BCA Indicators/Model

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

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of February 28, 2017. The model has maintained its large overweight in the U.S. Within the non-U.S. level 2 model, Spain and Italy weights have been increased at the expense of Japan and Switzerland. Japan and U.K. remain the two largest underweight countries. (Table 1). Table 1Model Allocation Vs. Benchmark Weights GAA Model Updates GAA Model Updates As shown in Table 2 and Charts 1, 2 and 3, both the level 1 and level 2 models outperformed their respective benchmarks in February, resulting in a 39 bps outperformance of the aggregate model vs. the MSCI World. Since inception, the GAA model has outperformed its benchmark by 30 bps. Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see the January 29th, 2016 Special Report "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model." http://gaa.bcaresearch.com/articles/view_report/18850. Table 2Performance (Total Returns In USD) GAA Model Updates GAA Model Updates Chart 1GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) GAA U.S. Vs. Non U.S. Model (Level1) GAA U.S. Vs. Non U.S. Model (Level1) Chart 3GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of February 28, 2017. The momentum component has shifted Consumer Discretionary from overweight to underweight. For mode details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Chart 4Overall Model Performance 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 Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Patrick Trinh, Associate Editor patrick@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com

Highlights U.S. Treasuries - Fair Value: The 10-year U.S. Treasury yield now appears 7 bps expensive on our model. Investors should maintain below-benchmark duration and continue to monitor bullish sentiment toward the U.S. dollar for signals about the breadth of the global economic recovery. U.S. Treasuries - Technicals: Large net short bond positions are in the process of being unwound. A more balanced technical picture removes one of the key impediments to the bond bear market and possibly sets the stage for another leg higher in yields. China: Chinese monetary policy that is sufficiently accommodative to spur economic growth, but not so accommodative that it causes undue strength in the trade-weighted U.S. dollar, is the most bearish outcome for U.S. bonds. Feature Bonds rallied strongly late last week without any obvious economic catalyst. Now that the dust has settled we find the 10-year U.S. Treasury yield trading at 2.34%, 7 bps below our estimate of fair value (Chart 1). Chart 12-Factor U.S. Treasury Model 2-Factor U.S. Treasury Model 2-Factor U.S. Treasury Model Updating Our U.S. Treasury Model That fair value estimate comes from our 2-factor U.S. Treasury model, based on the Global Manufacturing PMI and bullish sentiment toward the U.S. dollar. In our view, these two factors capture the most important macro drivers of U.S. bond yields. Stronger global growth, as proxied by the Global Manufacturing PMI, tends to push yields higher. However, to the extent that stronger global growth coincides with an appreciating U.S. dollar, the amount of monetary tightening that needs to be achieved through higher interest rates is limited. This caps the upside in long-dated U.S. bond yields. Put differently, it is not just the magnitude of the global growth impulse that matters for U.S. bond yields, but also the breadth of the recovery. The more broad-based the recovery, the less upward pressure on the U.S. dollar and the higher U.S. Treasury yields can rise. Last week we received Flash PMI estimates for the U.S., Eurozone and Japan that we can use to estimate the Global PMI for February. According to the Flash estimates, the U.S. PMI declined slightly in February, but this was more than offset by accelerations in both the Eurozone and Japan. Altogether, these three regions account for 48% of the Global PMI and, assuming PMIs in all other countries remain flat, we can calculate that the global PMI will nudge higher from 52.7 in January to 52.9 in February. Of course one month of data is much less important than the longer run trend. Taking a step back, we see that manufacturing PMIs are trending higher in every major economic bloc (Chart 2). Our diffusion index also shows that the global manufacturing recovery is more broadly based than at any time during the past three years (Chart 2, top panel). The synchronized nature of the recovery is also reflected in the behavior of the U.S. dollar, which has not appreciated during the past month even though Fed rate hike expectations have shifted up (Chart 3). The message from the survey of bullish dollar sentiment - the series that is included in our Treasury model - is more mixed. Bullish dollar sentiment plunged from elevated levels in January but has recovered somewhat during the past few weeks (Chart 3, panel 2). Meantime, U.S. Treasury spreads over German bunds and JGBs are also sending mixed signals. Short-maturity spreads have widened alongside increased U.S. rate hike expectations, while long-maturity spreads have been well contained (Chart 3, bottom 2 panels). Chart 2Synchronized Global Recovery Synchronized Global Recovery Synchronized Global Recovery Chart 3Keep Watching The Dollar Keep Watching The Dollar Keep Watching The Dollar Global bond investors should closely monitor trends in the U.S. dollar, bullish sentiment toward the dollar, and U.S. Treasury spreads over bunds and JGBs. Each of these indicators provides information about the breadth of the economic recovery. If Fed rate hike expectations remain firm, or even move higher, and that trend is not matched by a stronger dollar or wider Treasury spreads, then that would signal that the global recovery is becoming more synchronized, suggesting additional upside for bond yields. Bottom Line: The 10-year U.S. Treasury yield now appears 7 bps expensive on our model. Investors should maintain below-benchmark duration and continue to monitor bullish sentiment toward the U.S. dollar for signals about the breadth of the global economic recovery. Chart 4Positioning Becoming More Balanced Positioning Becoming More Balanced Positioning Becoming More Balanced Treasury Technicals Less Stretched This brings us back to last Friday's bond rally. Puzzlingly, the 2-year U.S. Treasury yield declined 6 bps and the 10-year yield fell 7 bps on a day without any significant economic or political news. In fact, Treasury yields managed to decline even though rate hike expectations embedded in the overnight index swap curve were unchanged and the probability of a March rate hike priced into fed funds futures actually increased from 31% to 33%! The unusual disconnect between Treasury yields and rate hike expectations is probably related to the expiry of the March bond futures contracts. Last week, traders had to decide whether to let their March contracts expire or roll them over into June. Positioning data show that speculators carried large net short positions into last week (Chart 4), so it is possible that it was the capitulation of these large short positions that drove yields lower on Friday. More timely data from the skew between payer and receiver swaptions show that swaption investors are no longer betting on rising rates (Chart 4, panel 4). Net speculative positions in Treasury futures could follow suit when the data are released later this week. In addition, our composite sentiment indicator has just recently ticked back above the zero line (Chart 4, panel 2). Bottom Line: Large net short bond positions are in the process of being unwound. A more balanced technical picture removes one of the key impediments to the bond bear market, and possibly sets the stage for another leg higher in yields. China's Bond Market Balancing Act Chart 5Easy Money Spurs Chinese Growth Easy Money Spurs Chinese Growth Easy Money Spurs Chinese Growth In the context