Asset Allocation

Highlights Eurostoxx50 versus S&P500 boils down to a simple choice: Banco Santander, BNP Paribas and ING; or Apple, Microsoft and Google? Right now, we would rather own the three tech stocks than the three banks - which necessarily means underweighting the Eurostoxx50 versus the S&P500. Eurostoxx50 performance relative to the FTSE100 boils down to the inverse direction of euro/pound. Right now, we expect euro/pound to strengthen - which necessarily means underweighting the Eurostoxx50 versus the FTSE100. Stay overweight Spanish Bonos versus French OATs as a structural position. Feature Which would you rather own: Banco Santander, BNP Paribas and ING; or Apple, Microsoft and Google?1 Surprising as it may seem, the all-important allocation decision between the Eurostoxx50 and the S&P500 boils down to this simple choice. The Chart of the Week should leave no doubt that everything else is largely irrelevant. Chart of the WeekEurostoxx50 Vs. S&P500 = Santander, BNP & ING Vs. Apple, Microsoft & Google Right now, we would rather own the top three U.S. tech stocks rather than the top three euro area banks - which necessarily means underweighting the Eurostoxx50 versus the S&P500. The Fallacy Of Division For Equities The fallacy of division is a logical fallacy. It occurs when somebody falsely infers that what is true for the whole is also true for the parts that make up the whole. As a simple example, somebody might infer that because their computer screen appears purple, the pixels that make up the screen are also purple. In fact, the pixels are not purple. They are either red or blue. The fallacy of division is that the property of the whole - purpleness - does not translate to the property of the constituent parts - redness or blueness. As investment strategists, we hear a common fallacy of division. Since global equities are a play on the global economy, it might seem that national equity markets - like Ireland's ISEQ or Denmark's OMX - are plays on their national economies. In fact, nothing could be further from the truth. The property of the equity market as a global aggregate does not translate to the property of equity markets as national parts. The equity markets in Ireland and Denmark are each dominated by one stock which accounts for almost a quarter of national market capitalization - in Ireland, Ryanair, the pan-European budget airline, and in Denmark, Novo Nordisk, the global pharmaceutical company. Therefore, the relative performance of Ireland's ISEQ has almost no connection with Ireland's economy; rather, it is a just a play on airlines. And given budget airlines' sensitivity to fuel costs, Ireland's ISEQ is counterintuitively an inverse play on the oil price (Chart I-2). Likewise, the relative performance of Denmark's OMX has no connection with Denmark's economy; it is just a strong play on global pharma (Chart I-3). Chart I-2Ireland = Short Oil Chart I-3Denmark = Long Pharma In a similar vein, the relative performance of Switzerland's SME is also a play on global pharma - via Novartis and Roche (Chart I-4); Norway's OBX is a play on global energy - via Statoil (Chart I-5); and Italy's MIB and Spain's IBEX are plays on banks (Chart I-6 and Chart I-7). We could continue, but you get our drift... Chart I-4Switzerland = Long Pharma / Short Oil Chart I-5Norway = Long Oil Chart I-6Italy = Long Banks Chart I-7Spain = Long Banks But what about a regional index like the Eurostoxx50 or Eurostoxx600: surely, with the broader exposure, there must be a strong connection with the euro area economy? Unfortunately not - at least, not when it comes to relative performance. Consider that for the past few years, the euro area economy has actually outperformed the U.S. economy2 (Chart I-8). Yet the Eurostoxx50 has substantially underperformed the S&P500 (Chart I-9). What's going on? The answer is that the Eurostoxx50 has a major 15% weighting to banks and a minor 7% weighting to tech. The S&P500 is the mirror image; a minor 7% weighting to banks and a major 22% weighting to tech. Chart I-8The Euro Area Economy ##br##Has Outperformed... Chart I-9...But The Eurostoxx50##br## Has Underperformed For the Eurostoxx50 the distinguishing property is 'bank'; for the S&P500 it is 'tech'. And as we saw earlier, these distinguishing properties are captured by just three large euro area banks and three large U.S tech stocks. So index relative performance simply boils down to whether the three euro area banks outperform the three U.S. tech stocks, or vice-versa. Everything else is largely irrelevant. Equities' Connection With Economies Is Often Counterintuitive When it comes to the FTSE100, it turns out that it is not more bank or tech than the Eurostoxx50. Major sector weightings across the two indexes are broadly similar. Hence, relative performance is more connected to relative economic performance. But there is a catch - the connection is not as intuitive as you might first think. You see, both major indexes are made up of dollar-earning multinational companies. Yet the index value and earnings are quoted in pounds and euros respectively. If the home currency appreciates, index earnings - translated from dollars into home currency - go down, depressing index relative performance with it. And the opposite happens if the home currency depreciates. So the counterintuitive thing is that a relatively strengthening home economy does not result in index outperformance. Quite the opposite, it normally means a relatively more hawkish central bank, and an appreciating currency (Chart I-10). Thereby it causes index underperformance. Hence, Eurostoxx50 performance relative to the FTSE100 boils down to the inverse direction of euro/pound. Once again, Chart I-11 should leave readers in no doubt. Chart I-10A Relatively More Hawkish Central Bank =##br## A Stronger Currency Chart I-11A Stronger Currency = ##br##Equity Index Underperformance Which neatly brings us to today's ECB meeting. The ECB is a tunnel-vision 2% inflation-targeting central bank. Any upgrade to its inflation forecast, as seems likely, would imply less need for its extreme and experimental monetary easing. Once digested by the market, this would support the euro. Meanwhile, on the other side of the Channel, the U.K. Government is preparing to trigger Article 50 of the Lisbon Treaty and start its formal divorce from the EU within a couple of weeks. Expect the EU's immediate response to cast long shadows across Theresa May's vision of a future in sunlit uplands. Once digested by the market, this would further weigh down the pound. A stronger euro/pound necessarily means underweighting the Eurostoxx50 versus the FTSE100. The Fallacy Of Division For Bonds The fallacy of division also applies to euro area sovereign bonds. The aggregate euro area sovereign yield just equals the average ECB policy rate anticipated over the lifetime of the bond (Chart I-12). This is directly analogous to the relationship between the U.K. gilt yield and the anticipated path of the BoE base rate, and the relationship between the U.S. T-bond yield and the anticipated path of the Fed funds rate (Chart I-13). Chart I-12The Aggregate Euro Area Bond Yield = ##br##The Average ECB Policy Rate Expected Chart I-13The U.S. T-Bond Yield = ##br##The Average Fed Funds Rate Expected But what is true for the whole is not necessarily true for the parts that make up the whole. Individual euro area sovereign bond yields carry a second component which can override everything else. This second component is a redenomination premium as compensation for the expected loss if the bond redenominates out of euros. For example, the redenomination premium on a Spanish Bono versus a French OAT equals: The annual probability of euro breakup Multiplied by The expected undervaluation of a new peseta versus a new franc. However, the ECB's own analysis shows that Spain is now as competitive as France (Chart I-14), meaning that a new peseta ultimately should not lose value versus a new franc. So irrespective of the probability of euro breakup, the second item of the multiplication should be zero. Meaning that the redenomination premium should also be zero, rather than today's 75 bps (on 10-year Bonos over OATs). Bear in mind that Spain's housing bust and subsequent recapitalisation of its banks has followed Ireland's template - just with a two year lag. And observe that the redenomination premium on Irish 10-year bonds over OATs, which once stood at a remarkable 1100 bps, has now completely vanished. We expect Spain to continue following in the footsteps of Ireland (Chart I-15). As a structural position, stay long Spanish Bonos versus French OATs. Chart I-14Spain Has Dramatically Improved##br## Its Competitiveness Chart I-15Spain Is Following In The##br## Footsteps Of Ireland Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Listed as Alphabet. 2 On a per capita basis. Fractal Trading Model* Long tin / short copper hit its 5% profit target, while short MSCI AC World hit its 2.5% stop-loss. This week's recommendation is to short ruble / dollar. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-16 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Highlights Chart 1Keep A Close Eye On Financial Conditions The market's rate hike expectations moved sharply higher during the past two weeks as a string of Fed speeches, including one by Chair Yellen, all but confirmed a March rate hike. The market is now priced for 75 basis points of hikes during the next 12 months, compared to 50 bps at the end of January. At least so far, broad indicators of financial conditions have not tightened in response to this re-rating of the Fed (Chart 1). However, there are some preliminary indications that the reflation trade is fraying at the edges. The trade-weighted dollar has appreciated +0.2% since the end of January, the 2/10 Treasury slope has flattened 9 bps and the 10-year TIPS breakeven inflation rate has declined 1 bp. The Fed is currently testing the markets with hawkish rhetoric but, with inflation and TIPS breakevens still below target, will ultimately support the reflation trade if it comes under threat. In this environment investors with 6-12 month investment horizons should maintain below-benchmark duration, remain overweight spread product and continue to position for a steeper curve and wider TIPS breakevens. Feature Chart 2Investment Grade Market Overview Investment Grade: Overweight Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 48 basis points in February. The index option-adjusted spread tightened 6 bps on the month and, at 112 bps, it remains well below its historical average (134 bps). Our research1 shows that when core PCE inflation is between 1.5% and 2%2 investment grade corporate bonds produce an average monthly excess return of close to zero. A 90% confidence interval places monthly excess returns between -19 bps and +17 bps with inflation in this range and excess returns do not turn decisively negative until core PCE is above 2%. Given the Fed's desire to nurture a continued recovery in inflation, we are not worried about significant spread widening until inflation is sustainably above 2%. In the meantime we expect corporate bond excess returns to be low, but positive. While supportive monetary policy should ensure excess returns consistent with carry, investors should not bank on further spread compression as corporate spreads have already discounted a substantial improvement in leverage (Chart 2). Energy related sectors still appear cheap after adjusting for differences in credit rating and duration (Table 3), and our commodity strategists expect oil prices to remain firm even in the face of a stronger U.S. dollar. This week we upgrade the Wireless and Packaging sectors from underweight to neutral and downgrade the Consumer Cyclical Services sector from neutral to underweight. The former two sectors now appear cheap on our model, while the latter has become expensive. Table 3ACorporate Sector Relative Valuation And Recommended Allocation*Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 112 basis points in February. The index option-adjusted spread tightened 25 bps on the month and, at 349 bps, it is currently 170 bps below its historical average. One of our key investment themes3 for this year is that the uptrend in defaults is likely to reverse (Chart 3), mostly due to recovery in the energy sector. However, still-poor corporate health and tightening monetary policy will lead to a resumption of the uptrend in 2018 and beyond. Despite the positive outlook for defaults, we retain only a neutral allocation to High-Yield because of very tight valuations. The index option-adjusted spread is now within a hair of the average level of 340 bps that prevailed during the 2004 - 2006 Fed tightening cycle, when indicators of corporate balance sheet health were in much better shape. In fact, the index spread is now only 116 bps wider than its all-time low of 233 bps, reached in 2007. Our preferred measure of High-Yield valuation is the default-adjusted spread - the average spread of the junk index less our forecast of 12-month default losses. At present, the default-adjusted spread is 142 bps. Historically, a default-adjusted spread between 100 bps and 150 bps is consistent with positive excess returns during the subsequent 12 months 64% of the time. It is only when the default-adjusted spread falls below 100 bps that positive excess returns become unlikely. Junk has provided positive excess returns over a 12-month horizon only 13% of the time when the starting default-adjusted spread is between 50 bps and 100 bps. MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 3 basis points in February. The conventional 30-year MBS yield fell 5 bps on the month, driven by a 7 bps decline in the rate component. The compensation for prepayment risk (option cost) increased by 1 bp, as did the option-adjusted spread. MBS spreads remain extremely tight relative both to history and Aaa-rated credit, although they have begun to widen somewhat relative to credit in recent weeks (Chart 4). More distressing is that the nominal MBS spread appears too tight relative to interest rate volatility (bottom panel). As we noted in a recent report,4 the long-run trend in interest rate volatility tends to be driven by uncertainty about the macroeconomic and political environment. In fact, rate volatility can be modeled using forecaster disagreement about GDP growth and T-bill rates. While the Fed's policy of forward guidance and a fed funds rate pinned at zero limited the amount of forecaster disagreement in recent years, this disagreement will re-emerge the further the fed funds rate moves off its lower bound. Another medium-term risk for MBS comes from the Fed ending the reinvestment of its MBS portfolio. As we described in a recent Special Report,5 the Fed is likely to allow its MBS portfolio to shrink at some point in 2018, putting further upward pressure on MBS spreads. Government Related: Underweight Chart 5Government-Related Market Overview The government-related index outperformed the duration-equivalent Treasury index by 30 basis points in February, bringing year-to-date excess returns up to +51 bps. The high-beta Sovereign and Foreign Agency sectors outperformed the Treasury benchmark by 90 bps and 59 bps, respectively. Meanwhile, the low-beta Domestic Agency and Supranational sectors each outperformed by 4 bps. Local Authorities returned 24 bps in excess of duration-matched Treasuries. Sovereigns have outperformed Baa-rated corporate bonds year-to-date, a trend consistent with the rise in commodity prices and a trade-weighted dollar that has weakened by 1.5% (Chart 5). However, the dollar has started to appreciate in recent weeks and probably has further upside in the medium-term, especially if the Fed maintains its hawkish posture. Historically, it has been very rare for Sovereigns to outperform U.S. corporate bonds when the dollar is appreciating. After