bull market will persist and bears will be humiliated. The snag is that productivity assessment is a judgement call, and only time will reveal true productivity dynamics. Not having more insight, we have so far assumed that the official statistics on productivity in the U.S. and EM are generally right. If U.S. productivity data are close to reality, unit labor costs - calculated as wages divided by productivity - are rising faster than underlying inflation (Chart I-3, top panel). This entails that U.S. corporate profit margins should be contracting. The middle and bottom panels of Chart I-3 portray our macro proxy for U.S. corporate profit margins based on core PCE inflation and unit labor costs. Chart I-2The U.S.: Very Low Nominal Growth Chart I-3A Macro Proxy For U.S. Corporate Profit Margins Entails Shrinking Margins Overall, if low inflation and weak U.S. nominal retail sales data are a true representation of current U.S. economic conditions, the corporate profit outlook cannot be benign, and American stock prices should be lower - not higher. If lower inflation and nominal growth of recent months in the U.S. were an aberration, U.S. interest rate expectations will have to be revised higher and the U.S. dollar will rally. We are even more puzzled by the nature of the drop in U.S. bond yields, and EM financial markets' reaction to it. Typically, EM risk assets negatively correlate with real (TIPS) yields (Chart I-4), and positively correlate with the inflation component of U.S. bond yields (Chart I-1 on page 1). The decline in U.S. bond yields since the beginning of the year has been almost entirely driven by the inflation component, with U.S. real yields actually not dropping at all. Yet, EM risk assets have rallied sharply. This goes against the predominant correlation of the past several years and is very puzzling. In short, the historical correlations between EM stocks and currencies on one hand and U.S. real yields and inflation expectations on the other, have in the past six months reversed for no reason. If the weaker U.S. dollar and lower U.S. bond yields/rate expectations represent an unwinding of the "Trump trade", why has the S&P 500 - which has surged amid "Trump trade" - not yet corrected? Broadly speaking, if U.S. bond yields drop further and the greenback continues deprecating, it would signal a major relapse in U.S. growth and U.S. share prices will dive. On the contrary, if U.S. growth is solid, the dollar selloff is overdone and the greenback is close to a major bottom. In addition, EM risk assets have decoupled from commodities prices, as we have detailed many times since early this year. Also, as a side note, the broad trade-weighted U.S. dollar decoupled from precious metals prices this whole year up until last week. These are non-trivial divergences that are by and large puzzling. Finally, EM net earnings-per-share revisions have rolled over, yet share prices have continued to move higher (Chart I-5). Such decoupling has simply never happened before. Chart I-4Another Breakdown In Correlations: ##br##EM Currencies And U.S. TIPS Yields Chart I-5EM EPS Net Revisions ##br##Have Failed To Turn Positive Besides, EM EPS net revisions have not turned positive throughout this 18-month rally. In short, analysts in aggregate have not upgraded their EPS estimates for EM companies at all. Bottom Line: There are a number of contradictions and inconsistencies that cannot be explained by the prevailing financial market narrative. What About Global Growth? One way to square the above inconsistencies is to argue that the drop in the U.S. dollar and the EM rally have little to do with U.S. dynamics and much to do with strength in the rest of the world, especially outside the U.S. This is coherent reasoning. We review global growth dynamics in this section and elaborate on China in the following one. Without disputing the fact that there has been a notable recovery in global growth and trade in the past year, we would like to emphasize that on a rate-of-change (second derivative) basis, global trade, and particularly Asian export growth, has already rolled over, and a slowdown will become pronounced in the months ahead. Consistently, the U.S. dollar should rise or EM risk assets should reverse their gains in the near future, if and as global trade/EM growth falters: The pace of export growth in key Asian manufacturing hubs such as Korea, Taiwan and Singapore has already rolled over (Chart I-6). Both Taiwanese exports of electronic parts and the country's overall exports to China have rolled over - the latter two lead global export volumes and Chinese exports, respectively, by a few months, as shown in Chart I-7. Chart I-6Asian Export Growth Has Rolled Over Chart I-7Global Export Growth Has Peaked The reason why Taiwanese exports of electronic parts lead global trade cycles is because these parts are used in the assembly of final products, and producers order and receive these parts before final products are made and shipped. Similarly, a lot of Taiwanese exports to China serve as inputs into final products assembled in China and are shipped worldwide. This is why Taiwanese shipments to China lead mainland aggregate exports. Provided U.S. consumer spending has recently weakened, as depicted by core retail sales, U.S. imports are bound to slump sooner than later (Chart I-8). Consequently, Asian