BCA Indicators/Model

Highlights BCA's Central Bank Monitors support the case for less stimulus. Yellen's "dovish" testimony does not change our Fed call. The BCA Beige Book Monitor and related indicators support our view on the economy and Fed. Maximum central bank policy divergence has not been reached. Too early to predict Trump's replacement for Yellen. Now that economic surprise index has bottomed, risk assets can outperform as the metric mean reverts. Some wage measures are accelerating as the economy approaches full employment. Feature Chart 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 Global bond investors were shocked in June when central bankers announced at the ECB's Forum on Central Banking what appeared to be a global recalibration of monetary policy. Until that time, investors had been lulled into a false sense of security that growth headwinds would prevent the Fed from hiking by more than once a year and keep the other major central banks on hold "indefinitely." The heads of the Bank of England (BoE), the Bank of Canada (BoC) and the Riksbank all took a less dovish tone, as they signaled less need for ultra-stimulative policies because the threat of deflation had diminished. Together with some better-than-expected U.S. economic data, this shift in tone led to a sharp sell-off in global bond markets (Chart 1). The BoC followed up last week by kicking off a prolonged tightening cycle. The central bank now expects the Canadian economy to reach full employment and hit the BoC's inflation targets by mid-2018, which is much earlier than expected. The global bond mini-rout actually began before the ECB Forum, when the ECB President gave a very upbeat description of the underlying strength of the Euro Area economy. BCA's Global Fixed Income Strategy service highlights that the Euro Area 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. Draghi's comments confirm that the ECB will announce this fall that a further tapering of its asset purchase program will take place in early 2018. The message that "emergency" levels of monetary accommodation are no longer needed is confirmed by our Central Bank Monitors (CB), which measure pressure on central bankers to raise or lower interest rates (Chart 2). The Monitors became less useful when rates hit the zero bound and quantitative easing became popular, but the measures are relevant again. All of our CB Monitors are in "tighter policy required" territory except for Japan (although even that one appears on the verge of breaking above the critical zero line). The Monitors have been rising due more to their growth than their inflation components. Bond investors may be startled by the ECB's posture because inflation remains well below target in all the major economies except the U.K. What is most worrying is the recent deceleration in U.S. inflation, where the economy is very close to or at full employment. Almost all of the major central banks point to temporary factors that will soon fade, which would allow inflation to escalate toward the target. Our Aggregate Inflation 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 3). 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 2All In The "Tighter Policy Required" Zone All In The "Tighter Policy Required" Zone All In The "Tighter Policy Required" Zone Chart 3BCA Aggregate Inflation Indicators BCA Aggregate Inflation Indicators BCA Aggregate Inflation Indicators These and other indicators support our view that core consumer price inflation will grind higher in the coming months in most of the advanced economies, including the U.S. Admittedly, all models and indicators have been poor predictors of inflation in this recovery. Nonetheless, historical relationships might begin to re-establish now that capacity utilization is rising and labor market slack has moderated significantly. Did Yellen Turn Dovish? June's FOMC minutes indicated that the consensus among Fed policymakers is willing to "look through" low inflation and maintain the current timetable on rate hikes. Yellen's Congressional testimony last week 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." The Fed asserts there are two neutral interest rates: short-term and long-term. Yellen argued that the actual policy rate is close to the short-term 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 Chair is at risk of confusing investors by discussing the concept of two neutral rates, although this may have been to head off demands by some Congressional lawmakers that the Fed should follow a mechanical policy rule when setting policy (such as the Taylor Rule). Nonetheless, the important point is that Yellen is not saying that the actual policy rate is close to the peak for the cycle. Yellen's testimony has not altered our Fed call for this year: balance sheet runoff beginning in the fall, 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. We expect more rate hikes in 2018/19 than are discounted in the bond market. That said, the soft June CPI data challenges our view that inflation will move higher in the second half. The bottom line is that the backdrop has turned decidedly 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. Global bond yields have already taken a step up in recent weeks, but they will have to rise further to catch up with the solid pace of global growth and diminishing economic slack. Duration should be kept short. The Beige Book: Another Inflation Anomaly The Beige Book released on July 12 supports the Fed's base case outlook for the economy and inflation. It also keeps the Fed on track to begin to trim its balance sheet in September and boost rates by another 25 basis points in December. Our quantitative approach2 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 4). Chart 4Beige Book Monitors Support Fed's Outlook##BR##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 At 62%, the BCA Beige Book Monitor remained near its cycle highs in July, providing more confirmation that the economy rebounded in Q2 after a desultory Q1. The July 12 Beige Book covered the period from late May through June 30. Based on the Beige Book, the dollar should not be much of an issue in Q2 earnings season. The greenback seems to have faded as a concern for small businesses and bankers, which is in sharp contrast to 2015 and early 2016 when mentions of a strong dollar in the Beige Book surged. The Q2 earnings reporting season will provide corporate managements with another forum to express their views of currency impact on their operations. Business uncertainty over government policy (fiscal, regulatory and health) remained elevated in the most recent Beige Book (not shown). The implication is that the business community is mindful of the lack of progress by Washington policymakers on Trump's agenda. Our analysis of the Beige Book also shows that real estate was still stout as Q2 ended. This implies that both residential and commercial real estate, the former a source of strength in Q1, will add to growth again in Q2. Moreover, the latest reading on the BCA Real Estate Monitor further widened the gap between the BCA Beige Book Real Estate Monitor and the relative performance of REITS to the S&P 500. Nonetheless, BCA's U.S. Equity Strategy service recently downgraded REITS to neutral,3 citing our expectation of higher Treasury yields, modest rent growth, some cracks in CRE credit quality, and tightening standards for bank lending in the CRE marketplace. 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. Inflation words hit a new peak in July, in sharp contrast with the recent 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 move higher in the coming months, supporting a gradual removal of policy accommodation. Uncertainty in Washington is distressing, but worries over the dollar seem to be fading. Max Policy Divergence Has Not Been Reached What about the dollar? Tighter Fed policy is dollar-bullish on its own, but some of the major central banks are also starting to remove the monetary punchbowl as well. Recent dollar action suggests that investors have decided that the peak Fed/ECB policy divergence is now behind us. We do not agree. The ECB may be tapering, but raising interest rates is a long way off because there is still a lot of economic slack in the Eurozone. In contrast, the Fed is increasingly concerned that allowing the unemployment rate to fall further below its estimate of full-employment risks too large an overshoot of the 2% target. We still believe that market pricing for the fed funds rate is too benign. 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. The major exception is the Canadian dollar, which we expect to appreciate versus the greenback. Does Gary Cohn Have What It Takes? A key wildcard in the financial outlook is the Fed Chair's replacement. Yellen's term as Chair will end in February 2018 and the markets have not yet shown any concerns about her potential replacement. The current frontrunner is Gary Cohn, the Chairman of President Trump's National Economic Committee; his appointment would conform to some historical precedents but violate others. Our March 6 Weekly Report4 provides a list of potential Fed appointees and also provides some background on the potential for the Fed to become more politicized under Trump. Since the late 1970s, Presidents have selected the Fed Chair based on their trust relationship with a candidate. Arthur Burns (Chair from 1970-1978) was the head of President Eisenhower's Council of Economic Advisors (CEA) and was a special counselor to President Nixon. William Miller (1978-1979) worked for the presidential campaigns of Hubert Humphrey and Jimmy Carter. Alan Greenspan (1987-2006) served as the Chair of President Reagan's Social Security Commission in the early 1980s, was the Chair of President Ford's CEA and advised President Nixon's campaign in 1968. Ben Bernanke (2006-2014) was George W. Bush's chief economist in 2005 and 2006 before Bush chose him to lead the Fed. Janet Yellen (2014-present) was Chair of Bill Clinton's CEA in the late 1990s, when she worked with many of Obama's economic team members. Paul Volcker (1979-1987) was the lone exception to this rule; he worked for Nixon, but not Carter, before becoming Fed Chair (Table 1). Table 1Characteristics Of Fed Chairs Since 1970 Global Monetary Policy Recalibration Global Monetary Policy Recalibration Cohn does not have any experience as a central banker, but that does not preclude him from holding the position. Volcker, Bernanke and Yellen, all held posts in the Federal Reserve System before their appointments as Chair. However, Miller was an outside director for the Boston Fed, and Burns and Greenspan had no prior experience at the monetary authority. Party identification is one area where Gary Cohn would stand out. Since at least 1970, the party affiliation of a new Fed Chair has matched that of the President. However, Presidents have crossed party lines to reappoint sitting Fed Chairmen to additional terms. Volker, Greenspan and Bernanke were reappointed to lead the Fed by Presidents from opposing political parties. The timing of Trump's announcement on Yellen's replacement may be critical. In the summer of 2013, names were already being floated by the Obama White House (and mainly rejected) by markets, before he finally settled on Yellen. The official announcement came in early October 2013. In August 2009, President Obama reappointed Bernanke for a second four-year term. Bernanke was initially nominated to be Fed Chair by George W. Bush in October of 2005. If the appointment comes in October and the nominee is perceived to be hawkish, the risk is that markets may begin to price in the regime change sometime in the next few months. Our U.S. Bond Strategy service argued in a recent report5 that rate hike expectations may already be ramping up, while the data on the economy and inflation begin to beat expectations again. Bottom Line: It is too early for the markets to be concerned about the next Fed Chair and their policies. The names mentioned in the summer may not be the ones offered the job in the fall. Surprise Index Finally Bottomed Out The June employment report marked a turning point for the Citigroup surprise index, following an extended period of disappointment that depressed the dollar and bond yields. The June reports on CPI and retail sales were disappointing, but June industrial production exceeded expectations. What does this mean for relative asset returns? After 86 days, expectations moved low enough to allow economic reality to begin to run ahead. It took as few as 8 business days (in 2009) and as many as 164 (2015) for the surprise index to return to the zero line, an average of 52 days (Chart 5). Chart 5Risk Assets Tend To Outperform As Economic Surprise Index Rebounds Risk Assets Tend To Outperform As Economic Surprise Index Rebounds Risk Assets Tend To Outperform As Economic Surprise Index Rebounds Mean-reversions in the surprise index following troughs have generally been good for risk assets in this recovery (Table 2). We have identified 11 periods since late 2009 when the surprise index bottomed out and then moved up toward zero. In 8 of those episodes, the total return on stocks was higher than 10-year Treasuries. Equities beat Treasuries by an average of 286 bps across all 11 periods, with a median outperformance of 400 basis points. Table 2U.S. Financial Market Performance As Economic Surprise Index Rises Global Monetary Policy Recalibration Global Monetary Policy Recalibration The total return on investment-grade corporate debt outperformed Treasuries in 6 of 11 episodes. In those six instances, investment grade credit outperformed on average by 132 bps. Nonetheless over all 11 episodes, the excess return was 0%. In contrast, high-yield bonds beat Treasuries in 7 of the 11 periods, with a median outperformance of 188 basis points. Similarly, small caps beat large caps 72% of the time as the economic surprise index moved back toward the zero line. The median outperformance of small over large in all 11 periods was 124 basis points. The performance of commodities was mixed as economic surprises climbed. Gold rose in 6 of the 11 times, but fell in 5. Oil prices posted increases in only 5 of the 11, but the median return for oil after economic surprise bottomed was -2.7%. Bottom Line: Economic expectations that ramped up post-election have now declined and allowed the economic surprise index to trough. The implication for investors is that risk assets tend to outperform as the economic surprise index moves back to zero. This supports our tactical views of stocks over bonds, small over large caps, and credit over Treasury. What's Up With Wages? The June jobs report released in early July6 only added to the market's fears that the Phillips Curve is dead because wage growth softened even as the labor market tightened. Unfortunately, no Fed officials including Yellen have addressed the topic in depth recently. The market does not believe the Fed when it says that the tighter labor market is pushing up wages. We see it another way. Chart 6 shows that wage inflation has accelerated since mid-to-late 2012, but some measures of wages have made more progress than others. Chart 7 and Chart 8 reinforce that, setting aside the rollover in average hourly earnings (AHE), wage inflation is accelerating, albeit modestly. Chart 6Plenty Of Signs That##BR##Wages Are Accelerating Plenty Of Signs That Wages Are Accelerating Plenty Of Signs That Wages Are Accelerating Chart 7Compositional Effects Do Not##BR##Explain Recent Rollover Compositional Effects Do Not Explain Recent Rollover Compositional Effects Do Not Explain Recent Rollover Chart 8Acceleration In Hours Worked Should##BR##Lead To Faster Wage Growth Acceleration In Hours Worked Should Lead To Faster Wage Growth Acceleration In Hours Worked Should Lead To Faster Wage Growth The Employment Cost Index (ECI) excluding bonuses (Chart 6, panel 1) is our favorite measure of labor compensation. It has accelerated steadily since 2010. It adjusts for compositional changes in the labor market (unlike the average hourly earnings measure) and is the broadest and most comprehensive wage metric. Its drawbacks are that it is released with a long lag. For example, the Q2 ECI data will not be released until the end of July. The AHE data is already available for June and Q2. On the other hand, unit labor costs (ULC) (panel 2) have stagnated for the past five years. Data starts in 1947, so it has the most history of any of the wage measures. However, it is even more delayed than the ECI: it is released five weeks after the end of the quarter. Moreover, these data are subject to revisions and tend to be more volatile than other wages measures, which makes it difficult to identify a change in trend. Productivity, which is used to construct ULC, is also very difficult to estimate. A recent BIS report7 notes that there is evidence that the relationship between ULC and labor market slack has diminished over time, but that ULC is a better measure of inflationary pressures than AHE. Median usual weekly earnings (panel 3) have also accelerated. This is not a pure wage measure; it combines hourly pay and hours worked and, therefore, is a good proxy for incomes. Income growth has picked up the pace, providing a solid underpinning for consumer spending. Panel 4 shows compensation per hour worked. It, too, has stalled and is subject to the same strengths and weakness as ULC because it is part of the quarterly Productivity and Costs report. This metric has run near 2% with no trend. Finally, average hourly earnings (panel 5) have sped up since 2012, but rolled over in late 2016. This wage gauge gets most of the market's attention although it is only one of many measures that the Fed watches. AHE is a timely data set, released alongside monthly payroll numbers. It includes average earnings of private non-farm production and non-supervisory positions. The major disadvantage of this measure is that hourly wage earners represent only about 58% of workers and do not account for trends in salaried jobs. Earnings do not include bonus pay or employee benefits. The data are available beginning only in 2006. In Chart 7, we created an "equally-weighted" AHE measure to adjust for shifts in the composition of the labor market, but we found that the recent deceleration is not linked to compositional effects. Since wage growth bottomed out in late 2012, the compositional shifts slightly lowered wage inflation on average, but the growth rates today are roughly the same. The Atlanta Fed wage tracker (not shown) is in a distinct uptrend. The Tracker has the advantage that it is not biased by compositional shifts. Chart 8 shows our update to a study by the Kansas City Fed8 that found only a few industries (mostly in the goods-producing sector of the economy) have accounted for most of the rise in wages, notably manufacturing, construction and wholesale trade. Financial services, retail, professional and business services, and leisure and hospitality - all service sector industries - were the laggards. The report shows that although earnings growth has fallen behind in service-oriented industries since 2015, hours worked have seen faster growth than in the goods-producing sector. We concur with the author that labor demand was strong in the past few years in areas that have not experienced much wage growth. As the labor market continues to tighten, wages in these industries may accelerate, but patience will be required. Bottom Line: The various measures of wage inflation provide a mixed picture. Taken as a group, however, we believe that wage growth has indeed accelerated as the labor market has tightened. The acceleration has admittedly been modest, but it is only recently that unemployment reached a full employment level. The real test for the Phillips curve will be in the coming quarters as the economy moves further into "excess labor demand" territory. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see BCA's 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 U.S. Investment Strategy Weekly Report "The Great Debate Continues", dated April 17, 2017. Available at usis.bcaresearch.com. 3 Please see U.S. Equity Strategy Weekly Report "SPX 3000?, dated July 10, 2017. Available at uses.bcaresearch.com. 4 Please see U.S. Investment Strategy Weekly Report "Trump And The Fed", dated March 6, 2017. Available at usis.bcaresearch.com. 5 Please see BCA's U.S. Bond Strategy Weekly Report "Summer Snapback", dated July 11, 2017. Available at usbs.bcaresearch.com 6 Please see U.S. Investment Strategy Weekly Report "Sizing up the Second Half", dated July 10, 2017. Available at usis.bcaresearch.com. 7 Monetary policy: inching towards normalization", Bank for International Settlements (BIS), 25 June 2017. 8 Wage Leaders and Laggards: Decomposing The Growth In Average Hourly Earnings", Willem Van Zandweghe, Federal Reserve Bank of Kansas City, February 15, 2017.