adjusting for credit rating and duration, the Foreign Agency and Local Authority sectors continue to appear cheap relative to U.S. corporate credit. In contrast, Sovereigns, Supranationals and Domestic Agencies all appear expensive. We continue to recommend overweight allocations to Foreign Agencies and Local Authorities, alongside underweight allocations to the rest of the government-related index. In a television interview last month Treasury Secretary Steven Mnuchin confirmed that GSE reform is still a priority for the new administration but that tax reform is much higher on the agenda. This means that agency spreads will likely remain insulated from any "reform risk" until next year at the earliest. Municipal Bonds: Neutral Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 13 basis points in February (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio has fallen 4% since the end of January and remains firmly anchored below its post-crisis average. The decline in the average M/T yield ratio was concentrated in short maturities, while ratios at the long-end of the curve actually rose (Chart 6). Accelerating fund flows and falling issuance will continue to support yield ratios in the near term. In fact, our tactical yield ratio model - based on issuance, fund flows and ratings migration - shows that yield ratios are presently very close to fair value. Although the average M/T yield ratio still appears expensive if we include the global economic policy uncertainty index as an additional explanatory variable.6 One risk to Munis is that yield ratios have already discounted a substantial reduction in state and local government net borrowing in Q1 (panel 3). While we expect this improvement will materialize in the next few quarters, net borrowing is biased upward beyond this year based on the lagged relationship between corporate sector and state and local government health.7 Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve has bear-flattened since the end of January as the market revised its Fed rate hike expectations sharply higher. Both the 2/10 and 5/30 Treasury slopes have flattened by 9 basis points since January 31. As such, our recommended position long the 5-year bullet and short the 2/10 barbell - designed to profit from a steeper yield curve - has returned -26 bps since the end of January, although it has returned close to 0 bps since it was initiated on December 20.8 As was stated on the front page of this report, the Fed's increasingly hawkish rhetoric has already caused the uptrend in TIPS breakevens to pause and the nominal Treasury slope to flatten (Chart 7). With inflation still below target these trends are not sustainable from the point of view of Fed policymakers. If the trend of decreasing TIPS breakevens and a flattening curve persists, we would expect the Fed to back away from its hawkish rhetoric. This dynamic will support a steeper yield curve at least until core PCE inflation is back to the Fed's 2% target and long-dated TIPS breakevens are anchored in a range between 2.4% and 2.5% (a range that is typically consistent with core PCE inflation at 2%). The persistent attractiveness of the 5-year bullet relative to the rest of the curve makes a position long the 5-year bullet and short a duration-matched 2/10 barbell the most attractive way to position for a steeper yield curve (panel 3). The carry buffer in the 5-year helps mitigate some of the risk of curve flattening. TIPS: Overweight Chart 8TIPS Market Overview TIPS underperformed the duration-equivalent Treasury index by 18 basis points in February. The 10-year TIPS breakeven rate declined 3 bps on the month and, at 2.04%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. While the catalyst for the recent softening in TIPS outperformance seems to be the hawkish re-rating of Fed rate hike expectations, the uptrend in TIPS breakevens was probably due for a pause in any case. Breakevens had become stretched relative to our TIPS Financial Model - based on the dollar, oil prices and the stock-to-bond total return ratio (Chart 8). Diffusion indexes for both PCE and CPI inflation have also shifted into negative territory, suggesting that realized inflation readings will soften during the next couple of months. On a cyclical horizon, however, the Fed will be keen to allow breakevens to rise toward levels more consistent with its inflation target and will quickly adopt a more dovish stance if breakevens fall significantly. This "Fed put" should remain in place at least until core PCE inflation is firmly anchored around 2% and long-dated TIPS breakevens return to a range between 2.4% and 2.5%. As we detailed in a recent report,9 while accelerating wage growth will ensure that inflation remains in a long-run uptrend, the impact from wages will be mitigated by deflating import prices meaning that the uptrend will be slow. We continue to expect that year-over-year core PCE inflation will not attain the Fed's 2% target until the end of this year. ABS: Maximum Overweight Chart 9ABS Market Overview Asset-Backed Securities performed in-line with the duration-equivalent Treasury index in February. Aaa-rated issues underperformed the Treasury benchmark by 2 basis points, while non-Aaa issues outperformed by 12 bps. The index option-adjusted spread for Aaa-rated ABS widened 3 bps on the month. At 50 bps, the spread remains well below its average pre-crisis level. Banks are now tightening lending standards on both auto loans and credit cards (Chart 9). While we do not think this will have much of an impact on consumer spending,10 it is usually an indication that there is growing concern about ABS collateral credit quality. While credit card charge-offs remain well below their pre-crisis levels, net losses on auto loans have in fact started to trend higher (bottom panel). We continue to recommend Aaa-rated credit cards over Aaa-rated auto loans, despite the spread advantage in autos. We will closely monitor the evolving credit quality situation, but for now continue to view consumer ABS as a very attractive alternative to other short-duration Aaa-rated spread product such as MBS and Agency bonds. The main reason being the sizeable spread advantage that has persisted in ABS for some time. At present, Aaa-rated consumer ABS offer an option-adjusted spread of 50 bps, compared to 31 bps for 30-year conventional Agency MBS and 18 bps for Agency bonds. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 34 basis points in February. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 7 bps on the month, but remains below its average pre-crisis level (Chart 10). Rising CMBS delinquency rates and tightening commercial real estate lending standards make us cautious on non-agency CMBS. This caution has only intensified now that spreads are firmly entrenched below their pre-crisis average. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 20 basis points in February. The index option-adjusted spread for Agency CMBS widened 5 bps on the month, and currently sits at 53 bps. The spread offered on Agency CMBS is similar to what is offered by Aaa-rated consumer ABS (50 bps) and greater than what is offered by conventional 30-year MBS (31 bps) for a similar amount of spread volatility. We continue to recommend an overweight position in Agency CMBS. Treasury Valuation Chart 11Treasury Fair Value Models The current reading from our 2-factor Treasury model (which is based on Global PMI and dollar sentiment) places fair value for the 10-year Treasury yield at 2.42% (Chart 11). Our 3-factor version of the model, which also incorporates the Global Economic Policy Uncertainty Index, places fair value at 2.21%. The lower fair value results from the large spike in the uncertainty index last November, which has only been partially unwound (bottom panel). Large spikes in uncertainty that do not coincide with deterioration in other economic indicators tend to mean revert fairly quickly. So we would be inclined to view the fair value reading from our 2-factor model as more indicative of true fair value at the moment. For further details on our Treasury models please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Model", dated October 11, 2016, available at usbs.bcaresearch.com At the time of publication the 10-year Treasury yield was 2.49%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Inflation: More Fire Than Ice, But Don't Sound The Alarm", dated January 24, 2016, available at usbs.bcaresearch.com 2 Year-over-year core PCE inflation is currently 1.74%. 3 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "The Road To Higher Vol Is Paved With Uncertainty", dated February 14, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy / Global Fixed Income Strategy Special Report, "The Way Forward For The Fed's Balance Sheet", dated February 28, 2017, available at usbs.bcaresearch.com 6 For further details on the model please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 7 For further details on the linkage between corporate sector health and state & local government health please see U.S. Bond Strategy Special Report, "Trading The Municipal Credit Cycle", dated October 18, 2016, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, "Inflation: More Fire Than Ice, But Don't Sound The Alarm", dated January 24, 2017, available at usbs.bcaresearch.com 10 Please see U.S. Bond Strategy Weekly Report, "The Odds Of March", dated February 21, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon) Current Recommendation

Highlights Assessing Our Tilts: Our decision to upgrade corporate spread product versus government debt in the U.S., and to reduce overall recommended duration exposure, at the end of January has been performing well. Maintain these tilts, with both soft and hard economic data pointing to a broadening global economic upturn and the Fed prepared to hike rates next week. Fed Vs ECB: Cyclical comparisons of the Euro Area today to the U.S. in the months prior to the Fed's 2013 "Taper Tantrum" show that the Euro Area is closer to full employment, with headline inflation at target, compared to the U.S. four years ago. The ECB may be facing its own tantrum pressures later in 2017. U.K.: Gilts have already priced in a significantly weaker U.K. economic outlook, especially with regards to consumer spending, yet inflation expectations are only now starting to peak. Raise U.K. bond exposure to neutral, from underweight. More clarity on the Brexit negotiations status is necessary to develop a firmer conviction on Gilts with yields already at rich levels. Feature Chart of the WeekAre Central Banks Getting ##br##Behind The Curve? A whiff of central bank hawkishness has quickly swept over the major bond markets. In the U.S., a series of Fed speeches, coming after a string of improving economic data amid booming asset markets, has turned a March Fed rate hike from a long-shot to a virtual certainty in little more than a week. In Europe, another round of stronger inflation data is emboldening some of the hawks at the European Central Bank (ECB) to more openly question if some tapering of the central bank's asset purchases will be necessary next year. Even in the U.K., the Bank of England (BoE) is letting its latest round of Gilt quantitative easing (QE) expire, although the BoE is not close to considering a rate hike, as we discuss later in this Weekly Report. Chart 2A Supportive Backdrop ##br##For Taking Credit Risk A move by the Fed next week now seems like a done deal, and the new question for investors is: how many more times the Fed will lift rates in 2017? The market is now pricing in "only" 75bps of hikes over the next year, even as the S&P 500 sits close to its all-time high and U.S. jobless claims hit a 43-year low last week (Chart 1). We still see three hikes - the Fed's current projection - to be the most that the Fed will deliver in 2017. Yet the fact that equity & credit markets have taken the rising odds of a March rate increase in stride might nudge the Fed towards even more hikes this year than currently forecast. Bond markets around the world will likely not take a shift higher in the Fed "dots" very well, although in the U.S. the immediate upside for yields remains tempered by the persistent short positioning in the U.S. Treasury market. We still expect Treasury yields to rise over the next 6-9 months, though, driven by additional increases in inflation expectations rather than a sharp repricing of the expected path of the funds rate. The biggest risk looming for global bonds, however, would come from any signal by the ECB that a taper is in the cards next year. That would likely result in wider term premiums and bear-steepening of yield curves in the major developed government bond markets. It would be a surprise if the ECB started preparing the markets for a less accommodative policy stance at this week's meeting, although questions about a taper will certainly be posed to ECB President Draghi by reporters after the meeting. Evaluating Our Recommendations As Global Growth Improves Back on January 31st, we shifted to a more pro-growth stance in our fixed income portfolio recommendations, moving our duration tilt back to below-benchmark, while downgrading government debt and upgrading corporate bond exposure.1 The key to that shift was a growing body of evidence pointing to a broadening global economic upturn. The latest round of global purchasing managers' indices (PMIs) released last week confirmed that the business cycle dynamics continue to accelerate to the upside (Chart 2). This will maintain upward pressure on bond yields and downward pressure on credit spreads. Our portfolio recommendations have generally done well since we made our shift. In Chart 3, we show the excess returns (on a currency-hedged basis) for the individual government debt markets versus the overall Barclays Global Treasury Index since the end of January. Our underweight positions in the U.S., Spain and Australia (up to February 21st, when we upgraded Aussie debt to neutral) performed well, as did our overweights in core Europe (Germany & France). Our worst performing tilts were our below-benchmark stances on Italy, which benefitted greatly from some diminished pressures on French government debt last week, and U.K. Gilts, which we discuss later in this report. In Chart 4, we show the excess returns (on a currency-hedged basis) for the major spread product markets, since January 31. Our decisions to upgrade U.S. investment grade (IG) to above-benchmark, and U.S. high-yield (HY) to neutral, have done well as U.S. corporate spreads continue to tighten in response to improving U.S. economic growth. Our relative exposures between the U.S. and Euro Area remain our biggest tilts between countries. Specifically, we remain overweight core Euro Area government debt versus U.S. Treasuries, while we are neutral U.S. HY and underweight Euro Area equivalents. On IG corporate debt, we are above-benchmark on both sides of the Atlantic. Our marginal preference, however, is for U.S. IG given the shifting changes in relative balance sheet health in the U.S. (improving, but from relatively poor levels) versus Europe (stable, but at relatively strong levels) suggested by our Corporate Health Monitors. On a currency-hedged and duration-matched basis, our relative U.S. vs Euro Area tilts have done well since our major allocation shift on January 31 (Chart 5), with Treasuries underperforming, U.S. HY outperforming and both U.S. and European IG performing similarly. Chart 3Our Recent Country Allocation Performance Chart 4Our Recent Spread Product Allocation Performance Chart 5Our Europe Vs U.S. Tilts Have Done Well Of Late Bottom Line: Our decision to upgrade corporate spread product risk versus government debt in the U.S., and to reduce overall recommended duration exposure, at the end of January has been performing well. Maintain these tilts, with both soft and hard economic data pointing to a broadening global economic