and European shipments to America are likely to roll over soon. Imports are more volatile than domestic demand, reflecting inventory re-stocking and de-stocking cycles. The decoupling between the not-so-strong U.S. final demand and robust imports suggests an inventory re-stocking cycle in the U.S. has recently been taking place. As such, this will be followed by a period of destocking, i.e., weaker imports, weighing on the rest of the world's shipments to the U.S.. A genuine area of global growth acceleration has been continental Europe. Undoubtedly, growth is extremely robust in these economies, and there is no reason for European economies to plunge into recession. That said, U.S. growth dynamics following the 2008 crisis have generally been "two steps forward, one step back." This has typically held true for post-crisis economic recoveries in all major economies. There is no reason why Europe's economic recovery will be any different. As such, having experienced "two steps forward" in the past year, European growth is more than likely to take a "one step back" - i.e., slow down a bit. In brief, if growth dynamics in Europe were to resemble that of the U.S. post-crisis era, mean reversion in European growth is overdue. Finally, global auto sales growth has rolled over decisively (Chart I-9, top panel). The deceleration is very broad-based including the U.S., Europe (Chart I-9, bottom panel) and China (please refer to Chart I-12 on page 10). Chart I-8Weak U.S. Retail Sales Entail ##br##U.S. Import Deceleration Chart I-9Global Vehicle Sales ##br##Growth Heading South Bottom Line: If the global growth recovery has been behind the U.S. dollar selloff and the EM rally, the forthcoming reversal in global trade will at minimum halt and reverse the EM rally. China is critical to our theme of slowdown in global trade. China's Growth: Looking Beyond Headlines China's headline growth numbers for GDP and industrial production have been on the strong side, but forward-looking variables such as money growth and various liquidity measures entail a major deceleration by the end of this year: Narrow and broad money growth - which have historically led the business cycle in China - have relapsed (Chart I-10). Although credit growth has not yet decelerated, money often leads or coincides with credit growth, suggesting a credit slowdown is forthcoming. Furthermore, commercial banks' excess reserves at the central bank are key to their lending capacity. The top panel of Chart I-11 demonstrates that China's money multiplier - the ratio of broad money-to-excess reserves, or banks' assets-to-excess reserves - have surged, implying that banks are over-extended. Chart I-10China: Money Leads Business Cycle Chart I-11China: Bank Loan Growth To Slow In addition, banks' shrinking excess reserves point to a rollover in bank loan growth in the months ahead (Chart I-11, bottom panel). The pace of growth in China's many economic indicators has already rolled over - i.e., their second derivative has turned negative. These include total and ex-oil imports, electricity output and auto production (Chart I-12). Finally, the central bank will continue to tighten liquidity. The recent softness in interest rates may have been temporary, as June is a month in which liquidity demand spikes, and the People's Bank of China probably did not want a replay of the June 2013 SHIBOR crisis. Notably, both core consumer prices and consumer services inflation measures in China are grinding higher (Chart I-13). This, along with "a mandate of preventing bubble formations," will all but ensure that the PBoC tightens further. Chart I-12China: The Pace Of Growth Has Already Rolled Over Chart I-13China: Inflation Is Rising Tighter liquidity/higher interest rates along with regulatory tightening on banks and shadow banking will cause credit growth to slow down considerably, weighing on the real economy. Bottom Line: In China, liquidity is tightening and interest rates are rising amid a credit bubble. Meanwhile, investors remain complacent, and the overwhelming majority of the global investment community believes that China will be able to deflate its financial bubbles and deleverage its corporate sector without a meaningful impact on the real economy. The reality is there has been no historical precedent of this occurring in any country. Strategy Considerations: The Dollar And China Hold The Key The greenback holds the key to EM strategy - not only because it mechanically drives the performance of EM financial markets, but also because it reflects many global financial and economic trends. Having taken into consideration various factors, we believe it would be wrong to change our strategy at a time when: There has already been capitulation by U.S. dollar bulls, the greenback is technically oversold and the Fed will soon commence reduction of its balance sheet. All of this makes us reluctant to change our view on the U.S. dollar and EM at the moment. Notably, the U.S. dollar is at a critical technical level against numerous currencies (Chart I-14A and I-14B). Chart I-14AThe U.S. Dollar Is At A Critical Technical Level (II) Chart I-14BThe U.S. Dollar Is At A Critical Technical Level (I) In short, it is too late to abandon a positive view on the dollar. We have been and remain much more certain about the U.S. dollar strength versus