of the 2-factor U.S. Treasury model presented above, there are two reasons why developments in China matter for U.S. bond markets. The first is that China accounts for the single largest weighting in the Global Manufacturing PMI, so stronger growth in the Chinese manufacturing sector will pressure bond yields higher, all else equal. But the Chinese economy can also influence U.S. bond yields if changes in the RMB exert meaningful influence on the trade-weighted U.S. dollar. For example, faster Chinese growth pressures U.S. bond yields higher, but some of that upward pressure could be mitigated if that strong growth is engineered through a rapid depreciation of the RMB relative to the U.S. dollar. On the first point, China's manufacturing PMI is in a clear uptrend although the recent contraction in the government's fiscal expenditures is a potential warning sign (Chart 5). Our China Investment Strategy service views the fiscal contraction as a risk but still expects the Chinese economy to remain buoyant this year.1 This is because Chinese monetary conditions remain supportive of further gains in the manufacturing sector, and the rebound in China's PMI that began early last year is more tied to easing monetary conditions - a weaker exchange rate and falling real interest rates - than to increased fiscal spending. On the second point, while a weaker trade-weighted RMB has helped spur the recovery in Chinese manufacturing, the impulse from a weaker RMB has so far not been potent enough to move the needle on the trade-weighted U.S. dollar (Chart 6). From the perspective of U.S. fixed income markets a continuation of this trend would be the most bond-bearish outcome. Chinese monetary policy remains easy enough to spur economic growth but not so easy that it causes the U.S. dollar to spike. For the time being at least, China has been actively selling Treasuries in order to mitigate the extent of its currency depreciation (Chart 7). If China were to suddenly stop selling Treasuries, then the RMB would likely depreciate sharply. This would actually have an ambiguous impact on U.S. Treasury yields since it would probably lead to both a stronger U.S. dollar and faster global growth. Chart 6USD So Far Not Impacted By RMB USD So Far Not Impacted By RMB USD So Far Not Impacted By RMB Chart 7China Is A Treasury Seller China Is A Treasury Seller China Is A Treasury Seller More likely, however, is that China will continue to manage the gradual depreciation of its currency unless it is forced to take more dramatic action in the face of a negative growth shock. Our China Investment Strategy team notes that the annual People's Congress in early March should offer some important clues about the Chinese government's growth priorities and policy direction going forward. Bottom Line: Chinese monetary policy that is sufficiently accommodative to spur economic growth, but not so accommodative that it causes undue strength in the trade-weighted U.S. dollar, is the most bearish outcome for U.S. bonds. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Be Aware Of China's Fiscal Tightening", dated February 16, 2017, available at cis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

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

Feature Chart I-1Corporate Leverage Situation##br## Has Continued To Improve Corporate Leverage Situation Has Continued To Improve Corporate Leverage Situation Has Continued To Improve This week we are updating our China Industry Watch thematic chartpack to present a visual presentation of the changing situation in China's corporate sector, and its relevance to broader stock market performance. Overall, the Chinese corporate sector's financial situation has improved modestly since mid-last year, as measured by BCA's Corporate Health Monitors1 (Box on page 3). The improvement is fairly broad based across sectors, but some highly cyclical sectors have witnessed sharper rebounds. Broadly speaking, several observations can be made (Appendix starting on page 4). First, the Chinese corporate sector's debt situation has improved, both in terms of leverage ratio and debt sustainability. The liabilities-to-asset ratio for all industries has continued to decline (Chart I-1). Even in some highly levered sectors such as coal producers and steelmakers, the debt ratios have rolled over after years of deterioration. Moreover, interest coverage ratio has increased across the board, particularly within the asset-heavy metals and energy sectors, due to a dramatic increase in profits. This stands in stark contrast to widely held concerns among investors over China's corporate leverage situation, discussed in detail in some of our recent Special Reports.2 Meanwhile, profit growth has also accelerated for all sectors due to a combination of higher revenue and wider margins. The profit picture has recovered strongly for coal mines, steelmakers and non-ferrous metals producers from deeply depressed starting points. The government's supply-side constraints on these sectors in the past year reduced production, which together with recovering demand led to a massive increase in prices and a drastic recovery in profitability. Profitability for most other sectors has also risen, albeit more moderately. In terms of efficiency, inventory turnover has improved across most industries, underscoring the de-stocking process of the corporate sector. Asset turnover has also stopped deteriorating, while there has not been much recovery in receivable turnover ratios in most industries. However, enterprise surveys have shown some notable improvement in fund turnover of late, which we suspect will soon show up in corporate financial statements (Chart I-2). Overall, our efficiency measures are showing some encouraging signs. Finally, the growth rate of total assets of all firms has continued to decelerate, consistent with the weak fixed asset investment (FAI) figures in recent years (Chart I-3). Decelerating asset growth is visible across the board, but is most pronounced in mining- and manufacturing-related sectors such as coal mines, metals producers and machinery manufacturers. The sharp turnaround in profitability and improving corporate health should begin to support capital spending in these sectors, which will likely support investment in the overall economy.3 Chart I-2Receivable Turnover Is On The Mend Receivable Turnover Is On The Mend Receivable Turnover Is On The Mend Chart I-3Capital Spending Slowdown Has Become Advanced Capital Spending Slowdown Has Become Advanced Capital Spending Slowdown Has Become Advanced BCA China Industry Watch includes four categories of financial ratios to monitor a sector's leverage, profitability, growth and efficiency, respectively. Some of these ratios, as shown in Table I-1, are slightly tweaked from conventional definitions due to data availability. The financial data in our exercise are from the official statistics on overall industrial firms, of which the listed companies are a subset, but most financial ratios based on the two sets of data are very similar, especially for the heavy industries that dominate the Chinese stock markets - both onshore and offshore. The financial ratios on leverage, growth and profitability are almost identical for some sectors, while some other sectors that are not well represented in the stock market, such as technology, healthcare and consumer sectors, show notable divergences. As the Chinese equity universe continues to expand, we expect that the two sets of data will increasingly converge. Table I-1The China Industry Watch Messages From BCA China Industry Watch Messages From BCA China Industry Watch Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Special Report, "Introducing The BCA China Industry Watch," dated February 10, 2016, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Special Reports, "Chinese Deleveraging? What Deleveraging!" dated June 15, 2016, and "Rethinking Chinese Leverage," dated October 27, 2016, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "Be Aware Of China's Fiscal Tightening," dated February 16, 2017, available at cis.bcaresearch.com. Appendix: China Industry Watch All Firms Chart II-1, Chart II-2, Chart II-3, Chart II-4, Chart II-5, Chart II-6 Chart II-1Non-Financial Firms: ##br##Stock Price & Valuation Indicators Non-Financial Firms: Stock Price & Valuation Indicators Non-Financial Firms: Stock Price & Valuation Indicators Chart II-2Non-Financial Firms: ##br##Relative Performance Of Valuation Indicators Non-Financial Firms: Relative Performance Of Valuation Indicators Non-Financial Firms: Relative Performance Of Valuation Indicators Chart II-3Non-Financial Firms: Leverage Indicators Non-Financial Firms: Leverage Indicators Non-Financial Firms: Leverage Indicators Chart II-4Non-Financial Firms: Growth Indicators Non-Financial Firms: Growth Indicators Non-Financial Firms: Growth Indicators Chart II-5Non-Financial Firms: Profitability Indicators Non-Financial Firms: Profitability Indicators Non-Financial Firms: Profitability Indicators Chart II-6Non-Financial Firms: Efficiency Indicators Non-Financial Firms: Efficiency Indicators Non-Financial Firms: Efficiency Indicators Oil&Gas Sector Chart II-7, Chart II-8, Chart II-9, Chart II-10, Chart II-11, Chart II-12 Chart II-7Oil&Gas Sector: ##br##Stock Price & Valuation Indicators Oil&Gas Sector: Stock Price & Valuation Indicators Oil&Gas Sector: Stock Price & Valuation Indicators Chart II-8Oil&Gas Sector:##br## Relative Performance Of Valuation Indicators Oil&Gas Sector: Relative Performance Of Valuation Indicators Oil&Gas Sector: Relative Performance Of Valuation Indicators Chart II-9Oil&Gas Sector: Leverage Indicators Oil&Gas Sector: Leverage Indicators Oil&Gas Sector: Leverage Indicators Chart II-10Oil&Gas Sector: Growth Indicators Oil&Gas Sector: Growth Indicators Oil&Gas Sector: Growth Indicators Chart II-11Oil&Gas Sector: Profitability Indicators Oil&Gas Sector: Profitability Indicators Oil&Gas Sector: Profitability Indicators Chart II-12Oil&Gas Sector: Efficiency Indicators Oil&Gas Sector: Efficiency Indicators Oil&Gas Sector: Efficiency Indicators Coal Sector Chart II-13, Chart II-14, Chart II-15, Chart II-16, Chart II-17, Chart II-18 Chart II-13Coal Sector: ##br##Stock Price & Valuation Indicators Coal Sector: Stock Price & Valuation Indicators Coal Sector: Stock Price & Valuation Indicators Chart II-14Coal Sector: ##br##Relative Performance Of Valuation Indicators Coal Sector: Relative Performance Of Valuation Indicators Coal Sector: Relative Performance Of Valuation Indicators Chart II-15Coal Sector: Leverage Indicators Coal Sector: Leverage Indicators Coal Sector: Leverage Indicators Chart II-16Coal Sector: Growth Indicators Coal Sector: Growth Indicators Coal Sector: Growth Indicators Chart II-17Coal Sector: Profitability Indicators Coal Sector: Profitability Indicators Coal Sector: Profitability Indicators Chart II-18Coal Sector: Efficiency Indicators Coal Sector: Efficiency Indicators Coal Sector: Efficiency Indicators Steel Sector Chart II-19, Chart II-20, Chart II-21, Chart II-22, Chart II-23, Chart II-24 Chart II-19Steel Sector: ##br##Stock Price & Valuation Indicators Steel Sector: Stock Price & Valuation Indicators Steel Sector: Stock Price & Valuation Indicators Chart II-20Steel Sector: ##br##Relative Performance Of Valuation Indicators Steel Sector: Relative Performance Of Valuation Indicators Steel Sector: Relative Performance Of Valuation Indicators Chart II-21Steel Sector: Leverage Indicators Steel Sector: Leverage Indicators Steel Sector: Leverage Indicators Chart II-22Steel Sector: Growth Indicators Steel Sector: Growth Indicators Steel Sector: Growth Indicators Chart II-23Steel Sector: Profitability Indicators Steel Sector: Profitability Indicators Steel Sector: Profitability Indicators Chart II-24Steel Sector: Efficiency Indicators Steel Sector: Efficiency Indicators Steel Sector: Efficiency Indicators Non Ferrous Metals Sector Chart II-25, Chart II-26, Chart II-27, Chart II-28, Chart II-29, Chart II-30 Chart II-25Non Ferrous Metals Sector: ##br##Stock Price & Valuation Indicators Non Ferrous Metals Sector: Stock Price & Valuation Indicators Non Ferrous Metals Sector: Stock Price & Valuation Indicators Chart II-26Non Ferrous Metals Sector: ##br##Relative Performance Of Valuation Indicators Non Ferrous Metals Sector: Relative Performance Of Valuation Indicators Non Ferrous Metals Sector: Relative Performance Of Valuation Indicators Chart II-27Non Ferrous Metals Sector: Leverage Indicators Non Ferrous Metals Sector: Leverage Indicators Non Ferrous Metals Sector: Leverage Indicators Chart II-28Non Ferrous Metals Sector: Growth Indicators Non Ferrous Metals Sector: Growth Indicators Non Ferrous Metals Sector: Growth Indicators Chart II-29Non Ferrous Metals Sector: Profitability Indicators Non Ferrous Metals Sector: Profitability Indicators Non Ferrous Metals Sector: Profitability Indicators Chart II-30Non Ferrous Metals Sector: Efficiency Indicators Non Ferrous Metals Sector: Efficiency Indicators Non Ferrous Metals Sector: Efficiency Indicators Construction Material Sector Chart II-31, Chart II-32, Chart II-33, Chart II-34, Chart II-35, Chart II-36 Chart II-31Construction Material Sector: ##br##Stock Price & Valuation Indicators Construction Material Sector: Stock Price & Valuation Indicators Construction Material Sector: Stock Price & Valuation Indicators Chart II-32Construction Material Sector: ##br##Relative Performance Of Valuation Indicators Construction Material Sector: Relative Performance Of Valuation Indicators Construction Material Sector: Relative Performance Of Valuation Indicators Chart II-33Construction Material Sector: ##br##Leverage Indicators Construction Material Sector: Leverage Indicators Construction Material Sector: Leverage Indicators Chart II-34Construction Material Sector: ##br##Growth Indicators Construction Material Sector: Growth Indicators Construction Material Sector: Growth Indicators Chart II-35Construction Material Sector: ##br##Profitability Indicators Construction Material Sector: Profitability Indicators Construction Material Sector: Profitability Indicators Chart II-36Construction Material Sector:##br## Efficiency Indicators Construction Material Sector: Efficiency Indicators Construction Material Sector: Efficiency Indicators Machinery Sector Chart III-37, Chart III-38, Chart III-39, Chart III-40, Chart III-41, Chart III-42 Chart III-37Machinery Sector: ##br##Stock Price & Valuation Indicators Machinery Sector: Stock Price & Valuation Indicators Machinery Sector: Stock Price & Valuation Indicators Chart III-38Machinery Sector: ##br##Relative Performance Of Valuation Indicators Machinery Sector: Relative Performance Of Valuation Indicators Machinery Sector: Relative Performance Of Valuation Indicators Chart III-39Machinery Sector: Leverage Indicators Machinery Sector: Leverage Indicators Machinery Sector: Leverage Indicators Chart III-40Machinery Sector: Growth Indicators Machinery Sector: Growth Indicators Machinery Sector: Growth Indicators Chart III-41Machinery Sector: Profitability Indicators Machinery Sector: Profitability Indicators Machinery Sector: Profitability Indicators Chart III-42Machinery Sector: Efficiency Indicators Machinery Sector: Efficiency Indicators Machinery Sector: Efficiency Indicators Automobile Sector Chart III-43, Chart III-44, Chart III-45, Chart III-46, Chart III-47, Chart III-48 Chart III-43Automobile Sector: ##br##Stock Price & Valuation Indicators Automobile Sector: Stock Price & Valuation Indicators Automobile Sector: Stock Price & Valuation Indicators Chart III-44Automobile Sector: ##br##Relative Performance Of Valuation Indicators Automobile Sector: Relative Performance Of Valuation Indicators Automobile Sector: Relative Performance Of Valuation Indicators Chart III-45Automobile Sector: Leverage Indicators Automobile Sector: Leverage Indicators Automobile Sector: Leverage Indicators Chart III-46Automobile Sector: Growth Indicators Automobile Sector: Growth Indicators Automobile Sector: Growth Indicators Chart III-47Automobile Sector: Profitability Indicators Automobile Sector: Profitability Indicators Automobile Sector: Profitability Indicators Chart III-48Automobile Sector: Efficiency Indicators Automobile Sector: Efficiency Indicators Automobile Sector: Efficiency Indicators Food&Beverage Sector Chart III-49, Chart III-50, Chart III-51, Chart III-52, Chart III-53, Chart III-54 Chart III-49Food&Beverage Sector: ##br##Stock Price & Valuation Indicators Food&Beverage Sector: Stock Price & Valuation Indicators Food&Beverage Sector: Stock Price & Valuation Indicators Chart III-50Food&Beverage Sector:##br## Relative Performance Of Valuation Indicators Food&Beverage Sector: Relative Performance Of Valuation Indicators Food&Beverage Sector: Relative Performance Of Valuation Indicators Chart III-51Food&Beverage Sector: Leverage Indicators Food&Beverage Sector: Leverage Indicators Food&Beverage Sector: Leverage Indicators Chart III-52Food&Beverage Sector: Growth Indicators Food&Beverage Sector: Growth Indicators Food&Beverage Sector: Growth Indicators Chart III-53Food&Beverage Sector: ##br##Profitability Indicators Food&Beverage Sector: Profitability Indicators Food&Beverage Sector: Profitability Indicators Chart III-54Food&Beverage Sector:##br## Efficiency Indicators Food&Beverage Sector: Efficiency Indicators Food&Beverage Sector: Efficiency Indicators Information Technology Sector Chart III-55, Chart III-56, Chart III-57, Chart III-58, Chart III-59, Chart III-60 Chart III-55Information Technology Sector: ##br##Stock Price & Valuation Indicators Information Technology Sector: Stock Price & Valuation Indicators Information Technology Sector: Stock Price & Valuation Indicators Chart III-56Information Technology Sector: ##br##Relative Performance Of Valuation Indicators Information Technology Sector: Relative Performance Of Valuation Indicators Information Technology Sector: Relative Performance Of Valuation Indicators Chart III-57Information Technology Sector: ##br##Leverage Indicators Information Technology Sector: Leverage Indicators Information Technology Sector: Leverage Indicators Chart III-58Information Technology Sector: ##br##Growth Indicators Information Technology Sector: Growth Indicators Information Technology Sector: Growth Indicators Chart III-59Information Technology Sector: ##br##Profitability Indicators Information Technology Sector: Profitability Indicators Information Technology Sector: Profitability Indicators Chart III-60Information Technology Sector: ##br##Efficiency Indicators Information Technology Sector: Efficiency Indicators Information Technology Sector: Efficiency Indicators Utilities Sector Chart III-61, Chart III-62, Chart III-63, Chart III-64, Chart III-65, Chart III-66 Chart III-61Utilities Sector: ##br##Stock Price & Valuation Indicators Utilities Sector: Stock Price & Valuation Indicators Utilities Sector: Stock Price & Valuation Indicators Chart III-62Utilities Sector: ##br##Relative Performance Of Valuation Indicators Utilities Sector: Relative Performance Of Valuation Indicators Utilities Sector: Relative Performance Of Valuation Indicators Chart III-63Utilities Sector: Leverage Indicators Utilities Sector: Leverage Indicators Utilities Sector: Leverage Indicators Chart III-64Utilities Sector: Growth Indicators Utilities Sector: Growth Indicators Utilities Sector: Growth Indicators Chart III-65Utilities Sector: Profitability Indicators Utilities Sector: Profitability Indicators Utilities Sector: Profitability Indicators Chart III-66Utilities Sector: Efficiency Indicators Utilities Sector: Efficiency Indicators Utilities Sector: Efficiency Indicators Cyclical Investment Stance Equity Sector Recommendations

Highlights The Fed & Yields: Positive U.S. growth and inflation momentum is maintaining the credibility of the Fed's 2017 rate hike plans. U.S. bond yields, in particular, and global yields, in general, will remain under upward pressure in this environment, despite the aggressive short positioning in the U.S. Treasury market. Maintain a below-benchmark portfolio duration stance. "Soft" vs. "Hard" Data: After a deep dive into the economic data for the major countries, both "hard" demand indicators and "soft" survey measures, we have little doubt that a tangible global growth acceleration is underway. This positive economic backdrop will continue to put upward pressure on government bond yields while boosting the relative return performance for corporate credit. Australia: The cyclical outlook Down Under has become murkier of late, even with the RBA starting to shift in a more hawkish direction. We are taking profits on our recommended pro-growth tilts in Australia. Feature The positive momentum on global growth continues to put upward pressure on bond yields, despite the large short positioning already in place in the government bond markets. The benchmark 10-year U.S. Treasury yield returned to 2.5% at one point last week, led by a rash of better-than-expected data on U.S. retail sales and inflation, combined with hawkish comments from numerous Fed officials (Chart of the Week). Markets started to more seriously consider a March Fed rate hike, although we still see June as the more likely date for the Fed's next tightening move. As we have discussed in several recent reports, it is a surge in global economic survey data that suggests that a broad-based upturn currently underway. While this is all good news for risk assets, there is some concern among investors that a pick-up in growth has been slow to appear clearly in the "hard" economic data related to final demand. Without a boost in actual economic activity, and not just "feel good" surveys, the pro-growth momentum currently embedded in equity and bond markets may melt away as rapidly as it was built up. Mark McClellan, the Chief Strategist at BCA's flagship publication, The Bank Credit Analyst, is releasing a report this week that digs into the differences between "soft data" (i.e. surveys) and "hard data" (i.e. employment and production).1 We present some excerpts from that report in the following section. Global Growth Pickup: Fact Or Fiction? Investors have taken some comfort from the fact that leading indicators are trending up across most of the developed and emerging economies. BCA's Global Leading Economic Indicator is moving higher and will climb further in the coming months given that its diffusion index is well above 50 (Chart 2). The Global ZEW indicator and the BCA Boom/Bust growth indicator are also constructive on the growth outlook. Chart of the WeekNo Bond-Bearish Data In The U.S. No Bond-Bearish Data In The U.S. No Bond-Bearish Data In The U.S. Chart 2A Consistent, Positive Message On Growth A Consistent, Positive Message On Growth A Consistent, Positive Message On Growth Consumers and business leaders are feeling more upbeat as well, both inside and outside of the U.S. (Chart 3). Importantly, the improvement in sentiment began before the U.S. election. Surveys of business activity, such as the Purchasing Managers Indices (PMI), are painting a uniformly positive picture for near-term global output in both the manufacturing and service industries. While this is all good news for risk assets, there is concern that a growth impulse has been slow to show up clearly in the "hard" economic data related to final demand. The good news is that there is more to the cyclical upturn than hope. The improved tone in the forward-looking data is now clearly showing up in some measures of final demand. The caveat is that there is no evidence yet that the cyclical mini up-cycle in 2017 is any less vulnerable to negative shocks than was the case in previous upturns since the Great Recession. The Hard Data First, we start with some bad news. There has been a worrying loss of momentum in job creation in recent months (Chart 4). While employment gains have accelerated in Japan, Canada and Australia, the payroll slowdown is mainly evident in the U.S. and U.K. This may reflect supply constraints as both economies are near full employment, but it is difficult to determine whether it is supply or demand-related. The good news is that the employment component of the global PMI has rebounded sharply following last year's dip, suggesting that the pace of job creation will soon turn up. Chart 3Surging Confidence, Production Following Suit Surging Confidence, Production Following Suit Surging Confidence, Production Following Suit Chart 4Global Employment Growth Cooling Off Global Employment Growth Cooling Off Global Employment Growth Cooling Off Also on the positive side, households are opening their wallets a little wider according to the retail sales data (Chart 5), where growth has accelerated sharply in all the major economies except U.K. and Australia (NOTE: we discuss the Australian bond outlook later in this Global Fixed Income Strategy report). Similarly, business capital spending is finally showing some signs of life following a rocky 2015 and early 2016. An aggregate of Japanese, German and U.S. capital goods orders2 is a good leading indicator for G7 real business investment (Chart 6). The acceleration of imported capital goods for our 20-country global aggregate corroborates the stronger new orders reports (bottom panel). Chart 5On Your Mark, Get Set, Shop!! On Your Mark, Get Set, Shop!! On Your Mark, Get Set, Shop!! Chart 6Global Capex Cycle Turning Positive Global Capex Cycle Turning Positive Global Capex Cycle Turning Positive Recent data on industrial production show that the global manufacturing sector is clearly emerging from last year's recession. Short-term momentum in production growth has accelerated over the past 3-4 months across all of the major advanced economies (Chart 7). Production growth has been particularly robust in the Eurozone, U.K. and Japan. Industrial output related to both household and capital goods is showing increasing signs of vigor in recent months (Chart 8). Chart 7A Global Manufacturing Upturn A Global Manufacturing Upturn A Global Manufacturing Upturn Chart 8A Broad-Based Acceleration A Broad-Based Acceleration A Broad-Based Acceleration At the moment, the upturn in manufacturing production is being driven by a broader pickup in business spending. The acceleration in production and orders related to consumer goods in the major countries suggests that household final demand is also showing increased vitality, consistent with the retail sales data. The Soft Data Chart 9Global GDP Growth Is Accelerating Global GDP Growth Is Accelerating Global GDP Growth Is Accelerating Notwithstanding the nascent upturn in the hard data, some believe that the soft data are sending an overly constructive signal in terms of near-term growth. The soft data generally comprise measures of confidence and surveys of business activity. One could discount the pop in U.S. sentiment as simply reflecting hope that President Trump's election promises to cut taxes, remove red tape and boost infrastructure spending will come to fruition. Nonetheless, improved sentiment readings are widespread across the major countries, which means that it is probably not just a "Trump" effect. Moreover, there is no reason to doubt the surveys of actual business activity. Surveys such as the PMIs, the U.K. CBI Business Survey, the German IFO current conditions index and the Japanese Tankan survey are all measures of activity occurring today or in the immediate future (i.e. 3 months). There is no reason to believe that these surveys have been contaminated by "hope" and are sending a false signal on actual spending. To test the reliability of the growth message from the "soft data", we employed these indicators in regression models for real GDP in the four major advanced economies and for the G7 as a group (Chart 9). The models predict that G7 real GDP growth will accelerate to 2½% on a year-over-year basis in the first quarter of 2017. We expect growth of close to 3% in the U.S. and a little over 2½% in the Eurozone, although the model for the latter has been over-predicting somewhat over the past year. Japanese growth should accelerate to about 2% in the first quarter based on these indicators. The implication is that the survey data are not sending a distorted message; underlying growth is accelerating even though it is only now showing up in the hard economic data. Turning for a moment to the emerging world, output is picking up on the back of an upturn in exports. However, we do not see much evidence of a domestic demand dynamic that will help to drive global growth this year. The main exception is China, where private sector capital spending growth has clearly bottomed. Stronger Chinese capital spending in 2017 will boost imports and thereby support activity in China's trading partners, particularly in Asia. Conclusions We have little doubt that a meaningful global growth acceleration is underway. Our sense is that 'animal spirits' are finally beginning to stir, following many years of caution and retrenchment. American CEOs appear to have more swagger these days. Since the start of the year there have been a slew of high-profile announcements of fresh capital spending and hiring plans from companies such as Amazon, Toyota, Walmart, GM, Lockheed Martin and Kroger. A return of animal spirits could prolong a period of stronger growth, even if President Trump's growth-boosting policies are delayed or largely offset by spending cuts or trade wars. This economic backdrop is positive for risk assets and bearish for government bonds. Bottom Line: After a deep dive into the economic data for the major countries, both "hard" demand indicators and "soft" survey measures, we have little doubt that a tangible global growth acceleration is underway. This positive economic backdrop will continue to put upward pressure on government bond yields while boosting the relative return performance for corporate credit. Australia: The Equation Gets More Complicated Two weeks ago, the Reserve Bank of Australia (RBA) unsurprisingly left its cash rate unchanged at 1.5%. The post-meeting statement by RBA Governor Philip Lowe was considered hawkish by economic analysts. Nonetheless, the market reaction has been relatively muted, with the Australian government bond yield curve steepening by only 5 bps, and the Aussie dollar remaining stable, since the meeting. Pricing in the OIS curve suggests that the RBA will probably remain on hold throughout 2017, but the implied odds of a rate hike are rising, standing now at 20%. The RBA's assessment of the current global economic backdrop was relatively constructive, pointing to above-trend growth expectations in a number of advanced economies. Domestically, the RBA foresees a boost to Australian export growth from the resource sector, an end to the decline in mining investment and a pick-up in non-mining capital spending.3 With such a tone, the central bank might have set up the market for some disappointments. The new forecast of economic growth around 3% for the next couple of years seems overly optimistic. This is higher than the median expectation of economists surveyed by Bloomberg, who foresee 2.5% and 2.8% growth for 2017 and 2018, respectively. The IMF does not expect growth to reach 3% until 2019. Granted, several parts of the economy have shown very robust performances of late. The service sector PMI has surged to pre-crisis levels. The NAB survey of business conditions also shot higher last week. Goods exports have exploded at a 40% annual growth rate, causing the December trade balance to jump to $3.5bn, nearly double the consensus $2.0bn estimate (Chart 10). Those jumps in activity are hard to ignore. From a big picture perspective, however, Australian economic data has not been surprising to the upside, unlike the trend in in the rest of the world over the past few months (Chart 11). This is intriguing, since an easy monetary policy, loose bank credit conditions, improving profit expectations and a reflationary impulse coming from China were all tailwinds that should have supported Australian growth; this was our view last year.4 Now, those favorable factors have started to reverse, raising the chances of a cyclical economic downturn. Chart 10Surging Numbers Surging Numbers Surging Numbers Chart 11Surprisingly Unsurprising Surprisingly Unsurprising Surprisingly Unsurprising Foremost, overall labor market conditions are uninspiring (Chart 12): Although the monthly employment change for January did positively surprise, at 13.3k versus an expected 10k, the pace of job creation remains under 1% year-over-year, which is low by historical standards. The diverging trend between plunging full-time and steady part-time job growth indicates a sub-optimal labor market. The labor force participation rate declined from 65.2 to 64.6 in 2016, suggesting an increasing amount of discouraged workers. Underemployment has not budged in the last two years and is stuck at historically high levels. As result, a rise in labor market slack poses a risk for the Australian consumer; wage growth has already been in a downtrend since 2011 (Chart 12, bottom panel). The construction sector further confirms our apprehensions on the true strength of the economy. Households believe that it is not a good time to buy a home, while building approvals for new dwelling units fell from bubbly levels at the end of last year. At the same time, speculative money, which was supposed to have been curbed by macroprudential policy measures, has returned to the housing market (Chart 13). Lower supply and increased speculation could push residential prices even higher, inflating debt burdens, and leaving households with fewer dollars to consume. Chart 12Consumption: Set To Deteriorate Consumption: Set To Deteriorate Consumption: Set To Deteriorate Chart 13The Foundations Are Shaking The Foundations Are Shaking The Foundations Are Shaking Externally, the Chinese reflationary mini-boom - which boosted the prices of iron ore and other commodities exported by Australia last year - will probably retreat to some extent in 2017. Although China's overall cyclical momentum remains solid, according to our GFIS China Checklist,5 government spending growth has severely relapsed, potentially signaling an end to last year's largesse (Chart 14). With that in mind, it has become difficult to envision a continuation of the positive effects from the terms of trade shock experienced by Australia in 2016. In a similar vein, but domestically-driven, Australia's credit growth has become a headwind. Between 2013 and 2015, business credit growth was expanding, creating a positive impulse for the economy. Unfortunately, this trend changed tack in 2016, with slowing credit growth now representing a negative economic force (Chart 15). With Australian banks having suffered declining profits and rising bad debt charges in the last few quarters, credit conditions could tighten going forward. This is especially worrisome since personal credit was already contracting in 2016. Chart 14China Mini-Boom Could Be Over China Mini-Boom Could Be Over China Mini-Boom Could Be Over Chart 15Negative Credit Impulse Negative Credit Impulse Negative Credit Impulse top of all this, the IMF is projecting that Australia's fiscal thrust - the change in the primary government budget balance - will be negative in each of the next five years (Chart 16). As such, this economy could run out of supporting impulses in the short to medium term. Summing it all up, we agree with the current market pricing of interest rates, given the economic uncertainties. The RBA will most likely remain on hold for the foreseeable future. The story remains the same; the central bank wants to depreciate the overvalued Aussie dollar, but excesses in the housing market prevent them from weakening the currency through interest rate cuts (Chart 17). Now, the declining cyclical outlook will only complicate the equation. Chart 16Negative Fiscal Impulse Negative Fiscal Impulse Negative Fiscal Impulse Chart 17The RBA Has Little Room To Maneuver The RBA Has Little Room To Maneuver The RBA Has Little Room To Maneuver Investment Implications Our updated and more balanced economic view of Australia leads us to neutralize our recommended pro-growth Australia bond tilts: Asset allocation. As discussed above, the previously favorable factors supporting the Australian economy are progressively reversing. This is not the case in most of the other bond markets where additional cyclical upward pressure on global yields is anticipated. To reflect this view, today we are upgrading our recommended Australian bond exposure to neutral, from below-benchmark, within global hedged bond portfolios. This underweight position produced +188bps of excess return versus the global benchmark since inception in June 2016. Duration. The 10-year Australian government bond yield, 1-year forward, is 3.04%, 25bps above the current yield of 2.79%. There is a good chance that yields will rise at a faster pace than implied by the forwards at times over the course of the year, given the improving global growth and inflation backdrop. However, these instances will be opportunities to extend duration within dedicated Australian fixed income portfolios. Current Australian government bond valuation has become very cheap and is now at a level that has been associated with the beginning of positive absolute performance in the past. Moreover, the 10-year inflation breakeven is already pricing in a fair amount of inflation increases; those expectations will be hard to surpass, especially considering the low starting point (Chart 18). Curve. In May 2016, we initiated an Australian butterfly curve trade, going long the 2-year/6-year barbell versus the 4-year bullet. At the time, the 2/4/6 part of the government bond yield curve was kinked, with the 4-year sector trading very expensive versus the 2-year and 6-year maturities, reflecting the perception of a dovish stance by the RBA. then, the market has priced out these rate cut expectations, as we expected, and this part of the curve has bear steepened (Chart 19). Today, we close this trade at a +36bps profit. The RBA's future potential actions - or, more likely, inaction - are now properly discounted in the curve and reflect our neutral stance on the RBA. Chart 18Time To Buy Australian Bonds Time To Buy Australian Bonds Time To Buy Australian Bonds Chart 19Taking Profits On Our 2/4/6 Butterfly Trade It's Real Growth, Not Fake News It's Real Growth, Not Fake News Credit trades. Developing economic uncertainties warrant more cautiousness towards Australian credit. In March 2016, we recommended going long Australian semi government debt versus federal government bonds as an initial way to play what was, at the time, a relatively constructive view on the Australian economy.6 Now, given the increased economic risks, we are closing this relative value trade with a +133bps profit. Mark McClellan, Senior Vice President markm@bcaresearch.com Jean-Laurent Gagnon, Editor/Strategist jeang@bcaresearch.com Robert Robis, Senior Vice President rrobis@bcaresearch.com 1 Please see The Bank Credit Analyst, Section II, "Global Growth Pickup: Fact Or Fiction?," dated March 2017, available at bca.bcaresearch.com 2 Machinery orders used for Japan 3 http://www.rba.gov.au/media-releases/2017/mr-17-02.html 4 For details, please see BCA Global Fixed Income Strategy Weekly Report, "Last Minute Recommendations Before The Brexit Vote," dated June 21, 2016, available at gfis.bcaresearch.com 5 For details concerning this indicator, please see BCA Global Fixed Income Strategy Weekly Report, "How To Assess The "China Factor" For Global Bonds," dated November 11, 2016, available at gfis.bcaresearch.com 6 Please see BCA Global Fixed Income Strategy Special Report, "Australian Credit: Time To Test The Waters," dated March 29, 2016, available at gfis.bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index