upturn and the Fed prepared to hike rates next week. The Timing Of A Potential "Bund Tantrum" Looking ahead, timing a potential turn in our U.S. versus Europe tilts will likely remain the biggest call we make this year. With the Fed now set to raise rates again next week, and the ECB likely to deflect any talk of a taper to after the upcoming French elections (at the earliest), the bias will remain toward Treasury market underperformance in the near term. Yet the marginal pressures on inflation in both the U.S. and Euro Area suggest that a turning point in U.S./Core Europe bond spreads could arrive sooner than many expect. While realized inflation rates are moving higher in both regions, the underlying price pressures have a different look. In the U.S., headline inflation (using the Fed's preferred measure, the change in the personal consumption expenditure, or PCE, deflator) has risen to 1.89%, a mere 15bps above core PCE inflation with both measures now sitting just below the Fed's 2% target. Yet the breadth of the rise in core inflation has rolled over, according to our diffusion index (Chart 6). This suggests that the recent acceleration in core inflation, which we believe the Fed is most focused on, may take a pause in the next few months. The opposite is true in the Euro Area, where headline HICP inflation (the ECB's target measure) has soared to 1.9%, right at the ECB target of "at or just below" 2%. The gap between headline and core HICP inflation has been widening, though, as there has been very little follow through from the acceleration in headline inflation, largely driven by base effects related to previous rises in energy prices and declines in the euro, into core prices. Our Euro Area headline inflation diffusion index is moving higher, highlighting that the increase in headline HICP inflation is becoming more broadly based (Chart 7). Chart 6A Narrowing Increase In U.S. Inflation Chart 7A Broadening Increase In Euro Area Inflation The cyclical uptrend in Euro Area growth and inflation is also fairly broad-based at the country level, with the individual country PMIs and headline HICP inflation rates all in solid uptrends for the major countries in the region (Chart 8). At the same time, core inflation rates remain well contained. Various ECB members have pointed to the benign core inflation readings as a reason to stay the course on extraordinarily accommodative monetary policy settings. Yet with unemployment rapidly falling in many parts of the Euro Area, it is becoming increasingly difficult to get a consensus view on maintaining the status quo on ECB policy. Already, the German Bundesbank has been quite vocal in questioning the need for the ECB to maintain the current pace of its asset purchase program, and that pressure will only grow with German inflation now above 2%. So how close is the ECB to a potential asset purchase taper? Some clues emerge when comparing Europe now to the U.S. around the time of the Fed's 2013 "Taper Tantrum." In Chart 9, we show "cycle-on-cycle" comparisons for both the Euro Area and U.S. All series in the chart are lined up to the peak in our Months-To-Hike indicator, which measures the number of months to the first rate hike of the next interest rate cycle, as discounted in the Overnight Index Swap (OIS) curve. That indicator peaked in the U.S. in late 2012, several months before Ben Bernanke's infamous speech in May 2013 that signaled the Fed's QE appetite was beginning to wane. Chart 8A Consistent Upturn##br## In Europe Chart 9Less Spare Capacity In Europe Now Vs ##br##Pre-Taper Tantrum U.S. In the Euro Area, the Months-To-Hike indicator peaked in July of last year right around the time of the U.K. Brexit vote. Interestingly, the indicator remains much higher than it ever was in the U.S. during the QE era, indicating how the market believes that the ECB will have to maintain zero (or lower) interest rates for longer. Yet, by some measures, the ECB is closer to reaching its policy goals then the Fed was in 2012/13. In the 2nd panel of Chart 9, we show the "unemployment gap" - the difference between the unemployment rate and the rate consistent with inflation stability - for the U.S. and Euro Area. Note that there is far less spare capacity in labor markets today in Europe than there was in the U.S. when the Fed raised the topic of a QE taper to the markets. The U.S. unemployment rate was a full three percentage points above the full employment level in 2012, while Euro Area unemployment is now only one percentage point above full employment. In the bottom two panels of Chart 9, we show the gap between headline and core inflation in both the U.S. and Euro Area, relative to the 2% inflation targets that both the Fed and ECB aim to hit. U.S. inflation was in the vicinity of the Fed's target around the time of the Taper Tantrum. While Euro Area headline inflation is similarly close to the ECB's 2% target today, core inflation is much further away from 2% than U.S. core inflation was four years ago. If the ECB focuses on headline rather than core inflation, then Europe could be getting close to its own Taper Tantrum. Yet the relatively calmer readings on Euro Area core inflation suggest that the ECB does not have to make a rush to judgement on its asset purchase program, especially given the uncertainties presented by the upcoming French elections in April & May. We are still maintaining our overweight stance on core European government debt versus U.S. Treasuries, but we are growing increasingly worried that a turning point may be on the horizon. As can be seen in the additional cycle-on-cycle comparisons in Chart 10, the benchmark 10-year German Bund is tracing out a similar path to that of the 10-year U.S. Treasury around the time of the Fed Taper Tantrum. If the ECB focuses on the tightening labor market and accelerating pace of headline inflation in the Euro Area, a "Bund Tantrum" could become the big story for global bond markets later this year. Bottom Line: Cyclical comparisons of the Euro Area today to the U.S. in the months prior to the Fed's 2013 "Taper Tantrum" show that the Euro Area is closer to full employment, with headline inflation at target, compared to the U.S. four years ago. The ECB may be facing its own tantrum pressures later in 2017. Gilt(y) Optimism? The British economy has surprised to the upside in the last few months. Policy uncertainty has collapsed, while inflation expectations have marched higher and business optimism has stabilized. Most surprising against this backdrop, Gilt returns, on a currency hedged basis, have beaten most of their developed market fixed income peers (Chart 11). Chart 10A Bund Taper On The Horizon? Chart 11Gilts Should Have Underperformed This outperformance cannot be linked to factors such as the usual safe-haven status of Gilts, with no signs of major financial stresses in the Euro Area that would cause money to flow into Gilts (Chart 12). Indeed, the opposite has been happening as foreigners have been net sellers of Gilts in recent months. A better explanation might come from what has become a bond-bullish linkage between the British currency, inflation, real wages and consumption. In all likelihood, investors have already incorporated most of the impact of a weak Pound on U.K. inflation expectations and Gilt yields. Yet higher expected prices continue to erode household purchasing power, leading to weaker consumer spending (Chart 13). This dynamic is bullish for bonds. Chart 12Can't Blame The Safe Haven Status This Time Chart 13Consumers Will Feel The Pinch Already, this backdrop has become widely accepted. The Bloomberg survey of economists' forecasts is calling for U.K. consumer spending growth to decelerate to 1.6% on a year-over-year basis in 2017, down from 2.8% in 2016. The BoE adopted a more dovish stance at last month's Monetary Policy Committee (MPC) meeting, citing the downside risks to consumption from high currency-driven inflation at a time of persistent spare capacity in labor markets and modest wage increases.2 This threat to U.K. growth from a more sluggish consumer should continue, at least in the short term. BCA's U.K. real average weekly earnings model is clearly pointing towards additional declines in inflation-adjusted wages (Chart 14). This should restrain consumption growth, especially as other factors boosting spending are likely to fade. For example, the gains to disposable income growth from falling interest rates are likely done for this cycle, with mortgage rates having little room to decline further from the current 2.5% level (Chart 15). Also, consumer credit is now expanding 10% year-over-year - a pace that is most likely unsustainable with household debt still at high levels relative to income and the savings rate having fallen close to pre-recession levels (Chart 16). As a result, U.K. consumers are unlikely to continue stretching their financial situation to support spending. Chart 14Real Wages Will Constrain Consumption Chart 15Little Room For Lower Mortgage Rates Chart 16Structural Limits On Consumer Credit Growth Additionally, the housing market could dent consumer confidence in the near term. Since the beginning of 2014, all measures of house price inflation have rolled over, while mortgage approvals have moved sideways (Chart 17). Signs of increased weakness are appearing and could force households to revise their spending habits downward. There are also potential risks coming from the business side, despite some more positive data of late. BCA's U.K. capex indicator, composed of several survey measures, points to a cyclical improvement in capital spending in the next few quarters. At the same time, net lending to non-financial institutions is growing at a robust rate (Chart 18), suggesting that credit availability is not an impairment for U.K. businesses. Chart 17Housing: From Tailwind To Headwind? Chart 18Some Optimism Is Warranted... However, the situation remains very fragile. The upcoming Brexit negotiations will keep animal spirits well contained. Firms have become more risk averse and less willing to take balance sheet risks according to the Deloitte CFO survey (Chart 19). Until the details on the U.K.'s future economic links to Europe are resolved, corporate decision-makers will be dissuaded from making long-term investments in productivity-enhancing capital such as plant and machinery. In turn, the continued lack of productivity gains will further depress U.K. corporate profitability (Chart 19, bottom panels). This uncertain environment will mean suppressed hiring intentions, greater slack in the economy and decreasing inflationary pressure. Consequently, the BoE should remain patient. The accommodative policy measures introduced last August after the Brexit vote have been working so far. Rock bottom real yields and highly expansionary money supply growth have spurred domestically generated inflation. While the BoE's latest Gilt QE program is expiring, there is no rush to hike rates until core inflation has reached the 2% threshold or until headline inflation tops out at 2.7% in Q1 2018, as the BoE predicts.3 As such, the probability of a rate hike this year, which has collapsed from 55% to 17% since January, will fall even further, to the benefit of Gilts (Chart 20). Chart 19...But The Brexit-Induced Stalemate ##br##Effects Still Prevail Chart 20More Time Needed ##br##For The BoE This week, we are upgrading our recommended stance on Gilts from below-benchmark to neutral. We have maintained an underweight posture since October 18th of last year, primarily driven by our expectation that rising U.K. inflation would put upward pressure on Gilt yields. Now that the main force driving inflation higher - the exchange rate - is bottoming out and possibly set to reverse, we have to change tack. On that note, our colleagues at BCA Geopolitical Strategy have recently laid out a very compelling bullish case for the Pound.4 They disagree with the assessment that further volatility in the currency is warranted because of the Brexit process. They oppose the market narrative that: Europeans will seek to punish the U.K. severely for Brexit, to set an example to their own Euroskeptics; Exiting the common market is negative for the country's economy in the short-term; Remaining legal uncertainties about Brexit could derail the process. In their view, two events that occurred in January - the U.K. Supreme Court decision that the U.K. parliament must have a say in triggering Article 50 and Prime Minister May's "Brexit means exit" speech - have reduced political uncertainty regarding Brexit. The first because parliament would ultimately be bound by the popular referendum. The second because the main cause of European consternation - the U.K. asking for special treatment with respect to the common market - was taken off the table. Thus, going forward, Europe will exact a price, but it will not be severe. And the negative economic repercussions of leaving will only be fully registered in the coming years. If our colleagues are right, an overweight position in Gilts could be tempting, as a stronger Pound would decrease inflation expectations, pushing nominal yields lower. This case is even stronger given the economic uncertainties we've laid out above. Despite their convincing arguments, we prefer to take a cautious approach, while waiting to see on what ground the Brexit negotiations will start. Moreover, Gilt valuations now seem rich, with spreads versus U.S. Treasuries at historic lows. Thus, we are only upgrading to a neutral allocation to Gilts for now. In our model portfolio (shown on Page 16), we are funding the increased Gilt allocations by equally reducing the U.S. and German exposure, given the upward pressure on yields in those markets described earlier in this Weekly Report. Bottom Line: The U.K. economy has surprised to the upside and inflation expectations have reacted in line with the domestic currency weakness. There is now a greater chance that both of those trends will reverse, to the benefit of Gilts. Raise U.K. bond exposure to neutral, from underweight. More clarity on the Brexit negotiations status is necessary to develop a firmer conviction on Gilts, especially with yield already at rich levels. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Jean-Laurent Gagnon, Editor/Strategist jeang@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "The Global Growth Upturn Has Legs: Reduce Duration, Upgrade Credit Exposure", dated January 31, 2017, available at gfis.bcaresearch.com 2 The BoE lowered its estimate of the full-employment level of the U.K. unemployment rate, consistent with accelerating wage growth, from 5% to 4.5% at the February MPC meeting. 3 Please see "Inflation Report", February 2017, Bank Of England, available at http://www.bankofengland.co.uk/publications/Pages/inflationreport/2017/feb.aspx 4 Please see BCA Geopolitical Strategy Weekly Report, "The "What Can You Do For Me" World?", dated January 25, 2017, available at gps.bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Portfolio Strategy A relapse in the global financials sector threatens to spill into U.S. financials as credit growth sinks. Bank equities are the most vulnerable to such a phase, given their reliance on rising interest rate expectations rather than increased lending. Take profits in the S&P health care facilities index and downgrade to neutral. Recent Changes S&P Health Care Facilities - Take profits of 12% and downgrade to neutral. Table 1Sector Performance Returns (%) Feature Momentum continues to trump all else, with the equity market surging to new all-time highs last week. However, in the background, the Fed is becoming steadily more hawkish, and the odds of a March rate hike have risen substantially. This should be cause for some trepidation. Chart 1Multiples Are Headed##br## Lower As The Fed Hikes The market advance since November has been supported primarily by valuation expansion, along with some improvement in corporate profits. The forward P/E has climbed to 18, its highest level in well over a decade. The scope for further expansion is limited. Importantly, if a transition to an earnings-led rally is in the offing, Fed funds expectations likely need to be ratcheted higher. Chart 1 shows that valuation multiples contract during Fed tightening cycles, using cycle-on-cycle analysis. Thus, the valuation expansion is inconsistent with a significant upgrade in the economic and profit outlook, particularly with return on equity so weak (Chart 1). In other words, the economy has good momentum, but that is not translating one for one to the corporate sector. Keep in mind that even a small two P/E multiple point decline requires 11% earnings growth for the market just to hold its ground. That is a tall order given the squeeze on profit margins from labor cost inflation and a strong U.S. dollar. Ironically, high multiples would be more durable if economic data softened enough for the Fed to hold its fire. Against this background, it is not surprising that a stealthy flight to safety has developed, although it is not uniform across asset classes. For instance, gold has outperformed most major currencies (note we recently upgraded the gold shares group as a portfolio hedge); global government yields have eased back while sovereign bond spreads have widened (Chart 2). In the U.S., the economically-sensitive transport group has rolled over in line with the yield curve narrowing (Chart 2), the equity SKEW index remains historically elevated, and a defensive vs. cyclical portfolio bias has outperformed handily since early December (Chart 2, bottom panel), on broad-based non-cyclical sector participation. These shifts, on the margin, signal that some investors are bracing for a bout of volatility. On the flipside, U.S. junk bond spreads have narrowed back to 2014 lows, and emerging market corporate bond spreads are testing similarly tight levels. The global purchasing manager survey recorded yet another monthly gain (Chart 3). Chart 2Contrarian##br##Alert... Chart 3... Defensives Can Outperform##br## When Growth Is Good Ergo, a systemic economic threat is not the main obstacle to further asset price appreciation. Rather, it is that expectations in some assets and sectors have become divorced from reality. Indeed, we have noted for the last two months the disturbing downtrend in bank credit growth and the unprecedented gap between strong 'soft' and pedestrian 'hard' economic data. Mixed economic and financial market messages suggest that any equity turbulence may be marked by a mostly rotational correction rather than a savage drawdown in the broad averages. Still, the latter cannot be ruled out given the high degree of complacency and buoyant profit and economic expectations. It is notable that defensive equities embarked on a massive outperformance phase when both U.S. and EM bond spreads were just as low as they are currently, i.e. they hit 'as good as it gets' levels (Chart 3). Any widening in corporate bond spreads would tighten financial conditions, spurring a slowdown in growth down the road. In sum, the odds of an equity market sweet spot extension beyond the very near run have diminished as a consequence of ongoing strong economic data, which reflects the easing in financial conditions a year ago. In terms of positioning portfolios, there is still a mismatch between developed and developing markets, as measured by the relative ISM indexes (Chart 3, fourth panel). The upshot is that defensives will continue to generate much more cash than their cyclical counterparts (Chart 3, bottom panel), supporting the nascent relative share price recovery. The financial sector could also be due for a correction. Financials And Banks: Where To Next? The global financials sector has cheered the firming in leading economic indicators and back up in bond yields since last autumn, but that celebration is likely drawing to a close. Euro area financials have rolled over, in line with renewed weakness in German government bond yields (Chart 4). Continued slippage in global yields could cap U.S. yields, thereby flattening the yield curve (Chart 5). U.S. financials are much more expensive than their euro area counterparts (Chart 5, bottom panel), suggesting heightened vulnerability. Chart 4Are EMU Financials ##br##Sending A Warning Signal? Chart 5Watch The##br## Yield Curve In our view, the S&P bank index contains the most downside vulnerability, in relative performance terms, of all the financial sector sub-components, especially if regulatory reform disappoints and/or is slow to evolve. True, as outlined in a Special Report published on October 3, 2016, interest rate expectations have a checkered history of predicting bank stock relative performance. When they do drive bank stocks, it is typically because most other profit drivers are lacking, as is currently the case (Chart 5, top panel). This cycle, interest rate spreads have been unduly suppressed by the zero lower bound. Under normal circumstances, when short-term interest rates are well above zero lower bound, banks can target a spread between rates on assets and liabilities. But when the fed funds rate is at zero, the spread is compressed, because banks generally cannot charge customers a penalty implied by negative interest rates on deposits (at least in the U.S.). As the Fed pushes interest rates back upward, banks may be able to return their spreads to their target levels, by raising deposit rates more slowly than loan rates. However, this dynamic has been fully priced in over the last few months and the risk is that higher net interest margins will not offset the lack of credit creation and/or that Fed funds rate expectations will level off if economic data start to disappoint. After all, Chart 6 shows that net interest margins can both widen and narrow when the Fed is hiking interest rates. Moreover, the yield curve is narrowing, after peaking two months ago. If rising fed interest rate expectations are the primary factor driving bank stock performance, then it follows that market expectations must continue to price in a much more hawkish rate environment in order to extend any rally in bank share prices. However, the global credit impulse is still negative, albeit less so, reflecting capital constraints and deleveraging. The Bank of International Settlements global credit impulse indicator has been an excellent leading indicator of relative bank profitability, and it is premature to expect earnings outperformance (Chart 7). U.S. credit data are also inconsistent with a major upshift in Fed funds interest rate expectations. Total loan growth is contracting, led by commercial & industrial loans (Chart 8). Commercial real estate loan growth has also turned lower. Chart 6Net Interest Margins And The Fed Chart 7Don't Chase Without Profit Support Chart 8Shrinking Balance Sheets The most recent Fed Senior Loan Officer Survey showed that banks are tightening lending standards in most categories, with the exception of mortgages (Chart 9). The number of banks reporting increased loan demand has also softened. Since the credit crisis, banks have shifted their balance sheet exposure toward businesses and away from consumers and residential mortgages, underscoring that a decent housing market is unlikely to provide an offset to lackluster corporate credit demand. Only mortgages have experienced an uptick in loan demand and availability of funds (Chart 9). This credit backdrop is not conducive to a much more aggressive Fed, reinforcing that it would be dangerous to discount a sustained and meaningful uptrend in net interest margins. To further confound the bank stock reward/risk profile, bank employment continues to rise steadily (Chart 10), even though balance sheet expansion is no longer a sure thing. We have shown in past Reports that bank stocks have almost always underperformed when bank employment is rising. Chart 9Credit Standars Are Tightening Chart 10Sagging Productivity The current combination of fading credit creation and rising employment has done a number on our bank productivity proxy. The latter is now contracting on a rate of change basis, warning that the expansion in bank stock valuations is due for a squeeze (Chart 10). Bottom Line: The run in bank stocks over the past few months is on the cusp of a reversal, based on the leading message from the euro area, sinking productivity and punk credit demand. Our financial sector preference remains skewed toward areas not dependent on credit creation, such as asset managers. Book Profits In Health Care Facilities We bought the S&P health care facilities index last December after a steep post-election sell-off created a valuation and technical undershoot relative to the fundamental outlook. The doomsday concern was that President Trump would tear up the Affordable Care Act (ACA), potentially leaving millions without insurance: treating the uninsured is the bane of any hospital's existence. At the time of purchase, the 52-week rate of change was diverging positively from the share price ratio after hitting deeply oversold levels, often a harbinger of a playable rally (Chart 11). That was particularly true given an historically high short position. The index has outperformed by 12% since then, encouraged by a jump in analyst net profit revisions following upbeat profit results and guidance from industry heavyweights such as HCA Holdings (Chart 11), and a realization that any ACA action is likely to be more of a rework than a total rebuild. Valuations remain appealing, but a technical breakout above key resistance levels requires increased confidence in the durability of profit outperformance. Is such a phase forthcoming? Our conviction level has decreased a notch. Our concern is primarily revenue based, rather than fear that provisions for doubtful accounts will suddenly deteriorate as a consequence of treating uninsured patients. Instead, the main push from the surge in the insured population and increase in procedures on the back of rising consumer confidence/job security is likely to peter out. Consumer spending on hospitals has already rolled over decisively on a growth rate basis (Chart 12, third panel), and is contracting compared with total consumer spending. The same is true of spending on physician visits. Fewer doctor visits mean a reduction in procedures performed at hospitals. Chart 11Hitting Resistance Chart 12Top-Line Trouble Ahead? Health care is a labor-intensive industry. Health care facilities staff up when they get busy and prune when capacity utilization slips. As such, slowing growth in hospital employment reinforces that patient volume growth is likely to ebb (Chart 12). In fact, the contraction in hospital hours worked signals the same ahead for hospital sales (Chart 12, bottom panel). The good news is that labor costs remain in check, as measured by the employment cost index for hospitals (Chart 13). Other input costs, such as the cost of medical equipment and supplies, have perked up (Chart 13), which may require increased pricing power in order to sustain profit margins. However, the revenue trends noted above suggest that hospitals may not experience a sufficient rise in patient volumes to the extent that restores pricing power to a more solid footing. Chart 14 shows that the consumer price index for hospitals is losing momentum relative to overall inflation. Durable outperformance phases require accelerating relative pricing power, in addition to a cooling in overall economic growth, as proxied by the ISM manufacturing index (see shading, Chart 14). Those conditions provide a durable competitive profit advantage. Chart 13A Mixed Picture For Costs Chart 14Shaky Long-Term Support Chart 15Macro Headwinds In addition, the ideal macro conditions for hospital stocks exist when consumer spending on overall health care services is accelerating relative to total spending. That implies that the providers of health care services have an advantage over those that pay for them, such as insurers. Total medical care spending is steadily decelerating (Chart 15), underscoring that investors are better off targeting investments in other parts of the sector. In sum, the forces required to sustain the oversold rally in the S&P 1500 health care facilities index are losing clout, so we recommend booking profits. Bottom Line: Downgrade the S&P 1500 health care facilities index to neutral, locking in a 12% profit since inception in December 2016. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

Highlights Risk assets have rallied smartly, yet key indicators like the relative performance of Swedish stocks or the price of kiwi equities are not corroborating these moves. With the Fed now very likely to increase rates in March, the broad-trade-weighted dollar could be about to resume its rally. This would prompt a correction in metals, and EM as well as commodity currencies. We think the tactical correction in the broad-trade-weighted dollar is over, and the cyclical dollar rally can resume. EUR and JPY will not suffer as much as the commodity currencies, go long EUR/AUD, short NZD/JPY. Feature In the Roman calendar, the Ides of March corresponds to the 15th of that month. Consigning that date to posterity in the year 44 BCE, Julius Caesar was assassinated on the floor of the senate in Rome, with his adoptive son Brutus, being among the conspirators. This event prompted yet another round of civil war in the republic, and ultimately a regime shift: the end of the Roman Republic and the Beginning of Imperial Rome under Augustus in 27 BCE. Fast forward 2061 years to the present. March 15th will be the day when the FOMC meeting ends. Will the period around the Ides of March represent a regime shift once again - albeit on a much different scale - where risk assets finally correct? Can the dollar resume its ascent? We believe the answer to both questions is yes. Unusual Market Moves Strange market dynamics have piqued our interest. In recent weeks, DM stock prices, and bond yields have been moving up (Chart I-1). This is consistent with investors pricing in an improving growth outlook and a Fed moving toward a tighter policy. On the other hand, EM stocks, metals, and gold in particular have also been moving up (Chart I-2). This move is more disturbing as it tends to imply an easing in monetary conditions, especially the strength in gold, even if it may have ended yesterday. This strange performance could be explained if the dollar was weakening or inflation expectations were moving up. However, the dollar has been strengthening in recent days and inflation expectations have been flat. Additionally, the U.S. yield curve has flattened, suggesting that the adjustment in the Fed's expected rate path is beginning to have marginally negative implications for future growth (Chart I-3). Chart I-1More Growth, More Hikes Chart I-2More Reflation As Well Chart I-3No Sign Of A Fed Behind The Curve So based on current information, how are these market moves likely to resolve themselves? Let's look at indicators. In the past, we have followed the common-currency performance of Swedish relative to U.S. equities as a gauge for the global growth outlook, and particularly non-U.S. growth relative to U.S. growth. This reflects the fact that U.S. stocks tend to be defensive, while Swedish stocks are very pro-cyclical. This dynamic is accentuated by the nature of the Swedish economy. Sweden is a small open nation that trades heavily with EM. While its biggest trading partner is the euro area, where it tends to export many intermediate goods and machinery, which are then re-exported as finished products to the EM space. Currently, Swedish equities continue to underperform U.S. ones. What is most striking is that this underperformance has happened despite a strong performance in EM stocks and metals, a very rare divergence (Chart I-4). Another worrying signal comes from New Zealand stocks in USD terms. New Zealand is another small open economy with deep trade links to the EM space. It is therefore very sensitive to global growth dynamics. While Kiwi equities did flag the rebound in EM growth and global manufacturing activity that happened in 2016, since late January, they have stopped participating in the rally in global risk assets despite a booming New Zealand economy. They have even begun swooning in recent weeks (Chart I-5). Chart I-4A Strange Divergence Chart I-5Are Kiwi Stocks Telling Us Something? Finally, two other reliable indicators of global growth are also not corroborating any further improvement in global growth from here: Small caps are underperforming large caps and oil is underperforming gold (Chart I-6). Obviously the next question becomes: are all these indicators likely to converge back toward EM equities, the AUD and the BRLs of the world or are the risk assets mentioned above likely to be the ones experiencing a downward adjustment? Here economics should give us a clue. For one, the 2016 rally in EM and risk assets can be explained by the large improvement in economic conditions. G10 and EM surprise indexes have moved up vertically in recent months (Chart I-7). However, this move might reflect the past not the future. Chart I-6Some Growth Indicators Are##br## Not Doing Well Anymore Chart I-7Too Much Of##br## A Good Thing? China has been a key reason explaining why EM assets and economic activity have been so positive. However, the large dose of fiscal stimulus that has supported that economy has dissipated (Chart I-8). Based on the IMF's October Fiscal Monitor, the fiscal thrust in China was 1.7% of potential GDP in 2015 (heavily loaded to the second half of that year), and 0.3% in 2016. It is moving to 0% in 2017. This means that as the lagged effects of the late 2015 fiscal surge dissipate, a key reflationary wind behind the global economy will disappear. The Keqiang index is mirroring these dynamics. After flirting with cyclical highs, and therefore highlighting a sharp improvement in the Chinese industrial sector, it has begun to roll over (Chart I-9). More weakness is likely in the cards. Fiscal dynamics have followed a similar pattern on a global level. The overall EM fiscal thrust was at its strongest in 2015, at 0.6% of EM potential GDP, fell to 0.1% in 2016, and is expected to hit -0.2% in 2017. In the DM, the pattern is slightly different. The high point of fiscal stimulus was 2016, when the fiscal impulse hit 0.4% of potential GDP. However, this measure is moving back to -0.1% in 2017. Chart I-8Losing A Source ##br##Of Reflation Chart I-9Chinese Industrial Activity ##br##May Be Rolling Over Additionally, the monetary environment is not as stimulative as it once was. Bond yields have risen in the whole DM space, with Treasury yields now more than 110bps higher than in July, Bund yields having moved from -0.18% to 0.31%, and JGB yields having adjusted 37bp higher to 0.07%. High-frequency loan data out of the U.S. already shows some strains caused by this rise in borrowing costs (Chart I-10). This combination points toward a deceleration in the growth impulse, especially in the goods sector. As such, we do expect the EM and G10 surprise indexes to roll over in coming weeks. Even if this phenomenon may prove temporary, the market is not priced for this event. Highlighting this vulnerability is the high level of complacency we have already flagged last week, which suggests that global investors are positioned for a continuation of the improvement in the growth outlook (Chart I-11). So high seems the conviction that growth will continue to accelerate that it is outweighing the move toward a tighter Fed going forward. Finally, the implied correlation in the S&P 500 has fallen to post 2010-lows. This could incentivize investors to take on more leveraged bets on portfolios of stocks. A low correlation results into higher diversification benefits and therefore, a lower portfolio volatility (Chart I-12). A rise in correlation would cause volatility to rise and thus a mini-deleveraging and de-risking cycle to take hold amongst investors. Chart I-10Response To Higher Yields Chart I-11Lots Of Complacency Globally Chart I-12Correlation-Induced Derisking On Its Way? Bottom Line: DM stocks are up, yields are up, the dollar is firming, yet EM equities, metals and gold especially have risen as well, and the U.S. yield curve is flattening while inflation expectations have recently been stable. We expect risk assets to end up buckling. Some reliable indicators of the trend in risk assets are pointing south, global investors are expecting further growth improvement in the coming months while global growth may in fact temporarily decelerate, and finally, if the low level of implied correlation in stocks normalizes, a correction may be catalyzed. What About The Fed Because Lael Brainard has been such a reliable dove on the FOMC, when she says that a hike is coming soon, we must listen. The fact that the market has come to price in an 83% probability of a Fed hike in March will only give the FOMC more comfort in increasing interest rate when it meets in two weeks (Chart I-13). While we have been expecting the Fed to move in line with its Summary of Economic Projection's interest rate forecast, and thus increase three times this year, we are surprised by the fast change of tune in recent days. Nonetheless, we are acknowledging this reality. Is this publication moving toward expecting four rate hikes in 2017? Not yet. We want to see how the market handles the coming hike going forward. A correction in risk assets, commodities, and EM is likely to force the Fed to pause again before resuming its hiking path. We are clearly expecting such a development. The broad dollar is likely to be caught in a bullish cross current. However, differentiation between the minors vis-à-vis the EUR and JPY might be essential for investors. Chart I-14 shows that recently, the broad-trade-weighted dollar has not kept pace with the increase in interest rate expectations for the U.S. With our capitulation index for this measure of the dollar moving closer to "oversold" territory, the weeks leading up to the Fed meeting could witness a stronger broad trade-weighted dollar. We are therefore removing our tactical short bias and moving in line with our cyclical bullish dollar stance. Chart I-13The Fed Tends To Telegraph ##br##Its Intention To Hike Chart I-14The Dollar Should ##br##Catch Up We believe that in this process, the dollar will be strongest against EM and commodity currencies. To begin with, the USD is trading near 19, 18, and 17 months lows against the BRL, ZAR, and RUB respectively. As recently as Wednesday, the AUD was also trading near the top of its distribution of the past two years (Chart I-15). Moreover, EM and commodity currencies are heavily geared to global growth. As such, the combination of a tightening Fed, rising bond yields, and a potential roll-over in global economic surprises may weigh especially heavily on them. On the other hand, in 2015 and 2016, the dollar has tended to be softer against the EUR and the JPY in periods of market turbulence. Thus, the call on EM and commodity currencies seems much cleaner than on these two currencies. In this regard, two crosses have caught our eye. One is EUR/AUD. Not only is it at the bottom end of a trading range established since June 2013, it has only traded lower at the apex of the euro area crisis between 2011 and the first half of 2013 (Chart I-16). The recent rollover in French / German bund spreads is potentially a good signal to buy this cross. The picture for JPY is now muddied. While higher interest rates should hurt the JPY, a period of risk-asset selloff should support the JPY. To play the cross-current described above, we are opening a short NZD/JPY position, a cross historically levered to rising volatility (Chart I-17). Chart I-15AUD Is Elevated Chart I-16To Fall From Here, EUR/AUD Needs A Euro Crisis Chart I-17Short NZD/JPY: A Risk-Off Play Bottom Line: The Fed moving forward its planned rate hike to March could be the ultimate catalyst to prompt a correction in risk assets, especially the segment of the market most levered to EM and growth conditions: EM and commodity currencies. We are removing our tactical USD stance and we are moving in line with our bullish cyclical stance. We are also buying EUR/AUD and shorting NZD/JPY. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Currencies U.S. Dollar USD Technicals 1 USD Technicals 2 Recent data paints a healthy picture for the U.S. economy: Fourth quarter annualized GDP came in unchanged from the previous quarter at 1.9%; PCE Price Index increased at a 1.9% annual pace, near the Fed's target; Core PCE remained steady at 1.7% annually and increased to 0.3% monthly, indicative of a robust economy; ISM Manufacturing PMI went up to 57.7. The market is now pricing in an 83% probability of a rate hike. Further enhancing growth prospects were Trump's remarks at his Joint Address to Congress, where he stated that there will be a "big, big cut" in corporate tax, and that he will seek to gain approval for a $1 trillion infrastructure plan. Hawkish comments from the previous FOMC meeting strengthened the dollar in February; Trump's comments may be an additional tailwind to the dollar's upside this month. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 The Euro EUR Technicals 1 EUR Technicals 2 Fundamentally, the euro area economy remains resilient: Services sentiment, business climate, and industrial confidence all picked up in February, outperforming expectations; Germany recorded a decrease in unemployed persons of 14,000; German CPI picked up to a 2.2% annual pace, also beating expectations Nevertheless, EUR/USD is unlikely to see any substantive upside in the coming months. With the Dutch elections in around 2 weeks, considerable volatility could rise up, something which has not been priced in. The Euro Stoxx 50 Volatility Index is showing a low reading of 16.55, just above the all-time low of 12. The ECB will meet next week and is likely to display a dovish bias due to potential political turmoil. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 The French Revolution - February 3, 2017 GBP: Dismal Expectations - January 13, 2017 The Yen JPY Technicals 1 JPY Technicals 2 On a cyclical basis we are still bearish on the yen, as the BoJ will continue to pursue radical measures to pull Japan out of its liquidity trap. Recent data seems to indicate that these measures have been somewhat successful: Retail trade YoY growth outperformed expectations coming in at 1%. Housing starts YoY growth also outperformed, coming in at 12.8%. On a tactical basis the picture is more nuanced. While it is very possible that the coming rate hike could lift rate expectations in the U.S., lifting USD/JPY, there is a risks that the hike might trigger a sell-off in risks assets, which could be very positive for the yen. For this reason we are shorting NZD/JPY, as this cross is very vulnerable to an increase in volatility. Report Links: JPY: Climbing To The Springboard Before The Dive - February 24, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 British Pound GBP Technicals 1 GBP Technicals 2 The past week has not been kind to the pound, with GBP depreciating by about 2% against both the Euro and the U.S. Dollar. This was in part due to the prospect of a Scottish Independence referendum. On the economic side, data for the U.K. continue to be mixed: House prices annual growth outperformed expectations coming in at 4.5% M4 broad money annual growth continues to climb higher and it is now at 7%. On the other hand manufacturing PMI, although still high, underperformed expectations, coming in at 54.6. Although the cyclical dollar bull market should continue to weigh on cable, we are more bullish on the pound, particularly against the euro, as expectations for the U.K. economy continue to be too pessimistic, while the dark cloud of this year's election cycle looms on the euro. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Australian Dollar AUD Technicals 1 AUD Technicals 2 AUD lost 1.3% of its value Thursday morning amid disappointing trade data. It seems that the market largely ignored stronger data this week: GDP grew at a 2.4% annual rate Q42016 and both NBS and Ciaxin Chinese Manufacturing PMI beat expectations. Exports, however, contracted at a 3% pace and the surplus missed expectations by 66%, most likely due to the AUD's strength this year, even alongside higher commodity prices. This is also particularly worrying seeing that exports failed to pick up despite a previously strong Chinese PMI reading. Now, alongside a Keqiang Index that is topping out, the future for Australian exports could be limited. Additionally, this outlook is further supported by investment diverting to the non-resource sector. It is difficult to see whether the RBA will respond to this export slump, as the contractionary Q32016 GDP data was largely overlooked and dismissed. Nevertheless, we stand by our bearish outlook on AUD. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 New Zealand Dollar NZD Technicals 1 NZD Technicals 2 The RBNZ continues to assert its neutral bias. On Wednesday, RBNZ Governor Graeme Wheeler stated that "there is an equal probability that the next OCR adjustment could be up or down". This caused the kiwi to come close to reaching 0.71, its lowest point since mid-January. We continue to believe that the RBNZ stance is not hawkish enough, as powerful inflationary forces continue to brew in New Zealand. That being said, it is very likely that the RBNZ will continue with its neutral tone up until the middle of the year, when we start to have a clearer picture about the outcome in European elections. Therefore, given that the Fed is likely to hike in March, diverging monetary policies should continue to weigh on NZD/USD until then. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Canadian Dollar CAD Technicals 1 CAD Technicals 2 The BoC left their overnight rate target unchanged at 0.5% despite a high CPI reading of 2.1% in January. A further surprise was a particularly dovish tone, highlighting that higher energy prices will have a temporary effect on inflation, and indicating "material excess capacity in the economy". Additional weaknesses were highlighted with regards to competitiveness challenges for the export sector and subdued wage growth accompanied by contracting hours worked. Trade developments are an additional headwind for the Canadian economy that the bank is monitoring and will continue to do so until the outlook clarifies. CAD has lost more than 2% of its value against the USD in 3 days due also to a stronger dollar based on Fed rate hike expectations and Trump's potential infrastructure spending and tax cuts. It is unlikely that CAD will see any strength in the near future as the Bank has set forth a rather cautious tone. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Swiss Franc CHF Technicals 1 CHF Technicals 2 Recent data has been mixed, which indicates that although economic activity in Switzerland is improving, it still is very tepid: The KOF leading indicator outperform expectations coming in at 107.2 Retail sales outperformed expectations. However they are still contracting by 1.4% GDP annual growth was 0.6%, falling significantly from last quarter reading of 1.4% The SNB is currently in a tight spot, as improvements are very marginal and it is evident that the economy is still plagued by strong deflationary forces. Meanwhile EUR/CHF is under 1.065 and has been unable to climb above this level this month, as the SNB continues to fight risk off flows coming into the franc due to the risks of the European election cycle. As these risks increase, the floor in this cross will continue to get tested. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Norwegian Krone NOK Technicals 1 NOK Technicals 2 Risks continue to point for further upside in USD/NOK. Oil is unlikely to rally much further from current levels, even if the OPEC agreement continues. Thus the movements in USD/NOK should be dominated by monetary divergences between the United States and Norway. These are likely to continue to favor the dollar, as the Fed should continue its hawkish tone. Meanwhile the Norges Bank is likely to stay dovish, as their economy has been to be very weak. GDP growth is negative, the output gap is over -2% of GDP and employment and real wages continue to contract. Meanwhile, the high inflation that Norway experiences last year is likely to continue its slowdown, as the effects of the currency depreciation should start to dissipate. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swedish Krona SEK Technicals 1 SEK Technicals 2 In past reports, we have argued that the Swedish economy is robust and inflation is picking up. This has been corroborated by strong consumer and business confidence, and high resource utilization and inflation expectations. Recent data has supported this view: Retail sales picked up 2.2% annually; Producer price index was up 8.2% from last year in January; Annual GDP growth came in at 2.3% at the end of last year. Growth and inflation have been supported by expansionary monetary policy. With the Riksbank stating that "there is still a greater possibility that the rate will be cut than... raised in the near future", these conditions are unlikely to falter. Nevertheless, it is important to note that it is this cautionary stance by the Bank that is the reason for the SEK's recent weakness, not fundamentals. It is now the probable case that any upside in the SEK will be noted and limited by the Riksbank, capping the upside on the krona. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of February 28, 2017. The model has maintained its large overweight in the U.S. Within the non-U.S. level 2 model, Spain and Italy weights have been increased at the expense of Japan and Switzerland. Japan and U.K. remain the two largest underweight countries. (Table 1). Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Charts 1, 2 and 3, both the level 1 and level 2 models outperformed their respective benchmarks in February, resulting in a 39 bps outperformance of the aggregate model vs. the MSCI World. Since inception, the GAA model has outperformed its benchmark by 30 bps. Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see the January 29th, 2016 Special Report "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model." http://gaa.bcaresearch.com/articles/view_report/18850. Table 2Performance (Total Returns In USD) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of February 28, 2017. The momentum component has shifted Consumer Discretionary from overweight to underweight. For mode details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Patrick Trinh, Associate Editor patrick@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com

How Long Is The Sweet Spot? Table 1Recommended Allocation The sweet spot on a baseball bat, scientists find,1 is the small area about two inches (5 cm) long, some six inches from the tip. The sweet spot for global risk assets may not be much bigger. The 22% rise in global equities since February last year has been driven by a "goldilocks" combination of recovering economic activity, quiescent inflation, and still-accommodative monetary policy. But, after such a strong rally, markets must walk a fine line - no slowdown in growth and no surprising tightening of monetary conditions - for prices to rise further. Our analysis suggests that they can, but the risk of a correction is rising. A lot of the better news of the past year has already been priced in. The price-to-sales ratio for U.S. stocks is close to an all-time high, and even the plain-vanilla 12-month forward PE ratio has reached 17.5x, the highest since 2002 (Chart 1). Volatility has fallen to a low level, with the VIX not rising above 12 over the past month, and the S&P500 index going 98 days without a one-day decline of 1% or more, the longest such period since 1995 (Chart 2). To a degree, this is justified by the recent strong pick-up in global growth. Sentiment indicators have accelerated since the election of President Trump, and even hard data is now showing the first signs of recovery (Chart 3) with, for example, U.S. retail sales rising 5.6% year-on-year in January, and core durable goods orders starting to follow the rise in companies' capex intentions (Chart 4). Similar positive economic surprises are visible in Europe, Japan, China and elsewhere. The problem is that further upside surprises are likely to be limited. Regional Fed NowCast surveys for Q1 real GDP growth are already at 2.5-3.1%. Consensus forecasts for S&P500 earnings growth in 2017 look about right at 10.5% but, with a stronger dollar and rising wages, are unlikely to be beaten. Chart 1Historically High Valuations Chart 2Time For A Pull-Back? Chart 3Hard Data Starting To Recover Too Chart 4Orders To Follow Capex Intentions Headline inflation has picked up (to 2.5% in the U.S. and 1.9% in the Eurozone), mainly because of higher oil prices, but core inflation remains sufficiently under control that central banks don't need to slam on the brakes. The rise in unit labor costs in the U.S. suggests that core PCE inflation will gradually move up to 2% during the year (Chart 5). The latest FOMC minutes revealed that members want a further rate hike "fairly soon", and BCA expects the Fed to raise three times this year (to which the futures market ascribes only a 36% probability). But Fed policy remains very accommodative (Chart 6), the European Central Bank is unlikely to end its asset purchases soon on account of political and banking system concerns, and the Bank of Japan remains committed to its 0% yield target for 10-year government bonds until inflation is well above 2%. Absent a powerful fiscal stimulus in the U.S. or a move by the "hard money" advocates in the Trump administration to change the Fed's modus operandi, we think its unlikely that a tightening of monetary policy will drag down asset prices. Chart 5Labor Costs Putting Pressure On Prices Chart 6Fed Policy Still Accomodative Risks certainly abound. The Trump administration could start a trade war with China. Its proposals for corporate and personal tax cuts could disappoint both in terms of their details and the timing of Congress's passing them. European politics remain a concern, with the probability of Marine Le Pen becoming French President increasing recently (though it remains small). But risk markets tend to rise on a wall of worry. Investor sentiment is not particularly bullish at the moment, with the bull/bear ratio among individual investors barely above 1 (Chart 7) and flows into equity funds in recent months not reversing the outflows of last year (Chart 8). Chart 7Retail Investors Not So Bullish Chart 8Equity Flows Are Still Tepid After a year of a strong cyclical risk-on rally, progress from now on will get tougher. A short-term change of direction is quite possible (and has already happened in some assets, with the yen moving back to 112 and the 10-year Treasury yield to 2.3%). But we expect economic growth to remain robust this year - with U.S. real GDP growth likely to come in close to 3% on the back of surprises in capex - which will push the 10-year Treasury yield above 3% by year-end. In this environment, we continue to favor equities over bonds, and maintain our pro-risk tilt in equity sectors, credit and alternative assets. Equities: U.S. equities have outperformed Eurozone ones by 5% year-to-date, mainly because of worries about Europe's political risk and the fragility of its banking sector. Though we think the political risks are overstated (except perhaps in Italy), we continue to prefer the U.S. in common currency terms because of our expectations of further dollar appreciation and because the lower volatility of the U.S. helps reduce the beta of our recommended portfolio. Emerging markets have outperformed global equities by 3% YTD, mainly on the back of stronger commodities prices. But we remain underweight EM because of the risks from a stronger dollar and rising global rates, concerns about protectionism and debt refinancing, and because of the likelihood that China's rebound will run out of steam over the next 12 months (Chart 9). Fixed Income: Rates have pulled back recently: long-term institutional investors have begun to find attraction in the long end of the U.S. Treasury yield curve at 2-3%, though speculative investors remain short (Chart 10). With the Fed likely to raise rates three times this year, inflation expectations to pick up further, and nominal GDP growth in the U.S. to reach 4.5-5%, we expect the U.S. 10-year yield to rise above 3%. We therefore remain underweight duration and prefer inflation-linked over nominal bonds. In the improving economic environment, we continue to like credit, but find valuations more attractive for investment-grade bonds than for high-yield. Currencies: Dollar appreciation has been on hold since January but we think the long-term trend remains in place because of the probable direction of relative interest rates. Neither Japan nor the Eurozone is likely to move towards monetary tightening over the next 12 months. Even if the Trump administration were to want a weaker dollar, a few tweets would not be enough to offset monetary fundamentals. And, while it is true that sentiment towards the dollar is already bullish, this has historically not precluded further appreciation, for example in the late 1990s (Chart 11). Chart 9EM Equities Correlated With China PMIs Chart 10Divergent Views On U.S. Bonds Chart 11Optimism Need Not Stop USD's Rise Commodities: The oil price remains close to its equilibrium level at around $55 a barrel, with the OPEC agreement largely holding but being offset by a production increase from the U.S. shale drillers, whose rig count has doubled since last May. We are neutral on industrial commodities: Chinese demand resulting from last year's reflationary policy is likely to be offset by the stronger dollar. Gold remains a useful portfolio hedge in a world of elevated geopolitical worries and inflation tail-risk, but is also negatively correlated with the U.S. dollar. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see, for example, "The Sweetspot of a Hollow Baseball or Softball Bat", by Daniel A. Russell, Pennsylvania State University, available at www.acs.psu.edu/drussell/bats/sweetspot.html Recommended Asset Allocation Model Portfolio (USD Terms)

Highlights Portfolio Strategy The market has quietly adopted a less cyclical sectoral tone since yearend, a trend that could amplify over the coming months, even if overall appreciation persists. Defense stocks have grown into previously extended valuations, warranting ongoing above-benchmark exposure. The opposite is true for aerospace equities. Data processing shares are more likely to roll over than break out and we recommend paring positions to underweight. Recent Changes S&P Data Processing - Downgrade to underweight from overweight. Table 1 Feature The stock market has cheered the broad-based rebound in earnings and improvement in corporate sector pricing power (Chart 1). Unbridled optimism about growth friendly policy tilts including potential tax reform and select regulatory relief combined with an easing in financial conditions have encouraged investors to make large down payments against expected future profit gains. Indeed, extreme economic and earnings bullishness is evident in record setting price/sales (P/S) multiples: Chart 1 shows that on a median basis, the industry group (P/S) ratio is far above the 2000 peak, providing yet another metric in a long list of yardsticks signaling that greed is the overriding market emotion. Nosebleed valuation levels are cause for significant cyclical concern, but as discussed last week, momentum and a valuation-agnostic transition from fixed income to equities are the dominant tactical forces at the moment. Since it is difficult to reconcile valuations at odds with realistic expectations about future earnings growth, we remain focused on sub-surface positioning to indemnify against disappointment. Since late last year, the market has adopted a more defensive than cyclically-oriented tenor. Defensive sectors have troughed at extremely attractive relative valuation levels, based on our models (Chart 2). Conversely, cyclical sectors have rolled over, meeting resistance at very demanding valuation levels of more than two standard deviations above normal (Chart 2). Chart 1Future Growth Has Been Paid For Already Chart 2The Market Tone Is Changing Contrarians should take note. These nascent trend changes have developed even though economic data have generally surprised on the upside, which may be an indication that a more forceful response will occur once the string of upside surprises loses momentum. The global PMI has been very strong, but any hint of a reversal would provide a catalyst for a full-fledged recovery in defensive vs. cyclical stocks (Chart 3). The contraction in U.S. bank lending growth may be heralding slippage in hard economic data (Chart 3), to the benefit of defensive vs. cyclical sectors. Keep in mind that the market is priced for non-inflationary growth nirvana, such that even modest economic disappointment could short circuit the buying binge. The yield curve has stopped widening and financial conditions are no longer easing (Chart 3), providing additional confirmation that the defensive vs. cyclical equity sector trough is more likely a budding trend change than a pause in a downtrend. A trend change is also consistent with the relentless downgrading in emerging market vs. developed country GDP growth expectations (Chart 4). Chart 3Forward Looking Yellow Flags Chart 4No EM Confirmation For Cyclicals The lack of a durable and credible growth thrust in EM is confirmed by regional share price performance, as EM equities have significantly lagged their developed country counterparts (Chart 4). Now that China's fiscal stimulus impulse has rolled over amidst ongoing currency depreciation, EM lacks a catalyst for incremental growth outperformance vs. developed markets. Adding it up, evidence of a sub-surface trend change continues to materialize, even in the face of upward momentum in the broad market. We expect a mostly defensive along with select interest rate-sensitive exposure to provide optimal portfolio performance in the next 3-6 months. Defense Stocks Will Continue To Protect Portfolios... A Special Report sent to clients on October 31 outlined the long-term appeal of defense stocks, prior to the installment of a new, bellicose U.S. Administration. If anything, the latter threatens to exacerbate the decline in globalization that was already in progress (as discussed since 2014 by BCA's Geopolitical Strategy Service), potentially creating a leadership vacuum that will raise the specter of open military conflict. More nationalistic foreign policies in a number of countries, i.e. moving away from collaboration and cooperation and toward isolationism and self-sufficiency, is a recipe for increased geopolitical instability. China's challenge to the status quo is also likely to motivate a boost to defense spending globally. The recent World Economic Forum estimates of global military spending by 2030 cite both China and India planning to quadruple military outlays over this time frame (Table 2). The U.S. Administration is already pressuring other NATO members to boost defense spending after a long contraction (Chart 5), which should eventually spillover into rising defense contractor sales. Reportedly, only 5 out of 28 NATO members reached the targeted goal of spending 2% of GDP on defense. Ergo, there is room for an increase, especially in some larger countries with fiscal room to maneuver. More imminently, the