EM, commodities, and Asian currencies than against the euro. Meanwhile, EM financial markets are overbought, and implied volatility across most global financial markets in general and EM in particular is at record-low levels (Chart I-15). Chart I-15Implied Volatilities Are Depressed ##br##Across Most Asset Markets The Fed will shrink its balance sheet, and high-power U.S. dollar liquidity will diminish. Besides, the PBoC will continue to tighten liquidity and guide interest rates higher amid lingering credit excesses. These developments are at the margin bullish for the greenback, and invariably bearish for EM/China-related plays. China's industrial cycle has peaked and Asian exports have rolled over, as we have illustrated above. China's narrow money (M1) growth is slowing, and broad money (M2) growth is at an all-time low. Money leads business cycles in China. Our biggest concerns have been and remain continued strong flows to EM and how well risk assets have been trading. Past flows are no guarantee of future flows. However, both DM and EM risk assets have been trading really well. It is hard to know and forecast when this will change. That said, we maintain that the next 20% move in EM share prices and commensurate moves in other EM risk assets will be down - not up. Weighing the pros and cons, we are reluctant to alter our view and recommended strategy at the moment. To change our EM strategy, we would need to change our view on China and accept that China's credit bubble - especially in combination with the ongoing policy tightening - does not constitute a material risk to mainland growth in the foreseeable future. We are simply not ready to make this call. It is a matter of time until mainland growth relapses and China-related plays (including commodities and EM) enter a new bear market. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

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

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

Highlights Monetary Policy: The Fed is still on track to start winding down its balance sheet in September, and will lift rates again in December if inflation starts to move higher. If the Fed continues to lift rates in the face of low inflation, then the real fed funds could soon overtake its estimated neutral level. TIPS: We attribute this year's decline in breakevens to the combination of disappointing realized inflation and the fact that they had appeared too wide on our TIPS Financial Model. Inflation: Core inflation disappointed once again in June. The pass-through from a depreciating dollar and accelerating wages should cause this weakness to reverse in the months ahead. Feature Chart 1Bond Bear Takes A Pause Globally, a shift toward less accommodative monetary policy remains the dominant market theme. However, the U.S. bond selloff did pause last week following some disappointing macro data and comments from Fed policymakers that were interpreted as dovish. The market is now discounting 30 bps of rate hikes during the next 12 months, down slightly from the recent peak of 36 bps (Chart 1). The dovish comments came from Governor Lael Brainard in a July 11 speech1 and were echoed one day later by Fed Chair Janet Yellen in her semi-annual testimony to Congress.2 Both comments related to the stance of monetary policy in relation to its neutral (or equilibrium) level. In my view, the neutral level of the federal funds rate is likely to remain close to zero in real terms over the medium term. If that is the case, we would not have much more additional work to do on moving to a neutral stance. - Fed Governor Lael Brainard Because the neutral rate is currently quite low by historical standards, the federal funds rate would not have to rise all that much further to get to a neutral policy stance. - Fed Chair Janet Yellen Contextualizing "Neutral" Contrary to how many have interpreted the above remarks, neither Chair Yellen nor Governor Brainard meant to suggest that the rate hike cycle is close to finished. In fact, Yellen went on to say in her testimony that: ...we also anticipate that the factors that are currently holding down the neutral rate will diminish somewhat over time, additional gradual rate hikes are likely to be appropriate over the next few years... This is the first important piece of context needed to understand how the Fed views the neutral rate. The Fed views the neutral rate as variable, and sees it increasing over time. This becomes clear when we look at the Fed's Summary of Economic Projections and note that the median forecast calls for a nominal fed funds rate of 2.9% at the end of 2019 and 3% in the longer run. Incorporating a 2% inflation target, we can infer that the Fed anticipates a real neutral rate of 1% in the longer run. Second, the Fed is likely tracking the real neutral fed funds rate using an estimate created by Laubach and Williams (LW).3 Chart 2 shows this estimate of the neutral rate alongside the real federal funds rate - deflated using 12-month trailing core PCE. We observe that the real fed funds rate has risen sharply during the past seven months, in part because the Fed lifted rates three times but also because inflation weakened. Chart 2Real Fed Funds Rate Getting Closer To Neutral We calculate that if the Fed lifts rates once more this year and core inflation stays flat, then the real fed funds