Highlights Portfolio Strategy The energy bear market is drawing to a close. Lift exposure to above benchmark. Firming refining operating conditions, at the margin, suggest that it no longer pays to underweight this energy sub-group. Book gains and lift to neutral. Softening profit fundamentals are weighing on the real estate outlook. Trim REITs to neutral. Recent Changes S&P Energy - Lift to overweight. S&P Oil & Gas Refining & Marketing - Upgrade to neutral, lock in profits of 14.3%. S&P Real Estate - Trim to neutral and remove from high-conviction overweight list. Table 1 SPX 3,000? SPX 3,000? Feature Equities wrestled to hold on to gains last week, fighting a spike in geopolitical tensions, synchronized global central bank hawkish rhetoric and sector rotation. Investors continued to shed tech stocks in favor of financials, pushing our recently initiated long financials/short tech pair trade return near double digits. Our view remains that a rotational correction is the dominant market theme. Nevertheless, on the eve of earnings season, profits will soon take center stage and serve as a catalyst for the overshoot equity phase to resume. Our sense is that before the end of the business cycle, there are high odds that the S&P 500 will hit the 3,000 mark. That does not mean it will be a straight line advance from here. Garden variety 5-10% corrections are all but inevitable. Rather, our point is that before the next recession hits late in the decade, the SPX can attain 3,000. How did we come up with this figure? We derived the S&P 500's peak cycle value using three different methods: Dividend Discount Model (DDM) Forward P/E and EPS growth sensitivity analysis Equity Risk Premium (ERP) Table 2SPX Dividend Discount Model SPX 3,000? SPX 3,000? Table 2 shows our DDM on the S&P 500. It assumes healthy dividend growth in 2017 and 2018. Our expectation of a 2019 recession drives a steep decline in dividends that year, followed by a slow climb in 2020 and 2021, in line with the 2009-2011 experience (Chart 1). 2022 is our terminal year when dividend growth settles at 6.6%, close to the long-term average. Our discount rate assumes a 3.2% 10-year Treasury yield and a 5% equity risk premium (the past decade's average, Chart 2). This discount rate mirrors the historical average corporate junk bond yield. This valuation model delivers an S&P 500 value of 2904. Chart 1Joined At##br## The Hip Joined At The Hip Joined At The Hip Chart 2FX10 ERP And The Economy##br## Are Inversely Correlated ERP And The Economy Are Inversely Correlated ERP And The Economy Are Inversely Correlated Alternatively, we examine the S&P 500's sensitivity to EPS growth rates and forward valuation multiples. If we use the street's 160.8 (or 10.6% implied CAGR) S&P 500 2019 EPS estimate and assign the current 12-month forward multiple as a starting point, Table 3 shows an S&P 500 value of just under 3,000. Downside risks look limited. Using this EPS forecast, even a 2-turn multiple contraction results in the S&P 500 appreciating 10% from here. Table 3SPX EPS & Multiple Sensitivity SPX 3,000? SPX 3,000? Lastly, a conservative ERP analysis reveals that SPX 3,000 is a realistic peak cycle estimate. Our assumptions include: a 200 bps ERP, a 3.2% 10-year Treasury yield and 160.8 SPX EPS. These assumptions result in an S&P 500 value of slightly over 3,000. How do we justify a decline in the ERP from its current level of 338 bps to our assumed 200 bps? G10 central banks are no longer putting out GFC-related fires; in fact, a slew of them are briskly turning from dovish to hawkish following the Fed's lead (Chart 3). As a result, a sustained decline in the ERP should follow as interest rates rise. Chart 3G10 Central Banks Map SPX 3,000? SPX 3,000? Chart 4Negative Correlation Is Re-Established Negative Correlation Is Re-Established Negative Correlation Is Re-Established The bottom panel of Chart 2 drives this point home. Since the history of SPX forward EPS data, the year-over-year change in the ERP has been almost perfectly inversely correlated with the ISM manufacturing index, i.e. an improving economy is synonymous with a receding ERP and vice versa. Lastly, keep in mind that a 200 bps ERP is still significantly higher than the 80 bps mean ERP that prevailed in the 1998-2007 decade (middle panel, Chart 2). The depreciating greenback is another source of support for our SPX 3,000 view. The yearlong positive correlation between the U.S. dollar and commodities has likely come to an end and the three plus decade inverse correlation has been re-established (Chart 4). As the cycle matures and enters its late stages, commodities and resource-related equities tend to pick up steam as profits rebound. Even energy stocks may catch a bid. Buy Energy Stocks... Energy equities are down roughly 20% year-to-date versus the broad market. In fact, the energy sector has broken down to a level last seen in 2004, when oil traded near $30/bbl (Chart 5). The three main culprits have been rising U.S. shale oil production, inventory accumulation, and investor doubts about whether all nations will comply with OPEC's mandated production cuts. While going overweight the energy space has been a "widow maker" trade recently, we are now tempted to take a punt on the S&P energy sector from the long side. There are tentative signs that this relative performance bear phase is drawing to a close. Three main drivers support our modestly sanguine view of energy stocks. First, as we mentioned above, the inverse correlation between the U.S. dollar and the commodity complex has been re-established after a one-year hiatus. Synchronized global growth suggests that a corresponding tightening interest rate cycle is brewing (Chart 3). Thus, there are high odds that a number of G10 central banks will hike rates later this summer or early this fall, now that the Fed has paved the path.1 As long as the greenback drifts lower, even energy stocks should catch a bid (Chart 6). Chart 5Crude Oil... Crude Oil... Crude Oil... Chart 6...And The Dollar Say Buy Energy Stocks ...And The Dollar Say Buy Energy Stocks ...And The Dollar Say Buy Energy Stocks Second, on the domestic operating front, the steepest drilling upcycle in recent memory is showing signs of fatigue. Baker Hughes reported the first weekly decline in 24 weeks in the oil rig count for the week ending June 30th. At least a modest deceleration in shale oil production is likely. Encouragingly, Cushing crude oil inventories are contracting on a year-over-year basis and OECD oil stocks appear poised to contract in late autumn/early winter (Chart 7). Predicting OPEC's compliance is tricky. However, BCA's Commodity & Energy Strategy service believes that little to no cheating will occur and in a worst case scenario Saudi Arabia will step in and curtail production were Libya and/or Iraq to pump oil above quota. Finally, our S&P energy sector Valuation Indicator has gravitated back to the neutral zone. Technicals are also washed out with our Technical Indicator breaching one standard deviation below its historical mean, a level that typically heralds a reversal (Chart 8). Recent anecdotes that the sell-side is throwing in the towel on their bullish oil forecasts for the remainder of the year are also contrarily positive. Chart 7Improving Supply Dynamics Improving Supply Dynamics Improving Supply Dynamics Chart 8S&P Energy Unloved And Fairly Valued Unloved And Fairly Valued Unloved And Fairly Valued Our newly introduced S&P energy sector relative EPS model encapsulates this cautiously optimistic industry backdrop (Chart 9). Simultaneously, the budding recovery in our S&P energy Cyclical Macro Indicator also signals that profits should best those of the overall market (second panel, Chart 8), giving us comfort to lift the S&P energy sector to a modest overweight position. ... As Refiners Are No Longer Cracking Under Pressure We are executing the upgrade to overweight in the broad energy sector via booking gains of 14.3% since inception in the S&P oil & gas refining & marketing sub-group and lifting exposure to neutral from underweight. It no longer pays to remain bearish on the pure play downstream energy business. Back in late September 2015, when we turned negative on refiners, we were anticipating a cyclical earnings downturn on the back of a refined product glut in this low margin / high volume industry. Fast forward to 2017 and that bearish profit view has materialized as relative EPS have fallen by roughly 60 percentage points from the most recent peak, and have only lately managed to stabilize (Chart 10). Chart 9EPS Model Waves Green Flag EPS Model Waves Green Flag EPS Model Waves Green Flag Chart 10Refining Profit Contraction Is Over Refining Profit Contraction Is Over Refining Profit Contraction Is Over If relative EPS have indeed troughed, then relative performance should soon find a bottom. Relative profit fortunes move with the ebb and flow of gasoline consumption. The latter is on the cusp of expanding for the first time since last November, heralding the same for relative profitability (bottom panel, Chart 10). Industry shipments tell a similar story. After recently bottoming at levels similar to those reached during the GFC, refinery shipments have staged a mini V-shaped recovery (top panel, Chart 11). Crack spreads have not collapsed to razor thin levels as the nearly eliminated Brent/WTI spread would suggest, but have remained resilient in the high-teens per barrel (third panel, Chart 11). Three forces are likely in play. First, not only is domestic gasoline demand underpinning refining margins, but petroleum products are also finding their way into foreign markets with net exports running at over 3 million bbl/day (bottom panel, Chart 11). Second, the U.S. dollar selloff since mid-December is making U.S. refined products more competitive in global markets. Finally, crude oil inventories are nearly 40% higher than gasoline inventories. Lower industry feedstocks represent a boost to refining margins (third, Chart 11). Nevertheless, we refrain from turning outright bullish on refiners. Refinery production hit all-time highs recently, refinery runs are climbing steadily and utilization rates are running hot north of 90%. Tack on, historically high refined products inventories and rising industry capacity growth and the profit backdrop darkens (Chart 12). Chart 11Three Positives... Three Positives... Three Positives... Chart 12...But Do Not Get Carried Away ...But Do Not Get Carried Away ...But Do Not Get Carried Away Netting it out, we expect a balanced refining profit outlook in the coming quarters. Bottom Line: Upgrade the S&P oil & gas refining & marketing index (PSX, VLO, TSO, MPC) to neutral and lock in profits of 14.3%. This also pushes the S&P energy index to an above benchmark allocation. Downgrade REITs We are making space for the energy sector upgrade to overweight via trimming the niche S&P real estate sector to neutral and concurrently removing it from the high-conviction overweight list. REITs have marked time year-to-date, but recently operating conditions have downshifted a notch. Three key drivers argue for lightening up exposure on this newly formed S&P GICS1 sector. First, REITs have been unable to materially benefit from the 50bps fall in the 10-year Treasury yield from the mid-December peak to the mid-June trough. As the economy recovers from the first quarter lull, Treasury yields will resume their advance. This is a net negative for the fixed income proxy real estate sector (top panel, Chart 13). Second, real estate occupancy rates have crested and generationally high supply additions in the apartment space are all but certain to push vacancies higher still. The implication is that rental inflation will remain under intense downward pressure (Chart 13). Worrisomely, credit quality in select commercial real estate (CRE) segments is deteriorating at the margin. The bottom panel of Chart 13 shows that retail and office delinquency rates have taken a turn for the worse, and represent a yellow flag. Finally, according to the Fed's latest Senior Loan Officer Survey, bankers are less willing to extend CRE credit. In fact, if one excludes the GFC spike, the tightening in CRE lending standards is near the two previous recessionary highs. If banks continue to close the credit taps, CRE prices will suffer a setback (Chart 14). Chart 13Time To Move To the Sidelines Time To Move To the Sidelines Time To Move To the Sidelines Chart 14Conflicting Signals Conflicting Signals Conflicting Signals Chart 15 puts the CRE price appreciation in historical perspective. Currently, CRE prices are on track to climb to two standard deviations above the long-term trend. Such exuberance is a cause for concern as it has historically marked the beginning of a corrective phase in CRE prices. Nevertheless, there are some positive offsets that prevent us from throwing in the towel in the S&P real estate sector. The tight labor market and accelerating industrial production explain the reacceleration in our REITs Demand Indicator, while the recent selloff in the bond market is a modest offset. If CRE appetite remains upbeat, this in turn suggests that CRE prices have a bit more room to run before reaching a cyclical peak (bottom panel, Chart 14). In addition, compelling relative valuations and washed out technicals argue against becoming overly bearish on REITs (Chart 16), as some of the bad news is already reflected in relative share prices. Chart 15An Historical Perspective An Historical Perspective An Historical Perspective Chart 16Positive Offsets Positive Offsets Positive Offsets Bottom Line: Trim the S&P real estate sector to neutral and remove it from the high-conviction overweight list. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see the June 30th, 2017 Foreign Exchange Strategy Service Special Report titled "Who Hikes Next?", available at www.bcaresearch.com Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of June 30th, 2017. The model has continued to reduce its allocation to the U.S. and now for the first time the U.S. allocation is slightly below benchmark. Within the non-U.S. universe of the 11 countries, the model has also made significant adjustments to shift weights to Italy (now the largest overweight) and Australia (now for the first time it is overweight by the model), while underweight Germany and France. These adjustments are mainly due to liquidity and technical indicators, as shown in Table 1. As shown in Table 2 and Charts 1, 2 and 3, the overall model underperformed its benchmark by 14 bps in June, largely due to the underperformance of Level 2 model where the overweight of the Euro area v.s. the underweight of Australia and Canada hurt the performance. Since going live, the overall model has outperformed its benchmark by 139 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) 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 June 30, 2017. Chart 3GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) 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 continues to overweight cyclicals versus defensives. Additionally, the model has turned overweight financials and underweight consumer discretionary on the back of momentum. This overweight in financials is now in line with our global sector recommendations published yesterday. 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

Our new Revealed Preference Indicator (RPI) is the latest installment in our ongoing research into trading rules that can augment our top-down macro approach to asset allocation. The RPI borrows from Paul Samuelson's "revealed preference" theory of consumer behavior to market behavior. It combines the idea of market momentum with valuation and the monetary policy backdrop. A trading rule for the stock/bond allocation based on the RPI outperforms traditional technical, monetary, and valuation indicators. It provides a powerful bullish signal if positive equity market momentum lines up with positive signals from policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. This model adds value on its own, but we feel that it is best used in conjunction with other indicators designed to improve performance around major market turning points. Future research will experiment with combining the RPI with other indicators to further enhance performance. In the meantime, we will present the RPI's signals each month in Section III of the monthly publication. As with all indicators and models, however, the RPI is only one input to our decision process. We base our asset allocation decision on a combination of indicators, macro themes, detailed data analysis and judgment. In 1938, economist Paul Samuelson published a paper entitled, "A Note on the Pure Theory of Consumer's Behavior," in which he outlined an alternative to the well-known economic principle, utility theory. He dubbed his work "revealed preference theory."1 His goal was to redefine utility - a measure of consumer satisfaction with a good or service - by observing behavior. He posited that when consumers reveal their preferences by buying one item rather than another, they reveal the way in which they maximize happiness or satisfaction. For instance, one can measure preferences via experiments in which a subject is given $200 and the choice between two brands of shoes at different prices. Repeating the exercise at different levels of income and relative prices generates "preference axioms." Samuelson's theory has many more layers of complexity, but this Special Report focuses on modelling investors' preferences through observed behavior. Borrowing from Samuelson's reasoning, we developed a methodology to identify investors' axioms of preference for equities and bonds at different levels of incomes and prices. Then we compared investors' real actions with those anticipated by our methodology. This allowed us to generalize our findings and analyze the effects on a portfolio of equities and bonds. The main finding of our statistical exercise is that asset allocators can profit from understanding how short-term moves are linked to the market's revealed preferences at different times during the economic cycle. We then use the results to construct an indicator and a trading rule that not only outperforms a buy-and-hold strategy by a wide margin, it outperforms other traditional trading rules as well. Building A Revealed Preference Model Our primary objective in constructing a revealed preference indicator (RPI) is to understand: (1) how market preferences shape the behavior of investors; and (2) how they ultimately affect future returns. To do so, we broke down our analysis into three key areas: Part I identifies market preferences for different levels of income and price in the economy. Part II defines a general investment strategy that utilizes historic preferences and short-term market movements as a market timing tool. Part III optimizes the RPI and compares its historical track record with a buy-and-hold asset allocation and trading rules based on other indicators. Part I - Developing The Framework The first step in building the RPI is to establish the proper control variables. We limited our basket of investable "goods" to U.S. equities and 10-year Treasurys. We also need a variable that is analogous to the income measure that Samuelson used in his study. For the choice facing investors who are deciding between buying two financial assets, we believe that a measure of market "liquidity" is more appropriate than income. By this we do not mean the ease by which financial assets can be bought and sold. Rather, it is "funding liquidity", or how easily it is to borrow to invest. BCA often uses the four phases of the Fed cycle, as interest rates fluctuate around the equilibrium level, as a measure of funding liquidity (Chart II-1):2 Chart II-1Fed Funds Rate As A Proxy For Income Fed Funds Rate As A Proxy For Income Fed Funds Rate As A Proxy For Income Phase I = Policy is accommodative but the fed funds rate is rising. Phase II = Policy is tight and the Fed is still tightening. Phase III = Policy is tight but the Fed is cutting rates. Phase IV = Policy is easy and the Fed is cutting rates. The rationale for using the fed funds-rate cycle as a proxy for income is that, when interest rates are below equilibrium, monetary conditions are accommodative. Leverage is easy to obtain because there is plenty of liquidity (income) to fund investments. When conditions are tight, funding liquidity is relatively scarce. To measure relative prices, we first divided the S&P 500 price index by its 12-month moving average and second, we took the inverse of the 10-year Treasury yield divided by 12-month moving average.3 We then used the ratio of these two deviations-from-trend to construct a relative price measure (Chart II-2). This ratio provides a single measure of how expensive stocks and bonds are, not only to each other, but to their own history as well. We then grouped the relative price data into four sets of percentiles, or buckets, shown in Table II-1. Stocks are expensive and bonds cheap at the top of the table, while the reverse is true at the bottom. Chart II-2Constructing A Single Price Measure For Equities And Bonds Constructing A Single Price Measure For Equities And Bonds Constructing A Single Price Measure For Equities And Bonds Table II-1Distribution Of Relative Price July 2017 July 2017 Table II-2A presents the average historical monthly percent change in stock prices for each combination of the four relative price and liquidity buckets over the entire dataset. In the fourth phase of the Fed cycle (when monetary conditions are easy and the Fed is still cutting interest rates), and when relative prices are in the first bucket (i.e. stocks are expensive), the average stock price increase during the month was slightly above 1% percent. Table II-2B provides the same breakdown for the average change in bond yields (shown in basis points, not returns). Tables II-2A and II-2B are recalculated at each point in time - meaning that we used an expanding sample to calculate the price buckets, and updated the results for the ensuing price or yield movements as new data are added. That way, we completely avoid the advantage of hindsight. To simplify our methodology, we coded the results to end up with the stock and bond returns for the 16 different combinations of Fed and relative price buckets. Table II-3 uses the results from Tables II-2A and II-2B in the last period of history as an example. The "Liquidity" and "Price" columns indicate the bucket (e.g. price in bucket 1 and liquidity in bucket 1). The "Stocks" and "Bonds" columns are coded as "1" if the asset appreciated during the month given the indicated liquidity/price bucket, and a "0" if it depreciated that month. Table II-2AEquity Market Reactions At Given Levels Of Price And Liquidity July 2017 July 2017 Table II-2BTreasury Market Reactions At Given Levels Of Price And Liquidity July 2017 July 2017 Chart II-3Revealing What Investors Prefer July 2017 July 2017 Part II - Habits Create Expectations It is important to keep in mind that the objective of our revealed preference model is not to use the revealed market preferences as forecasts but rather to examine what happens when investors decide to follow or ignore them. Our hypothesis in building this model is that, when investors go against their historical preferences, the result should be interpreted as short-term noise. It is only when preferences and (subsequent) short-term market moves are aligned that we should heed the signal and invest accordingly. Table II-3 can be thought of as the market's revealed preference. Again, keep in mind that we allowed revealed preferences to change over time by recalculating it under our stretching-sample approach. The following steps detail how we used investor preferences to create a trading rule that verifies our hypothesis empirically: Step 1 - Expected vs. Actual: The first step is to examine how actual equity prices and bond yields behaved relative to their expected trajectory. We created two variables - one for equities and one for bonds. If revealed preference last month (t-1) suggested that the asset's return should be positive in the subsequent month (t), and it indeed turned out to be positive in period t, then we coded month t as "1." If both the revealed preference and the actual outcome were negative, we coded it as "-1." If they did not match, the code is "0" (in other words, the market did not follow the typical historical revealed preference). Thus we have two time series, one for bonds and one for stocks, which are made up of 1s, -1s and zeros. Step 2 - Bullish, Bearish, and Neutral: We combined the coded series for stocks and bonds to encompass the nine possible outcomes in our model (i.e. both bonds and stocks can have a value in any month of 1, 0 or -1, providing 9 different combinations). Table II-4 presents the nine outcomes along with the asset allocation that would have maximized investor returns based on our historical analysis. For example, investors were paid to be overweight equities when equities and bonds have a code of "1" and "-1," respectively (top row in Table II-4). In other words, stocks tended to outperform bonds when revealed preferences from the month before predicted rising stock prices and rising bond yields, and these predictions were confirmed. Table II-4Understanding The Signals From Preferences July 2017 July 2017 If revealed preference is not confirmed for both bonds and stocks, then it is best for investors to stand aside with a benchmark allocation. Step 3 - "If It Don't Make Dollars, It Don't Make Sense": To test whether our theory would add strategic value, we computed a trading rule to see how well it performed against a benchmark portfolio of 50% equities and 50% Treasurys. The trading rule was computed as follows: when the revealed preference for equities is positive (at time t-1) and this signal is confirmed in t, then in t+1 we allocate 100% to the S&P 500 and 0% to Treasurys. When the revealed equity preference signal is correctly bearish, we removed all exposure to equities and allocated 100% to Treasurys. When the signal was neutral, we kept a benchmark allocation of 50% equities and 50% Treasurys. Chart II-3 shows that this trading rule outperforms the benchmark, confirming our initial hypothesis - one should fade the short-term movements when investors go against their preferences, and only follow the signals when those movements align with historical preferences. History shows that investors tend to underperform in terms of the stock/bond allocation when they deviate from their revealed preference. Chart II-3Correctly Gauging How Investors Behave Pays Off Correctly Gauging How Investors Behave Pays Off Correctly Gauging How Investors Behave Pays Off Part III - Validating The Results One drawback is that this trading rule would require frequent portfolio allocation changes every month, as shown in Chart II-4. As such, we constructed a smoothed version by imposing the rule that asset allocation is unchanged unless the model provides a new signal for two months in a row (Chart II-5).4 These restrictions not only dramatically reduced the frequency of the asset allocation adjustments, but it also augmented historical cumulative excess returns (Chart II-6). Chart II-4Revealed Preference Indicator Is Inherently Volatile Revealed Preference Indicator Is Inherently Volatile Revealed Preference Indicator Is Inherently Volatile Chart II-5Removing Some Of The Noise Removing Some Of The Noise Removing Some Of The Noise Any new indicator of course must be able to outperform a buy-and-hold strategy to be useful but it is also interesting to see how its performance ranks compared to a set of random portfolios. This way, we can identify if the indicator truly provides additional information. Random portfolios are generated using a monthly allocations of 100% or 0% to equities, with the remainder in Treasurys. Chart II-7 shows the performance of the smoothed indicator versus a set of 1,000 randomly generated portfolios. Chart II-6Once Smoothed, The RPI Truly Shines Once Smoothed, The RPI Truly Shines Once Smoothed, The RPI Truly Shines Chart II-7The RPI Adds A Significant Amount Of Information The RPI Adds A Significant Amount Of Information The RPI Adds A Significant Amount Of Information We compared the indicator's trading rule to simple moving averages or BCA's other indicators. We also wanted to ensure that the RPI adds value beyond investing based strictly on the four phases of the liquidity cycle or based on relative value alone. We therefore compared the track record of the RPI trading rule to rules that are based on: (1) the deviation of the S&P 500 from its 12-month moving trend; (2) BCA's monetary conditions indicator; (3) BCA's valuation indicator; (4) BCA's technical indicator; (5) the four phases of the Fed cycle; and (6) the relative price index. Charts II-8A and II-8B highlights that RPI indeed impressively dominates the other trading rules. The one exception is that, during the Great Recession, the model's performance fell to roughly match the performance of a S&P 500 technical trading rule. Chart II-8AThe RPI Outperforms The Sum Of Its Parts... July 2017 July 2017 Chart II-8B...As Well As Other Indicators July 2017 July 2017 Part IV - Conclusions The RPI is the latest installment in our ongoing research into trading rules that can augment our top-down macro approach to asset allocation. 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. This model adds value on its own, but we feel that it will best be used in conjunction with other indicators designed to improve performance around major market turning points. Future research will experiment with combining the RPI with other indicators to further enhance performance. In the meantime, we will present the RPI's signals each month in Section III of the monthly publication. As with all indicators and models, however, the RPI is only one input to our decision process. We base our asset allocation decision on a combination of indicators, macro themes, detailed data analysis and judgment. The indicator's current reading for stocks versus bonds, at benchmark, is more conservative than our official recommendation. The benchmark reading reflects the fact that equities are overvalued and that investors have deviated from their preferences in their past two quarters. David Boucher Associate Vice President Quantitative Strategist 1 For more information, please see P. A. Samuelson, "A Note on the Pure Theory of Consumer's Behavior," Economica 5:17 (1938), pp. 61-71. 2 Please see U.S. Investment Strategy Special Report "Stocks And The Fed Funds Rate Cycle," dated December 23, 2013, available at usis.bcaresearch.com 3 We tested a few other measures, most notably the stock-to-bond total return ratio (measured by comparing each asset's total returns), but the chosen measures provided the best and most robust results. 4 We conducted a statistical exercise to validate and optimize the allocations in Table 4 to provide a smoother performance.

Highlights A whiff of global deflation shook-up financial markets in June, driven by melting oil prices and a startling May U.S. CPI report. Nonetheless, we have not changed our recommended asset allocation. Bond markets have over-discounted the impact of the commodity price weakness, especially with regard to Fed policy and long-term inflation expectations in the major countries. We do not see the selling pressure in the commodity pits as a harbinger of slower global growth. Above-trend growth in the U.S. is likely in the second half of the year, along with continuing robust activity at the global level. Oil prices should rebound, based on our view that consumption will outstrip production in the second half of the year; the surprise will be how strong oil prices are in the coming months. The FOMC appears more determined than in the past to stick with the current policy normalization timetable. Unemployment will edge further below the full-employment level if the FOMC does not slow the pace of job creation. We believe that the labor market is tight enough to gradually push up inflation. Together with a rebound in the commodity pits, this means that the recent bond rally will reverse. Soft U.S. CPI readings are a challenge to our view. The Fed will delay the next rate hike into next year if core inflation does not move up in the next few months. The equity market is vulnerable to unforeseen shocks given stretched valuation. Nonetheless, none of the main indicators that have provided leading information in the past are warning of an equity bear market. The profit backdrop remains constructive. Our base case is that stocks beat bonds and cash for the remainder of 2017. We expect to trim exposure to equities next year, but the evolution of a number of indicators will influence the timing. The same is true for corporate bonds. The dollar's bull phase has one more upleg left. Japanese, European and U.K. equities will outperform the U.S. in local currency terms. Feature A whiff of global deflation shook-up financial markets in June, driven by melting oil prices and a startling May U.S. CPI report. Investors quickly concluded that the Fed will have to proceed even more slowly in terms of its policy normalization plan which, in turn, sent the dollar and global bond yields sharply lower. Equity indexes held up because of the dollar and bond yield "relief valves". Stocks are also benefiting from the continuing rebound in corporate earnings growth in the major economies. Nonetheless, the commodity pullback and soft U.S. inflation data are a challenge to our reflation theme, which includes a final upleg in the U.S. dollar and a negative view on bond prices. We believe that markets have over-discounted the impact of the commodity price weakness, especially with regard to Fed policy and long-term inflation expectations in the major countries. Above-trend growth in the U.S. is likely in the second half of the year, along with continuing robust activity at the global level. We also think that the FOMC is more determined than in the past to stick with the current policy normalization timetable. The bottom line is that we are not changing our recommended asset allocation based on June's market action. We remain overweight stocks and corporate bonds relative to government bonds and cash. We are also short duration and long the dollar. A key risk to our asset allocation relates to our contrarily bullish view on oil prices. Oil Drove The Bond Rally... The decline in long-term bond yields since March reflected in large part a drop in inflation expectations (Chart I-1). BCA's fixed-income strategists point out that the slump in long-term inflation expectations has been widespread across the major countries, irrespective of whether actual inflation is trending up or down.1 Core inflation has moved lower in the U.S., Japan, Canada and (slightly) in the Eurozone, but has increased in Australia and the U.K. In terms of diffusion indexes, which often lead core inflation, they are falling in the U.S., Japan and Canada, but are rising in the U.K., the Eurozone and Australia (Chart I-2). Chart I-1 Inflation Expectations Drive Bond Rally Inflation Expectations Drive Bond Rally Inflation Expectations Drive Bond Rally Chart I-2Diverging Inflation Trends Diverging Inflation Trends Diverging Inflation Trends Given all these diverging signals within the national inflation data, it is odd that there has been such a uniform decline in inflation expectations across the major bond markets. That leads us to look to the commodity price decline as the main driver of the downshift in expectations. Short-term moves in oil prices should not affect long-term inflation expectations, but in practice the correlation has been strong since the plunge in oil prices beginning in 2014. Weaker oil and other commodity prices have also fed investor concerns that global growth is waning. We see little evidence of any slowdown in global growth, although some leading indicators have softened. Key monthly data such as industrial production, retail sales and capital goods orders reveal an acceleration in growth for the advanced economies as a group (Chart I-3). There has also been a general upgrading of the consensus growth forecast for the major countries and for the world in both 2017 and 2018 (Chart I-4). This is unlike previous years, when growth forecasts started the year high, only to be slashed as the year progressed. Chart I-3No Slowdown In Advanced Economies No Slowdown In Advanced Economies No Slowdown In Advanced Economies Chart I-4Growth Expectations Revised Up Growth Expectations Revised Up Growth Expectations Revised Up ...But Watch Out For A Reversal The implication is that we do not see the selling pressure in the commodity pits as a harbinger of slower global growth. Nonetheless, the mini oil meltdown in June went against our medium-term bullish view. In a recent report,2 our Energy Sector Strategy team noted that investors are confused about conflicting supply signals in oil markets. Traders do not yet see the physical shortage that the IEA/EIA/OPEC and BCA's top-down supply & demand analyses argue will prevail in the coming months. Chart I-5Falling Inventories To Drive Oil Rebound Falling Inventories To Drive Oil Rebound Falling Inventories To Drive Oil Rebound The investment community is being overly pessimistic in our view. The coalition led by the Saudi Arabia and Russia will have removed 1.4 MMB/d of production on average from the market between January 2017 and end-March 2018, versus peak production in November of last year. This will be diluted somewhat by the Libyan and U.S. production gains, but the increased production will not be sufficient to counter the OPEC/Russia cuts entirely. We expect global production to increase by only 0.7 MMB/d in 2017, an estimate that includes rapid increases in U.S. shale output. Meanwhile, we expect consumption to grow by 1.5 MMB/d, implying that oil inventories will fall over the remainder of this year. If history is any guide, this will lead to a rebound in oil prices (Chart I-5). It will be quite a shock to markets if crude reaches $60/bbl by December as we expect. As for base metals, it appears that the correction is largely related to reduced speculative demand rather than weak global and/or Chinese demand. It is true that the Chinese economy has slipped a notch according to some measures, such as housing starts and M2 growth. Nonetheless, the government remains cognizant of the risks of tightening policy too aggressively, especially with the National Party Congress slated for this autumn. The PBoC injected 250 billion yuan into the financial system in June and fiscal policy has been eased. Real-time measures of industrial activity such as railway freight traffic, excavator sales, and electricity production remain upbeat. Retail sales continue to expand at a healthy clip. Export growth is accelerating thanks to a weaker currency and stronger global activity. Given that many investors remain concerned about a hard landing in China, the bar for positive surprises is comfortably low. If China can clear this bar, as we expect it will, it will be good news for the commodity currencies and other commodity plays. A rebound in base metal and, especially, oil prices would boost global inflation expectations and bond yields, especially since inflation expectations have fallen too far relative to underlying non-energy inflation pressures. This forecast also applies to the U.S. bond market, although there was more to the soft May CPI report than oil prices. Is The Fed's Inflation Target Credible? Investors are questioning whether the Fed has the ability to reach its inflation goals. Is it possible that the U.S. is following Japan's roadmap where even an over-heated labor market is insufficient to generate any meaningful inflation? We argued above that the moderation in inflation expectations in the major markets was mostly related to the decline in commodity prices. However, in the U.S., it also reflected a fairly widespread pullback in CPI inflation this year. This is contrary to Fed Chair Yellen's assertion that most of it reflects special factors such as wireless telecommunications prices. The deceleration in inflation began around the start of the year. The three-month rate of change of the headline index fell by more than five percentage points between January and May, of which energy accounts for 3.3 percentage points. The deceleration in the core rate was a less severe, but still substantial at 2.8 percentage points. Table I-1 presents the components of the CPI that made the largest contribution to the deceleration in core inflation. Motor vehicles, owners' equivalent rent, apparel, recreation, wireless telecom and medical care services accounted for 1.2 percentage points as a group. However, many other sectors contributed in a small way to the overall deceleration of core inflation in the first five months of the year. Table I-1Key Drivers Of U.S. Core Inflation Deceleration In 2017 July 2017 July 2017 Some special factors were at play. The moderation in rent inflation likely reflects the bottoming of the vacancy rate. Discounting in the auto sector is not a surprise given weak sales. Wireless prices can be viewed as a special case as well. Nonetheless, the breadth and suddenness of the deceleration in core inflation across such diverse sectors, some unrelated to labor markets, commodity prices, the dollar or on-line shopping, is worrying. The disinflation this year in the Fed's preferred measure, the PCE price index, is not as extended but the data are published almost a month behind the CPI data. A diffusion index made up of the components of the PCE index is still in positive territory, unlike the CPI's diffusion index (Chart I-6). Nonetheless, the CPI data suggest that core PCE inflation will edge lower when the May data are released at the end of June. There has also been a moderation in some of the wage inflation data, such as average hourly earnings (Chart I-7). The slowdown has been fairly widespread across manufacturing and services. However, the soft patch already appears to be over; 3-month rates of change have firmed almost across the board (retail is a major exception). There is no slowdown evident at all in the better-constructed Employment Cost Index (ECI) as of the first quarter (Chart I-8). The ECI is adjusted to avoid compositional effects that can distort the aggregate index. The related diffusion indexes also remain constructive. Chart I-6PCE Inflation Rate To Follow CPI Lower PCE Inflation Rate To Follow CPI Lower PCE Inflation Rate To Follow CPI Lower Chart I-7AHE SoftPatch Appears Over... AHE SoftPatch Appears Over... AHE SoftPatch Appears Over... Chart I-8...And The ECI Marches Higher ...And The ECI Marches Higher ...And The ECI Marches Higher We conclude from these and other wage measures that the Phillips curve is still operating in the U.S. Admittedly, the curve appears to be quite flat, which means it is difficult to generate inflation even with a tight labor market. Nonetheless, the relationship between the ECI and various measures of labor market tightness shown in Chart I-8 does not appear to have broken down. The percentage of U.S. states with unemployment below the Fed's estimate of full employment jumped to 70% in May. Anything over 60% in the past has been associated with wage pressure (Chart I-9). The bottom line is that, while we are concerned about the breadth of the soft patch in the consumer price data, we are in agreement with the Fed hawks that the labor market is tight enough to gradually push up inflation. We are willing at this point to chalk up the recent drop in core inflation partly to randomness in the data, and partly to lagged effects of the slowdown in real GDP growth in the first half of 2016 (Chart I-10). Admittedly, however, the U.S. inflation reports in the coming months are a key risk to our reflation-related asset allocation. Chart I-9More Than 70% Of U.S. States Have Excess Labor Demand More Than 70% Of U.S. States Have Excess Labor Demand More Than 70% Of U.S. States Have Excess Labor Demand Chart I-10Financial Conditions Point To Faster Growth And Inflation Financial Conditions Point To Faster Growth And Inflation Financial Conditions Point To Faster Growth And Inflation What Will The Fed Do? The CPI data have certainly rattled some members of the FOMC. Federal Reserve Bank Presidents Kaplan and Kashkari, for example, believe that the Fed needs to be patient to ensure that the inflation pullback is temporary. However, the June FOMC Statement and Yellen's press conference suggested that the consensus is determined to stick with the current tightening timetable in terms of rate hikes and balance sheet adjustment. She stressed that the FOMC makes policy for the "medium term," and should not over-react to short-term wiggles in the data. Vice President Dudley echoed this view in recent comments he made to the press. The Fed has been quick to back away from planned rate hikes at the first hint of trouble in recent years. However, it appears that the reaction function has changed, now that the labor market is at full employment. This is especially the case because financial conditions have eased further, despite the June rate hike. Unemployment will edge further below the full-employment level if the FOMC does not slow the pace of job creation. Policymakers know that the Fed has had little success in the past when it tried to nudge unemployment higher in order to relieve budding inflation pressure; these attempts almost always ended in recession. Dudley added that "...pausing policy now could raise the risk of inflation surging and hurting the economy." Other FOMC members are worried that financial stability risk will build if the low-rate environment extends much further. The bottom line is that we expect the Fed to stick with the game-plan for now. The FOMC will begin shrinking the balance sheet in September, but will wait until December for the next rate hike. That said, a stubbornly low inflation rate in the coming months would likely see the FOMC postpone the next rate increase into next year. Where Next For Bonds? We see three possible scenarios for the bond market: Reflation Returns: Weak recent inflation readings are nothing more than a lagged response to last year's deceleration in economic growth. U.S. growth accelerates in the second half, unemployment falls further and both wage growth and inflation pick up. Oil inventories begin to contract and prices head higher. The FOMC is vindicated in its inflation view and proceeds with the current rate hike and balance sheet adjustment agenda. Investors receive a "wake up call" from the Fed, bond prices get hit and recent curve-flattening trend reverses. Fed Capitulates: The U.S. labor market continues to tighten, but core PCE inflation is still close to 1½% by the September FOMC meeting. We would expect the Fed to lower its forecasted rate hike path, signaling that no further rate hikes are likely in 2017. Long-maturity real yields would fall in this scenario, although long-term inflation expectations could rise to the extent that the Fed's more dovish tilt will weaken the dollar and generate more inflation in the medium term. Nominal yields may not end up moving much in this scenario. A Policy Mistake: If core inflation remains low between now and the September FOMC meeting and the Fed continues to write-off low inflation as transitory, signaling its intention to stick to its current projected rate hike path, then the market would begin to discount a "policy mistake" scenario. The yield curve would flatten and long-maturity nominal yields would fall, led by tighter TIPS breakevens. In terms of probabilities, we would characterize Scenario 1 as our base case, Scenario 2 as unlikely and Scenario 3 as a tail risk. We remain short-duration in anticipation of a rebound in long-term inflation expectations and higher yields. A bond selloff, however, should not present a major headwind for stocks as long as the earnings backdrop remains constructive. Will The Real Profit Margin Please Stand Up For some time we have been highlighting the importance of the mini-cycle in U.S. earnings growth; the corporate sector is in a catch-up phase following last year's profit recession, a trend that extends beyond the energy patch. EPS growth has surged this year on the back of somewhat stronger sales and rising S&P 500 margins. The National Accounts (NIPA) data, however, paint a different picture. Earnings growth for the entire corporate sector fell sharply in the first quarter and margins continued to slide. If the NIPA data are telling the true story, then the equity market is in big trouble because it suggests that the earnings outlook is much weaker than what is discounted in stock prices. There are many definitional differences that make it difficult to reconcile the NIPA and S&P data.3 Nonetheless, we can make some general observations. Chart I-11 presents the 4-quarter growth rate of NIPA profits4 and a proxy for aggregate S&P earnings. For the latter, we multiplied earnings-per-share by the divisor to obtain an estimate of the level of aggregate earnings in dollar terms (i.e. not on a per-share basis). The bottom panel of Chart I-11 compares the level of profits, each indexed to be 100 in 2011 Q1. The charts highlight that, while there have been marked differences in annual growth rates between the two measures in some years, the levels ended up being close to the same point in the first quarter of 2017. The dip in NIPA profit growth in the first quarter was not reflected in the S&P measure. It appears that this is partly due to different profiles for profit growth in the energy and financials sectors. That said, broadly speaking, it does not appear that the difference in margins is due to a significant divergence in aggregate profits. It turns out that most of the margin divergence is related to the denominator of the calculation (Chart I-12). The NIPA denominator is corporate sector Gross Domestic Product (GDP). This is a value-added concept that is quite different from sales. It is not clear why, but GDP has grown much faster than sales since the end of 2014. It appears to us that the S&P data are telling the correct story at the moment. After all, sales are straight forward to measure, while value added is complicated to construct. The fact that sales are growing slowly 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 data are signaling strong profit growth when the reality is the opposite. 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 remains positive for stocks for now. The same is true in the Eurozone and Japan, where margins are also rising. It is worrying that a large part of this year's U.S. equity market advance has been concentrated in a small number of stocks, but that belies the breadth of the profit recovery (Chart I-13). The proportion of S&P industry groups with rising earnings estimates is above 75%. Such widespread participation is consistent with ongoing upward revisions to 12-month forward earnings estimates. Chart I-11S&P And NIPA Profit Comparison S&P And NIPA Profit Comparison S&P And NIPA Profit Comparison Chart I-12Denominator Explains S&P/NIPA Margin Divergence Denominator Explains S&P/NIPA Margin Divergence Denominator Explains S&P/NIPA Margin Divergence Chart I-13Positive Earnings Revisions Are Broadly Based Positive Earnings Revisions Are Broadly Based Positive Earnings Revisions Are Broadly Based The solid earnings backdrop is the main reason we remain overweight stocks versus bonds and cash. Of course, given poor valuation, we must be extra vigilant in watching for warning signs of a bear market. Valuation has never been good leading indicator for bear markets, but it does provide information on the risks. Monitoring The Bear Market Barometer BCA's Chief Economist, Martin Barnes, highlighted the best "equity bear market" indicators to watch in a 2014 Special Report.5 He noted that no two bear markets are the same, and that there are no indicators that have reliably heralded bear phases. Nonetheless, there are some common elements. The safest time to invest in the market is when monetary conditions are favorable, there are no signs of a looming economic downturn, there is not extreme overvaluation, and technical indicators are not flashing red. Some indicators related to each of these fundamental factors are shown in Chart I-14: Chart I-14Equity Bear Market Indicators Equity Bear Market Indicators Equity Bear Market Indicators Monetary Conditions: The yield curve is quite flat by historical standards, but it is far from inverting. Moreover, real short-term interest rates are normally substantially higher than today, and above 2%, when bear markets commence. Excess liquidity, which we define as M2 growth less nominal GDP growth, is also still well above the zero line, a threshold that has warned of a downturn in stock prices in the past. Valuation: Our composite valuation indicator is still shy of the +1 standard deviation level that defines over-valued. However, this is because of the components that compare equity prices to bond yields. The other three components of the equity indicator, which are unrelated to bond yields, suggest that stock valuation is quite stretched. Economic Outlook: Economic data such as the leading economic indicator and ISM have been unreliable bear market signals. That said, we do not see anything that suggests that a recession is on the horizon. Indeed, U.S. growth is likely to remain above-trend in the second half of the year based on its relationship with financial conditions. Technical conditions: Sentiment is elevated, which is bearish from a contrary perspective. However, breadth, the deviation from the 40-week moving average, and our composite technical indicator are not flashing red. Earnings: Trends in earnings and margins did not provide any additional reliable signals for timing equity market downturns in the past. Still, it has been a bad sign when EPS growth topped out. And this has often been preceded by a peak in industrial production growth. We expect U.S. EPS growth to continue to accelerate for at least a few more months, but are watching industrial production closely. EPS growth in Japan and the Eurozone will likely peak after the U.S., since these markets are not as advanced in the profit rebound. The bottom line is that the equity market is vulnerable to unforeseen shocks given stretched valuation. Nonetheless, none of the main indicators that have provided some leading information in the past are warning of an equity bear market. Investment Conclusions The major world bourses remain in a sweet spot because of the mini cyclical rebound in profits. One can imagine many scenarios in which equities suffer a major correction or bear phase. However, stocks would likely perform well under the two most likely scenarios for the remainder of the year. If U.S. and global growth disappoint, the combination of low bond yields and still-robust earnings growth will continue to support prices. Conversely, if world growth remains solid and the U.S. picks up, as we expect, then bond yields will rise but investors will pencil-in an even stronger profit advance over the next year. Of course, this win-win situation for stocks will not last forever. Perhaps paradoxically, the economic cycle could be shortened if the U.S. Congress gets around to passing a bill that imparts fiscal stimulus in 2018. The Fed would have to respond with a more aggressive tightening timetable, setting the stage for the next recession. In contrast, the economic cycle would be further stretched out in the absence of fiscal stimulus, keeping alive for a while longer the lackluster growth/low inflation/low bond yield backdrop that has been favorable for the equity market. We are watching the indicators discussed above to time the exit from our pro-risk asset allocation that favors stocks and corporate bonds to government bonds and cash. As for the duration call, the whiff of deflation that has depressed bond yields over the past month is overdone. Investors have also become too complacent on the Fed. We expect that the recent drop in commodity prices, especially oil, will reverse. If this view is correct, it means that the cyclical bull phase in the dollar is not over because market expectations for the pace of Fed rate hikes will rise relative to expectations in the other major economies (with the exception of Canada). We are still looking for a 10% dollar appreciation. It also means that Treasurys will underperform JGBs and Bunds within currency-hedged fixed-income portfolios. We expect the Eurostoxx 600 and the Nikkei indexes to outperform the S&P 500 this year in local currencies, despite our constructive view on U.S. growth. Stocks are cheaper in the former two markets. Moreover, both Japan and the Eurozone are earlier in the profit mini-cycle, which means that there is room for catch-up versus the U.S. over the next 6-12 months when growth in the latter tops-out. The prospect of structural reform in France is also constructive for European stocks, following the election of a reformist legislature in June. However, the upcoming Italian election warrants close scrutiny. The key risk to this base case is our view that oil prices will rebound. This is clearly a non-consensus call. If OPEC production cuts are unable to overwhelm the rise in U.S. shale output, then inventories will remain elevated and oil prices could move even lower in the near term. Our bullish equity view would be fine in this case, but the bond bear market and dollar appreciation we expect would at least be delayed. Finally, a few words on the U.K. Our geopolitical experts highlight two key points related to June's election outcome: fiscal austerity is dead and the U.K. will pursue a "softer" variety of Brexit. This combination should provide a relatively benign backdrop for U.K. stocks and the economy over the next year. Nonetheless, the cloud of uncertainty hanging over the U.K. is large enough to keep the Bank of England (BoE) on hold. Some BoE hawks are agitating for tighter policy due to the worsening inflation overshoot, but it will probably be some time before the consensus on the Monetary Policy Committee shifts in favor of rate hikes. This means that it is too early to position for gilt underperformance within fixed-income portfolios. Sterling weakness looks overdone, although we do not see much upside either. As long as Brexit talks do not become acrimonious (which is our view), the U.K. stock market should be one of the outperformers in local currency terms among the major developed markets. Mark McClellan Senior Vice President The Bank Credit Analyst June 29, 2017 Next Report: July 27, 2017 1 For more discussion, see Alternative Facts in the Bond Market at BCA Global Fixed Income Strategy Weekly Report, dated June 13, 2017 available at gfis.bcaresearch.com 2 Please see Energy Sector Strategy Weekly Report, "Views from the Road," dated June 21, 2017, available at nrg.bcaresearch.com 3 The first problem is that the S&P data are expressed on a per-share basis. Moreover, the NIPA data adjusts for inventory and depreciation allowance. S&P margins are calculated using sales in the denominator, while we generally use GDP as the denominator for calculating NIPA profits. 4 The NIPA data shown include financials and profits earned overseas, as is the case for the S&P. 5 Please see BCA Special Report "Timing The Next Equity Bear Market," dated January 24, 2014, available at bcaresearch.com II. Preferences As Trading Constraints: A New Asset Allocation Indicator Our new Revealed Preference Indicator (RPI) is the latest installment in our ongoing research into trading rules that can augment our top-down macro approach to asset allocation. The RPI borrows from Paul Samuelson's "revealed preference" theory of consumer behavior to market behavior. It combines the idea of market momentum with valuation and the monetary policy backdrop. A trading rule for the stock/bond allocation based on the RPI outperforms traditional technical, monetary, and valuation indicators. It provides a powerful bullish signal if positive equity market momentum lines up with positive signals from policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. This model adds value on its own, but we feel that it is best used in conjunction with other indicators designed to improve performance around major market turning points. Future research will experiment with combining the RPI with other indicators to further enhance performance. In the meantime, we will present the RPI's signals each month in Section III of the monthly publication. As with all indicators and models, however, the RPI is only one input to our decision process. We base our asset allocation decision on a combination of indicators, macro themes, detailed data analysis and judgment. In 1938, economist Paul Samuelson published a paper entitled, "A Note on the Pure Theory of Consumer's Behavior," in which he outlined an alternative to the well-known economic principle, utility theory. He dubbed his work "revealed preference theory."1 His goal was to redefine utility - a measure of consumer satisfaction with a good or service - by observing behavior. He posited that when consumers reveal their preferences by buying one item rather than another, they reveal the way in which they maximize happiness or satisfaction. For instance, one can measure preferences via experiments in which a subject is given $200 and the choice between two brands of shoes at different prices. Repeating the exercise at different levels of income and relative prices generates "preference axioms." Samuelson's theory has many more layers of complexity, but this Special Report focuses on modelling investors' preferences through observed behavior. Borrowing from Samuelson's reasoning, we developed a methodology to identify investors' axioms of preference for equities and bonds at different levels of incomes and prices. Then we compared investors' real actions with those anticipated by our methodology. This allowed us to generalize our findings and analyze the effects on a portfolio of equities and bonds. The main finding of our statistical exercise is that asset allocators can profit from understanding how short-term moves are linked to the market's revealed preferences at different times during the economic cycle. We then use the results to construct an indicator and a trading rule that not only outperforms a buy-and-hold strategy by a wide margin, it outperforms other traditional trading rules as well. Building A Revealed Preference Model Our primary objective in constructing a revealed preference indicator (RPI) is to understand: (1) how market preferences shape the behavior of investors; and (2) how they ultimately affect future returns. To do so, we broke down our analysis into three key areas: Part I identifies market preferences for different levels of income and price in the economy. Part II defines a general investment strategy that utilizes historic preferences and short-term market movements as a market timing tool. Part III optimizes the RPI and compares its historical track record with a buy-and-hold asset allocation and trading rules based on other indicators. Part I - Developing The Framework The first step in building the RPI is to establish the proper control variables. We limited our basket of investable "goods" to U.S. equities and 10-year Treasurys. We also need a variable that is analogous to the income measure that Samuelson used in his study. For the choice facing investors who are deciding between buying two financial assets, we believe that a measure of market "liquidity" is more appropriate than income. By this we do not mean the ease by which financial assets can be bought and sold. Rather, it is "funding liquidity", or how easily it is to borrow to invest. BCA often uses the four phases of the Fed cycle, as interest rates fluctuate around the equilibrium level, as a measure of funding liquidity (Chart II-1):2 Chart II-1Fed Funds Rate As A Proxy For Income Fed Funds Rate As A Proxy For Income Fed Funds Rate As A Proxy For Income Phase I = Policy is accommodative but the fed funds rate is rising. Phase II = Policy is tight and the Fed is still tightening. Phase III = Policy is tight but the Fed is cutting rates. Phase IV = Policy is easy and the Fed is cutting rates. The rationale for using the fed funds-rate cycle as a proxy for income is that, when interest rates are below equilibrium, monetary conditions are accommodative. Leverage is easy to obtain because there is plenty of liquidity (income) to fund investments. When conditions are tight, funding liquidity is relatively scarce. To measure relative prices, we first divided the S&P 500 price index by its 12-month moving average and second, we took the inverse of the 10-year Treasury yield divided by 12-month moving average.3 We then used the ratio of these two deviations-from-trend to construct a relative price measure (Chart II-2). This ratio provides a single measure of how expensive stocks and bonds are, not only to each other, but to their own history as well. We then grouped the relative price data into four sets of percentiles, or buckets, shown in Table II-1. Stocks are expensive and bonds cheap at the top of the table, while the reverse is true at the bottom. Chart II-2Constructing A Single Price Measure For Equities And Bonds Constructing A Single Price Measure For Equities And Bonds Constructing A Single Price Measure For Equities And Bonds Table II-1Distribution Of Relative Price July 2017 July 2017 Table II-2A presents the average historical monthly percent change in stock prices for each combination of the four relative price and liquidity buckets over the entire dataset. In the fourth phase of the Fed cycle (when monetary conditions are easy and the Fed is still cutting interest rates), and when relative prices are in the first bucket (i.e. stocks are expensive), the average stock price increase during the month was slightly above 1% percent. Table II-2B provides the same breakdown for the average change in bond yields (shown in basis points, not returns). Tables II-2A and II-2B are recalculated at each point in time - meaning that we used an expanding sample to calculate the price buckets, and updated the results for the ensuing price or yield movements as new data are added. That way, we completely avoid the advantage of hindsight. To simplify our methodology, we coded the results to end up with the stock and bond returns for the 16 different combinations of Fed and relative price buckets. Table II-3 uses the results from Tables II-2A and II-2B in the last period of history as an example. The "Liquidity" and "Price" columns indicate the bucket (e.g. price in bucket 1 and liquidity in bucket 1). The "Stocks" and "Bonds" columns are coded as "1" if the asset appreciated during the month given the indicated liquidity/price bucket, and a "0" if it depreciated that month. Table II-2AEquity Market Reactions At Given Levels Of Price And Liquidity July 2017 July 2017 Table II-2BTreasury Market Reactions At Given Levels Of Price And Liquidity July 2017 July 2017 Chart II-3Revealing What Investors Prefer July 2017 July 2017 Part II - Habits Create Expectations It is important to keep in mind that the objective of our revealed preference model is not to use the revealed market preferences as forecasts but rather to examine what happens when investors decide to follow or ignore them. Our hypothesis in building this model is that, when investors go against their historical preferences, the result should be interpreted as short-term noise. It is only when preferences and (subsequent) short-term market moves are aligned that we should heed the signal and invest accordingly. Table II-3 can be thought of as the market's revealed preference. Again, keep in mind that we allowed revealed preferences to change over time by recalculating it under our stretching-sample approach. The following steps detail how we used investor preferences to create a trading rule that verifies our hypothesis empirically: Step 1 - Expected vs. Actual: The first step is to examine how actual equity prices and bond yields behaved relative to their expected trajectory. We created two variables - one for equities and one for bonds. If revealed preference last month (t-1) suggested that the asset's return should be positive in the subsequent month (t), and it indeed turned out to be positive in period t, then we coded month t as "1." If both the revealed preference and the actual outcome were negative, we coded it as "-1." If they did not match, the code is "0" (in other words, the market did not follow the typical historical revealed preference). Thus we have two time series, one for bonds and one for stocks, which are made up of 1s, -1s and zeros. Step 2 - Bullish, Bearish, and Neutral: We combined the coded series for stocks and bonds to encompass the nine possible outcomes in our model (i.e. both bonds and stocks can have a value in any month of 1, 0 or -1, providing 9 different combinations). Table II-4 presents the nine outcomes along with the asset allocation that would have maximized investor returns based on our historical analysis. For example, investors were paid to be overweight equities when equities and bonds have a code of "1" and "-1," respectively (top row in Table II-4). In other words, stocks tended to outperform bonds when revealed preferences from the month before predicted rising stock prices and rising bond yields, and these predictions were confirmed. Table II-4Understanding The Signals From Preferences July 2017 July 2017 If revealed preference is not confirmed for both bonds and stocks, then it is best for investors to stand aside with a benchmark allocation. Step 3 - "If It Don't Make Dollars, It Don't Make Sense": To test whether our theory would add strategic value, we computed a trading rule to see how well it performed against a benchmark portfolio of 50% equities and 50% Treasurys. The trading rule was computed as follows: when the revealed preference for equities is positive (at time t-1) and this signal is confirmed in t, then in t+1 we allocate 100% to the S&P 500 and 0% to Treasurys. When the revealed equity preference signal is correctly bearish, we removed all exposure to equities and allocated 100% to Treasurys. When the signal was neutral, we kept a benchmark allocation of 50% equities and 50% Treasurys. Chart II-3 shows that this trading rule outperforms the benchmark, confirming our initial hypothesis - one should fade the short-term movements when investors go against their preferences, and only follow the signals when those movements align with historical preferences. History shows that investors tend to underperform in terms of the stock/bond allocation when they deviate from their revealed preference. Chart II-3Correctly Gauging How Investors Behave Pays Off Correctly Gauging How Investors Behave Pays Off Correctly Gauging How Investors Behave Pays Off Part III - Validating The Results One drawback is that this trading rule would require frequent portfolio allocation changes every month, as shown in Chart II-4. As such, we constructed a smoothed version by imposing the rule that asset allocation is unchanged unless the model provides a new signal for two months in a row (Chart II-5).4 These restrictions not only dramatically reduced the frequency of the asset allocation adjustments, but it also augmented historical cumulative excess returns (Chart II-6). Chart II-4Revealed Preference Indicator Is Inherently Volatile Revealed Preference Indicator Is Inherently Volatile Revealed Preference Indicator Is Inherently Volatile Chart II-5Removing Some Of The Noise Removing Some Of The Noise Removing Some Of The Noise Any new indicator of course must be able to outperform a buy-and-hold strategy to be useful but it is also interesting to see how its performance ranks compared to a set of random portfolios. This way, we can identify if the indicator truly provides additional information. Random portfolios are generated using a monthly allocations of 100% or 0% to equities, with the remainder in Treasurys. Chart II-7 shows the performance of the smoothed indicator versus a set of 1,000 randomly generated portfolios. Chart II-6Once Smoothed, The RPI Truly Shines Once Smoothed, The RPI Truly Shines Once Smoothed, The RPI Truly Shines Chart II-7The RPI Adds A Significant Amount Of Information The RPI Adds A Significant Amount Of Information The RPI Adds A Significant Amount Of Information We compared the indicator's trading rule to simple moving averages or BCA's other indicators. We also wanted to ensure that the RPI adds value beyond investing based strictly on the four phases of the liquidity cycle or based on relative value alone. We therefore compared the track record of the RPI trading rule to rules that are based on: (1) the deviation of the S&P 500 from its 12-month moving trend; (2) BCA's monetary conditions indicator; (3) BCA's valuation indicator; (4) BCA's technical indicator; (5) the four phases of the Fed cycle; and (6) the relative price index. Charts II-8A and II-8B highlights that RPI indeed impressively dominates the other trading rules. The one exception is that, during the Great Recession, the model's performance fell to roughly match the performance of a S&P 500 technical trading rule. Chart II-8AThe RPI Outperforms The Sum Of Its Parts... July 2017 July 2017 Chart II-8B...As Well As Other Indicators July 2017 July 2017 Part IV - Conclusions The RPI is the latest installment in our ongoing research into trading rules that can augment our top-down macro approach to asset allocation. 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. This model adds value on its own, but we feel that it will best be used in conjunction with other indicators designed to improve performance around major market turning points. Future research will experiment with combining the RPI with other indicators to further enhance performance. In the meantime, we will present the RPI's signals each month in Section III of the monthly publication. As with all indicators and models, however, the RPI is only one input to our decision process. We base our asset allocation decision on a combination of indicators, macro themes, detailed data analysis and judgment. The indicator's current reading for stocks versus bonds, at benchmark, is more conservative than our official recommendation. The benchmark reading reflects the fact that equities are overvalued and that investors have deviated from their preferences in their past two quarters. David Boucher Associate Vice President Quantitative Strategist 1 For more information, please see P. A. Samuelson, "A Note on the Pure Theory of Consumer's Behavior," Economica 5:17 (1938), pp. 61-71. 2 Please see U.S. Investment Strategy Special Report "Stocks And The Fed Funds Rate Cycle," dated December 23, 2013, available at usis.bcaresearch.com 3 We tested a few other measures, most notably the stock-to-bond total return ratio (measured by comparing each asset's total returns), but the chosen measures provided the best and most robust results. 4 We conducted a statistical exercise to validate and optimize the allocations in Table 4 to provide a smoother performance. III. Indicators And Reference Charts Thanks to the recent dollar and bond yield “relief valves”, the S&P 500 is stubbornly holding above the 2,400 level. The breakout above this level further stretched valuation metrics. Measures such as the Shiller P/E and price/book are at post tech-bubble highs. Stocks remain expensive based on our composite Valuation Index, although it is still shy of the +1 standard deviation level that demarcates over-valuation. This is because our composite indicator includes valuation measures that take into account the low level of interest rates. Of course, once interest rate normalization is well underway, these indicator will not look as favorable. It is good news for the equity market that our Monetary Indicator did not move further into negative territory over the past month. Indeed, the indicator has hooked up slightly and is sitting close to a neutral level. Our equity Technical Indicator remains constructive. Other measures, such as our Speculation Index, composite sentiment and the VIX suggest that equity investors are overly bullish from a contrary perspective. On the other hand, the U.S. earnings surprises diffusion index highlights that upside earnings surprises are broadly based. Our elevated U.S. Willingness-to-Pay (WTP) indicator ticked down from a high level this month, suggesting that ‘dry powder’ available to buy this market is depleted. This indicator tracks flows, and thus provides 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. In contrast to the U.S., 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 and has some ways to go. We remain overweight both the Eurozone and Japanese markets relative to the U.S. on a currency-hedged basis. The pull back in long-term bond yields since March was enough to “move the dial” in terms of the bond valuation or technical indicators. U.S. bond valuation has inched lower to fair value. However, we believe that fair value itself is moving higher as some of the economic headwinds fade. We also think that the FOMC is determined to stick with the current tightening timetable in terms of rate hikes and balance sheet adjustment, which support our negative view on bond prices. Now that oversold technical conditions have been unwound, it suggests that the consolidation phase for bond yields is largely complete. The trade-weighted dollar remains quite overvalued on a PPP basis, although less so by other measures. Technically, it is a bearish sign that the dollar moved lower and crossed its 200-day moving average. However, our Composite Technical Indicator highlights that overbought conditions have been worked off. We still believe the U.S. dollar’s bull phase has one more upleg left. Technical conditions are also benign in the commodity complex. Most commodities have shifted down over the last month to meet support at their 200-day moving averages. Base metals are due for a bounce, but we are most bullish on oil. 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-4U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-5U.S. Earnings U.S. Earnings U.S. Earnings Chart III-6Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-8U.S. Treasurys and Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-9U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-10Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1110-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-12U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-13Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-14Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-15U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-16U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-17U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-18Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-19Euro Technicals Euro Technicals Euro Technicals Chart III-20Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-21Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-22Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-23Commodity Prices Commodity Prices Commodity Prices Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-26Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-27U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-28U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-29U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-30U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-31U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-32U.S. Consumption U.S. Consumption U.S. Consumption Chart III-33U.S. Housing U.S. Housing U.S. Housing Chart III-34U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-35U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-36Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-37Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China

Feature The BCA Corporate Health Monitor (CHM) - designed to assess the financial well-being of companies - is one of our most reliable indicators that is also extremely popular with our clients. That is no surprise, as the CHMs have a solid track record in signaling broad turning points in company credit quality. This makes them useful in determining asset allocation recommendations on Investment Grade (IG) and High-Yield (HY) corporate bonds. Chart 1U.S. Corporates Outperforming, ##br##Despite Worsening Credit Quality U.S. Corporates Outperforming, Despite Worsening Credit Quality U.S. Corporates Outperforming, Despite Worsening Credit Quality In this Weekly Report, we present the "top-down" CHMs based on corporate data from national income (i.e. "GDP") accounts for the U.S., Euro Area and the U.K. We also show the "bottom-up" CHMs constructed using the actual reported financial data of individual companies in the U.S., Euro Area and Emerging Markets (EM). The CHMs are shown in a chartbook format that allows for quick visual analysis and comparisons. Going forward, we will publish this CHM Chartbook on a quarterly basis as a regular part of Global Fixed Income Strategy. The broad conclusion from looking at the CHMs is that corporate credit quality has been steadily improving in Europe, the U.K. and in the EM universe over the past couple of years, in sharp contrast to the worsening financial health of highly-levered U.S. companies. Bond investors seem to be ignoring the relative message sent by our CHMs, however, as U.S. corporate debt has outperformed other developed credit markets since the beginning of 2016 (Chart 1). An Overview Of The BCA Corporate Health Monitors The BCA Corporate Health Monitor (CHM) is an indicator designed to assess the underlying financial strength of the corporate sector for a country. The Monitor is an average of six financial ratios similar to those used by credit rating agencies to evaluate individual companies. However, we calculate our ratios using top-down (national accounts) data for profits, interest expense, debt levels, etc. The idea is to treat the entire corporate sector as if it were one big company, and then look at the credit metrics that would be used to assign a credit rating to it. Importantly, only data for the non-financial corporate sector is used in the CHM, as the metrics used to measure the underlying health of banks and other financial firms are different than those for the typical company. The six ratios used in the CHM are shown in Table 1 below. To construct the CHM, the individual ratios are standardized, added together, and then shown as a deviation from the medium-term trend. That last part is important, as it introduces more cyclicality into the CHM and allows it to better capture major turning points in corporate well-being. Largely because of this construction, the CHM has a very good track record at heralding trend changes in corporate credit spreads (both for Investment Grade and High-Yield) over many cycles. Top-down CHMs are now available for the U.S., Euro Area and U.K. The CHM methodology was extended in 2016 to look at corporate health by industry and by credit quality.1 The financial data of a broad set of individual U.S. and Euro Area companies was used to construct individual "bottom-up" CHMs using the same procedure as the more familiar top-down CHM. Some of the ratios differ from those used in the top-down CHM (see Table 1), largely due to definitional differences in data presented in national income accounts versus those from actual individual company financial statements. The bottom-up CHMs analyze the health of individual sectors, and can be aggregated up into broad CHMs for Investment Grade and High-Yield groupings to compare with credit spreads. An EM version of the bottom-up CHM was introduced by the BCA Emerging Markets Strategy team last September, which extends the CHM analysis to EM hard-currency corporate debt.2 Table 1Definitions Of Ratios That Go Into The CHMs BCA Corporate Health Monitor Chartbook BCA Corporate Health Monitor Chartbook U.S. Corporate Health Monitors: Still Deteriorating Chart 2Top-Down U.S. CHM: Still Deteriorating Top-Down U.S. CHM: Still Deteriorating Top-Down U.S. CHM: Still Deteriorating Our top-down CHM for the U.S. has been flashing a deteriorating state of corporate health since mid-2014 (Chart 2). That trend had been showing signs of stabilization last year, but the Q1/2017 data worsened on the back of lower profit margins and returns on capital. The latter now sits just above 5% - a level last seen during the 2009 recession. Corporate leverage, as measured in our top-down CHM using the value of debt versus equity, does not look to be a problem. The story is quite different when using alternative measures like net debt/EBITDA, however, with U.S. leverage exceeding the highs from the Telecom bubble of the early 2000s. While booming equity values certainly flatter the leverage ratio in our top-down CHM, a strong stock market should, to some degree, reflect a better backdrop for growth in corporate profits and creditworthiness. Even against this positive backdrop, however, other credit indicators are flashing some warning signs that leave our top-down CHM in the "deteriorating health" zone. Interest coverage and debt coverage ratios, while still above the lows seen during past recessions, are steadily falling. This does raise concerns for U.S. corporate health if U.S. bond yields begin to climb again, as we expect. However, given the historically low interest rate backdrop for corporate debt, a bigger threat to interest coverage ratios and overall credit quality would come from an economic slump that damages company profits. That is not going to be a problem for the rest of this year, but weaker growth is a more likely outcome in 2018 as the Fed continues its monetary tightening cycle. Our bottom-up CHMs for U.S. IG (Chart 3) and U.S. HY (Chart 4) have shown a bit of improvement in recent quarters relative to the signal from our top-down CHM. This is likely related to the growing gap between corporate profits as reported in the U.S. national accounts data, which are slowing, compared to the reported earnings of publicly traded companies, which are accelerating. Also, leverage in the bottom-up CHMs uses the book value of equity, which is more readily reported by individual companies, and is thus much higher than the measure used in our top-down CHM. Return on capital is at multi-decade lows for both IG and HY corporates, although profit margins look to be in much better shape for IG names relative to HY issuers. HY margins have enjoyed a cyclical improvement, however, largely due to better earnings from HY energy companies (Chart 4, panel 4). Interest coverage and debt coverage are depressed, with HY issuers in much worse shape than IG. Chart 3Bottom-Up U.S. Investment Grade CHM: ##br##Deteriorating Bottom-Up U.S. Investment Grade CHM: Deteriorating Bottom-Up U.S. Investment Grade CHM: Deteriorating Chart 4Bottom-Up U.S. High-Yield CHM: ##br##Some Cyclical Improvement Bottom-Up U.S. High-Yield CHM: Some Cyclical Improvement Bottom-Up U.S. High-Yield CHM: Some Cyclical Improvement The cumulative message from our top-down and bottom-up U.S. CHMs is that U.S. corporate health has enjoyed some cyclical improvement over the past few quarters, but the state of balance sheets is slowly-but-steadily worsening. High corporate leverage will become a major problem during the next U.S. recession, but is not a major factor weighing on credit spreads at the moment (Chart 5). We are maintaining our overweight stance on U.S. IG and higher-rated U.S. HY, both of which should continue to outperform Treasuries over the next few months, but a repeat performance is far less likely next year. Chart 5No Signs Of Concern##br## In U.S. Corporate Credit Spreads No Signs Of Concern In U.S. Corporate Credit Spreads No Signs Of Concern In U.S. Corporate Credit Spreads Chart 6Top-Down Euro Area CHM:##br## Improving Top-Down Euro Area CHM: Improving Top-Down Euro Area CHM: Improving Euro Area Corporate Health Monitors: Solid Improvement Our top-down Euro Area CHM has been showing steady improvement since 2013, driven by strong profit margins and rising interest and debt coverage ratios (Chart 6). The ultra-stimulative monetary policies of the European Central Bank (ECB) have likely played a large role in helping lower corporate borrowing costs and boosting the interest coverage ratio. The average coupon on bonds in the Bloomberg Barclays Euro-Aggregate Investment Grade corporate index is now down to a mere 2.3% - a far cry from the 5% level that prevailed during the peak of the 2011 Euro Debt crisis or the 3.5% level just before the ECB began its asset purchase program in 2015. Return on capital has fallen over the past decade and now sits at 8%, although profit margins remain quite strong on our top-down CHM measure. Short-term liquidity is at a record high, suggesting no imminent problems for European corporate borrowers. Our bottom-up CHMs for Euro Area IG (Chart 7) and HY (Chart 8) are telling a broadly similar story to the top-down CHM. The bottom-up CHMs have steadily improved in the past couple of years, most notably for domestic issuers of Euro-denominated debt.3 Some improvement in the bottom-up aggregates for operating margins and interest coverage ratios is providing a boost to European credit quality. Chart 7Bottom-Up Euro Area Investment Grade CHMs Bottom-Up Euro Area Investment Grade CHMs Bottom-Up Euro Area Investment Grade CHMs Chart 8Bottom-Up Euro Area High-Yield CHMs Bottom-Up Euro Area High-Yield CHMs Bottom-Up Euro Area High-Yield CHMs The bottom-up measure of leverage for domestic IG issuers has been steadily declining since the 2009 recession, a sign that European companies have been much more cautious in managing their balance sheet risk than their U.S. counterparts. The same cannot be said for Euro Area domestic HY issuers, where all the individual ratios are at weak absolute levels. When splitting our bottom-up Euro Area IG company list into issuers from core Europe versus countries on the Periphery (Chart 9), the "regional" European CHMs tell broadly similar stories of improving credit quality. The fact that even Peripheral issuers are seeing rising interest coverage and liquidity ratios, despite much higher levels of leverage than in the core, is an indication of how the ECB's low interest rate policies and asset purchase programs (which include buying corporate debt) have helped support the European corporate sector. Net-net, our Euro Area CHMs are sending a signal that there are no immediate stresses on corporate balance sheets or profitability. This is already reflected in the current low level of corporate bond yields and spreads, though (Chart 10). A bigger threat to Euro Area corporates comes from monetary policy. The ECB is under increasing pressure to consider announcing a tapering of its asset purchases - likely to include slower buying of corporates - starting in 2018. There is a risk of a negative market reaction that could undermine future Euro Area corporate bond performance. Because of this, we continue to prefer U.S. corporate debt over Euro Area equivalents, despite the large gap between the U.S. and European top-down CHMs (Chart 11). Chart 9Bottom-Up Euro Area IG CHMs: ##br##Core Vs. Periphery Bottom-Up Euro Area IG CHMs: Core vs Periphery Bottom-Up Euro Area IG CHMs: Core vs Periphery Chart 10Euro Area Corporate Bonds ##br## Have Had A Great Run Euro Area Corporate Bonds Have Had A Great Run Euro Area Corporate Bonds Have Had A Great Run Chart 11Relative CHMs Starting ##br##To Turn Less Favorable For U.S. Credit Relative CHMs Starting To Turn Less Favorable For U.S. Credit Relative CHMs Starting To Turn Less Favorable For U.S. Credit U.K. Corporate Health Monitor: Solid Balance Sheet Fundamentals The top-down U.K. CHM has steadily improved over the past couple of years, led by rising profit margins, higher interest coverage and very robust liquidity (Chart 12). Return on capital is low relative to its history, which is consistent with the trends seen in the U.S. and Euro Area and likely reflects the global low productivity backdrop. Fundamental analysis of U.K. corporates may not be of much use at the moment given the extremely accommodative monetary policy environment provided by the Bank of England (BoE). Low interest rates, combined with BoE asset purchases (which include a small amount of corporate debt) and a steep fall in the Pound in the aftermath of the Brexit-driven political uncertainty, are all helping keep the U.K. economy afloat. The BoE is now having to deal with a currency-driven climb in U.K. inflation, with three members of the BoE policy committee even calling for a rate hike at the latest policy meeting. The political backdrop after last year's Brexit vote and this month's closer-than-expected U.K. election result remains too volatile for the BoE to seriously consider any imminent tightening of monetary policy. While it can be debated how much the Brexit uncertainty is truly weighing on the U.K. economy, the BoE is unlikely to take any risks on triggering a growth slowdown by becoming too hawkish, too soon - even with the relatively high level of currency-driven inflation. A combination of a strong CHM and a dovish BoE will allow U.K. corporate debt, both IG and HY, to continue to outperform Gilts. We continue to recommend an overweight allocation to U.K. corporates even though, as in the other countries shown in this report, valuations are not cheap (Chart 13). We have not yet constructed bottom-up versions of the CHM for U.K. corporates to allow us to make any additional comments on the relative merits of U.K. IG and HY debt. This is something we intend to look into for future reports. Chart 12U.K. Corporate Balance Sheets ##br##Are In Good Shape... U.K. Corporate Balance Sheets Are In Good Shape... U.K. Corporate Balance Sheets Are In Good Shape... Chart 13...Which Is Already Reflected In ##br##Tight Credit Spreads ...Which Is Already Reflected In Tight Credit Spreads ...Which Is Already Reflected In Tight Credit Spreads Emerging Market Corporate Health Monitor: Cyclically Strong, Structurally Weak The CHM for EM corporates built by our Emerging Markets Strategy team is purely a bottom-up measure. The financial data from 220 EM companies in over 30 countries is used to construct the EM CHM. Only firms that issue U.S. dollar-denominated bonds are included, with banks and other financials also omitted in a similar fashion to the CHMs for the developed economies. A shorter list of financial ratios is used in the EM CHM than the developed CHMs, including: Profit margins Free cash flow to total debt: Liquidity Leverage Unlike the developed CHMs, the ratios are not equally weighted in the construction of the EM CHM. Profit margins and cash flow/debt combined represent 75% of the EM CHM. The weightings are designed to optimize the performance of the EM CHM versus the actual spread movements in the J.P. Morgan CEMBI benchmark index for EM corporate debt. Chart 14EM Corporate Health: Cyclically Solid... EM Corporate Health: Cyclically Solid... EM Corporate Health: Cyclically Solid... The EM CHM is currently pointing to very strong fundamental underpinnings for EM corporates with the indicator at the most credit-positive level in a decade (Chart 14). That recent strength is a modest cyclical improvement after a multi-year deterioration in all the individual EM CHM components (Chart 15). The uptick in global commodity prices in 2016 played a major role in the improvement in the growth-sensitive components (top two panels). However, the biggest structural headwind for EM corporates is the unrelenting rise in balance sheet leverage (bottom panel) - a problem that could come to the forefront if the recent slump in commodity prices persists or developed market interest rates begin to rise more sharply as central banks become marginally less accommodative. For now, we continue to recommend only a neutral allocation to EM hard currency debt, as the positive message sent by the EM CHM appears fully priced into the current low level of EM yields and spreads (Chart 16). Chart 15...But Structurally More Challenged ...But Structurally More Challenged ...But Structurally More Challenged Chart 16EM Corporate Debt Is Not Cheap EM Corporate Debt Is Not Cheap EM Corporate Debt Is Not Cheap Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see Section II of The Bank Credit Analyst, "U.S. Corporate Health Gets A Failing Grade", dated February 2016, available at bca.bcaresearch.com. 2 Please see BCA Emerging Markets Strategy Special Report, "EM Corporate Health Is Flashing Red" dated September 14 2016, available at ems.bcaresearch.com. 3 Given the large share of non-European issuers in the Euro-denominated corporate debt market, we have split our sample set of companies in our bottom-up Euro Area CHMs into "domestic" and "foreign" issuer groups. This allows a more precise analysis of the corporate health of European-domiciled companies. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns The GFIS Recommended Portfolio Vs. The Custom Benchmark Index BCA Corporate Health Monitor Chartbook BCA Corporate Health Monitor Chartbook

Highlights Risk Budgeting: We are introducing a more formal risk measurement element to our model global bond portfolio. This is to identify if our individual views are potentially creating too much volatility, in aggregate, but also as a way to express the conviction of our individual recommendations through allocation of a "risk budget". Tracking Error Of Our Portfolio: We are setting our maximum allowable tracking error, or excess volatility of our portfolio versus our benchmark index, at 100 basis points. Our current tracking error is just under ½ of that limit. We estimate that our highest conviction views at the moment - staying below-benchmark on duration risk, overweighting U.S. corporates, underweighting both U.S. Treasuries and Italian government debt - contribute nearly 4/5ths of our overall portfolio tracking error. Feature Last September, we introduced a model portfolio framework to Global Fixed Income Strategy.1 This was done to better communicate our investment research into actionable ideas more in line with the day-to-day decisions and trade-offs made by professional bond managers. We followed that up with the addition of performance measurement tools to more accurately track the returns of our model bond portfolio versus a stated benchmark.2 We are now initiating the final piece of our model bond portfolio framework in this Special Report - introducing a risk management component to identify cumulative exposures and guide the relative sizes of our suggested tilts. Our goal is to translate our individual investment recommendations into the language of a "risk budget", i.e. how much of the desired volatility of the portfolio would we suggest placing into any single trade idea. This will allow our readers to apply our proposed tilts - based on how much conviction (i.e. "risk") we allocate to each position - to their own portfolios which may have different risk limits and return expectations. For example, our current recommendation to overweight U.S. corporate debt, both Investment Grade (IG) and High-Yield (HY) represents nearly 1/3 of our estimated total portfolio risk, by far our largest source of potential volatility both in absolute terms and versus our benchmark index (Table 1). Overweighting U.S. corporates, both versus U.S. Treasuries and Euro Area equivalents, is one of our highest conviction trades at the moment. A client who may choose to run a lower risk portfolio can still follow our recommendation by placing enough into U.S. corporates so that 33% of the desired portfolio volatility will come from those positions. Table 1Risk Allocation In Our Model Bond Portfolio Adding A Risk Management Framework To Our Model Bond Portfolio Adding A Risk Management Framework To Our Model Bond Portfolio In the rest of this Special Report, we will discuss some of the various ways to measure fixed income portfolio risk, apply them to our model portfolio, and introduce some measures to monitor our aggregate portfolio volatility. Going forward, we will closely watch our established metrics and position sizes to ensure that the combination of our individual investment recommendations that we discuss on a week-to-week basis does not create a portfolio that is potentially more volatile than desired. Risk Measurement In Fixed Income Portfolios While investors are typically focused on meeting return targets for their portfolios, the other side of the equation - managing portfolio volatility - is often less stressed. This is especially true during bull markets for any asset class. Investors may become complacent if returns meet or exceed their targets when, in fact, excess returns may have actually been earned through overly risky positions that could have easily not worked in the investors' favor. In the current macro environment, where many financial asset prices are at new highs with stretched valuations and with most of the major global central banks incrementally moving towards less accommodative monetary policy stances, risk management should be even more important for investors. Overly concentrated positioning could now lead to considerable portfolio losses, especially if measuring risk with a metric that is flawed or incomplete, which can lead to a false sense of security. With that in mind, we consider some typical risk measurement metrics used by fixed income investors: Duration: Duration is usually the most popular risk metric for fixed income portfolios as it measures interest rate sensitivity. Duration is defined as the percentage change in a portfolio or asset resulting from a one percentage point change in interest rates. While it provides a solid base understanding of interest rate risk, it does make a simplifying assumption that there is a linear relationship between interest rates and bond prices. Value-At-Risk: Value-At-Risk (VaR) is a statistical technique that measures the loss of an investment, or of an entire portfolio, over a certain period with a given level of confidence. However, there are two considerable flaws with this approach. First, the VaR output suggests a portfolio can lose at least X%, it does not actually indicate how big the potential loss could be. Instead, using a measure such as Historical VaR, if a portfolio has a long enough track record, can better quantify potential losses. Second, VaR is highly susceptible to estimation errors. Certain assumptions on correlations and the normality of return distributions can have a substantial impact on VaR readings. Table 2Value At Risk Of Our Benchmark Adding A Risk Management Framework To Our Model Bond Portfolio Adding A Risk Management Framework To Our Model Bond Portfolio In Table 2, we show the Historical VaR (HVAR) of our benchmark index, calculating the potential monthly loss using data going back to 2005. On that basis, the worst expected monthly loss for our benchmark is -1.6% (using a 95% confidence interval) and -2.1% (using a 99% confidence interval). Tracking Error: Tracking error measures the volatility of excess returns relative to a certain benchmark. It is a standard risk measure used by a typical "real money" bond manager with a benchmark performance index, like a mutual fund. Tracking error does not offer information on alpha generation (i.e. how much you can expect to beat your benchmark based on your current investments), it simply indicates how much more volatile a portfolio is expected to be versus its benchmark. As our model portfolio returns are measured on a relative basis to our stated bond benchmark index, tracking error is quite appropriate as our main risk metric. A Historical Examination Of Our Portfolio When we first created our model portfolio, we also introduced a benchmark index against which we could measure our performance. Our customized benchmark differs from typical multi-sector measures like the Barclays Global Aggregate Index in that it has a broader scope, including sectors that can have credit ratings below investment grade such as High Yield corporates. The benchmark does, however, exclude smaller regions that we only occasionally discuss such as Sweden, Portugal, Norway and New Zealand. These smaller markets offer comparatively poor liquidity and we want our benchmark to be as investible as possible. Nevertheless, our customized benchmark has been highly correlated to the Barclays Global Aggregate Index over the past decade. As our portfolio has not had a full year of return data, its history is quite limited. Still, in our first performance review conducted two months ago, we indicated that our portfolio had been very closely tracking our customized benchmark. We have since increased our positions in our highest conviction views and our tracking error has risen noticeably and now sits at just over 40bps (Chart 1). Within our model portfolio, we are setting an expected excess return target of 100bps per year. That means that we are setting a goal of beating our benchmark index returns by one full percentage point per year. Given that we are measuring our performance versus currency-hedged benchmarks that are primarily rated investment grade or better, 100bps of annual excess return is a reasonable target. We are also setting a limit where the excess return/tracking error ratio should aim to be equal to 1 each year. This is under the simple assumption that we want an equal amount of return over our benchmark for our expected excess volatility versus our benchmark. On that basis, we are setting our tracking error "limit" at 100bps per year. That suggests that our current tracking error is relatively low. However, correlations between the individual components of our benchmark index have been rising over the past couple of years (Chart 2). Therefore, running a relatively low overall level of risk at a time where diversification among the positions within our portfolio is now harder to achieve, and when the valuations on most government bond and credit markets look rich, is prudent. Chart 1Higher Tracking Error, But Still Well Below Our Target Higher Tracking Error, But Still Well Below Our Target Higher Tracking Error, But Still Well Below Our Target Chart 2Correlations Across Fixed Income Sectors Have Been Rising Correlations Across Fixed Income Sectors Have Been Rising Correlations Across Fixed Income Sectors Have Been Rising This is another way that we can control the overall riskiness of our model portfolio. Not only by how much of our risk budget (tracking error) that we want to allocate to each of our recommended positions, but also how big of a risk budget do we want to run at any given point in time. If we see more assets trading at cheap valuations, then we could choose to run a higher tracking error than when most assets look expensive. Bottom Line: We are introducing a more formal risk measurement element to our model global bond portfolio. This is to identify if our individual views are potentially creating too much volatility, in aggregate, but also as a way to express the conviction of our individual recommendations through allocation of a "risk budget". We are setting our maximum allowable tracking error, or excess volatility of our portfolio versus our benchmark index, at 100 basis points. Measuring The Contribution To Risk From Our Market Tilts In our model portfolio, we include a wide range of geographies and sectors from the global fixed income universe. Understanding the risk contribution of each position to the overall portfolio provides a clearer picture as to where our potential risks lie, and by how much. To measure the risk contribution of each of our individual recommendations to our overall portfolio volatility, we used the following formula: wA * E CovAB * wB Where W = the weight of any single asset in our portfolio and COV is the covariance between the asset and other assets in the portfolio. As such, an asset's contribution to risk is a function of its weight in the portfolio and its covariance with the other assets. Importantly, since we are measuring our model portfolio performance in terms of excess returns, we examined each position's contribution to risk relative to the benchmark. All calculations begin in late 2005, when return data is available for all of the assets in our portfolio. The results are summarized in Table 1 on Page 1. Our portfolio tilts are based off of our four highest conviction themes. They include: Stronger global growth led by the U.S. The U.S. economy should expand at a faster pace in the latter half of the year on the back of a rebound in consumption and strong capital spending, all supported by solid income growth and easy financial conditions. We have expressed this theme through our overweight allocation to U.S. corporate debt. While our U.S. Corporate Health Monitor is flashing that balance sheets are becoming increasingly strained, easy monetary conditions and an expansionary economic backdrop should continue to support excess returns for U.S. corporates. More Fed rate hikes than expected. We expect U.S. economic and corporate profit growth to remain robust due to accommodative monetary conditions, diminishing slack and resilient consumption. As such, the Fed will continue tightening policy by more than what markets are currently pricing in. This theme is expressed through an underweight position in U.S. Treasuries, which accounts for 17% of our volatility versus 24% for that of the benchmark. This wide spread relative to the benchmark is a substantial source of our tracking error, but one that we are comfortable running given our view that U.S. Treasury yields are too low. Chart 3Realized Bond Volatility Has Been Declining Realized Bond Volatility Has Been Declining Realized Bond Volatility Has Been Declining Rising tapering risks in Europe. Our expectation is that the European Central Bank (ECB) will be forced to announce a slower pace (tapering) of bond buying starting next year, given the current robust economic expansion in Europe that is rapidly absorbing spare capacity. An ECB taper announcement is expected to lead to rising longer-term global bond yields, mostly via rising term premia. We are expressing that view in our portfolio through our overall underweight interest rate duration stance. Our current portfolio duration is 5.6 years versus our benchmark duration of 7.0 years. That is a large tilt that represents a significant portion of our tracking error, but given our view that U.S. Treasuries also look overvalued, running a large overall duration underweight does correlate to our conviction level. Rising geopolitical risks and banking sector issues in Italy. Geopolitical risks remain elevated leading up to parliamentary elections in 2018, and Italian banks remain undercapitalized with non-performing loans still in an uptrend. Therefore, we are underweight Italian debt, though this is a smaller deviation of portfolio risk versus our benchmark (around 2%), given the smaller size of Italy in our benchmark. Purely looking at geography and sector selection, our four highest conviction views make up almost 80% of the active portfolio risk that we are "running" in our model portfolio. That number may seem high but, as described earlier, our realized portfolio volatility has been quite low (Chart 3). That suggests that there could be some degree of underlying diversification within our recommended portfolio given lower correlations of certain assets to the rest of the portfolio. This is a topic that we will investigate more deeply in future Weekly Reports. Bottom Line: We estimate that our highest conviction views at the moment - staying below-benchmark on duration risk, overweighting U.S. corporates, underweighting both U.S. Treasuries and Italian government debt - contribute nearly 4/5ths of our overall portfolio tracking error. Patrick Trinh, Associate Editor Patrick@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Special Report, "Introducing Our Recommended Global Fixed Income Portfolio", dated September 20 2016, available at gfis.bcaresearch.com 2 Please see BCA Global Fixed Income Strategy Special Report, "An Initial Look At The Performance Of Our Model Bond Portfolio", dated April 18 2017, available at gfis.bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Table 4 Adding A Risk Management Framework To Our Model Bond Portfolio Adding A Risk Management Framework To Our Model Bond Portfolio

Highlights The main driving force behind EM risk assets this year has been downshifting U.S. interest rates and a weak U.S. dollar. These factors have more than offset the relapse in commodity prices and the deteriorating growth outlook for China/EM. Going forward, odds favor a rise in U.S. interest rates and a stronger dollar. If this scenario materializes, the EM rally will reverse. Meanwhile, China's liquidity conditions have tightened, warranting a meaningful slowdown in money/credit and economic growth. Altogether, the outlook for EM risk assets is extremely poor, and we reiterate our defensive strategy. In Argentina, we continue favoring local currency bonds and sovereign credit, especially relative to their EM counterparts. Feature What Has Not Worked In This Rally Financial market actions of late have been rife with contradictions, and momentum trades have been prevalent. In the past few months we have been highlighting that EM risk assets - stocks, currencies and bonds - have decoupled from most of their historically reliable indicators such as commodities prices, China's money and credit impulses and China/EM manufacturing PMI.1 This week we highlight several additional indicators and variables that EM risk assets have diverged from. Chinese H shares - the index that does not contain internet/social media stocks - have decoupled from the Chinese yield curve (Chart I-1). The mainstream press have been focused on inversion in the 10/5-year Chinese yield curve, but we do not find it to be a particularly credible or useful indicator for the economy. Our preference is the 5-year to 3-month yield curve to gauge the cyclical growth outlook. Chart I-1China's Yield Curve Heralds Lower Share Prices China's Yield Curve Heralds Lower Share Prices China's Yield Curve Heralds Lower Share Prices Not only has the yield curve been flattening, but it has also recently inverted, suggesting an impending downturn in China's business cycle (Chart I-2). Chart I-2China's Yield Curve Inversion Points To A Growth Slump China's Yield Curve Inversion Points To A Growth Slump China's Yield Curve Inversion Points To A Growth Slump In China, commercial banks' excess reserves at the People's Bank of China (PBoC) have begun shrinking since early this year, reflecting the PBoC's liquidity tightening (Chart I-3, top panel). Banks' excess reserves are the ultimate liquidity constraint on banks' ability to originate new credit/money and expand their balance sheets. Meanwhile, Chinese commercial banks are stretched and overextended, as illustrated by the record-high ratios of both M2 and commercial banks' assets-to-excess reserves (Chart I-3, bottom panel). These are true measures of the money multiplier, and they have surged to very high levels. Besides, financial/bank regulators are clamping down on speculative activities among banks and other financial intermediaries, and are also forcing banks to bring off-balance-sheet assets onto their balance sheets. Faced with dwindling liquidity (excess reserves), rising interest rates and a regulatory clampdown, banks will slow down credit / money origination. Slower credit growth will cause a considerable slump in capital spending, and overall economic growth will downshift. On a similar note, interest rates lead money/credit growth in China, as evidenced in Chart I-4. Chart I-3China: Dwindling Excess Reserves ##br##Will Cause A Credit Slowdown China: Dwindling Excess Reserves Will Cause A Credit Slowdown China: Dwindling Excess Reserves Will Cause A Credit Slowdown Chart I-4China: Interest Rates ##br##And Money Growth China: Interest Rates And Money Growth China: Interest Rates And Money Growth The considerable - about 200 basis points - rise in Chinese money market and corporate bond yields since November heralds a deceleration in money/credit growth. Historically, interest rates affect money/credit growth and ultimately economic activity with a time lag. There is no reason why this relationship will not hold in China this time around. Given that Chinese companies are overleveraged, credit growth is likely to be more sensitive to rising than falling interest rates. Hence, the lingering credit excesses in China make rising interest rates more dangerous. Industrial commodities prices have reacted to liquidity tightening in China sensibly by falling since early this year (Chart I-5A and Chart I-5B). Chart I-5AWidespread Decline In Commodities Prices (II) Widespread Decline In Commodities Prices (I) Widespread Decline In Commodities Prices (I) Chart I-5BWidespread Decline In Commodities Prices (I) Widespread Decline In Commodities Prices (II) Widespread Decline In Commodities Prices (II) The weakness in commodities prices since early this year is especially noteworthy because it has occurred at a time of U.S. dollar weakness and dissipating Federal Reserve tightening concerns. When and as the U.S. dollar gains ground again, the selloff in commodities will escalate. Outside commodities, there are early signposts that another Chinese slowdown is beginning to unfold - slowing exports in May from Korea and Taiwan to China, being one glaring example (Chart I-6). This chart corroborates our argument that the surge in Chinese imports in late 2016 and the first quarter 2017 was a one-off growth boost, and appeared very strong because of the low base from a year ago. Consistently, Taiwan's manufacturing shipments-to-inventory ratio has rolled over, which correlates well with the tech-heavy Taiwanese stock index (Chart I-6, bottom panel). With respect to the broader EM universe, EM equities and currencies have decoupled from U.S. inflation expectations (Chart I-7). Chart I-6Shipments To China Have Rolled Over Shipments To China Have Rolled Over Shipments To China Have Rolled Over Chart I-7EM And U.S. Inflation Expectations: ##br##Unsustainable Decoupling? EM And U.S. Inflation Expectations: Unsustainable Decoupling? EM And U.S. Inflation Expectations: Unsustainable Decoupling? Historically, falling U.S. inflation expectations have reflected dropping oil prices and caused real rates (TIPS yields) to rise. In turn, lower oil prices and/or rising TIPS yields weighed on EM risk assets. The decline in U.S. Treasurys yields since last December has been largely due to inflation expectations rather than real rates. Such a mixture has historically been ominous for EM risk assets. Notwithstanding, EM risk assets have rallied a lot, despite such a hostile backdrop year-to-date. Finally, the Brazilian and South African exchange rates and their bonds have been among the more stellar performers in the past 12 months. Nevertheless, first quarter GDP releases in Brazil and South Africa have confirmed that there has been little domestic demand recovery in either country. Remarkably, in both countries, agriculture and mining volumes boomed in the first quarter, boosting GDP growth, yet final domestic demand remained shockingly depressed, as illustrated in Chart I-8. This discards the popular EM rally narrative that improving global growth will lift EM economies. Neither a poor domestic growth backdrop and political volatility nor falling commodities prices have prompted a meaningful plunge in either the Brazilian or South African exchange rate. Chart I-9 portends that the BRL and ZAR have historically been correlated with commodities prices but have recently shown tentative signs of decoupling. Chart I-8Not Much Recovery In Brazil ##br##And South Africa's Domestic Demand Not Much Recovery In Brazil And South Africa's Domestic Demand Not Much Recovery In Brazil And South Africa's Domestic Demand Chart I-9BRL And ZAR And Commodities BRL And ZAR And Commodities BRL And ZAR And Commodities Bottom Line: EM financial markets have veered away from many traditional indicators. These constitute important contradictions and raise the question of whether this time is different. We do not think so. What Has Driven This EM Rally: U.S. Rates And The U.S. Dollar The variables that have explained the EM rally in the past six months have been falling U.S. interest rate expectations and a weaker U.S. dollar, as well as the global technology mania. We elaborated on the tech rally in recent weeks,2 and this week re-visit EM's link with U.S. interest rates and the greenback. The main driving force behind EM risk assets, year -to-date, has been U.S. TIPS yields and the greenback (Chart I-10). In short, it has been the carry trade that has transpired since the Fed's meeting on December 15, 2016 - regardless of EM growth dynamics and fundamentals. Going forward, barring a major growth relapse in China/EM growth and an associated U.S. dollar rally, the odds favor a rise in U.S. interest rates in general and U.S. TIPS yields in particular: The U.S. composite capacity utilization gauge (Chart I-11, top panel) - constructed by our Foreign Exchange Strategy team based on the unemployment gap and industrial capacity utilization - is moving above the zero line, denoting that there is little slack in the U.S. economy. Chart I-10U.S. TIPS Yields, Dollar And EM U.S. TIPS Yields, Dollar And EM U.S. TIPS Yields, Dollar And EM Chart I-11The U.S. Economy: Is It The Time To Bet On Higher Bond Yields? The U.S. Economy: Is It The Time To Bet On Higher Bond Yields? The U.S. Economy: Is It The Time To Bet On Higher Bond Yields? Any time the indicator has moved above the zero line in the past 55 years - the shaded periods on Chart I-11 - inflationary pressures, wages and bond yields have typically risen, and vice versa. The message from this indicator is unambiguous: U.S. inflationary pressures will become evident soon, and interest rates will rise. In this context, U.S. interest rate expectations are too low. Re-pricing of U.S. interest rates will shake off lingering complacency across many financial markets worldwide. Notably, the U.S. mortgage purchase index is surging, job openings are very elevated (Chart I-12), financial and property markets are buoyant and the dollar has been weak. If the Fed does not normalize interest rates now, when will it? Finally, both nominal and inflated-adjusted U.S. bond yields are at their technical support, and will likely bounce from these levels (Chart I-13). Chart I-12Are U.S. Rate Expectations Too Low? Are U.S. Rate Expectations Too Low? Are U.S. Rate Expectations Too Low? Chart I-13U.S. Bond Yields Are At A Critical Juncture U.S. Bond Yields Are At A Critical Juncture U.S. Bond Yields Are At A Critical Juncture Chart I-14U.S. Growth Underperformance Is Late U.S. Growth Underperformance Is Late U.S. Growth Underperformance Is Late Rising U.S. interest rates will trigger another up leg in the U.S. dollar. Notably, the relative economic surprise index between the U.S. and the G10 is close to its post-crisis lows (Chart I-14). The relative U.S. growth underperformance versus DM is late and will turn around very soon. While it does not always define the fluctuations in the U.S. dollar, we would still expect it to lend some support to the greenback. BCA's Emerging Markets Strategy service believes the broad trade-weighted U.S. dollar is still in a bull market, especially versus EM, DM commodities currencies and Asian currencies. We have less conviction on the magnitude of the downside in the euro, but the latter at minimum will not rally above 1.14 -1.15 for now. Finally, various EM currencies are facing an important technical resistance (Chart I-15A and Chart I-15B). We expect these technical levels to mark their top. Chart I-15AEM Currencies Are Facing Technical Resistance (II) EM Currencies Are Facing Technical Resistance (I) EM Currencies Are Facing Technical Resistance (I) Chart I-15BEM Currencies Are Facing Technical Resistance (I) EM Currencies Are Facing Technical Resistance (II) EM Currencies Are Facing Technical Resistance (II) At the same time, the precious metals index seems to be rolling over at its 200-day resistance level (Chart I-16). A top in the precious metals index would be consistent with a bottom in U.S. TIPS yields and the U.S. dollar. Chart I-16Precious Metals Are Facing ##br##A Major Resistance Precious Metals Are Facing A Major Resistance Precious Metals Are Facing A Major Resistance Bottom Line: U.S. interest rate expectations are too low and are set to rise. Rising interest rates will remove a major support underpinning the EM rally. A Resolution There are three potential scenarios as far as the ongoing EM rally is concerned: The goldilocks scenario of low interest rates in the U.S., a weaker dollar and steady-to-improving growth in EM/China. The markets have already priced in a lot of good news, but the rally could feasibly continue for some time if this scenario transpires. Re-pricing of the Fed. U.S. interest rates will rise and the dollar will get bid up. The rationale is the modest U.S. inflationary pressures will become evident amid solid U.S. growth. This will weigh on EM risk assets, even if EM/China growth does not falter. The basis for this is the EM rally year-to-date has been driven by diminishing U.S. interest rates expectations. Deflation trade redux. China/EM growth will deteriorate meaningfully (for reasons discussed above), causing a considerable downshift in commodities prices and EM risk assets. This could well occur even if U.S. rates stay low. In fact, this is the main plausible reason to bet against a rise in U.S. interest rate expectations from current levels. Investing is about assigning probabilities. We assign much lower probability to the first scenario (no more than 20%), while we see the odds of either the second or third scenarios playing out in the short term at closer to 40%. In the medium term (nine-to 12 months), scenario 3 will be the most prevalent one. If conditions in scenario 2 (rising U.S. bond yields) coincide with a deflationary shock emanating from China, EM financial markets will face a perfect storm. Bottom Line: We continue to recommend a defensive investment strategy for absolute-return investors, and recommend an underweight allocation towards EM within global portfolios across stocks, credit and currencies. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Report titled, "EM: Is This Time Different?", dated June 7, 2017, link available on page 19. 2 Please refer to the Emerging Markets Strategy Weekly Report titled, "Can Tech Drive EM Stocks Higher?", dated May 17, 2017, and Emerging Markets Strategy Weekly Report titled, "EM: Is This Time Different?", dated June 7, links available on page 19. Argentina: Favor Local Bonds And Sovereign Spreads EM fixed-income portfolio should continue to overweight Argentine local currency bonds and sovereign credit based on the following reasons: Policymakers continue pursuing credible orthodox policies. The central bank has been accumulating foreign exchange as a part of its explicit program to increase international reserves from 10% to 15% of GDP and keep the peso competitive. At the same time, the monetary authorities have partially siphoned off liquidity via reverse repos (Chart II-1). On a net-net basis, monetary stance is rather tight as evidenced by money and credit contraction in real (inflation-adjusted) terms (Chart II-2). Chart II-1Argentina: Rising Reserves ##br##And Reverse Sterilization Argentina: Rising Reserves And Reverse Sterilization Argentina: Rising Reserves And Reverse Sterilization Chart II-2Argentina: Inflation-Adjusted Money ##br##And Credit Are Contracting Argentina: Inflation-Adjusted Money And Credit Are Contracting Argentina: Inflation-Adjusted Money And Credit Are Contracting Rapid disinflation is proving difficult to achieve due to inflation inertia and high inflation expectations. However, the authorities are holding their position steady in wage negotiations. Wages in both the public and private sectors are contracting in real terms (Chart II-3). Provided wages are a major driver of inflation, employee compensation growing at a slower pace than inflation signals lower inflation ahead. The economy is not yet recovering as evidenced by Chart II-4 and lingering economic stagnation will foster disinflation. Chart II-3Argentina: Lower Wage Growth ##br##Is Critical To Anchor Inflation Argentina: Lower Wage Growth Is Critical To Anchor Inflation Argentina: Lower Wage Growth Is Critical To Anchor Inflation Chart II-4Argentina: The Economy ##br##Is Still In Doldrums Argentina: The Economy Is Still In Doldrums Argentina: The Economy Is Still In Doldrums A change in our fundamental view on inflation would require an irresponsible central bank tolerating run away money and credit growth. We find this scenario unlikely and hold the view that the inflation outlook will improve (Chart II-5). Chart II-5Argentina: Inflation Is On The Right Track Argentina: Inflation Is On The Right Track Argentina: Inflation Is On The Right Track In regard to the currency, the Argentine central bank will allow the peso to depreciate as maintaining a competitive exchange rate is a major policy priority for them. This is especially true if commodities prices fall and the regional currencies (BRL and CLP) depreciate versus the greenback. The current account and fiscal deficits are large but Argentina is seeing significant FDI and foreign portfolio capital inflows. Hence, funding will not be a problem for some time. The eventual economic recovery and the cheap currency, as well as slow but progressing reforms, will make Argentina a more attractive destination for foreign investors and ensure foreign capital inflows. Overall, there are many challenges, but the outlook for Argentina is much better compared with EM economies in general, and Brazil in particular. Hence, we recommend staying long Argentinian assets on a relative basis versus EM counterparts, particularly Brazil. Specifically, we maintain the following positions: Long ARS versus BRL. We do not expect the currency to depreciate more than what the NDF market is pricing in the next 12 months, and believe it will outperform the BRL on a total return basis (including carry). Stay long Argentine 7-year local currency government bonds. Stay long Argentine / short Brazilian and Venezuelan sovereign credit. Overweight Argentine stocks within the emerging and frontier market universes. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Duration & TIPS: The recent downtrend in nominal Treasury yields has been driven entirely by inflation that has come in weaker than expected. We are inclined to view inflation's weakness as transitory and suggest investors maintain a below-benchmark portfolio duration stance, as well as an overweight allocation to TIPS versus nominal Treasury securities. Corporate Debt & The Economy: High corporate debt levels are not indicative of over-investment on the part of the corporate sector. As such, they do not suggest an elevated risk of recession. Corporate Debt & Credit Spreads: While a supportive Fed will keep corporate spreads low for the time being, rising leverage is starting to send a worrying message. Feature It's All About Inflation Chart 1End Of The Trump Trade? End Of The Trump Trade? End Of The Trump Trade? Treasury securities have reversed a lot of their post-election sell off during the past few weeks, and the 10-year yield is now only 38 basis points above where it was last November (Chart 1). A quick glance at the 10-year's real and inflation components reveals that weaker inflation is the culprit. The real 10-year Treasury yield remains 31 bps above its pre-election level, but the 10-year TIPS breakeven inflation rate is now only 7 bps higher (Chart 1, bottom panel). This explains a lot about the broader financial environment. Stable growth and low inflation create a fertile breeding ground for risk assets, and corporate bond spreads are indeed considerably tighter than prior to the election. The average spread on the investment grade corporate bond index is currently 113 bps, down from 135 bps in November. The average junk spread is currently 365 bps, down from 489 bps. What explains the large drop in inflation breakevens? One reason is that they had simply overshot the fair value implied by other financial instruments (Chart 2). Our financial model- based on the oil price, the exchange rate and the stock-to-bond total return ratio - shows that the 10-year breakeven rate was around 20 bps too high earlier this year. It is now almost exactly in line with our model's fair value. The most likely explanation for the overshoot is that markets started to discount a much more stimulative fiscal policy in the immediate aftermath of the election. The potential for large tax cuts at a time of already tight labor markets caused investors' inflation expectations to ramp up. While tax cuts are still likely, it now appears as though they will occur much later and be smaller in scale than was originally thought. Falling oil prices have also exacerbated the drop in breakevens by causing the fair value reading from our model to roll over (Chart 2, bottom panel). Our commodity strategists do not think oil prices will stay this low for much longer.1 OPEC 2.0 production cuts and sustained growth in emerging market trade volumes will cause oil inventories to fall this year, leading to a rebound in prices. The second explanation for this year's drop in the inflation component of yields is that the core inflation data have disappointed during the past couple of months. After reaching 1.8% in February of this year, 12-month trailing core PCE inflation has deviated sharply from the uptrend that had been in place since mid-2015. As of April, it had fallen back to 1.5%, well below the level implied by our Phillips Curve inflation model (Chart 3). Chart 2TIPS Financial Model TIPS Financial Model TIPS Financial Model Chart 3A Phillips Curve Inflation Model A Phillips Curve Inflation Model A Phillips Curve Inflation Model With the labor market continuing to tighten and the dollar having depreciated in recent months, we are inclined to view the recent drop in core inflation as transitory. In fact, even after making some adjustments to the estimation interval (see Box), our Phillips Curve inflation model still projects that core PCE inflation will reach 2% by the end of this year in a base case scenario where the unemployment rate, the exchange rate and survey inflation expectations are all unchanged. Box: Incorporating Different Regimes Into Our Inflation Model As has been explored in depth in prior reports,2 we have been modeling core PCE inflation using a Phillips Curve model that is inspired by one that Janet Yellen mentioned in a 2015 speech.3 Essentially, we model core inflation using lagged inflation, the gap between the unemployment rate and the Congressional Budget Office's estimate of the natural unemployment rate, relative non-oil import prices and a survey measure of inflation expectations. Previously we estimated the coefficients for this model using the longest time interval we could obtain - starting in October 1979. However, a recent Fed paper by Jeremy Nalewaik4 motivated us to refine this approach. Nalewaik shows that core PCE inflation has been driven by different factors in different regimes, and that those regimes can be defined by whether inflation expectations were well-anchored or highly volatile. Specifically, in the 1970s, 1980s and early 1990s, inflation expectations were highly volatile and explained much more of the variation in actual core inflation than they did in the 1960s or from the mid-1990s until the present day. We confirmed this result by splitting our sample into two periods - 1979 to 1995, and 1995 to present. Our results show that inflation expectations were a much more significant driver of core inflation in the 1979-1995 regime than they are in the current regime (Table 1). As such, we have decided that the coefficients calculated using the 1995-present interval are probably more representative of the current environment. Applying these coefficients to the four scenarios we examined in our May 2 report, our model now projects that core PCE inflation will reach 2.03% by year end in our "base case" scenario, 1.93% in our "strong dollar" scenario, 1.97% in our "bad NAIRU" scenario and 1.87% in our "deflation case" scenario. Table 1BCA Phillips Curve Model* Of Core** PCE Inflation Under Different Regression Intervals Low Inflation And Rising Debt Low Inflation And Rising Debt Where Are Yields Headed From Here? We see two potential scenarios that could play out between now and the end of the year. The first is that core inflation rebounds during the next few months and ends the year closer to our model's fair value estimate. The inflation component of yields would move higher in this scenario and real yields would probably also increase. The 10-year real yield closely tracks our 12-month fed funds discounter, which measures the number of rate hikes the market expects during the next year (Chart 4). The discounter currently sits at 49 bps, meaning that the market expects fewer than 2 rate hikes during the next 12 months. This would certainly be revised higher if inflation were to rebound. Chart 4Fed Wants Wider Breakevens Fed Wants Wider Breakevens Fed Wants Wider Breakevens The second possible scenario is that while U.S. growth stays close to its current 2% pace, inflation simply does not bounce back. In other words, core PCE ends the year closer to 1.5% than to 2% and a large residual opens up between inflation and our Phillips Curve model. While TIPS breakevens would be unlikely to rise in this scenario, the downside is also probably limited unless inflation were to fall below its current 1.5%. If this second scenario plays out the Fed would also probably react by adopting a more dovish policy stance. This would cause the market's rate hike expectations, and 10-year real yields, to fall. But even here the downside would appear to be limited. With the market currently priced for a mere 39 bps of hikes between now and the end of 2017 and only another 24 bps for all of 2018, there simply isn't much scope for a large dovish re-rating of the Fed. Additionally, if the Fed were to adopt a sufficiently dovish reaction function in the face of persistently low inflation, it is possible that lower rate hike expectations could spur a recovery in long-maturity TIPS breakeven inflation rates. If the market believes that the Fed will stay dovish enough for inflation to recover to target, then the positive correlation between real yields and inflation breakevens could reverse. There are recent precedents for this (Chart 4, bottom panel). In 2011 and 2012, the Fed's Operation Twist caused rate hike expectations and real yields to fall, but also led to wider TIPS breakevens. The reverse scenario played out in 2015 when the market decided that the Fed was adopting an overly hawkish policy stance. This caused TIPS breakevens to fall as real yields rose. The conclusion here is that even if inflation stays stubbornly low for the remainder of the year, and the Fed responds by guiding the market toward a shallower rate hike path, then it is possible that some of the downside in real yields will be mitigated by rising TIPS breakevens. In our view, the risk/reward trade-off between the two scenarios outlined above suggests that investors should maintain a below-benchmark duration stance. Bottom Line: The recent downtrend in nominal Treasury yields has been driven entirely by inflation that has come in weaker than expected. We are inclined to view inflation's weakness as transitory and suggest investors maintain a below-benchmark portfolio duration stance, as well as an overweight allocation to TIPS versus nominal Treasury securities. Even in a scenario where inflation stays low despite continued above-trend economic growth, we view the downside in yields from current levels as limited. It's Late In The Game For Corporate Credit With last week's release of the U.S. Financial Accounts (formerly Flow of Funds) we are able to update some of our preferred credit cycle indicators. One concerning development is that net corporate leverage - defined as total debt less cash as a percent of EBITD - ticked higher for the second consecutive quarter in Q1 (Chart 5). Chart 5Corporate Balance Sheets Continue To Add Leverage Corporate Balance Sheets Continue To Add Leverage Corporate Balance Sheets Continue To Add Leverage As we have observed in previous reports,5 there is a strong correlation between net leverage and spreads. In fact, we are only able to identify one other period in which spreads were able to tighten as leverage rose. That period was in the late 1980s, immediately following the crash and subsequent rebound in oil prices. As is shown in Chart 5, net leverage correlates strongly with both corporate spreads and the default rate. However, in the late 1980s the collapse of the energy sector caused spreads to widen too far. Spreads then benefited from a "payback period" as energy prices recovered and defaults ebbed during the following two years. But in the background, net leverage only managed to level-off for a brief period before continuing to trend higher. The uptrend in leverage culminated in the 1990 default cycle and recession. We see a similar dynamic playing out at the moment. Spreads (and the default rate) are currently benefiting from the payback period following the 2014 collapse and subsequent recovery in commodity prices. But so far leverage has not managed to cease its upward march. What Is Leverage Telling Us Right Now? As was mentioned above, net leverage has now increased for two consecutive quarters. To see what this has meant historically, we looked at excess investment grade corporate bond returns over 6-month periods following different changes in net leverage. For example, we found that after leverage has increased for two consecutive quarters, the average (annualized) 6-month excess return to investment grade corporate bonds has been -190 bps, and also that corporate bonds outperformed Treasuries in 45% of those 6-month periods (Table 2). Table 26-Month Investment Grade Corporate Excess Returns* ##br##Following A Rise In Net Corporate Leverage** (1973 To Present) Low Inflation And Rising Debt Low Inflation And Rising Debt Conversely, in 6-month periods after leverage has declined for two consecutive quarters, average (annualized) excess returns came in at +120 bps, and corporate bonds outperformed Treasuries in 61% of those episodes (Table 3). Table 36-Month Investment Grade Corporate Excess Returns* ##br##Following A Decline In Net Corporate Leverage** (1973 To Present) Low Inflation And Rising Debt Low Inflation And Rising Debt Not surprisingly, the late 1980s episode was one that defied the above statistics. In fact, investment grade corporate bonds outperformed Treasuries by an annualized 5% in the 6-month span between September 1986 and March 1987, even though leverage had previously increased for 4 consecutive quarters. For this reason we remain comfortable with our overweight in corporate bonds for now, especially since the Fed is likely to remain sufficiently accommodative to support higher inflation and hence continued economic growth. However, it is obvious that trends in leverage will be critical to monitor going forward. Where Is Leverage Heading? A rebound in corporate profits would help stem the uptrend in leverage, and the outlook for that is good. Not only did our measure of EBITD diverge negatively from S&P 500 operating profits in the first quarter, but other leading profit indicators such as the growth in business sales less inventories suggest that EBITD should catch up to S&P 500 profits, and not the reverse (Chart 6). What remains unclear is whether the looming rebound in profit growth will be enough to cause leverage to fall. While debt growth has been rolling over (Chart 5, bottom panel), we think it will remain at a reasonably high level going forward. Meanwhile, the historical evidence suggests that net leverage does not usually reverse its uptrend unless first prompted by a recession. Turning to debt, the ratio of corporate debt to GDP is definitely eyebrow raising (Chart 7), as it is now very close to levels observed at the peak of the past two cycles. However, one important caveat is in order. While corporate debt levels have grown quickly, corporate investment has not. Chart 6Profit Growth Will Improve Profit Growth Will Improve Profit Growth Will Improve Chart 7Investment Is Coming Back Investment Is Coming Back Investment Is Coming Back The corporate financing gap - capital expenditures less internally generated revenue - is a good proxy for the amount of debt issued to fund investment. In the second panel of Chart 7 we see that it has only just moved into positive territory and is well below the levels observed at the end of the last two recoveries. The obvious conclusion is that most corporate debt issuance has not been used to finance investment, but rather has been used to buy back equities. This is bad news from the perspective of corporate bondholders who would certainly prefer more people below them in the capital structure, but it also means that high corporate debt levels are not indicative of over-investment on the part of the corporate sector. As such, high corporate debt levels do not suggest that the risk of recession is elevated. They merely suggest that corporations' capital structures have shifted in favor of shareholders over bondholders. Going forward, we see potential for a moderation in the amount of corporate debt issuance used to fund buybacks. This has already started to occur as evidenced by our buyback proxy (Chart 7, panel 3) - simply the difference between net issuance and the financing gap shown in panel 2. Not surprisingly, this buyback proxy is highly correlated with the difference between the equity risk premium and corporate bond spreads. However, any moderation in share buybacks will be at least partially offset by an increase in debt issuance to fund investment. Corporate investment has seen a revival during the past few quarters, and leading indicators such as ISM New Orders surveys suggest it will continue trending up (Chart 7, bottom panel). Bottom Line: While a supportive Fed will keep corporate spreads low for the time being, rising leverage is starting to send a worrying message. Unless strong profit growth causes leverage to reverse course, it will likely be appropriate to scale back on credit risk either later this year or early next year, once the monetary back-drop becomes less supportive. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report, "Strong EM Trade Volumes Will Support Oil", dated June 8, 207, available at ces.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Two Challenges For U.S. Policymakers", dated May 3, 2017, and "The Fed Doctrine", dated May 30, 2017, both available at usbs.bcaresearch.com 3 https://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 4 https://www.federalreserve.gov/econresdata/feds/2016/files/2016078pap.pdf 5 Please see U.S. Bond Strategy Weekly Report, "The Payback Period In Corporate Bonds", dated April 11, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Overall Investment Grade (IG) Corporates: An update of our regional sector relative value models shows that it has become increasingly difficult to find industries where debt looks cheap. Maintain overweight allocations to U.S. & U.K. IG, and stay underweight Euro Area IG, but keep overall spread risk close to neutral levels. U.S. IG: Within U.S. Investment Grade corporate debt allocations, upgrade Energy names (Oil Field Services, Integrated) and Cable & Satellite to overweight, while downgrading Consumer Cyclical sectors (Retailers) and Other Industrials to Underweight. Euro IG: Stay underweight and keep spread risk (i.e. DTS) close to index levels. Reduce exposure to Cable & Satellite, Electric Utilities and Natural Gas Utilities. U.K. IG: Stay overweight U.K. IG but keep overall spread risk near index levels. Feature Chart of the WeekCandidates For Additional Spread Convergence Candidates For Additional Spread Convergence Candidates For Additional Spread Convergence Back on January 24th, we published a Special Report that introduced specific Investment Grade (IG) corporate bond sector allocations for the U.S., Euro Area and U.K. to our model portfolio framework.1 The recommended weightings were based on the output from our sector relative value models for each region. We had presented those models on a semi-regular basis in the past, but without any specific numerical allocation among the sectors. By attaching actual weightings to each sector, within a "fully invested" model portfolio, we are now able to more accurately measure the aggregate success of our recommendations. In this follow-up report, we discuss the performance of our sector tilts since January, refresh our relative value models and present changes to our allocations. The broad conclusion is that, while our calls have done well over the past few months and our IG portfolios have outperformed the broad IG bond indices, it remains difficult to find compellingly cheap sectors (particularly in non-financial industries) given the overall tight level of corporate bond spreads. This is especially true in the Euro Area, where we see the poorest risk/reward tradeoff for IG exposure relative to the U.S. and U.K. We are more comfortable recommending an overweight stance on U.S. and U.K. IG corporates versus Euro Area equivalents, in line with our overall allocation in our main model portfolio. Given the tight overall level of spreads in all three regions, however, we are focusing our recommendations on sectors that have cheaper valuations but with riskiness closer to the overall IG indices - like Energy in the U.S. and Wireless in both the Euro Area and U.K. (Chart 1). Good Performance From Our Sector Tilts The performance of our sector recommendations has been reasonably solid since January (Chart 2). Our U.S. sector tilts added +5bps of excess return versus duration-matched U.S. Treasuries, coming mostly from our overweights in Energy and Financials. Within the Euro Area, we were able to generate +9bps of excess return versus government debt, also mainly from above-benchmark allocations to Energy and Financial names. In the U.K., our call to overweight Bank debt provided essentially all of our +23bps of outperformance versus Gilts. These strong excess returns came on top of a very strong performance for corporate debt since January 24th. Excess returns for IG in the U.S., Euro Area and U.K. were 0.9%, 1.3% and 1.3%, respectively. The detailed breakdown of the returns by sector are shown in Appendix Tables at the back of this report. To determine the success rate of our sector tilts, we can define "winners" as sectors where we had an active view (i.e. not neutral) and where the relative performance of the sector versus the overall IG corporate index was in the direction of that active view. For example, our decision to go underweight Diversified Manufacturing in the Euro Area was a good one, as that sector had an excess return of 0.7%, well below that of the overall Euro Area IG index (a 1.3% excess return). We can define "losers" in the same way, where the relative sector performance went against our active allocation. In Chart 3, we show the "winners" and "losers" for our U.S., Euro Area and U.K. sector allocations since late January. Our success rate was quite good, as we had far more winners than losers in all three regions. Chart 2 Chart 3 The Big Picture For Corporate Credit: Favorable Business Cycle, But Valuations Are Not Cheap We have been maintaining an overall overweight allocation to IG corporates since late January. This was based on a view that global economic activity was accelerating, which would support faster profit growth. This would provide cyclical relief for stressed corporate balance sheets in the U.S. Euro Area & U.K. corporates would also benefit from a better profit backdrop, with the added bonus of central bank asset purchases helping to improve the supply/demand balance for IG debt. Yet spreads have already tightened substantially throughout the IG universe. This reflects declining macro volatility and the ongoing investor stretch for yield after the rise in global government bond yields earlier this year faded significantly. The result is that there is now far less dispersion among corporate sectors, by industry or by credit quality, then we've seen in recent years (Charts 4, 5 & 6). Coming at a time of high corporate leverage, and with central bank liquidity growth starting to roll over as we discussed in last week's Weekly Report, we are recommending an "up in quality" bias to sector allocations and credit exposure, while favoring U.S. and U.K. corporates over Euro Area equivalents.2 Chart 4Tight Spreads, Flat Credit Curve##BR##In The U.S. Tight Spreads, Flat Credit Curve In The U.S. Tight Spreads, Flat Credit Curve In The U.S. Chart 5Tight Spreads, Flat Credit Curve##BR##In The Euro Area Tight Spreads, Flat Credit Curve In The Euro Area Tight Spreads, Flat Credit Curve In The Euro Area Chart 6Tight Spreads, Flat Credit Curve##BR##In The U.K. Tight Spreads, Flat Credit Curve In The U.K. Tight Spreads, Flat Credit Curve In The U.K. Bottom Line: An update of our regional sector relative value models shows that it has become increasingly difficult to find industries where debt looks cheap. Maintain overweight allocations to U.S. & U.K. IG, and stay underweight Euro Area IG, while keep overall spread risk close to neutral levels. U.S. Investment Grade: Stay Overweight, But Be Selective In Tables 1A and 1B, we present the results of our U.S. IG sector valuation model as of May 31st.3 We are maintaining an overweight recommendation on U.S. IG in our overall model portfolio, as we continue to see the backdrop for U.S. economic growth being much friendlier for corporate debt versus Treasuries. Credit spreads are very tight, however, so we are maintaining some degree of caution in our sector recommendations. Chart Chart Specifically, we are aiming to favor industries with option-adjusted spread (OAS) at or above that of the overall U.S. IG index, but with a positive valuation from our U.S. IG relative value model. We also wish to keep the aggregate level of spread risk, using our preferred "duration times spread" (DTS) metric, in line with that of the overall U.S. IG index. As can be seen in the scatter diagram in Chart 7, which plots the model valuations versus the DTS score for each sector, there are precious few non-financial sectors that offer attractive spreads that are not riskier than the overall index. Chart 7 Our model has shown some improvement in value within the sub-sectors of the Energy space, which is a consequence of the softness in oil prices over the past few months. With our commodity strategists calling for a recovery in oil prices back up towards to $55-60 range by year-end, we see this an opportunity to raise our allocations to Energy by upgrading the Independent and Integrated sub-sectors to overweight from neutral. At the same time, we are reducing the size of our prior overweights in Refining and Midstream to keep the overall Energy sector allocation to no more than two times that of the U.S. IG Energy index - a pure risk management move on our part. We are also upgrading some of our prior underweights in the Communications sectors to neutral (Media & Entertainment, Wirelines & Wireless) and to overweight (Cable & Satellite), given relatively attractive valuations in those areas. By the same token, we are cutting Other Industrials to underweight from neutral with valuations now looking unattractive. All of our U.S. sector changes result in an upgrade of our weighting to the broad Industrials grouping by 5 percentage points to 58.6%. We are reducing our large overweight to U.S. Banks by an equivalent amount to "fund" this new allocation within our 100% invested model IG portfolio. The net result of all these changes is that our U.S. IG portfolio has an overall DTS score of around 9, in line with that of the U.S. IG benchmark index. Thus, we are not making any changes to our aggregate recommended spread risk, in line with our top-down views on the overall level of credit spreads and curves, as described earlier. Bottom Line: Within U.S. Investment Grade corporate debt allocations, upgrade Energy names (Oil Field Services, Integrated) and Cable & Satellite to overweight, while downgrading Consumer Cyclical sectors (Retailers) and Other Industrials to Underweight. Euro Area Investment Grade: Not Much Value Left, Remain Underweight In Tables 2A and 2B, we show the output from our Euro Area IG sector valuation model. The scatter diagram showing the model residuals versus the individual sector DTS scores is shown in Chart 8. Chart Chart Chart 8 Finding value has become a problem in Europe, with only a few sectors (most notably, Metals & Mining, Oil Field Services, Life Insurance and P&C Insurance) showing a double-digit spread residual from our model. All those sectors also offer wider spreads than the overall Euro Area IG index, but the Insurers stand out as being much riskier from a DTS perspective. That is a function of the wide spread for the overall Insurance sector, which is nearly double that of the overall Euro Area IG index. We see no reason to change our existing allocations to those sectors in our model portfolio, keeping Metals & Mining and Oil Field Services at overweight and the Insurers at neutral (a prudent tradeoff between wide spreads and high risk). It would likely take a meaningful rise in European interest rates before any serious compression in Insurance spreads could unfold, given the struggles that industry faces from low yields on its fixed income investment assets. A rise in European bond yields could unfold later this year if the European Central Bank (ECB) signals that a tapering of its asset purchase program will begin next year. We see that scenario as increasingly likely, given the overall strength of the Euro Area recovery. The ECB will only shift its stance gradually, due to the lack of immediate inflation concerns. Any signal that that fewer bond purchases are in the offing, however, will pose a major risk for European corporates given the large ECB buying of that debt over the past year. We see very few necessary changes to our Euro Area allocations at the moment, as our overall portfolio DTS is in line with the IG benchmark index (around 6). We do recommend cutting Cable & Satellite and Utilities (Electric & Natural Gas) to underweight. Bottom Line: With corporate spreads at tight levels, and with few sectors showing compelling value, we are comfortable in remaining underweight Euro Area corporates, while keeping spread risk (i.e. DTS) close to index levels. Reduce Cable & Satellite, Electric Utilities and Natural Gas Utilities to underweight. U.K. Investment Grade: Stay Overweight, Focusing On Financials In Tables 3A and 3B, we present our update U.K. IG sector model, with the scatterplot of model residuals versus DTS scores shown in Chart 9. Not much has changed in terms of which sectors appear cheap in our model versus the late January levels. Financials, in general, have the cheapest spreads on an absolute basis, especially the Insurers. Although the cheap valuation on the Insurance debt mirrors the same problem highlighted above for the Euro Area insurers - interest rates that are too low to generate acceptable investment returns on the insurers' portfolios. Chart Chart Chart 9 We are maintaining our overall modest overweight allocation to U.K. IG, while keeping overall spread risk close to index levels. While the political and security risks within the U.K. are significant at the moment, there is no threat of the Bank of England moving to a less accommodative monetary policy anytime soon. A backdrop of churning economic growth, an undervalued British Pound and a central bank maintaining hyper-easy monetary policy is still a decent one for U.K. corporate debt. In terms of sector allocation changes based on our U.K. IG sector valuation model, we recommend upgrading Health Care and REITs to overweight, downgrading Other Industrials to neutral and cutting Tobacco to underweight. Bottom Line: Stay overweight U.K. IG but keep overall spread risk near index levels. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Special Report, "Adding Investment Grade Corporate Bond Sectors To Our Model Portfolio Framework", dated January 24 2017, available at gfis.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "Distant Early Warning", dated May 30 2017, available at gfis.bcaresearch.com. 3 Our valuation framework assesses the attractiveness of each IG sector within a cross-sectional analysis. The OAS for each sector is regressed against common risk factors (interest rate duration, credit quality) with the residual spread determining the valuation of each sector. Appendix Image Image Image