conditions that have created the gap between aerospace and defense relative performance are growing even stronger (Chart 6). Table 2A New Arms Race Underway Chart 5Lots Of Upside Chart 6A Growing Gap While U.S. defense spending has been through a soft patch for the past several years, new orders for defense goods have been one of the strongest components of overall durable goods orders (Chart 6). The unfortunate reality is that the incentive to boost defense and security spending has never been higher. Terrorist activity continues to proliferate around the world (Chart 7), raising a sense of geopolitical uncertainty and mistrust. With defense new orders continuing to make new cyclical highs, factory output should run at levels flattering operating margins. Shipments of defense goods are outpacing inventories by a wide margin, which is consistent with solid pricing power. Even exports of military goods are booming (Chart 7), despite the strong U.S. dollar, reflecting a strong undercurrent of global demand. Domestic defense spending has room to expand. Real defense outlays are only just starting to recover (Chart 8). President Trump ran on a campaign to protect the U.S. from terrorism. That should make it comparatively easy to increase defense spending in the years to come. It is normal for defense stocks to retain momentum as defense spending growth accelerates (Chart 8, top panel). Increased staffing at the U.S. Department of Defense (DOD) implies that purse strings may already be loosening in anticipation of heightened activity. DOD employment growth often provides a good leading indication for real defensive spending trends (Chart 8, bottom panel). Thus, while share prices have been on a tear and valuations are not cheap, rapid earnings growth has pushed down forward multiples to manageable, below-market, levels (Chart 9, shown as an average of the companies in the BCA Defense Index). Chart 7Powerful Momentum... Chart 8... With Long-Term Durability Chart 9Growing Into Valuations Prospects for strong multiyear growth should support a move to a premium valuation as margins expand (Chart 9), similar to what occurred during past defense spending booms, as chronicled in our October 31 Special Report. ...But Aerospace Stocks Are Out Of Fuel In terms of aerospace equities, the outlook is more challenging. New orders have been sinking steadily, reflecting a downturn in the commercial aerospace cycle. While long lead times and lengthy delivery schedules offer some earnings protection, dwindling order backlogs will ultimately undermine confidence in the long-term outlook. Chart 10 shows that aerospace unfilled orders are contracting, an environment typically associated with share price underperformance, or at least elevated volatility. Shipments of aerospace goods are falling, a rare occurrence (Chart 10). The implication is that aerospace industrial production is also shrinking (Chart 10). With a heavily unionized labor force, it will be difficult to maintain profitability. Will increased global growth translate into a recovery in aerospace new orders? Doubtful. Aerospace cycles tend to be long and are not always correlated with the business cycle. Aerospace new order growth has little correlation with the global leading economic indicator. In fact, if anything, it is more countercyclical. Ominously, there are signs of excess capacity. Our global airline consumer price index, a composite of airline pricing power in a number of major countries, is in negative territory. A negative CPI reflects excess capacity, and warns of grim prospects for a recovery in new airplane orders (Chart 11). Chart 10Running On Empty Chart 11Too Much Capacity Against this backdrop, aerospace profits will become increasingly reliant on maintenance, repair and consumables activity. However, weak pricing power suggests that this source of revenue is soft (Chart 11). Aerospace valuations are close to a par with those of defense stocks. Divergent profit outlooks imply that the latter should expand while the former get squeezed. Bottom Line: We remain confident that the BCA defense index (LMT, GD, RTN, NOC, LLL) will continue to generate above market returns, whereas the BCA aerospace index (BA, UTX, HON, TXT) exhibits asymmetric downside risk. Data Processors Are Losing Their Allure After a consolidation phase that restored value to a more neutral level, we upgraded the S&P data processing index to overweight in late-September, because it fit into our consumption vs. capital spending theme, outperforms in disinflationary environments and would benefit from a recovery in industry sales growth. While several of those factors still exist, the share price ratio has been unable to gain traction and the window for outperformance may be closing. The economic backdrop is no longer conducive to capital inflows. Data processing companies enjoy hefty recurring revenue and high returns on equity, warranting persistent above market valuations (Chart 12). However, the flipside of predictability is lower operating leverage than many other industries and a pattern of underperformance during periods of rising inflation expectations. Indeed, cyclical share price momentum tends to take its cue, inversely, from inflation expectations (inflation expectations shown inverted, middle panel, Chart 12). Renewed traction in global economic growth, as evidenced by the upturn in the global leading economic indicator (GLEI, shown inverted, top panel, Chart 13), represents a headwind to capital inflows and relative multiple expansion. The improvement in business sentiment has also boosted our capital spending model, albeit we are doubtful as to whether increased animal spirits will translate into much of a capital spending cycle in a world of deficient final demand and soft free cash flow. Still, any rise in capital spending would put the services-based data processing group at a disadvantage, in relative terms. The downturn in the ISM services index compared with the ISM manufacturing index reinforces that the external environment has become more challenging (Chart 13). All of these factors could be overcome if operating trends were set to improve. Data processing revenue trends are tightly linked with consumer spending (Chart 14). The personal savings rate has room to fall, facilitating an increase in outlays, particularly now that the labor market has tightened. Rising job security has buoyed consumer confidence, which has historically augured well for data processing sales growth. Chart 12The Window Has Closed Chart 13Sell Signals Chart 14Margin Squeeze But top-line growth has been in a funk of late, even with firming pricing power (second panel, Chart 14). Companies have made a significant investment to boost marketing, as evidenced by the surge in SG&A, but so far, this has sapped margins more than stoked revenue. Importantly, Visa has recently provided a fee break to retailers, who are increasingly banding together to put pressure on the industry to lower fees. Amidst increased competition on the payments processing side, this trend is likely to be structural and put downward pressure on profit margins. Thus, we are reluctant to embrace the jump in the producer price index, as future readings could be much weaker. The implication is that operating performance will not overcome macro hurdles. Bottom Line: Reduce the S&P data processing index (V, MA, PYPL, ADP, FIS, FISV, PAYX, ADS, GPN, WU, TSS) from overweight to underweight. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

The Tactical Asset Allocation model can provide investment recommendations which diverge from those outlined in our regular weekly publications. The model has a much shorter investment horizon - namely, one month - and thus attempts to capture very tactical opportunities. Meanwhile, our regular recommendations have a longer expected life, anywhere from 3-months to a year (or longer). This difference explains why the recommendations between the two publications can deviate from each other from time to time. Highlights In February, the model underperformed global equities and the S&P 500 in USD and local-currency terms. For March, the model slightly increased its allocation to stocks and cut its weighting in bonds (Chart 1). Within the equity portfolio, the allocation to Europe was increased. The model boosted its weightings to French and Australian bonds at the expense of Canadian and Swedish paper. The risk index for stocks, as well as the one for bonds, deteriorated in February. Feature Performance In February, the recommended balanced portfolio gained 2.1% in local-currency terms, and 0.2% in U.S. dollar terms (Chart 2). This compares with a gain of 3% for the global equity benchmark and a 3.3% gain for the S&P 500. Given that the underlying model is structured in local-currency terms, we generally recommend that investors hedge their positions, though we provide suggestions on currency risk exposure from time to time. The high allocation to bonds continued to hold back the model's performance. Chart 1Model Weights Chart 2Portfolio Total Returns Weights The model increased its allocation to stocks from 53% to 57%, and cut its bond weighting from 47% to 43% (Table 1). Table 1Model Weights (As Of February 23, 2017) The model increased its equity allocation to Dutch and Swedish equities by 4 points each, Germany and New Zealand by 2 points each, and France and Emerging Asia by 1 point each. Weightings were cut in Italy by 4 points, Latin America by 3 points, Spain by 2 points, and Switzerland by 1 point. In the fixed-income space, the allocation to Australia was boosted by 8 points, France by 6 points, and Germany by 4 points. The model cut its exposure to Swedish bonds by 9 points, Canadian bonds by 6 points, U.S. and U.K. bonds by 3 points each, and Kiwi bonds by 1 point. Currency Allocation Local currency-based indicators drive the construction of our model. As such, the performance of the model's portfolio should be compared with the local-currency global equity benchmark. The decision to hedge currency exposure should be made at the client's discretion, though from time to time, we do provide our recommendations. The most recent bout of dollar depreciation was halted in February. Our Dollar Capitulation Index is below neutral levels. However, it is not extended, meaning that it does not preclude renewed dollar weakness in the near term. That said, assuming no major negative economic surprises, a relatively more hawkish Fed versus its peers should provide support for the dollar (Chart 3). Chart 3U.S. Trade-Weighted Dollar* And Capitulation Capital Market Indicators The risk index for commodities was little changed in February. The model continues to avoid this asset class (Chart 4). The risk index for global equities rose to its highest level since early 2010, mostly on the back of deteriorating value. Despite this, the model slightly increased its allocation to equities (Chart 5). Chart 4Commodity Index And Risk Chart 5Global Stock Market And Risk The rally in U.S. stocks - driven by optimism about the economic outlook - pushed the value component of the risk index into expensive territory. The model kept a small allocation in U.S. equities. A change in the perception about the ability of the new U.S. administration to boost growth remains a risk for this market (Chart 6). The risk index for euro area equities continues to deteriorate. However, it remains lower than its U.S. counterpart. The continued flow of solid economic data and a weaker currency should bode well for euro area stocks, although political uncertainty is a potential headwind (Chart 7). Chart 6U.S. Stock Market And Risk Chart 7Euro Area Stock Market And Risk All three components of the risk index for Dutch equities are close to neutral levels. As a result, despite the recent deterioration in the overall risk index, it remains one of the lowest among the markets the model covers (Chart 8). The risk index for Swedish stocks worsened. However, the model increased its allocation to this bourse. Swedish equities would be a beneficiary of the continued risk-on environment (Chart 9). Chart 8Netherlands Stock Market And Risk Chart 9Swedish Stock Market And Risk The momentum indicator for global bonds is less stretched in February. Meanwhile, despite its latest decline, the cyclical indicator continues to signal that the positive global economic backdrop is firmly bond-bearish. Taken all together, the risk index for bonds deteriorated in February, although it still remains in the low-risk zone (Chart 10). U.S. Treasury yields moved sideways in February as investors await more guidance from the Fed on the timing of the next hike. A bond-negative cyclical indicator coupled with the unwinding of oversold conditions - as per the momentum measure - led to a deterioration in the risk index for U.S. Treasurys. The latter is almost back to neutral levels. The model trimmed the allocation to this asset class (Chart 11). Chart 10Global Bond Yields And Risk Chart 11U.S. Bond Yields And Risk The momentum indicator remains the main driver of the risk index for Canadian bonds. As a result, the less extreme momentum reading translated into an increase in the risk index for this asset class. (Chart 12). The risk index for Australian bonds moved lower in February, reflecting improvements in all three of its components. The model included the relatively high-yielding Aussie bonds in the portfolio. (Chart 13). Chart 12Canadian Bond Yields And Risk Chart 13Australian Bond Yields And Risk The cyclical indicator for euro area bonds is near expensive levels, and the momentum indicator shows heavily oversold conditions. These two measures are offsetting the cyclical one that is sending a bond-bearish message. While the overall risk index for euro area bonds is in the low-risk zone, the country allocation is concentrated in French paper (Chart 14). The risk level for French bonds is seen as low thanks to oversold momentum. French presidential elections are probably the most important political event in Europe this year. Whether the models' heavy allocation to this asset pans out hinges to a certain extent on the reduction of investor anxiety about this political risk (Chart 15). Chart 14Euro Area Bond Yields And Risk Chart 15French Bond Yields And Risk The 13-week momentum measure for the dollar broke below the zero line, and is currently sitting on its upward-sloping trendline, drawn from the 2010 lows, that has been broken only once before. Meanwhile, the 40-week rate of change measure is still suggesting that the dollar bull market has more legs on a cyclical horizon. Monetary divergences should lend support to the dollar over the cyclical horizon, although the new administration's attempts to talk down the dollar as well as heightened policy uncertainty could translate into more volatility (Chart 16). The weakening trend in the yen hit a snag two months ago, as the 13-week momentum measure reached the lows that previously foreshadowed a consolidation phase after sharp depreciations. This short-term rate-of-change measure has bounced smartly this year reaching a critical level. Meanwhile, the 40-week rate-of-change measure is not warning of a major change in the underlying trend which remains dictated by BoJ's dovish bias (Chart 17). EUR/USD has been gravitating towards 1.05 over the course of February. The short-term rate-of-change measure seems to be holding at the neutral level, while the 40-week rate-of-change measure is in negative territory, but hardly stretched. Political uncertainty has the potential to drive the euro in near term, but the longer-term outlook is mostly a function of the monetary policy divergence between the ECB and the Fed (Chart 18). Chart 16U.S. Trade-Weighted Dollar* Chart 17Yen Chart 18Euro Miroslav Aradski, Senior Analyst miroslava@bcaresearch.com