rate would end 2017 at 0.02%, only 42 bps below neutral. However, it's more likely that the Fed will need to see inflation rebound before it delivers another rate hike. In a scenario where core inflation rises to 1.9% and the Fed lifts rates once more, then the real fed funds rate would actually decline between now and the end of the year. In sum, the LW neutral rate is a useful tool for assessing the path of Fed policy. If the real fed funds rate gets too close to neutral, then the Fed will probably need to see inflation rise before it delivers another hike. This would appear to be the situation we are in at the moment. We continue to expect that the Fed will start to unwind its balance sheet in September, but will need to see some signs that core inflation is increasing before lifting rates again. Our forecast still calls for higher core inflation during the next few months and another Fed rate hike in December (see section titled "Inflation: Chalk Up Another Bad Month" below). A related issue is why the Fed thinks the neutral rate will rise during the next few years. In arguments that date back to Ben Bernanke's tenure,4 the Fed maintains that headwinds related to household deleveraging and balance sheet repair have depressed the neutral rate since the Great Recession and financial crisis. There is some evidence to support this stance. The LW neutral rate correlates quite strongly with the growth rate of household debt (Chart 3). Although the neutral rate hasn't kept pace so far this cycle, household debt is growing off an unusually low base (Chart 3, bottom panel) and that may mean it takes longer for the neutral rate to rise. There is one final important application for the neutral fed funds rate, and it relates to the timing of the corporate credit cycle (Chart 4). Typically, excess returns to corporate bonds do not start to decline until the following three criteria are met: Chart 3Household Leverage And The Neutral Rate Chart 4Neutral Rate Important For Credit Cycle Deteriorating corporate balance sheet health (Chart 4, panel 2) Restrictive monetary policy i.e. the fed funds rate above its neutral level (Chart 4, panel 3) Tightening bank lending standards (Chart 4, bottom panel) Notice that in the prior two cycles the real fed funds rate actually rose above the LW neutral level before our Corporate Health Monitor started to signal deteriorating corporate health. In contrast, corporate balance sheets have already aggressively added leverage this cycle and accommodative policy is the sole support for spreads. In this environment, we view inflation and the stance of Fed policy as the most important factors determining the medium term outlook for corporate bond returns.5 Policy Wildcard: A New Fed Chair In 2018 One potential wrinkle in our outlook for monetary policy is that Janet Yellen's term as Fed Chair will end in February 2018. If history is any guide, we should expect to learn the identity of the new Fed Chair sometime this fall. While we would not completely rule out the possibility that Janet Yellen is re-appointed, recently, the chatter is that Gary Cohn, the Chairman of President Trump's National Economic Committee, is the frontrunner for the position (see Box). Box 1: Fed Chairs Since 1970 Gary Cohn does not have any experience as a central banker, but that does not preclude him from holding the position. Since the late 1970s, Presidents have tended to select the Fed Chair based on their trust relationship with a candidate (Table 1). Table 1Characteristics Of Fed Chairs Since 1970 Arthur Burns (Chair from 1970 - 1978) was head of President Eisenhower's Council of Economic Advisors (CEA) and was a special counselor to President Nixon. William Miller (1978 - 1979) worked for the presidential campaigns of Hubert Humphrey and Jimmy Carter. Alan Greenspan (1987 - 2006) served as the Chair of Ronald Reagan's Social Security Commission in the early 1980s, was the Chair of President Ford's CEA and advised President Nixon's campaign in 1968. Ben Bernanke (2006-2014) was George W. Bush's chief economist in 2005 and 2006 before Bush chose him to lead the Fed. Janet Yellen (2014 - present) was Chair of Bill Clinton's CEA in the late 1990s, when she worked with many of Obama's economic team. Paul Volcker (1979 - 1987) was the lone exception to this rule, he worked for Nixon, but not Carter, before becoming Fed Chair. Volcker, Bernanke and Yellen, all held posts in the Federal Reserve System before their appointments as Chair. However, Miller was an outside director for the Boston Fed, and Burns and Greenspan had no prior experience at the monetary authority. Party identification is one area where Gary Cohn would stand out. Since at least 1970, the party affiliation of a new Fed Chair has matched that of the President. However, Presidents have crossed party lines to reappoint sitting Fed Chairmen to additional terms. Volcker, Greenspan and Bernanke were all reappointed to lead the Fed by Presidents from opposing political parties. Chart 5Yellen Vs. Summers Drove Markets In 2013 To see how the timing of the Fed Chair appointment can matter for markets in the short-term, we need only look back to the autumn of 2013 when two candidates - Larry Summers and Janet Yellen - were in the running for the position. Rightly or wrongly, Summers was viewed as the more hawkish candidate and once he