It's Real Growth, Not Fake News It's Real Growth, Not Fake News Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Feature Valuations, whether for currencies, equities, or bonds, are always at the top of the list of the determinants of any asset's long-term performance. In this optic, we regularly update the set of long-term valuation models for currencies we introduced in a February 16 Special Report titled "Assessing Fair Value In FX Markets." Included in these models are variables such as productivity differentials, terms-of-trade shocks, net international investment positions, real rate differentials, and proxies for global risk aversion.1 These models cover 23 currencies, incorporating both G10 and EM FX markets. Twice a year, we provide clients with a comprehensive update of all these long-term models in one stop. This time around, a few fair value estimates have changed. This reflects the revisions to the productivity estimates we source from the Conference Board. These models are not designed to generate short- or intermediate-term forecasts. Instead, they reflect the economic drivers of a currency's equilibrium. Their purpose is therefore threefold. First, they provide guideposts to judge whether we are at the end, beginning, or middle of a long-term currency cycle. Second, by providing strong directional signals, these models help us judge whether any given move is more likely be a countertrend development or not, offering insight on its potential longevity. Third, they help us and our clients to cut through the fog, and understand the key drivers of cyclical variations in a currency's value. The U.S. Dollar Chart 1Upward Revisions To Productivity Have Lifted The USD's Fair Value Upward Revisions To Productivity Have Lifted The USD's Fair Value Upward Revisions To Productivity Have Lifted The USD's Fair Value Based on its key long-term drivers - real yield differentials and the relative productivity trend between the U.S. and its trading partners - the U.S. dollar is trading around 5% above its upward-pointing fair value. Moreover, the equilibrium exchange rate for the USD has risen from previous estimations as the U.S. productivity series computed by the Conference Board have been revised upward. This comforts us in our bullish stance on the U.S. dollar. For one, the valuation premium has fallen relative to its previous estimate. Second, the dollar remains substantially below previous overvaluation peaks, where it traded at a more than 20% premium to fair value (Chart 1). Additionally, with the U.S. slack being much smaller than in most other major economies, the Fed is in a much firmer position to increase rates than most of its counterparts. This suggests that U.S. rates will continue to boost the dollar higher, justifying a growing premium to its long-term equilibrium. Finally, the dollar's recent valuation picture on a broad basis reflects the fact that many EM currencies and commodity producers are still pricey. As such, this also comforts us in our stance to underweight commodity currencies versus European ones and the yen. The Euro Chart 2The Euro Can Cheapen Further The Euro Can Cheapen Further The Euro Can Cheapen Further On a multi-year time horizon, the euro is driven by the relative productivity trend of the euro area with its trading partners, its net international investment position, terms-of-trade shocks, and rates differentials. The euro continues to trade at a 6% discount to its fair value (Chart 2). However, the euro was in fact 15% below equilibrium in both 1984 and 2002, respectively, suggesting that the valuation advantage of the euro is not yet large enough to justify aggressively bidding up the common currency. Additionally, monetary divergences with the U.S. will continue to weigh on the EUR. On a structural basis the euro area continues to exhibit signs of slack. The employment-to-population ratio for prime age workers is at 2008 levels and domestic inflationary pressures remain muted, especially when one considers how cheap the euro is. The ECB policy is therefore likely to remain very easy for the foreseeable future. Additionally, the ECB might leave policy even easier than the broad euro area economic averages would suggest as it focuses its efforts on the weakest members of the union. While in the early 2000s it was Germany, today it is the European periphery that is in need of easy money to create fiscal room and ease latent deleveraging pressures. The Yen Chart 3The Yen Will Stay Cheap The Yen Will Stay Cheap The Yen Will Stay Cheap The yen's long-term equilibrium is a function of Japan's net international investment position, global risk aversion, and commodity prices. The large Japanese current account surplus continues to lift the yen's fair value, albeit at a slower pace than last year. While the yen may have strengthened substantially in recent months against the dollar, on a broader basis the yen is still very cheap (albeit not as cheap as a year ago) (Chart 3). This simply reflects the fact that many Asian currencies and the euro - key competitors of Japan - and the CNY - the currency of the most crucial export market for the Japanese - have also fallen substantially versus the dollar. The current outsized efforts by the Bank of Japan to lift domestic inflation expectations at any costs suggest that Japanese policy will maintain a dovish bias for an extended period of time, even if realized inflation perks up. As such, like the euro, the yen is likely to remain a prey to global monetary policy divergences, especially against the USD. Nonetheless, the yen's attractive valuation - comparable to that which prevailed around the time of the Plaza Accord - implies that USD/JPY could stay as the preferred cross by which to play any dollar correction that should emerge along the upward trajectory of the greenback. The British Pound Chart 4GBP: The Economy Matters More Than Valuations GBP: The Economy Matters More Than Valuations GBP: The Economy Matters More Than Valuations The fair value of the pound has fallen over the past year and is projected to continue doing so in 2017. This development is explained by the U.K.'s poor trend productivity growth, falling real yields, and slowing house price appreciation. Despite this change in the fair value, following the drubbing received by the pound in the Brexit vote aftermath, GBP is cheap on a long-term basis (Chart 4). However, the decline in investment that may materialize following the fall in British FDI inflows mean that the U.K.'s productivity may deteriorate even faster than is currently projected. This would further depress the pound's fair value, implying that the GBP may not be as cheap as the model currently highlights. Even if this prospect were to materialize, the pound could still be an attractive play on a cyclical horizon. For one, British real rates are likely to pick up as the economy continues to surprise to the upside, mitigating some of the negative implications of falling productivity on the GBP's fair value. Additionally, the last legal hurdles to the invocation of the Article 50 of the Lisbon Treaty are being cleared, suggesting that the Brexit negotiations will begin in earnest in March. While this could create some episodes of currency volatility as the British and EU negotiators establish their stances, the end of the anticipation of this fearful moment may let investors focus on the U.K.'s economic robustness. The Canadian Dollar Chart 5CAD At Fair Value: The Future Depends On Oil CAD At Fair Value: The Future Depends On Oil CAD At Fair Value: The Future Depends On Oil The Loonie's fair value is driven by commodity prices, relative productivity trends, and the Canadian net international position. While the Canadian current account deficit and the nation's poor productivity growth would argue for a lower fair-value, these have been compensated by a rebound in commodity prices, creating stability for the CAD's equilibrium exchange