Highlights Gold volatility is trending lower, suggesting unresolved economic and political issues are diminishing, and investors' confidence in the global economy is improving. This is a false positive. Uncertainty is elevated. "Known unknowns" loom large: U.S. and Chinese fiscal policy, which drive USD dynamics and commodity supply and demand, are unresolved; The outcome of French and Italian elections could shock the euro zone; The reaction functions of systemically important central banks as they navigate these risks remain opaque. Given gold's exquisite sensitivity to political and policy nuances globally, our attention naturally turns to it when we look for ways to position in the face of this political and policy-related uncertainty. Our analysis suggests the low volatility in gold markets is the result of traders and investors being driven to the sidelines, where they await clarity re politics and policy. This is keeping trading volumes low: No one wants to be long or short lacking critical information necessary to take a view on the evolution of asset-price paths. Lower trading volumes, therefore, reflect a paucity of information in the price-discovery process, which, all else equal, will tend to keep commodity prices range bound until new information arrives to propel them in one direction or the other. With fewer prints going up across markets, realized and implied volatilities remain low ... for the moment. Energy: Overweight. We are taking profits basis today's close on our WTI Dec/17 vs. Dec/18 backwardation spread initiated February 9 at -$0.11/bbl. We also will be taking profits on our Dec/19 WTI vs. Brent spread, elected February 6 at +$0.07/bbl, after WTI traded premium to Brent in anticipation a U.S. border-adjusted tax would be enacted. Base Metals: Neutral. Copper remains well bid amid transitory supply outages. Workers resumed their strike at BHP's Escondida mine in Chile, while Anglo American temporarily suspended work at its El Soldado mine in a regulatory dispute, according to Metal Report. Freeport-McMoRan declared force majeure on Grasberg deliveries. Precious Metals: Neutral. We are withdrawing our gold buy-stop, and are recommending long gold options spreads to position for higher volatility (see below). Ags/Softs: Underweight. Corn and wheat came under selling pressure over the past week, but still are holding trend-line support from end-2016. We continue to monitor these markets for signs of a short-term rally. We remain strategically bearish, however. Feature While we believe the Efficient Market Hypothesis (EMH) holds most of the time - at least in semi-strong form (i.e., all public information is fully reflected in prices) - traders and investors now find themselves in something of a quandary.1 Much of the information needed to assess future paths for asset prices and form expectations for returns has yet to be revealed. In other words, there are large parts of markets' information sets made up of "known unknowns," which, once resolved, will be of enormous consequence to the paths taken by different asset prices. This is particularly true for gold. Our analysis suggests this lack of information is keeping trading volumes in gold markets low. As a result, the price-discovery process is stymied, which, all else equal, tends to keep prices range bound until new information arrives to propel them in one direction or the other. With fewer prints going up across markets, realized and implied volatilities remain low. Investors accustomed to viewing low volatility as an indication unresolved economic and political issues are diminishing therefore have to adapt to a new reality, one in which low volatility actually is the product of heightened uncertainty (Chart of the Week). Granted, financial stress is low. This contributes to lower volatility, particularly in gold, which is highly sensitive to U.S. real rates and USD levels. However, we find low trading volumes in gold markets also are responsible for the lower-trending realized and implied volatility prevailing in in gold markets (Chart 2).2 Chart of the WeekVolatility Is Low, Despite Uncertainty Being High Chart 2Realized And Implied Gold Vols Are Trending Lower This suggests there is an opportunity to position ahead of the resolution of these "known unknowns" in the gold market, given the low volatility levels we see. This is driven largely by our view that there are numerous risks in near- and longer-term price distributions, which imply much fatter tails than markets are pricing in at the moment.3 Indeed, the CBOE Gold VIX is running at ~ 13.5% presently vs. a post-Global Financial Crisis (GFC) average of 18.8% p.a.4 First, The Fat Left Tail There are a number of risks pumping up the left tails of many commodity price distributions - e.g., how long China will continue to tighten fiscal policy (Chart 3), and the effect this will have on the prices of base metals and bulk commodities like iron ore and steel. And, of course, markets will continue to hang on every utterance of Federal Reserve officials, attempting to discount rate-hike probabilities and their implications for the USD and real rates, the critical drivers of gold prices (Chart 4). Chart 3China Fiscal Stimulus Grinds To A Halt Near term, these risks will continue to loom large, but they are dwarfed by a possible border-adjusted tax (BAT) being imposed in the U.S. In our estimation, this is the largest left-tail risk we've identified for commodity markets over the near term. It is being championed by Republican leaders in the U.S. House of Representatives - led by Speaker Paul Ryan and Ways and Means Chairman Kevin Brady.5 A BAT would raise the price of commodities subject to the tax in the U.S. Domestically, producers of commodities subject to the tax would benefit from this increase in prices, since it would boost their revenues and incentivize increased domestic production. This would be used to displace imports and take market share from exporters to the U.S. Once the domestic market has been saturated with the higher domestic output, U.S. producers would turn to export markets to sell their increased output. A BAT would shrink the U.S. trade deficit, which would, all else equal, raise the trade-weighted value of the USD. Our expectation is there is a 50:50 chance a BAT is enacted, but that it will exclude oil and apparel. We expect the USD would appreciate ~ 10% on the back of this scheme, on top of the 5% increase in the value of the dollar we already were expecting from the Fed's continued push to normalize monetary policy. On the back of this 15% appreciation in the USD over the next year or so, commodity prices ex U.S. would increase in local-currency terms, which would crimp demand in EM and DM economies. On the supply side, the cost of producing commodities ex U.S. would fall in local-currency terms, which would increase supply at the margin. Net, net: A BAT would cause global commodity demand to fall and supply to increase, which would, all else equal, send a deflationary impulse back to the U.S., and DM and EM economies. Fat Right Tails Permanent and transitory commodity supply losses constitute large right-tail risks for investors, in our estimation, as does stronger-than-expected demand. Chief among these are ongoing losses in copper markets in the near term, which we believe to be transitory. The massive $1 trillion+ capex cuts registered in the oil markets in the wake of the price collapse induced by OPEC's market share war leave us with low confidence our oil-price expectation of $55/bbl will prevail beyond 2018. Near term, however, the timing and type of infrastructure projects that will be funded under the Trump administration's forthcoming fiscal roadmap, and whether Congress will be supportive represent the largest right-tail risk for gold markets. Highly expansive fiscal stimulus could spur inflation in the U.S., given this stimulus will be hitting an economy that already is at or near full employment. Given the synchronized global economic recovery currently underway, we believe an inflationary impulse could percolate into near-term inflation realizations, and into inflation expectations longer term. Chart 4Markets Will Continue To Hang On Every Fed Utterance This elevated inflation risk will be bullish for gold, as we showed in recent research.6 Indeed, we noted, "All else equal, with the U.S. labor market at or close to full employment, and the Trump administration signaling its desire for stimulative fiscal policy, we would be inclined to look for inflation hedges within commodities that are highly sensitive to rising inflation." Topping that list is gold, in our estimation. Taking A View On Volatility Chart 5Gold Provides A Good Hedge For Equity Volatility Volatility is trading-market shorthand for the annualized standard deviation of expected returns for an underlying asset. It is a parameter used to price options. Options markets are unique in that they allow investors to take a view on the dispersion of the expected returns of the asset against which the option is written.7 Volatility is a calculated value, whereas the other components of an option's price - i.e., the underlying asset's price, the strike price, time to expiration, and interest rates - all are known inputs. Volatility, like the price of the underlying asset, therefore is "discovered" when a trade occurs. After an option trades and its premium becomes known, an option-pricing model - e.g., the Black-Scholes-Merton model - can be run backwards, so to speak, to see what level of volatility solves the pricing model for the value that cleared the market. This is known as the option's implied volatility, because it is the expected standard deviation of returns implied by the price at which the option clears the market. One reason investors and traders buy and sell options is to express a view on implied volatility. Option buyers who think the market is underestimating the likelihood of sharply higher or sharply lower returns can express this view by buying out-of-the-money options - calls or call spreads on the upside, puts or put spreads on the downside. This can arise for any number of reasons, but they all boil down to one essential point: Option buyers think there is a higher probability returns will be higher or lower during the life of an option than what is being priced in the options market presently.8 Option sellers, on the other hand, are expressing the opposite view. We believe the fat-tail risks we've discussed in this article are not being fully reflected in the options markets most sensitive to this information, among them the gold market. Our own assessment of these risks implies much fatter tails than we currently observe in the out-of-the-money gold options, as noted above. For this reason, we are recommending investors consider buying put spreads and call spreads against June-delivery gold. We will look to get long Jun/17 $1,200/oz puts vs. selling $1,150/oz puts, and getting long $1,275/oz calls vs. selling $1,325/oz calls, basis tonight's closing levels for the underlying contract. This is a low-risk strategic recommendation, with the put and call spreads roughly equidistant from where the Jun/17 gold contract is trading. The motivation for this recommendation is simple: We believe volatility is low, given the "known unknowns" and their associated fat tails, which are not being accounted for in options prices. This makes these options cheap. Gold Can Hedge Equity Risk As Well Our analysis reveals gold provides a good edge against rising equity volatility, as measured by the CBOE's equity volatility index (CBOE VIX).9 From 1995 to the present, gold's monthly percentage returns outperformed those of the S&P 500 61% of the time when the VIX was increasing, and 36% of the time when the VIX was decreasing (Chart 5). Over the entire sample, gold outperformed the S&P 500 in average by 2.25% in periods of increasing equity volatility as measured by the VIX. However, if we focus only on sub-sample periods where the VIX was increasing but from an already-elevated level (20% or above), gold returns outperformed S&P 500 returns by 4.57% on average. Given our assessment that current volatility is abnormally low, particularly for gold, we believe the gold options exposure recommended here will provide investors protection against increasing equity volatility, as well. Moreover, if market sentiment changes and volatility begins to increase significantly, our analysis provides evidence that gold's volatility-risk-mitigation properties increase even more when the VIX is already at a high level. Bottom Line: Markets lack sufficient information to fully price the risks in potential fat-tail events on the down- and up-side of commodity price distributions. We believe gold options - particularly put and call spreads - offer a low-risk way to position for the eventual resolution of this uncertainty. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Assistant hugob@bcaresearch.com 1 For an excellent discussion of the EMH, please see Timmermann, Allan, and Clive W.J. Granger (2004), "Efficient market hypothesis and forecasting," in the International Journal of Forecasting, Vol. 20, pp. 15 - 27. 2 When we regress CBOE gold volatility on first-nearby gold futures volume using daily data over January 2016 to February 2017 using an error-correction model, we find trading volume explains ~ one-third of the CBOE implied gold volatility's level. 3 Many of these risks are geopolitical in nature, which our colleague Marko Papic considers at length in "A Fat-Tails World," published February 22, 2016, in BCA Research's Geopolitical Strategy Weekly Report, available at gps.bcaresearch.com. 4 We mark the post-GFC period as Jan/10 to present. 5 A BAT essentially would tax imports coming in to the U.S. and subsidize exports, using proceeds to reduce corporate taxes. We are not ready to pronounce the BAT dead, as some pundits already have. We think the market's 20% probability that such a tax becomes law is too low: We give it a 50:50 chance of passage, albeit in a watered down form likely calling for a 10% tax on imports, which likely will not include oil or apparel. Base metals and agricultural imports likely would be taxed under this scheme. We analyzed the commodity impacts of this proposed scheme in "Taking a BAT To Commodities," which was published in the January 26, 2017, issue of BCA Research's Commodity & Energy Strategy Weekly Report, available at ces.bcaresearch.com. 6 Please see issue of BCA Research's Commodity & Energy Strategy Weekly Report, "Gold Will Perform...," dated February 2, 2016, available at ces.bcaresearch.com. 7 Call options give the buyer the right to go long an underlying asset at the price at which an option contract is struck - i.e., the option's strike price. Puts give option buyers the right to go short the underlying asset at the price at which the contract is struck. While an option buyer is not required to ever exercise an option, option sellers must take the other side of the deal if the buyer chooses to exercise. Option buyers pay a premium for the put or call they purchase. 8 This probability also can be expressed in terms or price levels, which allows investors to take an explicit view on the likelihood of a particular price being realized during the life of the option being purchased. Please see Ryan, Bob and Tancred Lidderdale (2009), "Energy Price Volatility and Forecast Uncertainty," published by the U.S. Energy Information Administration, for a discussion of options markets and implied volatility. "Appendix II: Derivation of the Cumulative Normal Density for Futures Prices" beginning on p. 22 shows how to transform the returns distribution into a price distribution. It is available at https://www.eia.gov/outlooks/steo/special/pdf/2009_sp_05.pdf. 9 Our results are similar to those reported in "Gold is still a good hedge when volatility rises," by Russ Koesterich, CFA, published by Blackrock on its Blackrock Blog September 9, 2016. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in