withdrew from the race on September 15, the market's expected pace of rate hikes plunged and long-dated TIPS breakevens surged on the expectation of a more dovish Fed (Chart 5). Bottom Line: The Fed is still on track to start winding down its balance sheet in September, and will lift rates again in December if inflation starts to move higher. If the Fed continues to lift rates in the face of low inflation, then the real fed funds could soon overtake its estimated neutral level. What's Driving The TIPS Breakeven Rate? We maintain an overweight position in TIPS relative to nominal Treasury securities on the view that long-maturity TIPS breakeven inflation rates will eventually settle into a range between 2.4% and 2.5%, once core inflation gets back to the Fed's 2% target. At the time of publication the 10-year TIPS breakeven inflation rate was 1.76%. In that sense, we view the medium to longer-run driver of TIPS breakevens as the path of inflation itself. However, we also acknowledge that breakevens are highly correlated with other financial asset prices, which can explain many of the near-term moves (Chart 6). In fact, our TIPS Financial Model - a model of the 10-year TIPS breakeven rate based on the oil price, the dollar and the stock-to-bond total return ratio - was flagging that breakevens were far too wide earlier this year (Chart 6, panel 1). Through this lens, the year-to-date decline in breakevens can be attributed simply to overvaluation being wrung out of the market. Digging a little deeper into the model, we find that breakevens have maintained their strong positive correlation with energy prices this year (Chart 6, panel 2), while non-energy commodity prices exhibit a weaker positive correlation (Chart 6, panel 3). Interestingly, the negative correlation between breakevens and the trade-weighted dollar has broken down during the past year (Chart 6, bottom panel). If dollar weakness persists, we would eventually expect it to translate into higher realized inflation - via higher import prices - and also wider breakevens. Other pipeline inflation measures, which tend to correlate with breakevens, are sending mixed signals. Core PPI inflation for intermediate goods remains elevated (Chart 7, panel 2), while the supplier deliveries component of the ISM manufacturing survey is trending higher (Chart 7, panel 3). The prices paid component of the ISM manufacturing survey has followed breakevens lower (Chart 7, bottom panel). Chart 6TIPS Breakevens: Financial Drivers Chart 7TIPS Breakevens: Pipeline Inflation Drivers Bottom Line: We attribute this year's decline in breakevens to the combination of weak realized inflation data (Chart 7, panel 1) and the fact that they had appeared too wide on our Financial Model. Going forward, we expect TIPS breakevens to increase as the realized inflation data bounce back. Inflation: Chalk Up Another Bad Month Core CPI increased just 0.12% month-over-month in June, marking the fourth consecutive downside surprise. The year-over-year growth rate also moderated from 1.74% to 1.71%, and the weakness was once again broad based across the four major components (Chart 8). The cost of shelter continues to decelerate from a high level, and our model - based largely on the rental vacancy rate - forecasts further moderation in the months ahead (Chart 8, panel 1). Core goods prices continue to deflate, though dollar weakness should filter through to higher core goods prices in the coming months (Chart 8, panel 2). In last week's report we showed that non-oil import prices have already moved higher in response to the weaker exchange rate.6 The big drag on inflation in recent months has been the failure of core services inflation (excluding shelter and medical care) to respond to rising wage pressures. The third panel of Chart 8 shows that core services inflation (excluding shelter and medical care) correlates strongly with the employment cost index. Further, the employment cost index itself has been accelerating since 2010 alongside improvement in the prime-age employment-to-population ratio (Chart 9). Chart 8Core CPI Components Chart 9Wages Will Grow As Labor Market Heals We expect wages will continue to accelerate as the labor market remains on a steadily improving path. Eventually this will bleed into core services inflation, as it has in the past. In the near term, the employment cost index for the second quarter will be a crucial input for the direction of both inflation and monetary policy. It will be released on July 28. Bottom Line: Core inflation disappointed once again in June. The pass-through from a depreciating dollar and accelerating wages should cause this weakness to reverse in the months ahead. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 https://www.federalreserve.gov/newsevents/speech/brainard20170711a.htm 2 https://www.federalreserve.gov/newsevents/testimony/yellen20170712a.htm 3 Laubach, Thomas, and John C. Williams. 2003. "Measuring the Natural Rate of Interest," Review of Economics and Statistics, 85(4), November, 1063-1070. 4 https://www.federalreserve.gov/newsevents/speech/bernanke20121120a.htm 5 Please see U.S. Bond Strategy Weekly Report, "Low Inflation And Rising Debt", dated June 13, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Summer Snapback", dated July 11, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification