BCA Indicators/Model

Highlights Beige Book highlights disconnect between inflation words and inflation data. Peak in auto sales is not a harbinger of recession. Capital spending still trending higher. Inflation and inflation surprise will need to move higher before Fed hikes again. Big disconnect between 10-year yield and our fair value model. Feature Disconnect On Inflation Chart 1Beige Book Monitors Support##BR##Fed's Outlook On Economy And Inflation Beige Book Monitors Support Fed's Outlook On Economy And Inflation Beige Book Monitors Support Fed's Outlook On Economy And Inflation The Beige Book released on September 6 supports the Fed's base case outlook for the economy and inflation. It also keeps the Fed on track to begin trimming its balance sheet in September and boost rates by another 25 basis points in December if the CPI and PCE inflation readings turn higher. Our quantitative approach to the qualitative data in the Beige Book points to an acceleration in GDP and inflation, less business unease from a rising U.S. dollar, and ongoing improvement in real estate, both commercial and residential (Chart 1). At 64%, the BCA Beige Book Monitor was still near its cycle highs in September, providing further confirmation that economic growth was sturdy in the first two months of Q3. The Fed noted that "the information included in the report was primarily collected before Hurricane Harvey made landfall on the Gulf Coast." However, there was a mention of the storm's clout based on preliminary assessments of business and banking contacts across several districts. The U.S. dollar should not be much of an issue in the Q3 earnings season, according to the Beige Book. The greenback seems to have faded as a concern for small businesses and bankers, in sharp contrast with 2015 and early 2016 when Beige Book references to a strong dollar surged. The Q3 earnings reporting season will provide corporate managements with another forum to discuss the currency's impact on their operations. The 2% decline in the dollar over the past 12 months suggests that the dollar may even provide a small lift to Q3 results (Chart 1, panel 4). Remarkably, business uncertainty over government policy (fiscal, regulatory and health) has moved lower in 2017. The implication is that the business community is largely ignoring the lack of progress by Washington policymakers on Trump's agenda (Chart 1, panel 5). Echoing the market's disagreement with the Fed on inflation, the big disconnect in the Beige Book showed up in the number of inflation words (Chart 1, panel 3). Expressions of inflation dipped between the July and September reports. That said, a wide disconnect remains between the elevated inflation mentions and the soft readings on CPI and PCE. In the past, increased references to inflation have led measured inflation by a few months, suggesting that the CPI and core PCE may soon turn up. Bottom Line: The Beige Book backs the Fed's assertion that the economy will expand around 2% this year and inflation will mount in the coming months, supporting a gradual removal of policy accommodation. Policy uncertainty in Washington and worries over the dollar seem to be fading. The divide between the quantity of inflation words in the Beige Book and measured inflation remains unresolved. Neither the soft data in the Beige Book nor the hard data on the economy suggest that an economic downturn is nigh. Recession Not Imminent Some investors have concluded that the peak in auto sales, a key component of consumer spending on durable goods, suggests that a recession is imminent (Chart 2). We take a different view. Zeniths in consumer durable goods, followed closely by consumer services, were primary harbingers of economic downturns in the post-WWII period. However, expenditures on autos, light trucks and other durables tend to peak seven quarters before the onset of recession. Consumer spending on nondurable goods and services provide less of a warning, topping out just five and four quarters out, respectively. The implication for investors is that the peak in auto sales suggests that a recession is still several years away (Chart 3, panels 1-4). Chart 2Vehicle Sales May##BR##Have Peaked Vehicle Sales May Have Peaked... Vehicle Sales May Have Peaked... Chart 3Consumer Spending And##BR##Housing Prior To Recessions Consumer Spending And Housing Prior To Recessions Consumer Spending And Housing Prior To Recessions Housing investment provides an even earlier indication that a recession is on the horizon (Chart 3, panel-panel 5). Housing peaked 17 quarters before the start of the 2007 recession and 20 quarters, on average, before the onset of the 2001 and 1991 recession. Since the early 1960s, a crest in housing provided seven quarters of warning before a downturn commenced. While housing's contribution to overall economic growth plunged in Q2, we expect housing to provide fuel for the next few years as pent up demand from the depressed household formation rate since the GFC is worked off. The implication from our upbeat view on housing is that the next recession is still several years away. Bottom Line: We expect the next recession to be triggered by an over aggressive Fed, not by imbalances in one of more segments of the economy. It is premature to say that the economy is headed into recession based on a peak in auto sales. Stay long stocks versus bonds, but we recommend that clients be prudent, paring back any overweight positions and holding some safe-haven assets within diversified portfolios. Business Capital Spending Still Up Elevated readings on capex in the first half of the year should persist into the second half. Corporate managements may be postponing investment decisions until they have more clarity on federal tax policy and the Trump administration's plans for infrastructure investment. In short, corporations continue to struggle with how much and when to spend, rather than whether to invest at all. The key supports for sustained corporate spending stayed in place despite the soft July factory orders report and lackluster C&I loan growth. BCA's model for capex (based on non-residential fixed investment, small business optimism and the speculative-grade default rate) suggests lending is poised to climb on a 12-month basis (Chart 4) despite the softening of C&I loan growth since November 2016. Moreover, the 3.3% month-over-month (m/m) drop in factory orders in July masked an upward revision to orders in June and a substantial 1.0% m/m gain in core orders. Core shipments, which feed directly into GDP, rose 1.2% m/m in July. Almost all of the weakness in orders and shipments in July was linked to a 71% plunge in the volatile aircraft orders segment. BCA's research shows that sustainable capital spending cycles get underway only when businesses see evidence that consumer final demand is on the upswing. Consumer expenditures averaged an above-trend 2.7% in 1H. We anticipate that household spending will continue to improve in the second half of 2017.1 Moreover, recent readings on core durable goods orders and shipments show that the uptrend that began in mid-2016 persists, despite recent monthly wiggles in the data (Chart 5). Chart 4BCA Capex Model Points##BR##To Further Improvement BCA Capex Model Points To Further Improvement BCA Capex Model Points To Further Improvement Chart 5Capital Spending##BR##Remains In An Uptrend Capital Spending Remains In An Uptrend Capital Spending Remains In An Uptrend CEO confidence, still a primary support for capex, recently soared to a 13-year high in Q1, but retreated modestly in Q2. The last reading on this survey was in mid-July, and the dip in sentiment reflects the lack of legislative progress in Washington (Chart 5, top panel). The next CEO survey is set for mid-October. The dip in CEO sentiment in Q2 stands in sharp contrast with the easing of concerns around policy in the Beige Book. Chart 6Surprising Drop In Policy##BR##Uncertainty This Year Surprising Drop In Policy Uncertainty This Year Surprising Drop In Policy Uncertainty This Year Surprisingly, the chaos in Washington during the first eight months of the Trump administration has not led to an increase in economic policy uncertainty (Chart 6). Instead, after rising sharply in the wake of the Brexit vote in mid-2016 and the U.S. presidential election in November, policy uncertainty has ebbed. While uncertainty over economic policy remains elevated relative to the past few years, the concern under Trump is surprisingly subdued. This metric is in line with the Beige Book's assessment of Trump's impact on sentiment. A series of business-friendly legislative wins for the GOP and President Trump would further reduce any qualms. Even so, a failure by Congress to boost the debt ceiling and fund the U.S. government later this month would increase business worries/fears. Late last week, Trump cut a deal with Congressional Democrats to extend the debt ceiling for three months and is in talks to do away with it altogether. Bottom Line: The fundamentals still support solid business spending. However, BCA's positive capex outlook in the U.S. could be blemished if the Republicans fail to deliver on their promises to cut taxes and boost infrastructure spending in the next several months. Inflation Surprise And The Fed Chart 7The Fed Cycle And Inflation Surprise The Fed Cycle And Inflation Surprise The Fed Cycle And Inflation Surprise We expect inflation surprise to move higher, which could spur the Fed to resume its rate hike campaign. A disconnect has opened between economic surprise and inflation surprise.2 In the past 13 years, there have been 15 periods when economic surprise has climbed after a trough. The inflation surprise index temporarily increased in 13 of those episodes. For example, in the aftermath of the oil price peak in the U.S. in mid-2014, both economic surprise and inflation surprise diminished through early 2015 and then began climbing. However, today's inflation surprise index has rolled over while economic surprise has gained. The inflation surprise index escalated during previous tightening regimes when the economy was at full employment and the Fed funds rate was in accommodative territory (Chart 7). The last time those conditions were in place, which was in 2005, the Fed was wrapping up a rate increase campaign that began in mid-2004. Mounting inflation surprise also accompanied most of the Fed's rate increases from mid-1999 through mid-2000 under similar conditions. In late 2015, as the current set of rate hikes commenced, the inflation surprise index was on the upswing, the economy was close to full employment and the Fed funds rate was accommodative. What Does This Mean For The Fed? The above analysis underscores that economic growth is in good shape and it is likely to remain so for the next year at a minimum, barring any nasty shocks. Normally, the positive U.S. (and global) growth backdrop would place upward pressure on bond yields. It has not been the case this time. Investors appear skeptical of the ability of strong economic growth to generate higher inflation. The attitude seems to be "we will believe it when we see it". Some on the FOMC are taking a similar attitude. Lael Brainard, a FOMC governor, presented an interesting speech last week that makes this point. She speculated that inflation has been lower post-Lehman for structural reasons related partly to a drop in long-term inflation expectations. The Fed has been reluctant in the past to even hint that inflation expectations have become unmoored, because that could reinforce the trend, thus making it harder for the Fed to move inflation up to target. Brainard, a voting member of the committee with a dovish bias, argued that unemployment may have to undershoot the full employment level for longer than normal because low inflation expectations will be a persistent headwind. She also implied that the central bank should allow inflation to temporarily overshoot the 2% target. At a minimum, she wants to see evidence of rising inflation and inflation expectations before the Fed delivers the next rate hike. In the past, Brainard's speeches have sometimes heralded shifts in the FOMC's consensus. An example is her December 1, 2015 speech at Stanford.3 It is not clear if this is the case this time, but it does reinforce the view that a strong economy and a falling unemployment rate is not enough to justify another rate hike this year according to the consensus on the FOMC. Bottom Line: Our inflation indicators are pointing mildly up. Nonetheless, timing the upturn in inflation is difficult and the Fed will not hike in December without at least a modest rise in inflation (together with higher inflation expectations). We are short duration because Treasuries are overvalued and market expectations for Fed rate hikes over the next year are overly complacent (see next section). Nonetheless, a rise in yields may not be imminent. Disconnect On Duration The Global Manufacturing PMI reached a more than 6-year high in August, climbing from 52.7 in July to 53.1 last month (Chart 8, panel 3). Meanwhile, bullish sentiment toward the U.S. dollar continues to plunge (Chart 8, bottom panel). Together, these two factors suggest that global growth is accelerating and becoming broader based. BCA's U.S. Bond Strategy service4 views the improving global economic backdrop as an extremely bond-bearish development. A wide global recovery means that when U.S. data turns surprisingly positive, it is less likely that any increase in Treasury yields will be met with an influx of foreign demand and surge in the dollar. Our Treasury model (based on Global PMI and dollar sentiment) currently places fair value for the 10-year Treasury yield at 2.67% (Chart 8, top panel). Moreover, our 3-factor version of the model (which includes the Global Economic Policy Uncertainty Index), puts fair value slightly higher at 2.68% (not shown). Investors should continue to position for a steeper curve by favoring the 5-year bullet versus a duration-matched 2/10 barbell. After adjusting for changes in credit rating and duration over time, the average spread offered by the Bloomberg Barclays corporate bond index is fairly valued relative to similar stages of past business cycles. However, the Aaa-rated portion of the market looks expensive. Further, strong Q2 profit growth likely foreshadows a decline in net leverage. This lengthens the window for corporate bond outperformance. We recommend an overweight in the high-yield market. In the early stages of the previous two Fed tightening cycles (February 1994 to July 1994 and June 2004 to December 2005), the index option-adjusted spread averaged 342 bps and traded in a range between 259 bps and 394 bps. This puts the current junk spread (378 bps) almost in line with the average achieved during other similar monetary conditions (Chart 9). We continue to favor a "buy on the dips"5 approach in the high-yield market. Chart 8Treasury Fair Value Models Treasury Fair Value Models Treasury Fair Value Models Chart 9High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview Regarding high-yield valuation, our estimated default-adjusted spread stands at 245 bps. Historically, this level is consistent with excess returns of just under 3% versus duration-matched Treasuries over the subsequent 12 months. Our estimated default-adjusted spread is based on an expected default rate of 2.6% and recovery rate of 49% (Chart 9, bottom panel). We remain underweight MBSs; While MBS are starting to look more attractive, especially relative to Aaa credit, we think it is still too soon to buy. The Fed will announce the run-off of its balance sheet when it meets later this month. The market has been pricing in this eventuality for most of the year, leading to a significant widening in MBS OAS. More recently, the option cost component of MBS spreads has joined in, widening alongside falling mortgage rates and expectations of rising prepayments. Bottom Line: Rates have tested their post-election lows, but BCA's fair value model suggests a bounce higher, which supports our stocks-over-bonds stance. In terms of U.S. bonds, we favor short duration over long and credit over high quality. MBSs will be hurt more than Treasuries as the Fed begins to shrink its balance sheet. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Ryan Swift, Vice President U.S. Bond Strategy ryans@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see BCA's U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate", July 24, 2017. Available at usis.bcaresearch.com. 2 Please see BCA's U.S. Investment Strategy Weekly Report, "Surprise, Surprise", August 28, 2017. Available at usis.bcaresearch.com. 3 https://www.federalreserve.gov/newsevents/speech/brainard20151201a.htm 4 Please see U.S. Bond Strategy Portfolio Allocation Summary, "The Cyclical Sweet Spot Rolls On," September 5, 2017. Available at usbs.bcaresearch.com. 5 Please see BCA's U.S. Bond Strategy Weekly Report, "Keep Buying Dips," March 28, 2017. Available at usbs.bcaresearch.com.

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

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of August 30th, 2017. The model has continued to reduce its allocation to the U.S. driven by worsening liquidity condition, and it's the second consecutive month that the U.S. allocation is the largest underweight. Australia is downgraded to neutral on concern of valuation. Germany and Netherland continued to receive more allocation and Canada's underweight is reduced as well, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights GAA Model Updates GAA Model Updates Table 2Performance (Total Returns In USD) GAA Model Updates GAA Model Updates As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed its benchmark by 18 bps in August, entirely due to the 43 bps outperformance of Level 2 model where the overweight in Italy and Germany versus the underweight in Japan, Spain and Canada worked very well. Chart 1GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level1) GAA U.S. Vs. Non U.S. Model (Level1) GAA U.S. Vs. Non U.S. Model (Level1) Chart 3GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) 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. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of August 30, 2017. Chart 4Overall Model Performance Overall Model Performance Overall Model Performance Table 3Allocations GAA Model Updates GAA Model Updates Table 4Performance Since Going Live GAA Model Updates GAA Model Updates The model is optimistic on global growth and maintains in cyclical tilt. However, the magnitude of overweight in cyclical sectors has reduced on the back of momentum indicators. The biggest change has been utilities which has moved from a 2% underweight to a 1.7% overweight. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com

Highlights Dear Client, The Global Fixed Investment Strategy will not be publishing next week. Our regular publishing schedule will resume on September 12, 2017. Jackson Hole: Last week's Fed conference did not produce any signals on policy shifts from the Fed or ECB. Yet the outlook for either central bank over the next year has not changed. The Fed will deliver more hikes than currently discounted by the market, while the ECB will taper the pace of its asset purchases. A below-benchmark duration stance is warranted on a 6-12 month horizon. IG Sector Performance: Our Investment Grade (IG) corporate sector allocations for the U.S., Euro Area and U.K., taken from our relative value models, have generated outperformance versus the regional benchmarks since the beginning of the year, led by overweights to Banks. The alpha of sector selection should start to outweigh the beta of owning corporates in the next 6-12 months, given the tight overall level of spreads and flat credit curves. Feature Markets Were Too Jacked Up For Jackson Hole Well, so much for that. The highly anticipated Federal Reserve symposium in Jackson Hole last weekend provided little in the way of guidance on the future monetary policy moves in the U.S. or Europe. The speakers at Jackson Hole, including Fed Chair Janet Yellen and ECB President Mario Draghi, instead chose to focus more on factors that they cannot directly control, such as trade protectionism, income inequality and technological change. Chart of the WeekTougher Regulations Or Just Easy Money? Tougher Regulations Or Just Easy Money? Tougher Regulations Or Just Easy Money? The market reaction was interesting. Bond yields and equities were essentially unchanged on the day last Friday, but the U.S. dollar ended softer, especially versus the euro. Perhaps this was simply a function of very short-term positioning in currency markets. The speculation prior to Jackson Hole was that Yellen might talk up another Fed rate hike to offset to stimulative effects of booming financial asset prices, perhaps in the absence of any renewed pickup in U.S. inflation. At the same time, there were expectations that Draghi could use his speech to dial back expectations of a reduction in ECB asset purchases, which have helped fuel the strong rally in the euro. With both central bankers delivering a big "nothing burger" with regards to policy changes, speculators likely covered their positions. The speeches from Yellen and Draghi were not totally without meaningful content, however. They both warned about the potential risks from dialing back some of the post-crisis regulatory changes to the infrastructure of the global financial system. Both of them went as far as stating that the stronger regulatory backdrop has been a major factor behind the current health of the global economy: Yellen: "Our more resilient financial system is better prepared to absorb, rather than amplify, adverse shocks, as has been illustrated during periods of market turbulence in recent years." Draghi: "[...] lax regulation runs the risk of stoking financial imbalances. By contrast, the stronger regulatory regime that we now have has enabled economies to endure a long period of low interest rates without any significant side-effects." This is an interesting way to spin the events of the past decade. Yes, regulatory reforms have forced global banks to hold higher levels of capital. This should, in theory, help mitigate the spillover effects on the real economy from periodic financial market sell-offs that could make banks more risk-averse. Yet central banks have, at the same time, maintained incredibly loose monetary policies that have helped support both global growth and bull markets in risk assets (Chart of the Week). It is, at best, complacency and, at worst, hubris for Yellen or Draghi to say that the financial system can handle market shocks better when their own hyper-easy monetary policies are a big reason why asset markets have avoided protracted sell-offs. "Buy the dip" is an easy investment strategy when central banks are providing a liquidity tailwind while keeping risk-free interest rates at unattractive levels. Yet market valuations are now at the point where the payoff to buying the dips will be much lower than in recent years, presenting a challenge to financial stability for policymakers looking to incrementally become less accommodative. In Charts 2A & 2B, we show the range of asset prices and valuations for key fixed income and equity markets since 1990. The blue dots in each panel represent the latest reading, while the historical ranges are the thick lines. The benchmark 10-year government bond yields for the U.S., Germany, Japan and the U.K. are shown in Chart 2A, both in nominal and inflation-adjusted terms.1 In Chart 2B, the trailing price-earnings multiples for global equity markets and option-adjusted spreads for the major global credit sectors (corporate bonds and Emerging Market debt) are displayed. Chart 2AGlobal Asset Valuations, 1990-2017 A "Hole" Lot Of Nothing A "Hole" Lot Of Nothing Chart 2BGlobal Asset Valuations, 1990-2017 A "Hole" Lot Of Nothing A "Hole" Lot Of Nothing Within fixed income, nominal government bond yields and credit spreads are trading at the low end of the historical ranges. Equity valuations are not yet at the stretched extremes seen during the late 1990s dot-com bubble, although longer-term measures like the CAPE (cyclically-adjusted price earnings) ratio are much closer to all-time highs. By any measure, most financial assets are not cheap, thanks in large part to the easy monetary backdrop. Right now, the current tranquil market backdrop is increasingly at risk from a shift in monetary policies. The Fed and ECB are still confronted with the problem of tight labor markets alongside tame inflation (Chart 3). While there has been a much more vigorous debate among central bankers on the effectiveness of using a Phillips Curve framework for forecasting inflation, the plain truth is that policymakers do not have any reliable alternative. The best they can do is stick with the unemployment-versus-inflation trade-off and go more slowly on policy adjustments when inflation undershoots levels suggested by strong labor markets. At the moment, there is no immediate need for either the Fed or ECB to tighten monetary policy. Realized inflation rates on both sides of the Atlantic are still below the 2% target. Our Central Bank Monitors for the U.S. and Euro Area are both hovering around the zero line (Chart 4), also indicating that no imminent changes in the policy stance are required. Chart 3Fed & ECB Facing The Same##BR##Phillips Curve Dilemma Fed & ECB Facing The Same Phillips Curve Dilemma Fed & ECB Facing The Same Phillips Curve Dilemma Chart 4Bond & FX Markets Look Fully##BR##Priced For A Stronger Europe Bond & FX Markets Look Fully Priced For A Stronger Europe Bond & FX Markets Look Fully Priced For A Stronger Europe The improvement in the Euro Area Monitor is related to both faster domestic economic growth and a slow-but-steady rise in inflation, trends that are likely to be maintained over at least the next 6-12 months given the strength of European leading economic indicators. However, the decline in the U.S. Monitor is largely a function of the recent surprising dip in U.S. inflation (both prices and wages) over the past few months. We expect that to soon begin to reverse on the back of reaccelerating U.S. growth and a rebound in inflation fueled in part by the lagged impact of the weaker U.S. dollar. The greenback's decline this year versus the euro has been a reflection of a more rapid improvement in European economic growth (3rd panel). Although this looks to have overshot with the EUR/USD exchange rate rising far more rapidly than implied by interest rate differentials between the U.S. and Europe (bottom panel). This either suggests that European bond yields must rise relative to U.S. yields to justify the current level of EUR/USD (a UST-Bund spread close to 100bs based on the relationship over the past three years), or that the currency must pull back to valuations more consistent with interest rate differentials (around 1.10, also based on the post-2014 correlations). The easier path is for the currency to soften up rather than European bond yields rising faster than U.S. Treasuries. The ECB is still far from contemplating an actual interest rate hike, and is only debating the need to continue buying European bonds at the current pace. At the same time, there is now barely one full 25bp Fed rate hike discounted by the market, which makes Treasuries more vulnerable to the rebound in U.S. growth and inflation that we expect. That outcome is not conditional on any easing of U.S. fiscal policy, but any success by the Trump White House in delivering tax cuts would only force the Fed to hike rates to offset the stimulus to an economy already at full employment. In other words, we see more reasons for both U.S. Treasury yields and the U.S. dollar to go up from current levels versus European equivalents. Bottom Line: Last week's Fed conference at Jackson Hole did not produce any signals on policy shifts from the Fed or ECB. Yet the outlook for either central bank over the next year has not changed. The Fed will deliver more hikes than currently discounted by the market, while the ECB will taper the pace of its asset purchases. A below-benchmark duration stance is warranted on a 6-12 month horizon. A Brief Update On The Performance Of Our Corporate Bond Sector Allocation Recommendations Chart 5Performance Of Our IG Sector Allocations A "Hole" Lot Of Nothing A "Hole" Lot Of Nothing We last published an update of our Investment Grade (IG) sector valuation models for the U.S., Euro Area and U.K. back on June 6th.2 This followed up on our report from January 24th of this year where we added our IG sector recommendations to our model bond portfolio.3 That meant putting actual weightings to each sub-sector within the overall IG index for each region, rather than a more nebulous "overweight", "underweight" or "neutral" recommendation. This was in keeping with the spirit of our overall model bond portfolio framework, which is to present a more transparent measure of how our recommended tilts would perform as a hypothetical fully-invested fixed income portfolio. Our IG sector allocations come from our IG relative value model, which is designed to measure the valuation of each sector relative to the overall Barclays Bloomberg corporate bond index for each region. The latest output of the model can be found in the Appendix on page 14. The current valuations have not changed material from that June 6th report, suggesting that the rally in corporate bond markets has been more about beta driving the valuations of all sectors. In other words, the sectors have maintained their value relative to each other and to the overall IG index over the past few months. Having said that, our sector allocations have still been able to deliver some extra return versus the regional benchmarks since we started putting specific weights to our sector tilts back in January. Since then, our sector tilts have added +3bps of "active" excess return (i.e. returns over duration-matched government bonds) versus the IG benchmark in the U.S., +9bps in the Euro Area and an impressive +32bps in the U.K. (Chart 5). Most of that outperformance came between January and our last update, with only the U.K. showing gains since June. The specifics of the returns can be found in Table 1 for the U.S., Table 2 for the Euro Area and Table 3 for the U.K. For all three regions, the biggest source of the outperformance of our allocations has come from the overweight positions in Financials, specifically Banks. As any corporate bond portfolio manager will attest, the large weighting of Financials in IG bond indices makes the Financials versus Non-Financials decision the most important one to make. Our model bond portfolio is no different. Table 1U.S. Investment Grade Performance A "Hole" Lot Of Nothing A "Hole" Lot Of Nothing Table 2Euro Area Investment Grade Performance A "Hole" Lot Of Nothing A "Hole" Lot Of Nothing Table 3U.K. Investment Grade Performance A "Hole" Lot Of Nothing A "Hole" Lot Of Nothing Looking ahead, we expect that sector allocations may soon begin to have a greater impact on the performance of IG corporate bond portfolios, given how flat credit curves have become (Chart 6). The spread between BBB-rated corporates and A-rated corporates is at historically narrow levels in all regions. The flattening of credit curves may be reaching a resistance level in the U.S. and U.K., but not so in the Euro Area where the gap between BBB-rated and A-rated corporates is now a mere 34bps. Chart 6Credit Quality Curves Are Very Flat Credit Quality Curves Are Very Flat Credit Quality Curves Are Very Flat The combination of a solid Euro Area economic upturn and persistent ECB buying of corporates as part of its asset purchase program has driven a reduction of risk premiums throughout the Euro Area credit markets. Given our expectation that the ECB will be forced to begin tapering its asset purchase program in 2018, including the pace of corporate buying, we continue to maintain an underweight allocation to Euro Area IG corporates in our overall model portfolio. We are also seeking to limit our overall recommended spread risk to around index levels using our preferred metric, Duration Times Spread (DTS). At the same time, we are maintaining our recommended overweights to U.S. IG and U.K. IG, sticking with above-benchmark tilts in the Banks, while maintaining a portfolio DTS close to the overall index DTS. In the U.S., we are also keeping an overweight bias on Energy-related sectors, which offer the most attractive valuations despite having a higher DTS than the overall benchmark index. Our underweights in higher DTS U.S. sectors, specifically in the Consumer Non-Cyclicals and Utilities groupings, offset the DTS exposure from our recommended Energy overweight. Bottom Line: Our Investment Grade (IG) corporate sector allocations for the U.S., Euro Area and U.K., taken from our relative value models, have generated outperformance versus the regional benchmarks since the beginning of the year, led by overweights to Banks. The alpha of sector selection should start to outweigh the beta of owning corporates in the next 6-12 months, given the tight overall level of spreads and flat credit curves. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 In the bottom panel of Chart 2A, we deflate nominal 10-year bond yields by a 3-year moving average of realized headline inflation to smooth out the fluctuations in inflation. 2 Please see BCA Global Fixed Income Strategy Special Report, "Updating Our Investment Grade Corporate Bond Sector Allocations", dated June 6th 2017, available at gfis.bcaresearch.com. 3 Please see BCA Global Fixed Income Strategy Special Report, "Adding Investment Grade Corporate Bond Sectors To Our Model Portfolio Framework", dated January 24th 2017, available at gfis.bcaresearch.com. Appendix Appendix Table 1U.S. Corporate Sector Valuation And Recommended Allocation* A "Hole" Lot Of Nothing A "Hole" Lot Of Nothing Appendix Chart 1U.S. Corporate Sector Risk Vs. Reward* A "Hole" Lot Of Nothing A "Hole" Lot Of Nothing Appendix Table 2Euro Area Corporate Sector Valuation And Recommended Allocation* A "Hole" Lot Of Nothing A "Hole" Lot Of Nothing Appendix Chart 2Euro Area Corporate Sector Risk Vs. Reward* A "Hole" Lot Of Nothing A "Hole" Lot Of Nothing Appendix Table 3U.K. Corporate Sector Valuation And Recommended Allocation* A "Hole" Lot Of Nothing A "Hole" Lot Of Nothing Appendix Chart 3U.K. Corporate Sector Risk Vs. Reward* A "Hole" Lot Of Nothing A "Hole" Lot Of Nothing A "Hole" Lot Of Nothing A "Hole" Lot Of Nothing Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns The GFIS Recommended Portfolio Vs. The Custom Benchmark Index A "Hole" Lot Of Nothing A "Hole" Lot Of Nothing

Highlights GFIS Portfolio: The GFIS model bond portfolio has lagged its benchmark index since inception last September and since our previous performance update in April. All of that underperformance can be accounted for this month, however, given the risk-off moves seen in global financial markets. As investors begin to shift their attention away from the current geopolitical blustering over North Korea and back towards the solid global economic upturn, our current tilts should begin to outperform again. Risk Management: We have successfully raised the amount of overall portfolio risk (tracking error) since our last portfolio performance update in April. The tracking error remains below our self-imposed limit of 100bps, however, giving us the ability to make further adjustments to our tilts as opportunities arise. Tactical Overlay: Our Tactical Overlay trades have delivered a positive average return over the past year, led by the current open trades that have produced an average gain of +30bps. Feature In this Special Report, we are presenting a performance update for our Global Fixed Income Strategy (GFIS) model bond portfolio. We did the first such update back in mid-April, and we will continue to publish periodic portfolio reviews going forward. As a reminder to our readers, the GFIS model portfolio is intended to be a tool for us to both communicate and evaluate our fixed income investment recommendations. By putting actual weightings to each of our country and sector calls, against a bond benchmark index with an overall portfolio risk limit, we are aiming to express the convictions of our views in a manner more in line with the actual day-to-day portfolio trade-offs faced by bond managers. The model portfolio is a relatively new addition to the GFIS service, starting only in September 2016, thus the return history is still limited. We have built out several pieces of the GFIS model portfolio framework over the past year, and the process is nearing completion. We now have a custom performance benchmark index that reflects the universe of fixed income sectors that we regularly cover in GFIS (essentially, the Bloomberg Barclays Global Aggregate Index plus riskier fixed income classes like High-Yield corporates). We also have performance measurement metrics and a way to regularly present the portfolio returns, while we have also added a risk management (tracking error) element to help size our relative tilts. The final piece will be to incorporate our corporate bond sector recommendations within the model portfolio, both as a source of potential return and a use of our risk budget (tracking error). We intend to add that final element in the coming weeks. Overall Performance Review: Winners & Losers Chart 1GFIS Model Portfolio Performance GFIS Model Portfolio Performance GFIS Model Portfolio Performance As of August 11th, the GFIS model portfolio has produced a total return of +0.93% (hedged into U.S. dollars) since inception on September 20, 2016 (Chart 1). This has underperformed our custom benchmark index by -14bps. Since our last performance review on April 18th, the model portfolio has lagged the benchmark by -10bps. The portfolio has suffered in the risk-off environment seen so far in August, with a -14bp underperformance seen month-to-date, equal to the entire underperformance since inception. Our core structural positions of maintaining a below-benchmark duration stance, while staying underweight government bonds versus overweight spread product, have all suffered of late (bottom two panels). Our government bond country allocation has been the biggest overall drag on returns (Table 1) since last September (-26bps versus our benchmark). Japan (+5bps) and Spain (+3bps) have been the biggest positive contributors since inception, while Italy, the U.K. and France have a combined underperformance of -31bps. That more than accounts for the entire underperformance of the government bond sleeve of the model portfolio since inception (Chart 2). Since our last portfolio update in April, our government bond allocations have lagged our benchmark index by -29bps. Small gains in Spain and Germany (+2bps each) have been dwarfed by underperformance in the U.S. (-16bps), Italy (-10bps) and France (-5bps). Across almost every country, our below-benchmark duration positioning has translated into a bear-steepening yield curve bias, as we have been recommending substantially reduced exposure to the 10+ year maturity buckets in the major countries (U.S., Germany, France, Italy, and Japan). The bull-flattening of global yield curves between March and June, led by a downturn in inflation expectations, was more than large enough to offset any of the potential benefits from our country allocation. Yield curves did began to bear-steepen in July after the European Central Bank (ECB) sent signals that a tapering of its asset purchase program next year was increasingly likely. That move has quickly reversed this month, however, as financial markets have shifted to a risk-off stance on the back of rising geopolitical tensions on the Korean Peninsula. Table 1A Detailed Breakdown Of The GFIS Model Portfolio A Performance Update For Our Model Bond Portfolio A Performance Update For Our Model Bond Portfolio Chart 2GFIS Model Portfolio Government Bond Performance Attribution By Country A Performance Update For Our Model Bond Portfolio A Performance Update For Our Model Bond Portfolio The news is better with regards to our global spread product allocations. Those have delivered a total return of +1.41% since last September (beating the benchmark by +12bps) and +0.98% since the last performance review in April (+19bps versus the benchmark). Our allocations to U.S. Investment Grade (IG) and High-Yield (HY) have combined for a +30bps outperformance since September and a +23bps outperformance since April (Chart 3). Euro Area corporate debt has been a modest drag, with the combined allocation to IG and HY debt underperforming by -7bps since September and -3bps since April. Emerging Market corporate debt contributed -2bps of underperformance, while U.K. IG corporates added +1bp of excess return. Chart 3GFIS Model Portfolio Spread Product Performance Attribution A Performance Update For Our Model Bond Portfolio A Performance Update For Our Model Bond Portfolio Among other spread sectors, U.S. Mortgage-Backed Securities (MBS) have generated a -12bps contribution to our excess return, although this entirely came from a period immediately after the inception of our model portfolio (Sept-Nov 2016) where we briefly moved to a tactical overweight stance. We have since maintained a structural underweight posture on U.S. MBS, but this has barely generated any relative performance (-1bp) since our last portfolio review in April. Net-net, the GFIS model portfolio has generally performed in line with where our recommendations are concentrated, both in absolute terms and on a relative basis between sectors. Our below-benchmark stance on overall duration has suffered as the government bond yield curves have exhibited more volatility than trend. At the same time, our structural overweights on global corporate debt, favoring the U.S. over non-U.S. equivalents, have contributed positively to the overall portfolio performance. In Charts 4-7, we show the relative performance of some individual countries and sectors that are part of our GFIS benchmark index. We specifically singled out our major asset allocation calls between sectors made over the past year, with a vertical line drawn at the date when the change was recommended. The data shown in all three charts is the relative performance of each tilt on a duration-adjusted basis and (where applicable) hedged back into U.S. dollars, indexed to 100 at the date of implementation in our model portfolio. Shown this way, we can evaluate the success of the timing of our calls. Our shift to an overweight stance on U.S. corporate debt versus U.S. Treasuries both for IG and HY in the first quarter of this year can be judged a success both in terms of timing and magnitude, with IG outperforming Treasuries by 217bps and HY outperforming by 826bps (Chart 4). Within our HY allocation, we left some performance on the table by concentrating our overweights on the higher-rated credit tiers (bottom panel), but this was a move we felt comfortable with (and still do) as a way of staying a bit up in quality at a time when lower-rated spreads were looking fully valued. In terms of our cross-Atlantic credit allocation, we shifted to an overweight stance on U.S. corporates versus Euro Area equivalents back on January 31st of this year (Chart 5). Since then, U.S. IG has underperformed Euro Area IG by -142bps, but U.S. HY has outperformed by a much larger 581bps. Taken together, these positions have contributed positively to the overall performance of the model portfolio. We continue to like U.S. corporates over Euro Area corporates from a valuation standpoint, thus we are keeping this tilt in the portfolio. Chart 4Our Overweights On##BR##U.S. Corporates Have Done Well Our Overweights On U.S. Corporates Have Done Well Our Overweights On U.S. Corporates Have Done Well Chart 5Our Combined Tilt Towards##BR##U.S. Corporates Has Outperformed Our Combined Tilt Towards U.S. Corporates Has Outperformed Our Combined Tilt Towards U.S. Corporates Has Outperformed With regards to our other major spread sector tilts, our shift to an underweight stance on U.S. MBS versus Treasuries back in November has essentially been a wash (Chart 6). Looking ahead, the combination of unattractive valuations and, more importantly, reduced buying of Agency MBS by the Federal Reserve as it begins to shrink its balance sheet will weigh on MBS performance in the next 6-12 months - we are staying underweight. At the same time, we are maintaining our long-held overweight stance on U.K. IG corporates versus Gilts (bottom panel). The Bank of England will be keeping interest rates unchanged over the next year given mixed readings on U.K. economic growth and the lingering uncertainties over the Brexit negotiations, thus going for the added carry of corporates versus expensive Gilts still makes sense. As for our cross-country government bond allocations, our underweight stance on Italy versus Spain, and our overweight stance on Japan versus Germany, have been volatile while delivering no excess performance (Chart 7). Chart 6Sticking With Our Tilts On##BR##U.S. MBS & U.K. IG Sticking With Our Tilts On U.S. MBS & U.K. IG Sticking With Our Tilts On U.S. MBS & U.K. IG Chart 7Our Cross-Country Government Bond##BR##Tilts Have Been Volatile Our Cross-Country Government Bond Tilts Have Been Volatile Our Cross-Country Government Bond Tilts Have Been Volatile Looking ahead, we continue to expect the global growth backdrop to be supportive of spread product over government debt over the next 6-12 months, particularly with central banks unlikely to shift to a restrictive monetary stance. At the same time, we should soon begin to claw back some of the underperformance of the government bond sleeve of the GFIS model portfolio coming from our below-benchmark duration stance, for several reasons: Our colleagues at BCA's Geopolitical Strategy service do not expect the current standoff between Pyongyang and Washington to devolve into a shooting war, even though the tough talk on both sides will likely continue for some time. As the military tensions begin to subside, this should reverse some of the safe-haven bid for government bonds seen in the past couple of weeks, causing yields to drift higher. The solid global growth backdrop, confirmed by the still-rising trend in leading economic indicators, will continue to force central banks to slowly shift to a less dovish policy stance. U.S. inflation will begin to rebound in the next few months, led by the lagged impact of the U.S. dollar weakness seen in 2017 and continued tightening of the U.S. labor market. This will prompt the Fed to hike rates in December and deliver more hikes in 2018, which is NOT currently priced into U.S. Treasuries. We expect the ECB to soon signal a reduction of the size of its asset purchase program starting in 2018, which will put upward pressure on core Euro Area bond yields, and widen Peripheral European spreads, as the market moves to price in a smaller amount of future bond supply that will be absorbed by the central bank. The combination of modest increases in global inflation, a rebound in investor risk sentiment, and an ECB taper announcement should all place bear-steepening pressures on developed market yield curves (ex-Japan). This will benefit the curve-steepening bias we have in the U.S., Euro Area and U.K., while also supporting our country allocation of a maximum overweight to low-beta Japanese Government Bonds (JGBs). Net-net, we see no reason to alter any of current portfolio tilts at the moment based on any change in our market views. Bottom Line: The GFIS model bond portfolio has lagged its benchmark index since inception last September and since our previous performance update in April. Our overweight credit allocations have performed well but our below-benchmark duration tilts have not. All of that underperformance can be accounted for this month, however, given the risk-off moves seen in global financial markets. As investors begin to shift their attention away from the current geopolitical blustering over North Korea and back towards the solid global economic upturn, our current tilts should begin to outperform again. A Very Brief Comment On Our Risk Management Framework In our prior portfolio update in April, we noted that the initial sizes we placed on the tilts in the GFIS model portfolio proved to be far too small to generate any meaningful outperformance.1 After that, we increased the sizes of our all our existing positions in the portfolio. We later introduced a "risk budget" into our framework that would allow us to measure the tracking error (excess volatility versus the GFIS benchmark index) of our portfolio to ensure that we were taking adequate levels of risk.2 So far, our changes have had the desired effect of raising the tracking error of the portfolio to more realistic levels to try and generate outperformance. The average allocations to our government bond underweights and our spread product overweights have increased since that April portfolio review (Chart 8). This has helped raise the tracking error of the model portfolio to 61bps from 25bps in April (Chart 9). This is still below our risk limit of 100bps of tracking error, giving us room to add positions to the model portfolio if we see opportunities come up. Chart 8We've Increased The Sizes Of##BR##Our Tilts Since April ... A Performance Update For Our Model Bond Portfolio A Performance Update For Our Model Bond Portfolio Chart 9...Which Has Boosted The Tracking##BR##Error Of The Model Portfolio ...Which Has Boosted The Tracking Error Of The Model Portfolio ...Which Has Boosted The Tracking Error Of The Model Portfolio Bottom Line: We have successfully raised the amount of overall portfolio risk (tracking error) since our last portfolio performance update in April. The tracking error remains below our self-imposed limit of 100bps, however, giving us the ability to make further adjustments to our tilts as opportunities arise. Tactical Overlay Bets Have Been Helpful In addition to our GFIS model bond portfolio, we also are running recommended trades in our Tactical Overlay portfolio. These are positions that typically have a shorter-term investment time horizon (0-6 months) than those in the model portfolio. They can also be in less-liquid markets that are not included in the custom bond benchmark index for the model portfolio, like U.S. TIPS or New Zealand government bonds. The Overlay is intended to produce ideas for more tactical traders than portfolio managers, although the trades can also be viewed as a compliment to the model bond portfolio. The performance of our Tactical Overlay can be seen in Table 2 (for our current open trades) and Table 3 (for our past closed trades). We have shown the trade performance going back to the inception date of our model bond portfolio in September 2016, to facilitate apples-for-apples comparisons. We are currently working on developing a trade sizing and risk management framework along the lines of our model portfolio. For now, we can only present average return numbers and not a meaningful cumulative return measure. Table 2The Current Open GFIS Tactical Overlay Trades Are Performing Well A Performance Update For Our Model Bond Portfolio A Performance Update For Our Model Bond Portfolio Table 3The Closed GFIS Tactical Overlay Trades Have Been A Mixed Bag A Performance Update For Our Model Bond Portfolio A Performance Update For Our Model Bond Portfolio Our closed Overlay trades since last September generated only an average total return of a mere +1bp, but this weighed down by a large losing position on shorting Portuguese government bonds versus German Bunds. The average trade return would have been +21bps, on fifteen closed trades, excluding that Portuguese bet. The notable winners were long positions in 10-year French government bonds versus German Bunds (+130bps), a long position on Australian Semi-Government debt versus Federal government debt (+159bps) and a long positon on Korean 5-year government bonds vs. 5-year JGBs on a currency-unhedged basis (+195bps). The other notable loser besides the Portuguese trade was a failed long position on Japanese CPI swaps (-111bps). The current open Overlay trades have performed much better, delivering an average gain of +30bps. 14 of the current 16 open trades have a positive gain, thus the batting average is solid. Notable winners are an overweight on U.S. TIPS versus U.S. Treasuries (+197bps) and our Canada/U.K. 2-year/30-year yield curve box trade (+110bps). The only serious losing trade at the moment is our long position in 5-year New Zealand government bonds versus 5-year German debt (-123bps), although this is the only trade in the table that is currency UN-hedged and is a bet on a stronger New Zealand dollar versus the euro as well as a relative bond spread trade. Net-net, our Tactical Overlay trades have generated a positive average return since last September. In the next few months, we will look to introduce a weighting scheme and risk budget for the Overlay trades to better present these trades as a true complement to our model bond portfolio. Bottom Line: Our Tactical Overlay trades have delivered a positive average return over the past year, led by the current open trades that have produced an average gain of +30bps. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Special Report, "An Initial Look At The Performance Of Our Model Bond Portfolio", dated April 18th 2017, available at gfis.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Special Report, "Adding A Risk Management Framework To Our Model Bond Portfolio", dated June 20th 2017, available at gfis.bcaresearch.com. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index A Performance Update For Our Model Bond Portfolio A Performance Update For Our Model Bond Portfolio Appendix - Selected Sectors From The GFIS Model Portfolio Appendix 1 Appendix 1 Appendix 2 Appendix 2 Appendix 3 Appendix 3 Appendix 4 Appendix 4 Appendix 5 Appendix 5 Appendix 6 Appendix 6 Appendix 7 Appendix 7 Appendix 8 Appendix 8

Highlights Over the years, BCA has created numerous macro (and other) indicators and models to forecast U.S. equity markets. These models are designed to include both cyclical and structural cycles, i.e. mini-cycles within longer-term trends. Feature Recently, we have been inundated by client requests to update these indicators, which has spurred us to put together this Special Report (there will also be a Part II in the near future). We compiled the most sought after Indicators in one place (accessible also from BCA's EDGE platform for seamless continual updates) and used three time horizons: tactical (1-3 months), cyclical (3-12 months) and structural (1-3 years). Historically, sentiment-based high-frequency indicators have done an excellent job in forecasting the tactical outlook (top panel, Chart 1). By cyclical backdrop, we refer to the mini-equity market cycles and sub-surface sector rotations within the business cycle (middle panel, Chart 1).Finally, we reserved the structural time horizon for forecasting the end/beginning of the business cycle (i.e. commencement or ending of recession, bottom panel, Chart 1). Chart 1 Chart 1 Chart 1 This Special Report is split into three time frame-driven sections: tactical, cyclical and structural. Within each time horizon, we provide a brief description of each Indicator, the rationale behind it, and comment on the Indicator's current signal. This White Paper of overall equity market indicators and models is by no means exhaustive. Rather, it represents a roadmap of Indicators we track to gauge the direction of equity markets in all three time frames. We trust you will find this Special Report useful and insightful. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com Dulce Cruz, Senior Analyst dulce@bcaresearch.com Tactical Indicators (1-3 months) BCA Complacency-Anxiety Index BCA's Complacency-Anxiety index tracks the bullish/bearish equity market sentiment. It includes the CBOE's VIX index, the S&P 500 put/call ratio, bull/bear ratio and the emerging markets high yield bond spread. When this indicator nears one standard deviation above the historical mean, greed takes over. When it falls to one standard deviation below the mean, fear dominates markets. Currently, complacency reigns (Chart 2). Chart 2 BCA Complacency-Anxiety Index & BCA Equity Speculation Index BCA Complacency-Anxiety Index & BCA Equity Speculation Index BCA Equity Speculation Index The BCA Equity Speculation Index (ESI) measures the speculative activity in the stock market incorporating measures of leverage, sentiment, valuation and supply. The leverage component includes margin debt and security credit; the sentiment component is a composite of sentiment measures; valuation includes the proprietary BCA Secular Valuation Index (not shown); and finally the supply component measures the supply of new issues and secondary offerings. Presently, the ESI signals that the equity market advance is at a very high risk stage. However, the chart shows that the ESI can stay in elevated territory for a prolonged period, as occurred in 2014/2015, before a correction unfolds (bottom panel, Chart 2). Volatility-Adjusted Valuation Metrics (Part I) Chart 3 shows the price-to-earnings (P/E) ratio (12-month forward and cyclically adjusted P/E) and momentum (year-over-year percentage change) of S&P 500 index adjusted for volatility. While we prefer not to use valuations as stock market timing tools, currently, the reward/risk tradeoff of the volatility-adjusted P/E multiple is more than two standard deviations above normal, implying market mania. We would note that this is driven by record low volatility (see the Complacency-Anxiety Index above) rather than extreme valuations. Chart 3 Volatility-adjusted Valuation Metrics (Part 1) Volatility-adjusted Valuation Metrics (Part 1) Volatility-Adjusted Valuation Metrics (Part II) Chart 4 shows the high yield corporate bond total return index controlled for the bond market's volatility. The message in both the equity and bond market is clear: we are in stretched territory, near a level that has historically led to a mean reversion phase. Chart 4 Volatility-adjusted Valuation Metrics (Part 2) Volatility-adjusted Valuation Metrics (Part 2) Equity And Bond Market Volatility Curves CBOE 3-Month Volatility Index / 30-Day Volatility Index (VXV/VIX) is a technical indicator that moves in lockstep with stock prices. When the volatility market is in steep contango, complacency reigns and vice versa. Similarly, when the 3-Month Merrill Lynch bond market volatility (MOVE) index is higher than the front MOVE index, euphoria is evident. When this volatility curve flips to backwardation, panic grips markets. At the current juncture, waters are calm both in the equity and bond markets (Chart 5). Chart 5 Equity and Bond Market Volatility Curves Equity and Bond Market Volatility Curves TED Spread Vs. VXO Index TED spread is the difference between the three-month LIBOR and the three-month T-bill interest rate. The TED spread is an indicator of perceived credit risk in the economy. The VXO is volatility on the S&P 100. These indexes tend to move in tandem, but steep divergences do occur from time-to-time, during which the TED spread has leading properties and tends to exert pull on the VXO. Currently, both measures of risk are quiet (Chart 6). Chart 6 TED Spread vs. VXO Index TED Spread vs. VXO Index CBOE SKEW Index / VIX Index The SKEW index (tail risk measure), controlled for the VIX, has an excellent track record in forecasting market corrections. This indicator has risen above 12, warning that at least a tactical pullback is near at hand (Chart 7). In contrast, when this relative risk measure plunges below 5, a buying opportunity in equities emerges. Chart 7 CBOE SKEW Index / VIX Index CBOE SKEW Index / VIX Index Currency Implied Volatility Currency implied volatility is an average of Yen, Euro and Sterling (all versus the U.S. dollar) 3-month option implied volatility. Chart 8 shows the S&P 500 Index and currency volatility are inversely correlated, reflecting the impact of currency swings on policy decisions and corporate competiveness/profits. Presently, this measure of volatility is calm. Chart 8 Currency Implied Volatility Currency Implied Volatility AUD/JPY Historically, the AUD/JPY FX cross does an excellent job in tracking risk-on/risk-off phases in the equity market. Investors use the zero-yielding Yen as a funding currency and buy the higher yielding Australian dollar in order to generate a positive carry. In times of duress, investors scramble to repatriate Yen and shed Australian dollars and vice versa. Also the "Aussie" in general is a great China/commodity indicator that rises when the global economy picks up steam. The growth sensitive AUD/JPY cross rate has picked up recently, sending a positive signal (Chart 9). Chart 9 AUD/JPY AUD/JPY BCA Equity Market Internal Dynamics Indicator The BCA Equity Market Internal Dynamics Indicator (shown as an equally weighted z-score) comprises relative bank and transports performance, the small/large ratio and industrials/utilities (or cyclicals/defensives), and captures shifting internal forces that drive market returns. It is a coincident-to-leading market indicator. Currently, this economically sensitive indicator signals that the broad equity market may suffer a setback (Chart 10). Chart 10 BCA Equity Market Internal Dynamics & Sell-Off Indicator BCA Equity Market Internal Dynamics & Sell-Off Indicator BCA's U.S. Sell-Off Indicator BCA's Sell-Off Indicator is a composite of market-based measures of risk appetite that are regularly featured in our Weekly Reports, including credit spreads, currencies, government bond yields and cyclical and defensive equities. This market-based measure of risk appetite is not sending any warning signals yet. Financial Conditions Index The Financial Conditions Index tracks the overall level of financial stress in the money, bond, and equity markets to help assess the availability and cost of credit. A positive value indicates accommodative financial conditions, while a negative value indicates tighter financial conditions. Financial conditions have been easing recently, underpinning the broad equity market (Chart 11). Chart 11 Financial Conditions Index Financial Conditions Index 5Y/5Y CPI Swap Forward Rate This is a measure of expected inflation over the five-year period that begins five years from today. Historically, equity markets have been positively correlated with this inflation expectation measure and the current fall in the latter suggests that equities are fully priced (Chart 12). Chart 12 5Y/5Y CPI Swap Forward Rate 5Y/5Y CPI Swap Forward Rate Confirming Equity Indicator The Confirming Equity Indicator (CEI) is a composite of economic data that has provided useful validation for broad equity market trends, and it was designed so that a positive reading is generally bullish while a negative reading is bearish. The CEI is well into bullish territory; more recently, the economic variables in the model have firmed, providing an additional lift to our CEI (Chart 13). Chart 13 Confirming Equity Indicator Confirming Equity Indicator BCA Investor Sentiment Composite This gauge comprises surveys of traders, individuals and investment professional sentiment. The sentiment indicator shows the percent of bulls. When the majority is optimistic, the equity market is nearing a peak. Conversely, when psychology is pessimistic, prices are near a low. Bullish individual investor sentiment has also eclipsed the 50% zone in advance of the two largest post-GFC drawdowns. Individual investors are currently upbeat, though not so much that we are concerned (Chart 14). Chart 14 BCA Investor Sentiment Composite BCA Investor Sentiment Composite S&P 500 Measures Of Breadth The Advance/Decline line and the net new highs indicator (the difference between stocks at their 52-week high and those at their low) are measures of market breadth. The technical backdrop is positive when breadth and prices are rising. Conversely, weakness in breadth, i.e. a loss of market participation, heralds lower prices. In contrast, the proportion of sub-indexes with a positive 52-week rate of change and/or trading above their 40-week moving average remain well above 60% (Chart 15). Our breadth indicators are currently positive. Chart 15 S&P 500 Measures Of Breadth S&P 500 Measures Of Breadth Cyclical Indicators (3-12 months) BCA Intermediate Equity Indicator Our Intermediate Equity Indicator (IEI) is designed to help anticipate intermediate term trends (3 to 6 months and rises or falls of at least 10%) with the primary bull and bear markets. Buy signals are generated by the indicator rising substantially above 1 while sell signals are generated by declines below zero. The IEI remains near bullish territory (Chart 16). Chart 16 BCA Intermediate Equity Indicator BCA Intermediate Equity Indicator BCA Cyclical Macro Indicator Our broad equity market Cyclical Macro Indicator (CMI) is a mix of fundamental macro and financial variables that lead profits, and has tracked the S&P 500 for the past two and half decades. The CMI is used as a check, rather than as a definitive catch-all, because every business cycle has unique characteristics (Chart 17). Chart 17 Cyclical Macro, Valuation & Technical Indicator Cyclical Macro, Valuation & Technical Indicator BCA Valuation Indicator Our VI is based on P/E, Price/Sales, Price/Dividends and Price/Book. It is currently at one standard deviation above the historical mean (Chart 17) which would typically signal a pullback is near at hand. We would caution that valuations can remain extended for prolonged periods and the one standard deviation level is not necessarily a trigger point. BCA Technical Indicator Our TI is driven primarily by momentum components, gauges the trend in equities and determines if the market is at an extreme in terms of momentum or investor psychology. Overbought conditions are signaled once it hits one standard deviation above the mean. Currently, the TI remains slightly below this threshold. Importantly, when the TI swings quickly from deeply oversold to overbought levels, there can be a multi month lead before the broad market crests or suffers a sustained setback, and the bulk of those moves are associated with economic recessions and/or growth disappointments (Chart 17). U.S. Equity Capitulation Indicator Our Equity Capitulation Indicator (comprising measures of equity breadth, trader sentiment, insider Sell/Buy ratio and momentum) is used to predict cyclical equity turning points. A reading above the zero line is positive for equity markets. When this Indicator plunges to -1 or lower, capitulation is evident. Currently, this proprietary Indicator says there is no capitulation (Chart 18). Chart 18 U.S. Equity Capitulation Indicator U.S. Equity Capitulation Indicator U.S. S&P 500 Earnings Growth Diffusion Index The S&P 500 Index earnings growth diffusion index is based on the percentage of equity subsectors with an improving 12-month forward earnings growth figure compared with the prior year. At the current juncture, this diffusion index is pointing to a broad-based brightening profit backdrop, underpinning an equity melt-up phase (Chart 19). Chart 19 U.S. S&P 500 Earnings Growth Diffusion Index U.S. S&P 500 Earnings Growth Diffusion Index Global Equity Market EPS Diffusion Index The Global Equity Market EPS Diffusion Index comprises 44 country (DM and EM) forward EPS and gauges the percentage of countries that are experiencing negative year-over-year EPS growth. Chart 20 shows this index on an inverted scale: as fewer and fewer regions have contracting forward EPS, global equity prices tend to rise and vice versa. Currently, a synchronized EPS recovery is unfolding, heralding more gains for the overall equity market. Chart 20 Global Equity Market EPS Diffusion Index Global Equity Market EPS Diffusion Index U.S. M&A Number Of Deals U.S. merger & acquisition activity usually moves with the ebb and flow of equity markets. High stock prices, low interest rates and high valuations are a boon for M&A. The opposite is also true. Presently, the number of M&A deals has rolled over, and this coincident indicator is waving a yellow flag for the U.S. equity market (Chart 21). Chart 21 U.S. M&A Number of Deals U.S. M&A Number of Deals Global Equities Cross Correlation Index BCA's Global Equities Cross Correlation Index is based on an equally weighted average of 26-week pairwise moving correlation of weekly returns between the S&P 500, EUROSTOXX 600, TOPIX and MSCI emerging market stock price indexes. Receding global equity index correlations have been associated with positive S&P 500 returns, as is currently the case (Chart 22). This inverse correlation is also mirrored in the CBOE's implied correlation index, which tracks the correlation of the S&P 500 stocks with one another: tumbling correlations imply solid overall equity returns (not shown). Chart 22 Global Equities Cross Correlation Index Global Equities Cross Correlation Index U.S. S&P 500 Cyclical / Defensives Cyclical sectors include materials, energy, industrials and technology. Defensive sectors include telecom, consumer staples, health care and utilities. Chart 23 shows that, broadly speaking, the S&P 500 is positively correlated with the cyclicals/defensives (C/D) ratio. Currently, the C/D ratio has negatively diverged from the broad market warning that an indigestion phase may loom. Chart 23 S&P 500 Cyclicals / Defensives S&P 500 Cyclicals / Defensives Global Net Earnings Revisions Indicators Sell side analysts' forward net EPS revisions (NER, upward minus downward revisions as a percent of total revisions) are an excellent indicator of the stage of the profit cycle. Historically, regional NERs have been inversely correlated with the respective currencies with the exception of the EM index where the correlation is a positive one. In the EM a rising FX rate represents capital flowing back to those economies, and stocks, bonds and FX markets tend to all move together. In the DM, given increasingly foreign sourced profits, a rising currency caps EPS and vice versa. Currently, a synchronized global EPS revival is in order with the exception of the Eurozone (Chart 24). Chart 24 Global Net Earnings Revisions Indicators Global Net Earnings Revisions Indicators U.S. High-Yield Bond Yield, Option Adjusted Spread And Total Return Index The high yield bond market total return index has a positive correlation with equity markets as high yielding corporates are a good proxy for the overall stock market, while the high yield bond OAS is inversely correlated with stock prices. The bond market tends to sniff out equity market tops and bottoms. Currently, there is no trouble for equity markets according to this bond market indicator. However, spreads are getting extremely tight. A push to all-time lows in the global junk OAS would be a red flag (Chart 25). Chart 25 High-Yield Bond Yield, OAS and Total Return Index High-Yield Bond Yield, OAS and Total Return Index U.S. Corporate Bond Migration Index BCA's U.S. corporate bond migration index is calculated as the number of bond ratings downgrades minus upgrades by Moody's. Historically, credit quality and stock market momentum have been joined at the hip: the current message is to expect recent stock market euphoria to persist (ratings migration shown inverted, Chart 26). Chart 26 U.S. Corporate Bond Migration Index U.S. Corporate Bond Migration Index Economic Surprise Indexes A positive reading of the CITIGROUP Economic Surprise Index suggests that economic releases on balance beat expectations. The indexes are calculated daily in a rolling three-month window. Currently, the G10 is in a mini economic surprise soft patch with the U.S. leading the way and the EM as an exception, holding on to recent positive surprises (Chart 27). Chart 27 Economic Surprise Indexes Economic Surprise Indexes "Soft Data" Vs. "Hard Data" The so-called "soft data" surprise index comprises survey measures of economic activity: business and consumer surveys surprise indexes. The "hard data" index includes five surprise indexes: housing, industrial, labor, household and retail. Historically, the soft/hard (S/H) data index has been positively correlated with the S&P 500. Unsurprisingly, therefore, it remains near all-time high levels along with the S&P 500. The S/H index has been a leading-to-coincident indicator and as long as it avoids a collapse below the zero line, the equity market overshoot phase should remain intact (Chart 28). Chart 28 Soft data' vs. 'Hard data' Soft data' vs. 'Hard data' BCA Boom / Bust Indicator BCA's boom/bust indicator measures the ratio of a basket of commodity equities, the CRB Raw Industrials Index and unemployment claims. A move above zero signals that reflation is dominating global economies and represents fertile ground for equities. A fall below the zero line indicates that deficient demand and economic trouble are brewing, warning that investors should lighten up on equities. Currently, the boom/bust indicator is comfortably above zero, signaling that the equity blow off phase has more legs (Chart 29). Chart 29 BCA Boom / Bust Indicator BCA Boom / Bust Indicator Global Trade Activity Indicator Our Global Trade Activity Indicator (GTAI) comprises the Baltic Dry Index and lumber prices, two hypersensitive economic yardsticks, and gauges the stage of the global trade/inventory/export cycle. Historically, the GTAI has been an excellent leading indicator of global export volume growth, and the latest reading points to a reacceleration in global trade (Chart 30). Chart 30 Global Trade Activity Indicator Global Trade Activity Indicator Korean & Taiwanese Exports Taiwan and Korea are two small open economies, with net exports dominating GDP. Thus, export growth figures from these two countries are a microcosm of the state of the affairs of global trade. Exports in Korea and Taiwan are positively correlated with equity momentum. Currently, booming exports in both regions are a boon for U.S. equities (Chart 31). Chart 31 Korean & Taiwanese Exports Korean & Taiwanese Exports ISM New Orders-To-Inventories Ratio The ISM manufacturing new orders-to-inventories (NOI) ratio tends to lead the overall ISM manufacturing survey. When the ratio crosses below 1 it signals that economic strains exist. A move above 1 signals that end-demand is firing on all cylinders. Historically, the ISM NOI ratio has also been positively correlated with S&P 500 and the current message is that momentum in the latter should hold up (Chart 32). Chart 32 ISM New Orders-To-Inventories Ratio ISM New Orders-To-Inventories Ratio BCA U.S. Capital Spending Indicator BCA's U.S. Capital Spending Indicator (CSI) is a leading indicator of capital formation. The indicator comprises a labor market series, a measure of momentum in the broad equity market and a capex intention survey data series. Our CSI snapped back into positive territory early in 2016 and recently made fresh cyclical highs. A durable global capex revival is looming (Chart 33). Chart 33 BCA U.S. Capital Spending Indicator BCA U.S. Capital Spending Indicator G7 Policy Uncertainty Index The G7 policy uncertainty index is a GDP-weighted index of U.K., Germany, France, Italy, Japan, Canada, and U.S. policy uncertainty indexes, developed by Baker, Bloom & Davis. These indexes measure uncertainty of economic policy-making. Empirical evidence suggests that low G7 policy uncertainty underpins global equity performance. Similarly, surging policy uncertainty spells trouble for the broad equity market. Currently, global policy uncertainty has receded, heralding a fertile global equity market backdrop (Chart 34). Chart 34 G7 Policy Uncertainty Index G7 Policy Uncertainty Index BCA Bank Loans & Leases Growth Model Our U.S. bank loan growth model suggests that banks could enjoy the largest upswing in credit growth of the past 30 years. Soaring consumer and business confidence, rising corporate profits and a potential capital spending revival are the key model drivers (Chart 35). Chart 35 BCA Bank Loans & Leases Growth Model BCA Bank Loans & Leases Growth Model This matters for the broad equity market as a vibrant banking sector - representing the nervous system of the economy - is a necessary requirement for sustainable long term broad equity market gains. Global Credit Impulse The global credit impulse is calculated as a 12-month change of the annual percentage change in total global credit, using BIS data. Since the late-1970s there has been a tight positive correlation between BCA's global credit impulse and global EPS momentum. In fact, global loan creation has, more often than not, been an excellent leading indicator for global profit growth. Currently, our global credit impulse has surged signaling that the synchronized global EPS recovery remains intact (Chart 36). Chart 36 Global Credit Impulse Global Credit Impulse BCA's Global & Regional Earnings Growth Models Our global earnings model (comprising interest rates, oil prices, global manufacturing PMI and the U.S. dollar) has recently shown tentative signs of cresting, but that is at a high level and difficult year-over-year comparisons will only arise later this year, especially in the U.S. The bottom three panels of Chart 37 show our EPS models in the major regions of the world. All three regional EPS models are expanding. Chart 37 BCA's Global & Regional Earnings Growth Models BCA's Global & Regional Earnings Growth Models Margins, Financial Conditions & Monetary Indicator Our Margins, Financial Conditions & Monetary Indicators in Chart 38 demonstrate the close inverse relationship between the former and each of the two latter. Chart 38 Margins, Financial Conditions & Monetary Indicator Margins, Financial Conditions & Monetary Indicator Since mid-December, both the U.S. dollar and 10-year Treasury yields have fallen in tandem. As a result monetary conditions have eased, reversing the tightening that occurred in the second half of 2016. Further, the recent downswing in the U.S. Monetary Indicator is bullish for S&P 500 margins. S&P 500 40 Sector Cross-Correlation Index In Chart 39, we show an average of the pairwise 52- week moving correlations between 40 equity sectors using S&P return data starting in the late-1990s, alongside the S&P 500 (correlation index shown inverted). Usually, falling correlations imply diminished macro tail risks and earnings fundamentals coming to the forefront as the key driver of returns. Chart 39 S&P 500 40 Sector Cross-Correlation Index S&P 500 40 Sector Cross-Correlation Index Our 40 sector cross-correlation is currently in steep decline; the message is positive for the S&P 500. Equity Risk Premium In Chart 40, we show the near-perfect inverse correlation between changes in the Equity Risk Premium (ERP) and the ISM manufacturing index. The implication is that an improving economy is synonymous with a receding ERP and vice versa. We further show the average ERP's of the past 3 business cycles which are all well below the current cycle. Overall, declining ERP's are positive for the S&P 500; there appears to be considerable room for the ERP to fall and this indicator is bullish for the S&P 500. Chart 40 FX10 ERP And The Economy FX10 ERP And The Economy Global Synchronicity Indicator Our Global Synchronicity Indicator, presented in Chart 41, shows the degree to which a global economic revival is coordinated. Highly synchronized global growth implies a strong export market and domestic earnings growth. Chart 41 Global Synchronicity Indicator Global Synchronicity Indicator The indicator is currently reading nearly as high as possible as virtually all G20 economies are in expansion mode. Consumer Drag Indicator The Consumer Drag Indicator comprises mortgage rates and gasoline prices and is a strong indicator for consumer discretionary earnings (Chart 42). Chart 42 Consumer Drag Indicator Consumer Drag Indicator The drag indicator is currently very low, implying strong consumption resilience, which should translate into ongoing consumer discretionary EPS gains. Recreational Goods & Consumption Expenditure Recreational goods & vehicles represent the most cyclical corner of U.S. personal consumption expenditure (PCE), easily surpassing it during expansions, and significantly trailing it in times of distress (Chart 43). An upswing in spending in this segment indicates strong consumer confidence and heralds an increase in overall PCE. Currently, according to the BEA, recreational goods & vehicles outlays are expanding at a healthy clip, underscoring that overall PCE will likely rebound in the coming quarters. Chart 43 Recreational Goods & Consumption Expenditure Recreational Goods & Consumption Expenditure Unconventional Indicators (Part I) How can investors differentiate between a minor correction and a major trend change? We showcase several useful, but somewhat unconventional, indicators to monitor that have been helpful at past bull market peaks. None of these indicators are meant to be foolproof and/or a substitute for the valuation, profit and global economic and policy outlook. But they do provide additional tools to help investors distinguish between temporary and sustained equity market pullbacks. They are meant to augment rather than replace fundamental factors. Each of the indicators measures either: profits, business confidence, investor confidence and/or reflects how liquidity conditions are impacting market dynamics. Investor confidence can be measured through margin debt. While extremely elevated, there is no concrete sign that access to funds is being undermined by the modest backup in interest rates. When the cost of borrowing becomes too onerous, it will manifest in reduced margin debt and forced selling, which will be a serious threat to stocks given that leverage is challenging levels experienced at prior peaks, as a share of nominal income (Chart 44A). Chart 44A Unconventional Indicators (Part I) Unconventional Indicators (Part I) Unconventional Indicators (Part II) The relative performance of consumer discretionary to consumer staples can provide a read on purchasing power and/or the marginal propensity to spend. This share price ratio does not suggest any consumption concerns exist. If consumer staples begin to outperform, then it would warn of a more daunting economic outlook. Temporary employment continues to rise. When temp workers shrink, it is often an early warning sign that companies are entering retrenchment mode, given the ease and low cost of reducing this source of labor costs. If temporary employment falls at the same time as share prices, that would be a red flag. Current economic signals are mostly positive (Chart 44B). Chart 44B Unconventional Indicators (Part II) Unconventional Indicators (Part II) Pricing Power And Wage Growth Indicators Our corporate pricing power proxy compiles the relevant CPI, PPI, PCE or underlying commodity price for 60 S&P 500 industry groups. On a broad basis, growth in pricing power has slowed. On the flip side, rising labor costs look set to take a breather, with the net effect of modest margin expansion. Compensation growth has crested, and according to our diffusion index, fewer than half of the 18 industries tracked have higher wages than last year. The wage growth diffusion index provides a reliable leading indication for the trend in labor expenses. Overall, there are strong odds that resilient forward operating margin expectations can be met (Chart 45). Chart 45 Pricing Power and Wage Growth Indicators Pricing Power and Wage Growth Indicators BCA Reflation Gauge The RG is a combination of oil prices, Treasury yields and the U.S. dollar and has recently exploded to the highest level since 2010 and just shy of all-time highs. The RG leads both the U.S. economic surprise index and equity sentiment. If, as we expect, economic activity continues to accelerate, irrespective of tax reform success, the window is open for additional equity market gains (Chart 46). Chart 46 BCA Reflation Gauge BCA Reflation Gauge Total Returns: Stock-To-Bond The Stock-to-Bond (S/B) ratio is not signaling any trouble ahead. History shows that the time to worry about the bond market's message is when the S/B ratio contracts; the opposite is currently underway. Part of the decline in long-term interest rates reflects a slower expected pace of fed funds rate increases. The bond market doubts the FOMC's 2.125% interest rate estimate for 2018, forecasting a fed funds rate roughly 63bps lower. If the bond market is accurate and the Fed recalibrates its 18-month rate outlook even modestly lower, then the S/B ratio has more upside (Chart 47). Chart 47 Total Returns: Stock-To-Bond Total Returns: Stock-To-Bond Structural Indicators (1-3 years) U.S. Equity Net Debt/EBITDA & Interest Coverage Zero and negative interest rate policies have enticed CEOs to issue debt and retire equity (and increase dividend payments) and effectively change the capital structure of the firm over the past 7 years. Recently, net debt/EBITDA has reversed some of the significant increases of the past 5 years as earnings have been growing faster than leverage. Historically, net debt/EBITDA has been inversely correlated with the equity market; the current trend of declining leverage ratios is positive for equity markets (Chart 48). Chart 48 U.S. Equity Net Debt/EBITDA & Interest Coverage U.S. Equity Net Debt/EBITDA & Interest Coverage U.S. Dollar-Based Liquidity Indicator BCA's U.S. dollar-based liquidity is calculated as Federal Reserve assets plus foreign central bank U.S. government security purchases held by the Federal Reserve. When U.S. Treasurys are sold by Central Banks it represents a defacto tightening in global monetary conditions. Moreover, the Fed recently announced that it will likely commence renormalizing its balance sheet later this year, further tightening global monetary conditions. This matters most for EM that hold a large stock of hard currency debt. Why? Because historically a collapse in U.S. dollar based liquidity has been associated with a rise in the U.S. dollar. As a result, if such tightening goes unchecked then a traditional EM crisis is inevitable. Currently, U.S. dollar based liquidity has plunged to a level associated with recession, warning that the broad equity market rests on a shaky foundation especially given lofty valuations (Chart 49). Chart 49 U.S. Dollar-Based Liquidity Indicator U.S. Dollar-Based Liquidity Indicator BCA Credit Bust Indicator Using BIS data, we constructed a BCA Credit Bust Indicator by averaging and aligning seven previous non-financial corporate debt cycles at respective peaks, both in EM and DM. The common denominator in the four DM busts was a burst housing market bubble, while the three EM crises were related to currency devaluations. While Chart 50 shows that 17 EM non-financial corporate debt levels as a percentage of GDP have not yet reached the average of previous cycle busts, one important insight from our analysis is that it pays to get out of the stock market while the leverage cycle is still on the upswing, potentially leaving some money on the table, but protecting wealth from an inevitable crunch once the leverage cycle hits the point of economic instability. Chart 50 BCA Credit Bust Indicator BCA Credit Bust Indicator U.S./Eurozone 10-Year Sovereign Bond Spread The U.S./Eurozone 10-year sovereign bond spread has been an excellent leading indicator of the broad equity market, and the current message is to expect at least a tactical pullback. In fact, every time the spread has hit 100 basis points, relative bond market mean reversion has subsequently occurred, leading also to a broad equity market wobble (top panel, Chart 51). Chart 51 U.S./Eurozone 10-Year Sovereign Bond Spread U.S./Eurozone 10-Year Sovereign Bond Spread The rationale of this indicator is that Central Bank policy divergence is not sustainable for prolonged periods. Currently, the Fed is, with a few exceptions, going it alone and tightening monetary policy, while the ECB, BOJ and BOE are still extremely accommodative. If policy divergence continues, then the U.S. dollar will make a run to fresh all-time highs and will come to haunt equity markets via an EM accident. As Chart 50 shows, EM debt is quickly building and a spike in the U.S. dollar is destabilizing especially for the "fragile five" twin deficit economies that also have a hard currency debt burden to service. U.S. Yield Curve Corporate profits and the yield curve are joined at the hip. The yield curve is the ultimate leading indicator of revenue growth and earnings health, underscoring that EPS caution is warranted, especially when the yield curve inverts and signals that a recession is nearing. We are not there yet, but there are good odds that if the Fed continues to tighten monetary policy and lift rates near the neutral rate, the economy will suffer. Likely this is a late-2018 early-2019 narrative (Chart 52). Chart 52 U.S. Yield Curve U.S. Yield Curve Industrial Production Minus Money Supply A simple liquidity indicator (industrial production (IP) minus money supply growth) has had a tight positive correlation with EPS for decades. This indicator gauges how quickly money created gets translated into economic growth. Given the current state of affairs of recovering IP growth and decelerating M2 growth, a sustained profit recovery is in the cards in the back half of 2017 and in 2018 (Chart 53). Chart 53 Industrial Production minus Money Supply Industrial Production minus Money Supply Federal Reserve Bank Of Philadelphia Coincident U.S. State Activity Diffusion Index The coincident U.S. State activity diffusion index is a one-month diffusion index of state coincident indexes produced by the Federal Reserve Bank of Philadelphia. The index includes nonfarm payroll employment, the unemployment rate, average hours worked in manufacturing, the consumer price index, wages and salary disbursements and gross domestic product.1 Empirical evidence shows that every time this index falls through the 45% level the global equity market hits a wall as the odds of a U.S. recession skyrocket. While there have been some false positives over the past three decades, this diffusion index has a great track record in predicting recessions. Currently, the steep fall is a cause for concern, but until the 45% level is breached, the equity market will be smooth sailing (Chart 54). Chart 54 Federal Reserve Bank of Philadelphia Coincident U.S. State Activity Diffusion Index Federal Reserve Bank of Philadelphia Coincident U.S. State Activity Diffusion Index Federal Funds Rate In times of crisis, the Federal Reserve cuts the federal funds rate to stimulate demand and the economy. Similarly, when the economy is heating up and inflation is rising, the Fed raises rates to slow down economic activity. Historically, a peak in the fed funds rate has been an excellent leading indicator of recession. Chart 55 shows that since the early-1970s a tick down in the fed funds rate following a series of hikes signifies the end of the business cycle. There have been two false positives, once in the mid-1980s and one in the late-1990s. Chart 55 Federal Funds Rate Federal Funds Rate This June the Fed hiked for the fourth time this tightening cycle and more hikes are to follow according to the Fed's own estimates of interest rate projections into 2019. A reversal of interest rate policy will be significant and likely mark the end of the current business expansion. Stay tuned. BCA U.S. 10-Year Bond Valuation Index The Treasury market can provide clues as to when vulnerabilities in the equity market will intensify. According to BCA's Treasury Bond Valuation Model, yields usually need to be at least one standard deviation above normal before stocks, and the economy, are at risk of a major downturn (Chart 56). Chart 56 BCA U.S. 10-Year Bond Valuation Index BCA U.S. 10-Year Bond Valuation Index Global Auto Sales Indicator Global auto sales have tentatively peaked. While this indicator has been coincident at times, it has also correctly forewarned of global equity market peaks both in 2000 and 2007 (Chart 57). As a highly priced durable good, vehicle sales provide an excellent read on both consumer confidence and their ability/willingness to finance a long-term purchase. The implication of slowing sales is that some doubt about the rate of consumption growth will contribute to a higher equity risk premium. Nevertheless, the equity bull market should remain on track until consumer confidence takes a turn for the worse. Chart 57 Global Auto Sales Indicator Global Auto Sales Indicator GDP Growth Minus Treasury Yield GDP growth minus the Treasury yield is a simple yet reliable measure of excess liquidity. Bear markets have only typically occurred when this gauge downshifts into negative territory, given that slumping GDP usually coincides with a profit recession. Currently, nominal GDP growth is comfortably above the 10-year Treasury yield, signaling that financial conditions will stay sufficiently easy for some time, barring a major bond selloff (Chart 58). Chart 58 GDP Growth Minus Treasury Yield GDP Growth Minus Treasury Yield Cross-Sector Correlation Equity correlations have often led the business cycle. When correlations drop precipitously, recession warnings abound, with the notable exceptions of the mid-80s and mid-to-late-90s when commodity deflation (particularly energy) morphed into a mid-cycle economic slowdown, but the broad market stayed resilient because the economy skirted recession. While we are in the midst of a steep fall in correlations, we are not worried about a U.S. recession just yet. Instead, equities have likely navigated through a mid-cycle correction, as in the mid-80s and mid-to-late-90s (Chart 59). Chart 59 Cross-Sector Correlation Cross-Sector Correlation Long-Term Total Return/GDP Our long-term total return indicator inverts and advances market capitalization/GDP by 10-years, and plots that with 10-year rolling equity returns. The relationship indicates the economic growth the market is discounting into the future (Chart 60). Chart 60 Long-Term Total Return/GDP Long-Term Total Return/GDP The current soaring growth expectations mean that a volatile equity validation phase is inevitable. The timing is difficult to pinpoint, however, because momentum can be a powerful and seductive force. In other words, performance anxiety and fear of missing out are strong cyclical warning flags. 1 https://www.philadelphiafed.org/research-and-data/regional-economy/indexes/coincident/

The GAA DM Equity Country Allocation model is updated as of July 31st, 2017. The model has continued to reduce its allocation to the U.S. and now the U.S. allocation is the largest underweight. The funds from the U.S. are largely used to reduce the large underweight in the U.K. such that now the U.K. is in slight overweight. Other changes in the non-U.S. universe are the downgrade of Spain in favor of Germany, Italy and Netherland. These adjustments are mainly due to changes in liquidity indicators, as shown in Table 1. As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed its benchmark by 88 bps in July, entirely due to the 213 bps outperformance of Level 2 model where the overweight in Italy, Spain , Australia and Netherland vs the underweight in Japan, Germany, Sweden and Switzerland worked very well. Since going live, the overall model has outperformed its benchmark by 257 bps. Table 1Model Allocation Vs. Benchmark Weights GAA Model Updates GAA Model Updates Table 2Performance (Total Returns In USD) GAA Model Updates GAA Model Updates Chart 1GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) GAA U.S. Vs. Non U.S. Model (Level1) GAA U.S. Vs. Non U.S. Model (Level1) Chart 3GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) 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. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of July 31, 2017. Chart 4Overall Model Performance Overall Model Performance Overall Model Performance Table 3Allocations GAA Model Updates GAA Model Updates Table 4Performance Since Going Live GAA Model Updates GAA Model Updates The model continue to be bullish on global growth and hence the cyclical tilt. However, consumer discretionary is the only cyclical sector to have an underweight. This recommendation is mainly driven by the unfavorable liquidity and technical backdrop. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com.

The performance of European stocks relative to the U.S. has been dismal in the post-Lehman period. However, the Eurozone economy is performing impressively, profit growth is accelerating and margins are rising. This points to a period of outperformance for Eurozone stocks, at least in local currency terms. Standard valuation measures based on index data suggest that Eurozone stocks are cheap to the U.S. Nonetheless, the European market almost always trades at a discount, due to persistent lackluster profit performance. In Part II of our series on valuation, we approach the issue from a bottom-up perspective, utilizing the powerful analytics provided by BCA's exciting new Equity Trading Strategy (ETS) platform. The ETS software allows us to compare U.S. and European companies on a head-to-head basis and rank them based on a wide range of characteristics. The bottom-up approach avoids the problems of index construction. Investors can be confident that they will make money on a 12-month horizon by taking a position when the new bottom-up indicator reaches +/-1 standard deviations over- or under-valued, although technical information should be taken on board to sharpen the timing. The +/-2 sigma level gives clear buy/sell signals irrespective of fundamental or technical factors. Valuation alone does not justify overweight Eurozone positions at the moment, although we like the market for other reasons. The bottom-up valuation indicator will not replace our top-down version that is based on index data, but rather will be considered together when evaluating relative value. Total returns in the European equity market have bounced relative to the U.S. since 2016 in both local-currency and common currency terms (Chart II-1). However, this has offset only a tiny fraction of the dismal underperformance since 2007. In local currencies, the relative EMU/U.S. total return index is still close to its lowest level since the late 1970s. Compared with the pre-Lehman peak, the U.S. total return index is more than 96% higher according to Datastream data, while the Eurozone total return index is only now getting back to the previous high-water mark when expressed in U.S. dollars (Chart II-2). Chart II-1EMU Stocks Lag Massively... EMU Stocks Lag Massively... EMU Stocks Lag Massively... Chart II-2...Due To Depressed Earnings ...Due To Depressed Earnings ...Due To Depressed Earnings The yawning return gap between the two equity markets was almost entirely due to earnings as market multiples have moved largely in sync. Earnings-per-share (EPS) generated by U.S. companies now exceed the pre-Lehman peak by about 19%. In contrast, earnings produced by their Eurozone peers are a whopping 48% below their peak (common currency). This reflects both a slower recovery in sales-per-share growth and lower profit margins. Operating margins in Europe have been on the upswing for a year, but are still depressed by pre-Lehman standards. Margin outperformance in the U.S. is not a sector weighting story; in only 2 of 10 sectors do European operating margins exceed the U.S. The return-on-equity data tell a similar story. Nonetheless, a turning point may be at hand. Chart II-3Europe Trades At A Discount Europe Trades At A Discount Europe Trades At A Discount The Eurozone economy has been performing well, especially on a per-capita basis, and forward-looking indicators suggest that growth will remain above-trend for at least the next few quarters. U.S. profit margins have also been (temporarily) rising, but the Eurozone economy has more room to grow because there is still slack in the labor market. There is also more room for margins to rise in the Eurozone corporate sector than is the case in the U.S., where the profit cycle is further advanced. Traditional measures of value based on the MSCI indexes suggest that European stocks are on the cheap side. But are they really that cheap? Based on index data, Eurozone stocks trade at a hefty discount across most of the main valuation measures (Chart II-3). This is the case even for normalized measures such as price-to-book (P/B). However, Eurozone stocks have almost always traded at a discount. There are many possible explanations as to why there is a persistent valuation gap between these two markets, including differences in accounting standards, discount rates and sector weights. The wider use of stock buybacks in the U.S. also favors American stock valuations relative to Europe. But most important are historical differences in underlying corporate fundamentals. U.S. companies on the whole were significantly more profitable even before the Great Financial Crisis (Chart II-3). U.S. companies also tend to have lower leverage and higher interest coverage. Better profitability metrics in the U.S. are not solely an artifact of sector weighting either. RoE and operating margins are lower in Europe even applying U.S. sector weights to the European market.1 Why corporate Europe has been a perennial profit under-achiever is beyond the scope of this paper. U.S. companies reaped most of the benefit from productivity gains over the past 25 years, with the result that the capital share of income soared while the labor share collapsed. European companies were less successful in squeezing down labor costs. Measuring Value In the first part of our two-part Special Report on valuation, published in July 2016, we took a top-down approach to determine whether Eurozone stocks are cheap versus the U.S. after adjusting for different sector weights and persistent differences in the underlying profit fundamentals. A regression approach that factored in various profitability measures performed reasonably well, but the top-down "mechanical" approach that relied on a 5-year moving average provided the most profitable buy/sell signals historically. We approach the issue from a bottom-up perspective in Part II of our series, utilizing the powerful analytics provided by BCA's exciting new Equity Trading Strategy (ETS) platform. The software allows us to compare U.S. and European companies on a head-to-head basis and rank them based on a wide range of characteristics. The bottom-up approach avoids the problems of index construction when trying to gauge valuation across countries. The web-based platform uses over 24 quantitative factors to rank approximately 10,000 individual stocks in 23 countries, allowing clients to find stocks with winning characteristics at the global level. Users can rank and score individual equities to support a broad set of investment strategies and apply macro and sector views to single-name investments. The ETS approach has an impressive track record. Historically, the top-decile of stocks ranked using the "BCA Score" methodology have outperformed stocks in the bottom decile by over 25% a year.2 The BCA Score includes all 24 factors when ranking stocks, but we are interested in developing a valuation metric that provides valued added on its own and is at least as good as the top-down index-based measure developed in Part I. The five valuation measures in the ETS database are trailing P/E, forward P/E, price-to-book, price-to-sales and price-to-cash flow. We combine all of the Eurozone and U.S. companies that have total assets of greater than $1 billion into one dataset. The ETS platform then ranks the stocks from best to worst on a daily basis (i.e. cheapest to most expensive), using an equally-weighted average of the five valuation measures. The average score for U.S. stocks is subtracted from the average score for European stocks, and then divided by the standard deviation of the series. This provides a valuation metric that fluctuates roughly between +/- 2 standard deviations. Chart II-4 presents the resulting bottom-up indicator, along with our previously-published top-down valuation measure. A high reading indicates that European stocks are cheap to the U.S., while it is the opposite for low readings. Chart II-4Eurozone Equity Relative Valuation Indicators Eurozone Equity Relative Valuation Indicators Eurozone Equity Relative Valuation Indicators The underlying bottom-up data extend back to 2000. However, the bursting of the tech bubble in the early 2000's causes major shifts in relative valuation among sectors and between the U.S. and Eurozone that skew the indicator when constructed using the entire data set. We obtain a cleaner indicator when using only the data from 2005. As with any valuation indicator, it is only useful when it reaches extremes. We calculated the historical track record for a trading rule that is based on critical levels of over- and under-valuation. For example, we calculated the (local currency) excess returns over 3, 6, 12 and 24-month horizon generated by (1) overweighting European stocks when that market was one and two standard deviations cheap versus the U.S. market, and (2) overweighting the U.S. when the European market was one and two standard deviations expensive (Table II-1). Table II-1Value Indicator: Trading Rule Returns And Batting Average August 2017 August 2017 The trading rule returns were best when the indicator reached two standard deviations cheap or expensive, providing average returns of almost 11 percent over 12 months. The trading rule returns when the indicator reached +/-1 standard deviation were not as good, but still more than 3% on 12- and 24-month horizons. Table II-1 also presents the trading rule's batting average. That is, the number of positive excess returns generated by the trading rule as a percent of the total number of signals. The batting average ranged from 50% on a 3-month horizon to 68% over 24 months when buy/sell signals are triggered at +/- 1 standard deviation. The batting average is much higher (80-100%) using +/- 2 standard deviations as a trigger point, although there were only five months over the entire sample when the indicator reached this level. The charts and tables in the Appendix present the results of the same analysis at the sector level. The results are equally as good as the aggregate valuation indicator, with a couple of exceptions. European stocks are cheap to the U.S. in the Energy, Financials, and Utilities sectors, while U.S. stocks offer better value in Consumer Discretionary, Consumer Staples, Health Care, Industrials and Technology. Materials, Real Estate, and Telecommunications are close to equally valued. Sharpening The Buy/Sell Signals We then augmented the valuation analysis by adding information on company fundamentals, such as EPS growth and profit margins among others. The ETS software ranked the companies after equally-weighting the valuation and fundamental factors. However, this approach yielded poor results in terms of the trading rule. This is because, for example, when European stocks reach undervalued levels relative to the U.S., it is usually because the European earnings fundamentals have underperformed those of the U.S. companies. Thus, favorable value is offset by poor fundamentals, muddying the message provided by valuation alone. In contrast, adding some information from the technical factors in the ETS model does add value, at least when using +/-1 standard deviations as the trigger point for trades (Chart II-5). Excess returns to the trading rule rise significantly when the medium-term momentum and long-term mean reversion factors are included in the valuation indicator (Table II-2). The batting average also improves. Chart II-5Indicators: Value And Value With Technical Information Indicators: Value And Value With Technical Information Indicators: Value And Value With Technical Information Table II-2Value And Technical Indicator: Trading Rule Returns And Batting Average August 2017 August 2017 Adding technical information does not improve the trading rule performance when +/-2 sigma is used as the trigger point. Investment Conclusions Our new ETS platform provides investors with a unique way of picking stocks by combining top-down macro themes with company-specific information. It also allows us to develop valuation tools that avoid some of the pitfalls of index data by comparing stocks on a head-to-head basis. Historical analysis using a trading rule demonstrates that the new bottom-up valuation indicator provides real value to investors. We would normally evaluate its track record using stretching analysis, where we use only the historical information available at each point in time when determining relative value. However, the relatively short history of the available data precludes this test because we need at least a few cycles to best gauge the underlying volatility in the data. Still, investors can be fairly confident that they will make money on a 12-month horizon by taking a position when the bottom-up indicator reaches +/-1 sigma over- or under-valued, although technical information should be taken on board to sharpen the timing. The +/-2 sigma level gives clear buy/sell signals irrespective of the fundamental or technical factors. The bottom-up valuation indicator will not replace our top-down version that is based on index data, but rather will be considered together when evaluating relative value. At the moment, the top-down version proposes that European stocks are somewhat cheap to the U.S., while the bottom-up indicator points to slight overvaluation. Considering the two together suggests that valuation is close enough to fair value that investors cannot make the decision on value alone. Valuation indicators need to be near extremes to be informative. Our global equity strategists recommend overweighting Eurozone stocks versus the U.S. at the moment, although not because of valuation. Rather, the Eurozone economy and corporate earnings have more room to grow because of lingering labor market slack. This also means that the ECB can keep rates glued to the zero bound for at least the next 18 months while the Fed hikes, which will place upward pressure on the dollar and downward pressure on the euro. Mark McClellan Senior Vice President The Bank Credit Analyst Appendix: Trading Rule Returns By Sector Chart II-6, Chart II-7, Chart II-8, Chart II-9, Chart II-10, Chart II-11, Chart II-12, Chart II-13, Chart II-14, Chart II-15, Chart II-16. Chart II-6Consumer Discretionary Consumer Discretionary Consumer Discretionary Chart II-7Consumer Staples Consumer Staples Consumer Staples Chart II-8Energy Energy Energy Chart II-9Financials Financials Financials Chart II-10Health Care Health Care Health Care Chart II-11Industrials Industrials Industrials Chart II-12Materials Materials Materials Chart II-13Real Estate Real Estate Real Estate Chart II-14Utilities Utilities Utilities Chart II-15Technology Technology Technology Chart II-16Telecommunication Telecommunication Telecommunication 1 Please see The Bank Credit Analyst Special Report, "Are Eurozone Stocks Really That Cheap?" July 2016, available at bca.bcaresearch.com. 2 Please see Equity Trading Strategy Special Report, "Introducing ETS: A Top Down Approach to Bottom-Up Stock Picking," December 2, 2015, available at ets.bcaresearch.com.

Highlights Major central banks outside the U.S. have fired a warning shot across the bow of global bond markets by signaling that "emergency" levels of monetary accommodation are no longer required. Pipeline inflation pressures have yet to show up at the consumer price level outside of the U.K. Most central bankers argue that temporary factors are to blame, but longer-lasting forces could be at work. There are numerous examples of deflationary pressure driven by waves of innovation, cost cutting and changing business models. However, this is not confirmed in the productivity data. Productivity is dismally low and we do not believe it is due to mismeasurement. The Phillips curve is not dead. We expect that inflation will firm by enough to allow central banks to continue scaling back monetary stimulus. The real fed funds rate is not far from the neutral short-term rate, but it is still well below the Fed's estimate of the long-run neutral rate. Market expectations for the Fed are far too complacent; keep duration short. The failure to repeal Obamacare could actually increase the motivation of Republicans to move forward on tax cuts. Expansionary fiscal policy would make life more difficult for the FOMC, given that unemployment is on course to reach the lowest level since 2000. This would force the Fed to act more aggressively, possibly triggering a recession in 2019. The peak Fed/ECB policy divergence is not behind us, implying that recent dollar weakness will reverse. However, the next dollar upleg has been delayed. Fading market hopes for U.S. fiscal stimulus this year have not weighed on equities, in part because of a solid earnings backdrop. Global EPS growth continues to accelerate in line with the recovery in industrial production. In the U.S., results so far suggest that Q2 will see another quarter of margin expansion. Overall earnings growth should peak above our 20% target later this year. It will be tougher sledding in the equity market once profit growth peaks in the U.S. because of poor valuation. Expect to downgrade stocks in the first half of 2018. Corporate bonds are also benefiting from the robust profit backdrop. Balance sheet health continues to deteriorate, but the spark is missing for a sustained corporate bond spread widening. Feature Chart I-1Sell-Off In Global Bond Markets ##br##Triggered By Central Bank Talk Sell-Off In Global Bond Markets Triggered By Central Bank Talk Sell-Off In Global Bond Markets Triggered By Central Bank Talk Major central banks outside the U.S. fired a warning shot across the bow of global bond markets by signaling a recalibration of monetary policy at the ECB's Forum on Central Banking in late June (Chart I-1). The heads of the Bank of England (BoE), Bank of Canada (BoC) and Swedish Riksbank all took a less dovish tone, warning that the diminished threat of deflation has reduced the need for ultra-stimulative policies. The BoC quickly followed up in July with a rate hike and a warning of more to come. The central bank now expects the economy to reach full employment and hit the inflation target by mid-2018, much earlier than previously expected. The Riksbank also backed away from its easing bias at its most recent policy meeting. The ECB's shift in stance was evident even before its Forum meeting, when President Draghi gave a glowing description of the underlying strength of the Euro Area economy. The labor market is about two percentage points closer to full employment than the U.S. was just before the infamous 2013 Taper Tantrum.1 European core inflation is admittedly below target today, but so was the U.S. rate leading up to the 2013 Tantrum. We have not forgotten about Europe's structural problems or the inherent contradictions of the single currency. Banks are still laden with bad debt (although the recapitalization of Italian banks has gone well so far). Nonetheless, from a cyclical economic standpoint, solid momentum this year will allow Draghi to scale back the ECB's ultra-accommodative monetary stance by tapering its asset purchase program early in 2018. The message that "emergency" levels of monetary accommodation are no longer needed is confirmed by our Central Bank (CB) Monitors, which measure pressure on central bankers to raise or lower interest rates (Chart I-2). The Monitors became less useful when rates hit the zero bound and quantitative easing was the only game in town, but they are becoming relevant again as more policymakers consider their exit strategy. All of our CB Monitors are currently in "tighter policy required" territory except for Japan and the Eurozone (although even those are close to the zero line). The Monitors have been rising due to both their growth and underlying inflation components. Another tick higher in PMI's for the advanced economies in July underscored that the rebound in industrial production is continuing (Chart I-3). Our short-term forecasting models, which include both hard and soft data, point to stronger growth in the major countries in the second half of 2017 (Chart I-4). Chart I-2Most In The "Tighter Policy Required" Zone Most In The "Tighter Policy Required" Zone Most In The "Tighter Policy Required" Zone Chart I-3Industrial Production Recovery Is Intact Industrial Production Recovery Is Intact Industrial Production Recovery Is Intact On the inflation side, our pipeline indicators have all signaled a modest building of underlying inflation pressure over the past year (although they have softened recently in the U.S. and Eurozone; Chart I-5). In terms of the components of these indicators, rising core producer price inflation has been partly offset by slower gains in unit labor costs in some economies. Chart I-4Our Short-Term Growth Models Are Bullish Our Short-Term Growth Models Are Bullish Our Short-Term Growth Models Are Bullish Chart I-5Some Rise In Pipeline Inflation Pressure Some Rise In Pipeline Inflation Pressure Some Rise In Pipeline Inflation Pressure These pipeline pressures have yet to show up at the consumer level. Most central bankers argue that temporary special factors are to blame, but many investors are wondering if longer-lasting forces are at work. There are numerous examples of deflationary pressure driven by waves of innovation, cost cutting and changing business models. Amazon, Uber, robotics and shale oil production are just a few examples. If this is the main story, then the inability for central banks to reach their inflation targets is a "good thing" because it reflects the adaptation of game-changing new technology. There is no doubt that important strides are being made in certain areas where new technologies are clearly driving prices down. The problem is that, at the macro level, it is not showing up in the productivity data. Productivity is dismally low across the major countries and we do not believe it is simply due to mismeasurement. A Special Report from BCA's Global Investment Strategy2 service makes a convincing case that mismeasurement is not behind the low productivity figures. In fact, it appears that productivity is over-estimated in some industries. It is also important to keep in mind that technological change is nothing new. There is a vigorous debate in academic circles on whether today's new technologies are anywhere near as positive as previous ones like indoor plumbing, electricity, the internal combustion engine and the internet. We are wowed by today's new gizmos, but they are not as transformative as previous innovations. While productivity is surging in some high-profile firms, studies show that there is a long tail of low-productivity companies that drag down the average. A full discussion is beyond the scope of this report and more research needs to be done, but we are not of the view that technology and productivity preclude rising inflation. We expect that inflation will firm by enough to allow central banks to continue scaling back monetary stimulus in the coming months and quarters. Did Yellen Turn Dovish? As with other central banks, the consensus among Fed policymakers is willing to "look through" low inflation for now. Yellen's Congressional testimony did not deviate from that view, although investors interpreted her remarks as dovish. The financial press focused on her statement that "...the policy rate is not far from neutral." However, this was followed up by the statement that "...because we also anticipate that the factors that are currently holding down the neutral rate will diminish somewhat over time, additional gradual rate hikes are likely to be appropriate over the next few years to sustain the economic expansion and return inflation to our 2 percent goal." Chart I-6Bond Market Does Not Believe The Fed Bond Market Does Not Believe The Fed Bond Market Does Not Believe The Fed The Fed believes there are two neutral interest rates: short-term and long-term. Yellen argued that the actual policy rate is currently close to the short-term neutral level, which is depressed by economic headwinds. However, Yellen and others have made the case that the short-term neutral rate is trending up as headwinds diminish, and will converge with the long-term neutral rate over time. The Fed's Summary of Economic Projections reveals what the FOMC thinks is the neutral long-term real fed funds rate; the median forecast calls for a nominal fed funds rate of 2.9% at the end of 2019 and 3% in the longer run. Incorporating a 2% inflation target, we can infer that the Fed anticipates a real neutral rate of 1% in the longer run. The Fed is likely tracking the real neutral fed funds rate using an estimate created by Laubach and Williams (LW).3 Chart I-6 shows this estimate of the neutral rate, called R-star, alongside the real federal funds rate that is calculated using 12-month trailing core PCE. The resulting real fed funds rate has risen sharply during the past seven months due to both three Fed rate hikes and a decline in inflation. If the Fed lifts rates once more this year and core inflation stays put, then the real fed funds rate would end 2017 close to zero, only 42 bps below neutral. However, it's more likely that the Fed will need to see inflation rebound before it delivers another rate hike. In a scenario where core inflation rises to 1.9% and the Fed lifts rates once more, then the real fed funds rate would actually decline between now and the end of the year. The implication is that the real fed funds rate is not far from R-star, but the nominal rate will have to rise a long way before the real rate reaches the Fed's estimate of the long-term neutral rate. Investors simply don't believe Fed policymakers. According to the bond market, the real fed funds rate will not shift into positive territory until 2021 (see real forward OIS line in Chart I-6). We think this is far too complacent. U.S. Health Care Reform: RIP The speed at which short-term rates converge with the long-run neutral rate will depend importantly on the path of fiscal policy. The Republicans' failure to pass their health care legislation is leading the investors to doubt the prospect for (stimulative) tax cuts. This may be premature. Ironically, the failure to jettison Obamacare may turn out to be a blessing in disguise for President Trump and the Republican Party. According to the Congressional Budget Office, the proposed legislation would have caused 22 million fewer Americans to have health insurance in 2026 compared with the status quo. The Senate bill would have also led to substantial cuts to Medicaid relative to existing law, as well as deep cuts to insurance subsidies for many poor and middle-class families. Many of these voters came out in support of Trump last year. The failure to repeal Obamacare could actually increase the motivation of Republicans to move forward on tax cuts anyway. The chances for broad tax reform have certainly diminished, since that will be just as difficult to get passed as healthcare reform. The GOP also wanted to use the roughly $200 billion in savings from healthcare reform to fund reduced tax rates. However, tax cuts are something that all Republicans can easily agree too, and they will need to show a legislative victory ahead of next year's mid-term elections. The difficulty will be how to pay for these cuts. We expect them to be "fully funded" in the sense that there will be offsetting spending cuts, but these will be back-loaded toward the end of the 10-year budget window, whereas the tax cuts will be front-loaded. This would generate a modest amount of fiscal stimulus over the next few years. Sub-4% U.S. Unemployment Rate Followed By Recession? Chart I-7Inside The Fed's Forecasts Inside The Fed's Forecasts Inside The Fed's Forecasts Expansionary fiscal policy would make life more difficult for the FOMC, which may have already fallen behind the curve. The unemployment rate is below the Fed's estimate of the full employment level, and it will continue to erode unless productivity picks up soon. We backed out the productivity growth rate implied by the Fed's latest Summary of Economic Projections, given its assumption that real GDP growth will be roughly 2% over the next couple of years and that the unemployment rate will stabilize near the current level. This combination implies that productivity growth will accelerate from the average rate observed so far in this expansion (0.7%) to about 1%, which is consistent with monthly payrolls of 135,000 assuming real GDP growth of 2% (Chart I-7). If we instead assume that productivity does not accelerate (and real GDP growth is 2%), then payrolls must jump to 160,000 and the unemployment rate would fall below 4% next year. The implication is that the unemployment rate is likely to soon reach levels not seen since 2000, which would force the FOMC to tighten more aggressively. The Fed would hope for a soft landing as it tries to nudge the unemployment rate higher, but the more likely result is a recession in 2019. For this year, we expect the Fed to begin balance sheet runoff in the autumn, followed by a rate hike in December. The latter hinges importantly on at least a modest rise in core PCE inflation in the coming months. A rebound in oil prices would help the Fed reach its inflation goal, even though energy prices affect the headline by more than the core rate. Saudi Energy Minister Khalid al-Falih indicated at a recent press conference in St. Petersburg that no changes are presently needed to the production deal under which OPEC and non-OPEC producers pledged to remove 1.8mn b/d from the market. The Saudi energy minister's remarks leave open the possibility of deeper cuts later this year if global inventories do not draw fast enough, or for the cuts to be extended beyond March 2018 if officials are not satisfied with progress on the storage front. We still believe they are capable of meeting this goal, despite rising shale production. Chart I-8Forecast Of Oil Inventories Forecast Of Oil Inventories Forecast Of Oil Inventories Our commodity strategists expect OECD oil inventories to reach their five-year average level by year-end or early 2018 Q1 (Chart I-8). In the absence of additional cuts, the five-year average level of OECD inventories will be higher than we estimated earlier this year, indicating that our expectation for the overall inventory drawdown later this year has been trimmed. Still, our oil strategists believe the inventory drawdowns will be sufficient to push WTI above the mid-$50s by year-end. If this forecast pans out, rising oil prices will push up headline inflation and inflation expectations in the major advanced economies. The bottom line is that the backdrop has turned bond-bearish now that central bankers in the advanced economies are in the process of scaling back the easier monetary policy that followed the deflationary 2014/15 oil shock. Duration should be kept short within global fixed income portfolios. In terms of country allocation, our global fixed income strategists have downgraded the Eurozone government bond market to underweight, joining the Treasury allocation, in light of the pending ECB tapering announcement that could place more upward pressure on yields. This was offset by upgrading Japan to maximum overweight. Max Policy Divergence Has Not Been Reached Chart I-9Europe Has A Lower Neutral Rate Europe Has A Lower Neutral Rate Europe Has A Lower Neutral Rate The change in tone by central bankers outside the U.S. has weighted heavily on the U.S. dollar. The Canadian dollar and the Euro have been particularly strong. Investors have apparently decided that the peak Fed/ECB policy divergence is now behind us. We do not agree. The ECB may be tapering, but rate hikes are a long way off because there remains a substantial amount of economic slack in the Eurozone. Laubach and Williams estimate R-star in the Eurozone to be close to zero, which is 50 basis points below the U.S. neutral rate (Chart I-9). The difference is related to slower potential growth and greater unemployment. Labor market slack across the euro area as a whole is still 3.2 percentage points higher than in 2008, and 6.7 points higher outside of Germany. The current real short-term rate is about -1%. We expect U.S. R-star to rise in absolute terms and relative to the neutral rate in the Eurozone because the U.S. is further advanced in the economic expansion. As Fed rate hike expectations ratchet up in the coming months, interest rate differentials versus Europe will widen in favor of the dollar. It is the same story for the dollar/yen rate because the Bank of Japan is a long way from raising or abandoning its 10-year bond yield peg. Japanese core inflation has fallen back to zero and medium-to-long-term inflation expectations have dipped so far this year. The annual shunto wage negotiations this summer produced little in the way of salary hikes. The major exception to our "strong dollar" call is the Canadian loonie, which we expect to appreciate versus the greenback. We also like the Aussie dollar, provided that the Chinese economy continues to hold up as we expect. Stocks Get A Free Pass For Now Chart I-10Global EPS And Industrial Production Global EPS And Industrial Production Global EPS And Industrial Production Fading market hopes for U.S. fiscal stimulus have weighed on both U.S. Treasury yields and the dollar, but the equity market has taken the news in stride. Are equity investors simply in denial? We do not think so. The equity market appears to have been given a "free pass" for now because earnings have been supportive. The combination of robust earnings growth, steady real GDP growth of around 2%, and low bond yields has been bullish for stocks so far in this expansion. At the global level, EPS growth continues to accelerate in line with the recovery in industrial production, which is a good proxy for top line growth (Chart I-10). Orders and production for capital goods in the major advanced economies have been particularly strong in recent months. The global operating margin flattened off last month according to IBES data, although margins continued to firm in the U.S. and Europe (Chart I-11). The profit acceleration is widespread across these three economies in the Basic Materials and Consumer Discretionary sectors. Industrials, Energy, Health Care and Consumer Staples are also performing well in most cases. Telecom is the weak spot. Our sector profit diffusion indexes paint an upbeat picture for the near term (Chart I-12). Chart I-11Operating Margins On The Rise Operating Margins On The Rise Operating Margins On The Rise Chart I-12Earnings Diffusion Indexes Are Bullish Earnings Diffusion Indexes Are Bullish Earnings Diffusion Indexes Are Bullish In the U.S., the second quarter earnings season is off to a good start. Results so far suggest that Q2 will see another quarter of margin expansion. We believe that U.S. margins are in a secular decline, but they are in the midst of a counter-trend rally that will last for the rest of this year. Using blended results for the second quarter, trailing S&P 500 EPS growth hit 18½% on a 4-quarter moving total basis (Chart I-13). The acceleration in earnings is impressive even after excluding the Energy sector. We projected early this year that EPS growth would peak at around 20%4 by year end, but it appears that earnings will overshoot that level. Chart I-13Robust EPS Growth Even Without Energy Robust EPS Growth Even Without Energy Robust EPS Growth Even Without Energy It will be tougher sledding in the equity market once profit growth peaks in the U.S. because of poor valuation. We are expecting to scale back our overweight equity recommendation sometime in the first half of 2018, although the global rally could be extended by constructive earnings data in Europe and Japan. The earnings recovery in both economies is behind the U.S., such that peak growth will come later in 2018. There is also more room for margins to expand in Europe than in the U.S. The relative earnings cycle is one of the reasons why we continue to favor Eurozone and Japanese stocks to the U.S. in local currency terms. Japanese stocks are also cheap to the U.S. based on our top-down valuation indicator (Chart I-14). European stocks are not far from fair value relative to the U.S., after adjusting for the fact that Europe trades structurally on the cheap side. The message from our top-down valuation indicator for European stocks is confirmed when using the bottom-up information contained in the new BCA Equity Trading Strategy platform. The Special Report beginning on page 20 describes a bottom-up valuation measure that we will use in conjunction with our top-down (index-based) measures. Corporate Bonds: Kindling And Sparks Healthy EPS growth momentum is also constructive for corporate bonds, although overall balance sheet health continues to erode in the U.S. The release of the U.S. Flow of Funds data allows us to update BCA's Corporate Health Monitor (CHM) for the first quarter (Chart I-15). The level of the CHM moved slightly deeper into "deteriorating health territory." Chart I-14Top-Down Relative Equity Valuation Top-Down Relative Equity Valuation Top-Down Relative Equity Valuation Chart I-15Deteriorating Since 2015, But... Deteriorating Since 2015, But... Deteriorating Since 2015, But... The Monitor has been a reliable indicator for the trend in corporate bond spreads over the years, calling almost all major turning points in advance. However, spreads have trended tighter over the past year even as the CHM began to signal deteriorating health in early 2015. Why the divergence? The CHM is only one of three key items on our checklist to underweight corporate bonds versus Treasurys. The other two are tight Fed policy (i.e. real interest rates that are above the neutral level) and the direction of bank lending standards for C&I loans. On its own, balance sheet deterioration only provides the kindling for a spread blowout. It also requires a spark. Investors do not worry about high leverage or a profit margin squeeze, for example, until the outlook for defaults sours. The latter occurs once inflation starts to rise and the Fed actively targets slower growth via higher interest rates. Banks see trouble on the horizon and respond by tightening lending standards, thereby restricting the flow of credit to the business sector. Defaults start to ramp up, buttressing banks' bias to curtail lending in a self-reinforcing negative feedback loop. The three items on the checklist normally occurred at roughly the same time in previous cycles because a deteriorating CHM is typically a late-cycle phenomenon. But this has been a very different cycle. High stock prices and rock-bottom bond yields have encouraged the corporate sector to leverage up and repurchase stock. At the same time, the subpar, stretched-out recovery has meant that it has taken longer than usual for the economy to reach full employment. It will be some time before U.S. short-term interest rates reach restrictive territory. As for banks, they tightened lending standards a little in 2015/16 due to the collapse of energy prices, but this has since reversed. The implication is that, while corporate health has deteriorated, we do not have the spark for a sustained corporate bond spread widening. Indeed, Moody's expects that the 12-month default rate will trend lower over the next year, which is consistent with constructive trends in corporate lending standards, industrial production and job cut announcements (all good indicators for defaults). Chart I-16 presents a valuation metric that adjusts the HY OAS for 12-month trailing default losses (i.e. it is an ex-post measure). In the forecast period, we hold today's OAS constant, but the 12-month default losses are a shifting blend of historical losses and Moody's forecast. The endpoint suggests that the market is offering about 200 basis points of default-adjusted excess yield over the Treasury curve for the next 12 months. This is roughly in line with the mid-point of the historical data. In the past, a default-adjusted spread of around 200 basis points provided positive 12-month excess returns to high-yield bonds 74% of the time, with an average return of 82 basis points. It is also a positive sign for corporate bonds that the net transfer to shareholders, in the form of buybacks, dividends and M&A activity, eased in the fourth quarter 2016 and the first quarter of 2017 (Chart I-17). Ratings migration has also improved (i.e. moderating net downgrades), especially for shareholder-friendly rating action, which is a better indicator for corporate spreads. The diminished appetite to "return cash to shareholders" may not last long, but for now it supports our overweight in both investment- and speculative-grade bonds versus Treasurys. That said, excess returns are likely to be limited to the carry given little room for spread compression. Chart I-16Still Some Value In ##br##High-Yield Corporates Still Some Value In High-Yield Corporates Still Some Value In High-Yield Corporates Chart I-17Net Transfers To Shareholders ##br##Eased In Past Two Quarters Net Transfers To Shareholders Eased In Past Two Quarters Net Transfers To Shareholders Eased In Past Two Quarters Within balanced portfolios, we recommend favoring equities to high-yield at this stage of the cycle. Value is not good enough in HY relative to stocks to expect any sustained period of outperformance in the former, assuming that the bull market in risk assets continues. Investment Conclusions A key change in the global financial landscape over the past month is a signal from central banks that they see the need for policy recalibration. Policymakers view sub-target inflation as temporary, and some are concerned that low interest rates could contribute to the formation of financial market bubbles. The bond market remains skeptical, given persistent inflation undershoots and growing anecdotal evidence that new technologies are very deflationary. It would be extremely bullish for stocks if these new technologies were indeed boosting the supply side of the economy at a faster pace than the official data suggest. Robust advances in output-per-worker would allow profits to grow quickly, and would provide the economy more breathing space before hitting inflationary capacity limits (keeping the bond vigilantes at bay). We acknowledge that there are important technological breakthroughs being made, but we do not see any evidence that this is occurring on a widespread basis sufficient to "move the dial" in terms of overall productivity growth. Indeed, the stagnation of middle class personal income is consistent with a poor productivity backdrop. Chart I-18 highlights that "creative destruction" is in a long-term bear market. Chart I-18Less Creative Destruction Less Creative Destruction Less Creative Destruction That said, the equity market is benefiting from the mini-cycle in corporate profits, which are still recovering from the earnings recession in 2015/early 2016. We expect the recovery to be complete by early 2018, which will set the stage for a substantial slowdown in EPS growth next year. It won't be a disaster, absent a recession, but demanding valuations suggest that the market could struggle to make headway through next year. We expect to trim exposure sometime in the first half of 2018. To time the exit, we will watch for a roll-over in the growth rate of S&P 500 EPS on a 4-quarter moving total basis. Investors should look for a peak in industrial production growth as a warnings sign for profits. We are also watching for a contraction in excess money, which we define as M2 divided by nominal GDP. Finally, a rise in core PCE inflation to 2% would be a signal that the Fed is about to ramp up interest rates. For now, remain overweight equities relative to bonds and cash. Favor equities to high yield, but within fixed-income portfolios, overweight investment- and speculative-grade corporates versus Treasurys. We are comfortable with our pro-risk recommendations and our below-benchmark duration stance. Unfortunately, that can't be said of our bullish U.S. dollar and oil price house views. Both are controversial calls among our strategists. As for oil, supply and demand are finely balanced and our positive view hinges importantly on OPEC agreeing to more production cuts. The obvious risk is that these cuts do not materialize. The dollar call has gone against us as the latest signs of improving global growth momentum have admittedly been outside the U.S. Meanwhile, the U.S. is stuck in a political morass, which delays the prospect of fiscal stimulus. This is not to say that U.S. growth will slow. Rather, the growth acceleration may fall short of the high expectations following last November's election. We continue to believe that the market is too complacent on the pace of Fed rate hikes in the coming quarters. An upward adjustment in rate expectations should push the dollar higher on a trade-weighted basis, as outlined above. Nonetheless, this shift will require higher U.S. inflation, the timing of which is highly uncertain. We remain dollar bulls on a 12-month horizon, but we are stepping aside and calling for a trading range in the next three months. Mark McClellan Senior Vice President The Bank Credit Analyst July 27, 2017 Next Report: August 31, 2017 1 Please see Global Fixed Income Strategy Weekly Report, "Central Banks Are Now Playing Catch-Up," dated July 4, 2017, available at gfis.bcaresearch.com 2 Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com 3 Kathryn Holston, Thomas Laubach, and John C. Williams "Measuring The Natural Rates Of Interest: International Trends And Determinants," Federal Reserve Bank of San Francisco, Working Paper 2016-11 (December 2016). 4 Calculated as a year-over-year growth rate of a 4-quarter moving total of S&P data. II. The BCA ETS Trading Platform Approach To Valuing Eurozone Stocks The performance of European stocks relative to the U.S. has been dismal in the post-Lehman period. However, the Eurozone economy is performing impressively, profit growth is accelerating and margins are rising. This points to a period of outperformance for Eurozone stocks, at least in local currency terms. Standard valuation measures based on index data suggest that Eurozone stocks are cheap to the U.S. Nonetheless, the European market almost always trades at a discount, due to persistent lackluster profit performance. In Part II of our series on valuation, we approach the issue from a bottom-up perspective, utilizing the powerful analytics provided by BCA's exciting new Equity Trading Strategy (ETS) platform. The ETS software allows us to compare U.S. and European companies on a head-to-head basis and rank them based on a wide range of characteristics. The bottom-up approach avoids the problems of index construction. Investors can be confident that they will make money on a 12-month horizon by taking a position when the new bottom-up indicator reaches +/-1 standard deviations over- or under-valued, although technical information should be taken on board to sharpen the timing. The +/-2 sigma level gives clear buy/sell signals irrespective of fundamental or technical factors. Valuation alone does not justify overweight Eurozone positions at the moment, although we like the market for other reasons. The bottom-up valuation indicator will not replace our top-down version that is based on index data, but rather will be considered together when evaluating relative value. Total returns in the European equity market have bounced relative to the U.S. since 2016 in both local-currency and common currency terms (Chart II-1). However, this has offset only a tiny fraction of the dismal underperformance since 2007. In local currencies, the relative EMU/U.S. total return index is still close to its lowest level since the late 1970s. Compared with the pre-Lehman peak, the U.S. total return index is more than 96% higher according to Datastream data, while the Eurozone total return index is only now getting back to the previous high-water mark when expressed in U.S. dollars (Chart II-2). Chart II-1EMU Stocks Lag Massively... EMU Stocks Lag Massively... EMU Stocks Lag Massively... Chart II-2...Due To Depressed Earnings ...Due To Depressed Earnings ...Due To Depressed Earnings The yawning return gap between the two equity markets was almost entirely due to earnings as market multiples have moved largely in sync. Earnings-per-share (EPS) generated by U.S. companies now exceed the pre-Lehman peak by about 19%. In contrast, earnings produced by their Eurozone peers are a whopping 48% below their peak (common currency). This reflects both a slower recovery in sales-per-share growth and lower profit margins. Operating margins in Europe have been on the upswing for a year, but are still depressed by pre-Lehman standards. Margin outperformance in the U.S. is not a sector weighting story; in only 2 of 10 sectors do European operating margins exceed the U.S. The return-on-equity data tell a similar story. Nonetheless, a turning point may be at hand. Chart II-3Europe Trades At A Discount Europe Trades At A Discount Europe Trades At A Discount The Eurozone economy has been performing well, especially on a per-capita basis, and forward-looking indicators suggest that growth will remain above-trend for at least the next few quarters. U.S. profit margins have also been (temporarily) rising, but the Eurozone economy has more room to grow because there is still slack in the labor market. There is also more room for margins to rise in the Eurozone corporate sector than is the case in the U.S., where the profit cycle is further advanced. Traditional measures of value based on the MSCI indexes suggest that European stocks are on the cheap side. But are they really that cheap? Based on index data, Eurozone stocks trade at a hefty discount across most of the main valuation measures (Chart II-3). This is the case even for normalized measures such as price-to-book (P/B). However, Eurozone stocks have almost always traded at a discount. There are many possible explanations as to why there is a persistent valuation gap between these two markets, including differences in accounting standards, discount rates and sector weights. The wider use of stock buybacks in the U.S. also favors American stock valuations relative to Europe. But most important are historical differences in underlying corporate fundamentals. U.S. companies on the whole were significantly more profitable even before the Great Financial Crisis (Chart II-3). U.S. companies also tend to have lower leverage and higher interest coverage. Better profitability metrics in the U.S. are not solely an artifact of sector weighting either. RoE and operating margins are lower in Europe even applying U.S. sector weights to the European market.1 Why corporate Europe has been a perennial profit under-achiever is beyond the scope of this paper. U.S. companies reaped most of the benefit from productivity gains over the past 25 years, with the result that the capital share of income soared while the labor share collapsed. European companies were less successful in squeezing down labor costs. Measuring Value In the first part of our two-part Special Report on valuation, published in July 2016, we took a top-down approach to determine whether Eurozone stocks are cheap versus the U.S. after adjusting for different sector weights and persistent differences in the underlying profit fundamentals. A regression approach that factored in various profitability measures performed reasonably well, but the top-down "mechanical" approach that relied on a 5-year moving average provided the most profitable buy/sell signals historically. We approach the issue from a bottom-up perspective in Part II of our series, utilizing the powerful analytics provided by BCA's exciting new Equity Trading Strategy (ETS) platform. The software allows us to compare U.S. and European companies on a head-to-head basis and rank them based on a wide range of characteristics. The bottom-up approach avoids the problems of index construction when trying to gauge valuation across countries. The web-based platform uses over 24 quantitative factors to rank approximately 10,000 individual stocks in 23 countries, allowing clients to find stocks with winning characteristics at the global level. Users can rank and score individual equities to support a broad set of investment strategies and apply macro and sector views to single-name investments. The ETS approach has an impressive track record. Historically, the top-decile of stocks ranked using the "BCA Score" methodology have outperformed stocks in the bottom decile by over 25% a year.2 The BCA Score includes all 24 factors when ranking stocks, but we are interested in developing a valuation metric that provides valued added on its own and is at least as good as the top-down index-based measure developed in Part I. The five valuation measures in the ETS database are trailing P/E, forward P/E, price-to-book, price-to-sales and price-to-cash flow. We combine all of the Eurozone and U.S. companies that have total assets of greater than $1 billion into one dataset. The ETS platform then ranks the stocks from best to worst on a daily basis (i.e. cheapest to most expensive), using an equally-weighted average of the five valuation measures. The average score for U.S. stocks is subtracted from the average score for European stocks, and then divided by the standard deviation of the series. This provides a valuation metric that fluctuates roughly between +/- 2 standard deviations. Chart II-4 presents the resulting bottom-up indicator, along with our previously-published top-down valuation measure. A high reading indicates that European stocks are cheap to the U.S., while it is the opposite for low readings. Chart II-4Eurozone Equity Relative Valuation Indicators Eurozone Equity Relative Valuation Indicators Eurozone Equity Relative Valuation Indicators The underlying bottom-up data extend back to 2000. However, the bursting of the tech bubble in the early 2000's causes major shifts in relative valuation among sectors and between the U.S. and Eurozone that skew the indicator when constructed using the entire data set. We obtain a cleaner indicator when using only the data from 2005. As with any valuation indicator, it is only useful when it reaches extremes. We calculated the historical track record for a trading rule that is based on critical levels of over- and under-valuation. For example, we calculated the (local currency) excess returns over 3, 6, 12 and 24-month horizon generated by (1) overweighting European stocks when that market was one and two standard deviations cheap versus the U.S. market, and (2) overweighting the U.S. when the European market was one and two standard deviations expensive (Table II-1). Table II-1Value Indicator: Trading Rule Returns And Batting Average August 2017 August 2017 The trading rule returns were best when the indicator reached two standard deviations cheap or expensive, providing average returns of almost 11 percent over 12 months. The trading rule returns when the indicator reached +/-1 standard deviation were not as good, but still more than 3% on 12- and 24-month horizons. Table II-1 also presents the trading rule's batting average. That is, the number of positive excess returns generated by the trading rule as a percent of the total number of signals. The batting average ranged from 50% on a 3-month horizon to 68% over 24 months when buy/sell signals are triggered at +/- 1 standard deviation. The batting average is much higher (80-100%) using +/- 2 standard deviations as a trigger point, although there were only five months over the entire sample when the indicator reached this level. The charts and tables in the Appendix present the results of the same analysis at the sector level. The results are equally as good as the aggregate valuation indicator, with a couple of exceptions. European stocks are cheap to the U.S. in the Energy, Financials, and Utilities sectors, while U.S. stocks offer better value in Consumer Discretionary, Consumer Staples, Health Care, Industrials and Technology. Materials, Real Estate, and Telecommunications are close to equally valued. Sharpening The Buy/Sell Signals We then augmented the valuation analysis by adding information on company fundamentals, such as EPS growth and profit margins among others. The ETS software ranked the companies after equally-weighting the valuation and fundamental factors. However, this approach yielded poor results in terms of the trading rule. This is because, for example, when European stocks reach undervalued levels relative to the U.S., it is usually because the European earnings fundamentals have underperformed those of the U.S. companies. Thus, favorable value is offset by poor fundamentals, muddying the message provided by valuation alone. In contrast, adding some information from the technical factors in the ETS model does add value, at least when using +/-1 standard deviations as the trigger point for trades (Chart II-5). Excess returns to the trading rule rise significantly when the medium-term momentum and long-term mean reversion factors are included in the valuation indicator (Table II-2). The batting average also improves. Chart II-5Indicators: Value And Value With Technical Information Indicators: Value And Value With Technical Information Indicators: Value And Value With Technical Information Table II-2Value And Technical Indicator: Trading Rule Returns And Batting Average August 2017 August 2017 Adding technical information does not improve the trading rule performance when +/-2 sigma is used as the trigger point. Investment Conclusions Our new ETS platform provides investors with a unique way of picking stocks by combining top-down macro themes with company-specific information. It also allows us to develop valuation tools that avoid some of the pitfalls of index data by comparing stocks on a head-to-head basis. Historical analysis using a trading rule demonstrates that the new bottom-up valuation indicator provides real value to investors. We would normally evaluate its track record using stretching analysis, where we use only the historical information available at each point in time when determining relative value. However, the relatively short history of the available data precludes this test because we need at least a few cycles to best gauge the underlying volatility in the data. Still, investors can be fairly confident that they will make money on a 12-month horizon by taking a position when the bottom-up indicator reaches +/-1 sigma over- or under-valued, although technical information should be taken on board to sharpen the timing. The +/-2 sigma level gives clear buy/sell signals irrespective of the fundamental or technical factors. The bottom-up valuation indicator will not replace our top-down version that is based on index data, but rather will be considered together when evaluating relative value. At the moment, the top-down version proposes that European stocks are somewhat cheap to the U.S., while the bottom-up indicator points to slight overvaluation. Considering the two together suggests that valuation is close enough to fair value that investors cannot make the decision on value alone. Valuation indicators need to be near extremes to be informative. Our global equity strategists recommend overweighting Eurozone stocks versus the U.S. at the moment, although not because of valuation. Rather, the Eurozone economy and corporate earnings have more room to grow because of lingering labor market slack. This also means that the ECB can keep rates glued to the zero bound for at least the next 18 months while the Fed hikes, which will place upward pressure on the dollar and downward pressure on the euro. Mark McClellan Senior Vice President The Bank Credit Analyst Appendix: Trading Rule Returns By Sector Chart II-6, Chart II-7, Chart II-8, Chart II-9, Chart II-10, Chart II-11, Chart II-12, Chart II-13, Chart II-14, Chart II-15, Chart II-16. Chart II-6Consumer Discretionary Consumer Discretionary Consumer Discretionary Chart II-7Consumer Staples Consumer Staples Consumer Staples Chart II-8Energy Energy Energy Chart II-9Financials Financials Financials Chart II-10Health Care Health Care Health Care Chart II-11Industrials Industrials Industrials Chart II-12Materials Materials Materials Chart II-13Real Estate Real Estate Real Estate Chart II-14Utilities Utilities Utilities Chart II-15Technology Technology Technology Chart II-16Telecommunication Telecommunication Telecommunication 1 Please see The Bank Credit Analyst Special Report, "Are Eurozone Stocks Really That Cheap?" July 2016, available at bca.bcaresearch.com. 2 Please see Equity Trading Strategy Special Report, "Introducing ETS: A Top Down Approach to Bottom-Up Stock Picking," December 2, 2015, available at ets.bcaresearch.com. III. Indicators And Reference Charts Stocks continue to outperform bonds against a constructive backdrop of improving global economic prospects and accelerating EPS growth, while low inflation is expected to keep central banks from tightening quickly. Our main equity and asset allocation indicators remain bullish for risk, with a few exceptions. Our new Revealed Preference Indicator (RPI) jumped back to a 100% equity weighting in July. We introduced the RPI in last month's Special Report. Quite simply, it combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Our Willingness-to-Pay (WTP) indicators are also bullish on stocks for the U.S., Europe and Japan. These indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors often say they are bullish but remain conservative in their asset allocation. The U.S. WTP remains bullish, but has topped out, suggesting that flows into the U.S. market are beginning to moderate. In contrast, the WTP indicators for both the Eurozone and Japan are rising from a low level. This suggests that a rotation into these equity markets is underway, although it has not yet shown up in terms of equity market outperformance versus the U.S. On the negative side, our Monetary Indicator last month fell a little further below the zero line and our composite Technical Indicator appears to be rolling over; the latter generates a 'sell' signal when it drops below its 9-month moving average. Value is stretched, but our Valuation Indicator has not yet reached the +1 standard deviation level that indicates clear over-valuation. As highlighted in the Overview section, the U.S. and global earnings backdrop continues to support equity markets. Forward earnings estimates are in a steep uptrend, and the recent surge in the net revisions ratio and the earnings surprise index suggests that EPS growth will remain impressive for the remainder of the year. Bond valuation is largely unchanged from last month, sitting very close to fair value. We still believe that fair value is rising as economic headwinds fade. However, much depends on our forecast that core inflation in the major countries will grind higher in the coming months. Central banks stand ready to "remove the punchbowl" if they get the green light from inflation. The dollar's downdraft in July reduced some of its overvaluation based on purchasing power parity measures. The dollar appears less overvalued based on other measures. Our composite Technical Indicator has fallen hard, but has not reached oversold levels. This suggests that the dollar has more downside before it finds a bottom. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-10U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China

Highlights Trading The Yield Curve: Butterfly trades, going long or short a bullet versus a barbell, offer exposure to changes in the slope of the yield curve while remaining insulated from small parallel curve shifts. This will always be true provided that the cash allocation to the two bonds in the barbell is chosen to make the dollar-duration of the barbell equal to that of the bullet. Yield Curve Models: Using a model of the butterfly spread versus the slope, we can calculate how much curve steepening or flattening is being discounted by the current yield curve. Our strategy is to only implement a steepening/flattening butterfly trade if we think the curve will steepen/flatten by more than what is currently priced in. Empirical Performance: Incorporating the reading from our butterfly spread model improves on the performance of a purely macro-based yield curve trading strategy, both in theory and empirically. A purely mechanical trading rule based on our model also displays encouraging results over time. Feature One of the mandates of this publication is to take a view on the slope of the yield curve. Typically, we implement these views by recommending butterfly trades. A butterfly trade consists of two legs: A Barbell. Defined as a weighted combination of the two bonds that bound the yield curve segment you want to trade. For example, to take a view on the 2/10 slope, the barbell leg of the trade would be a weighted combination of the 2-year and 10-year notes. A Bullet. Defined as a bond that sits near the middle of the yield curve segment you want to trade. For example, the 5-year note would be a good choice for the bullet leg of a trade designed to profit from shifts in the 2/10 slope. A butterfly trade is defined as going long either the bullet or barbell while simultaneously shorting the other. This provides exposure to the slope of the curve because bullets tend to outperform barbells when the yield curve steepens and vice-versa (Chart 1 on page 1). Chart 1Gain Curve Exposure Through Butterfly Trades Gain Curve Exposure Through Butterfly Trades Gain Curve Exposure Through Butterfly Trades In this Special Report, we explain why butterfly trades are the best way to gain exposure to changes in the slope of the yield curve. We also explain how we think about the trade-off between our macro-informed view of whether the yield curve will steepen or flatten and how much steepening/flattening is already discounted in the market. To determine what is discounted in the market we rely on fair value models of the butterfly spread, which are also described in this report.1 Note: In the remainder of this report we focus exclusively on the 2/10 slope of the curve and the 2/5/10 butterfly spread, although the logic of butterfly trades applies to any yield curve segment. We will explore different yield curve segments in future reports. The Mechanics Of Butterfly Trades The first choice that must be made when implementing a butterfly trade is how to weight the two bonds used in the barbell. The chosen weighting scheme depends on what sort of curve movement you want to profit from. For our purpose, which is to gain exposure to changes in the slope of the yield curve while remaining insulated from parallel shifts, we adopt a dollar duration (DV01)2 weighting scheme. In this weighting scheme, the barbell weights are set so that the DV01 of the bullet leg of the trade matches the DV01 of the barbell. Table 1 presents an illustrated example of how this works. Table 1Butterfly Trade Performance Illustrated Bullets, Barbells And Butterflies Bullets, Barbells And Butterflies The top half of Table 1 shows an example based on hypothetical bonds derived from the Federal Reserve's par coupon constant-maturity yield curve. By definition, each of these hypothetical bonds trades at par ($100) and we use that fact along with the par coupon yield to calculate each bond's duration. After calculating the DV01 for each hypothetical bond by multiplying its duration by its price and dividing by 104, we can calculate that placing 40% of the barbell's cash in the 10-year note and 60% in the 2-year note leads to identical DV01's in both the bullet and barbell. Shocking The Yield Curve Identical DV01's in each leg of the trade means that if we go long one leg and short the other, our butterfly trade is immune to small parallel shifts in the yield curve. This is shown in the sixth column of Table 1, where we see that a +1 basis point parallel shift in the curve results in a loss of $0.0475 in both the bullet and barbell. It should be noted that this immunization from parallel curve shifts only works for small changes in yields. This is because while we have matched the DV01 between each leg of the trade, we have not matched the convexity. In this weighting scheme the barbell will always have a greater convexity than the bullet and will outperform in the event of a large parallel curve shift (in either direction). However, large parallel curve shifts are quite rare in practice. Usually, big yield moves are associated with either a steepening or a flattening of the curve. As such, convexity differences are only a minor consideration when we recommend butterfly trades. While the DV01 of each leg of the trade is the same, within the barbell itself there is a mismatch between the 2-year and 10-year notes. The fifth column of Table 1 shows that the weighted DV01 contribution to the barbell is $0.0117 from the 2-year note and $0.0357 from the 10-year note. The greater "weighted DV01" means that the barbell is more sensitive to changes in the 10-year yield than to changes in the 2-year yield. It is this mismatch that gives the butterfly trade exposure to the slope of the curve. For example, column 7 of Table 1 presents a scenario where the curve steepens by a small amount. Specifically, the 10-year yield rises 1 bp, the 2-year yield falls 1 bp and the 5-year yield remains flat. In this scenario, the losses in the 10-year note more than offset the gains in the 2-year note, causing the barbell to underperform the bullet. The opposite scenario is presented in column 8, which shows that the barbell outperforms the bullet when the curve flattens. The bottom half of Table 1 replicates the same analysis using the current on-the-run 2-year, 5-year and 10-year notes instead of hypothetical par bonds. It shows that the same logic and methodology apply in both cases. Bottom Line: Butterfly trades, going long or short a bullet versus a barbell, offer exposure to changes in the slope of the yield curve while remaining insulated from small parallel curve shifts. This will always be true provided that the cash allocation to the two bonds in the barbell is chosen to make the dollar-duration of the barbell equal to that of the bullet. Modeling The Butterfly Spread Often, it is not sufficient to just know whether the curve will steepen or flatten and then put on the appropriate butterfly trade. In an efficient market the butterfly spread (defined in this report as the yield on the bullet minus the yield on the DV01-matched barbell) should adjust to expected changes in the slope of the curve so that no excess profits can be earned. We see evidence for this in the bottom panel of Chart 1 on page 1. Here, the 2/5/10 butterfly spread widens as the 2/10 slope steepens and vice-versa. The logic of this relationship depends on mean reversion. As the curve steepens investors start to discount a greater probability of curve flattening in the future. This means that investors will also demand greater compensation to enter steepener trades (long bullet, short barbell) as the curve steepens. We can take advantage of this positive relationship between the slope of the curve and the butterfly spread by creating a fair value model (Chart 2). The model is simply a regression of the 2/5/10 butterfly spread on the 2/10 Treasury slope. Chart 22/5/10 Butterfly Spread Fair Value Model 2/5/10 Butterfly Spread Fair Value Model 2/5/10 Butterfly Spread Fair Value Model We tested the model using many different time intervals and settled on a regression coefficient of 0.14. As shown in Chart 3, the coefficient has been reasonably close to 0.14 for most of its history, with the exception of the period immediately following the financial crisis when the fed funds rate was pinned at the zero-lower-bound. The zero-lower-bound caused the relationship between the butterfly spread and the slope to weaken dramatically, but it began to re-assert itself once the Fed started to lift rates at the end of 2015. At present, the coefficient from a 3-year trailing regression is 0.17. Chart 3Choosing The Right Beta Choosing The Right Beta Choosing The Right Beta What's Priced Into The Curve? One obvious application of our fair value model is that we can identify periods when the butterfly spread is too high or too low relative to the slope of the curve. Put differently, when the butterfly spread's deviation from fair value is above zero, the bullet looks attractive relative to the barbell. When the deviation from fair value is below zero, the barbell looks attractive compared to the bullet. However, if we make a few simplifying assumptions, we can express the model's deviation from fair value in a more helpful way. If we assume that: The butterfly spread will revert to its fair value during the next 6 months During this time period returns to the bullet and barbell legs of the trade will be equal3 Then we can calculate how much the slope of the curve must change to satisfy both conditions. In other words, we can answer the question of what change in the slope is being discounted by today's butterfly spread. Chart 4How Our Models Add Value How Our Models Add Value How Our Models Add Value The third panel of Chart 2 shows the change in the 2/10 slope that is currently being discounted by the butterfly spread. The bottom panel shows the level of the slope that is implied by the model compared to the actual 2/10 slope. A recent example of why it's important to consider what is priced into the curve is shown in Chart 4. Last December 20,4 we recommended entering a butterfly trade that is long the 5-year bullet and short the 2/10 barbell, a trade designed to profit from curve steepening. Since then, however, the 2/10 slope has flattened 44 bps. Despite the curve flattening, our recommended trade is 21 bps in the money. The reason is that, according to our model, on December 20 the butterfly spread was discounting a whopping 49 bps of flattening during the next 6 months. Significantly more flattening than what actually occurred. We continue to recommend this trade going forward, even though the curve is now already priced for 6 bps of 2/10 steepening during the next six months. This means that we will need the yield curve to steepen more than 6 bps for our trade to outperform. We continue to see this as the most likely outcome.5 Bottom Line: Using a model of the butterfly spread versus the slope, we can calculate how much curve steepening or flattening is being discounted by the current yield curve. Our strategy is to only implement a steepening/flattening butterfly trade if we think the curve will steepen/flatten by more than what is currently priced in. Empirical Testing Charts 5 and 6 illustrate the importance of relying on both a macro call about the slope of the curve and the reading from our butterfly spread model. In Chart 5 we plot 6-month excess returns in the 5-year bullet over the 2/10 barbell versus the 6-month change in the 2/10 slope. While we see a reasonably strong positive correlation, there are still many periods of steepening when the bullet underperforms and many periods of flattening when the barbell underperforms. Chart 5Performance Of A Bullet Over Barbell Strategy Vs. ##br##The Actual Change In The 2/10 Nominal Treasury Slope Bullets, Barbells And Butterflies Bullets, Barbells And Butterflies Chart 6Performance Of A Bullet Over Barbell Strategy Vs. The Difference Between ##br##Actual And Discounted Change In The 2/10 Nominal Treasury Slope Bullets, Barbells And Butterflies Bullets, Barbells And Butterflies Chart 6 plots the same 6-month excess return, but this time against the difference between the actual change in the 2/10 slope and what was priced-in according to our model. Here we observe a much stronger correlation and fewer examples of the butterfly trade not performing as expected. Going one step further, Table 2 shows the results of implementing butterfly trades over 6-month horizons assuming perfect knowledge of how the yield curve will move. The first row shows that, during our sample period, a long 5-year bullet, short 2/10 barbell trade produced positive returns 71% of the time when the 2/10 slope steepened, for an average un-levered 6-month return of 34 bps. Similarly, long 2/10 barbell, short 5-year bullet trades produced positive returns 71% of the time when the 2/10 slope flattened, for an average un-levered 6-month return of 24 bps. Table 2Performance Of Butterfly Trades Over 6-Month Horizons ##br##Assuming Perfect Knowledge Of Curve Movements (1976-Present) Bullets, Barbells And Butterflies Bullets, Barbells And Butterflies The bottom two rows of Table 2 show that the performance of these trades improves when we also incorporate the reading from our model, only putting on trades when the steepening or flattening is greater than what was initially priced in. In fact, incorporating the output from our butterfly spread model led to 128 instances when we would have reversed the trade that would have been implemented if all we knew was which direction the slope would move. Out of those 128 instances, 60% of the time the change led to a better trade. Cumulatively, incorporating the reading from the model produced an extra return of more than 11% throughout our entire sample. Can We Just Follow The Model? This begs the question of whether we can create a mechanical trading rule based purely on the output from our butterfly spread model that will produce positive results. To test this we first look at excess returns in the 5-year bullet over the 2/10 barbell in 6-month periods following different readings from our model (Table 3). Table 3Performance Of Butterfly Trades Over 6-Month ##br##Horizons Based Only On Our Model (1976-Present) Bullets, Barbells And Butterflies Bullets, Barbells And Butterflies We find that bullets outperform barbells in more than 70% of 6-month periods when the 5-year bullet appears more than 5 bps undervalued. Similarly, barbells outperform in 56% of 6-month periods when the 2/10 barbell is more than 5 bps undervalued. Second, we created a trading rule where every month you invest either: Chart 7A Model-Driven Curve Trading Strategy A Model-Driven Curve Trading Strategy A Model-Driven Curve Trading Strategy 100% in the 5-year bullet, if the bullet appears more than 5 bps cheap on our model. 50% in the 5-year bullet and 50% in the 2/10 barbell, if the bullet is between 5 bps expensive and 5 bps cheap compared to the barbell. 100% in the 2/10 barbell, if the barbell appears more than 5 bps cheap on our model. The cumulative results from this model since 1980 relative to a curve-neutral benchmark that is always invested 50% in the bullet and 50% in the barbell are shown in Chart 7. We observe a clear outperformance over time, with relatively few periods of sustained losses. Bottom Line: Incorporating the reading from our butterfly spread model improves on the performance of a purely macro-based yield curve trading strategy, both in theory and empirically. A purely mechanical trading rule based on our model also displays encouraging results over time. Going forward we will consider both the output from our butterfly spread model and our macro view of the yield curve when recommending butterfly trades. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 These models were first introduced in a Global Fixed Income Strategy Special Report from February 1, 2002. Please contact your sales representative to request a copy. 2 DV01 is the dollar value of a basis point. It measures the dollar change in the price of a given bond assuming a one basis point change in its yield. It is calculated as the bond's duration times its price, divided by 104. 3 A 6-month time period was arbitrarily chosen to line up with our preferred investment horizon. We also need to assume how much of the discounted shift in the yield curve occurs at the long-end relative to the short-end. We assume that half the change in slope occurs at each maturity, but the results are not very sensitive to changing this assumption. 4 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 5 For further details on our macro outlook for the yield curve please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com