rate. The sharp rebound in the Canadian dollar over the past 12 months means that the exceptional undervaluation in February last year has been fully eradicated (Chart 5). However, the CAD is not experiencing the same level of overvaluation as many of the other commodity currencies, like the AUD, the NZD, the BRL, or the RUB. This could reflect the NAFTA discount now created by Trump's demanding a renegotiation of the trade deal, which puts Canadian exports at marginal risk. Ultimately, with the CAD troughs and peak very much a direct negative function of the USD, our bullish stance on the greenback suggests that the CAD could once again experience a discount in the coming 12 to 18 months, especially as the U.S. dollar carries such a heavy weight in the trade-weighted CAD. In fact, we expect the Canadian economy to underperform that of the U.S. as the Canadian consumer remains hampered by higher debt loads and as Canadian capex remains hurt by excess capacity. This will only accentuate the monetary divergence between the CAD and the USD. The Australian Dollar Chart 6The AUD Has Overshot Fundamentals: Use Further Rallies To Sell The AUD Has Overshot Fundamentals: Use Further Rallies To Sell The AUD Has Overshot Fundamentals: Use Further Rallies To Sell The fair value of the Aussie, driven by Australia's net international position and commodity prices, has stabilized. However, it may begin to deteriorate anew if commodity prices lose some of their luster, a growing probability event in the face of a strong USD. Moreover, the AUD's rally has only caused this currency to become ever more expensive and it now offers one of the poorest risk-reward profiles in the G10. Historically, current levels of overvaluation have proved a reliable sell-signal for the Aussie and warrant shorting this currency right now (Chart 6). Our portfolio has a negative AUD bias. The AUD's poor valuations suggest that it is discounting an extremely positive growth outcome in the Chinese economy. We think China is likely to surprise to the downside, especially against such lofty expectations. Raising the AUD's risk profile even further, China has not only exhausted its latest fiscal stimulus and clamped down on the real estate market, but also cracked down on excess steel production. This means that the demand for iron ore and coking coal - of which China has accumulated large inventory piles - could weaken even more than a Chinese economic deceleration would imply. Australian terms-of-trades could suffer a nasty shock. The New Zealand Dollar Chart 7NZD Is Expensive, But Not As Much As The AUD NZD Is Expensive, But Not As Much As The AUD NZD Is Expensive, But Not As Much As The AUD Natural resources prices, real rate differentials, and the VIX are the key determinants of the Kiwi's fair value, highlighting the NZD's nature as both a commodity currency and a carry currency. Both the fall in the VIX and the rebound in commodities are currently causing the gradual appreciation in the New Zealand's dollar equilibrium exchange rate. Thus, this trend could easily reverse if the global reflation trade begins to wane. Currently, the NZD is expensive (Chart 7), albeit not as exceptionally so as the AUD, the BRL, or the RUB. This partly explains why we like the Kiwi more than these currencies. In fact, while we worry about the outlook for the NZD versus the USD, the attractive domestic situation in New Zealand, where growth is the highest in the G10 and employment is growing at an eye-popping 6% annual rate, suggests that the RBNZ could abandon its new-found neutral bias in favor of a hawkish one later this year. Hence, we like the Kiwi against the AUD, the BRL, or the RUB. The Swiss Franc Chart 8The Swiss Net International Investment Position Makes The SNB's Life Difficult The Swiss Net International Investment Position Makes The SNB's Life Difficult The Swiss Net International Investment Position Makes The SNB's Life Difficult Switzerland's enormous and growing net international investment position continues to be the most important factor lifting the fair value of the Swiss franc. Yet, in the short-term, this is irrelevant. The SNB has demonstrated its capacity and credibility when it comes to keeping a floor under EUR/CHF. Thus, the Swiss franc will continue to trade in line with the euro, even if the current French political risks would have normally caused an appreciation in the Swiss Franc versus the euro. This means that the real trade-weighted CHF should not deviate much from its long-term fair value estimate (Chart 8). Nonetheless, this peg contains the seeds of its own demise. The cheaper the CHF gets, the larger the economic distortions in the Swiss economy become. Already, Switzerland sports the most negative interest rates in the world. This directly reflects the large injections of liquidity required from the SNB to stem any CHF appreciation. A consequence of these low real rates has been the appreciation in the already-expensive Swiss real estate. Ultimately, we expect the SNB to be forced to capitulate to all the inflows and abandon its floor. While this will not happen tomorrow, it will likely result in a comparable move to the one that followed the tentative unpegging of January 2015. Back then, the CHF was not particularly cheap. While it is too early to make this bet, we suspect that a pick-up in actual inflation will constitute the key signal for investors to begin betting against the SNB's current policy. The Swedish Krona Chart 9The Riksbank Has Achieved One Of Its Goal: SEK Is Cheap The Riksbank Has Achieved One Of Its Goal: SEK Is Cheap The Riksbank Has Achieved One Of Its Goal: SEK Is Cheap The Swedish krona continues to trade cheaply, even if its long-term fair value remains on a secular downward trajectory (Chart 9). Yet, the undemanding valuations of the SEK hides a complex picture. It is approximately fairly valued against the GBP and expensive against the NOK, two of its largest trading partners. However, the SEK is cheap against the USD and the euro. Amongst the latter two, we prefer buying the Swedish krona against the EUR rather than against the USD. The SEK has historically been very sensitive to the USD; therefore, USD/SEK is very exposed to the dollar's cyclical bull market. However, the current widening of European government spreads echoes the 2010-2012 period, when EUR/SEK softened considerably as the survival of the euro was up in the air in investors' minds. Dutch, French, and potential Italian elections this year could prove similarly unnerving for investors, creating a source of downside risk in EUR/SEK. Moreover, Swedish domestic fundamentals remain much stronger than those of the euro area, further strengthening the case of for shorting EUR/SEK. The Norwegian Krone Chart 10NOK, Still Undervalued Despite The Rally NOK, Still Undervalued Despite The Rally NOK, Still Undervalued Despite The Rally A year ago, when global markets were in full panic mode, the Norwegian krona became the most attractive currency in the world on a valuation basis. After a blistering rally, this is not the case anymore (Chart 10). Nonetheless, it continues to trade on the cheap side, and remains the cheapest commodity currency in the world along with the Colombian peso. We therefore maintain a positive bias toward the NOK against the rest of the commodity complex, especially the very expensive and equally oil-exposed RUB. While USD/NOK, like USD/SEK, is very exposed to general dollar strength, we remain short EUR/NOK on a 12-month basis. The NOK's main long-term favorable factor still is its enormous net international investment position of 194% of GDP, which creates a structural upward bias on the country's current account surplus. Today, while the euro area runs a record high current account surplus of 3% of GDP, its net international investment position remains negative at 8% of GDP. Additionally, in an almost perfect mirror image to the euro area, Norway shows little signs of having entered a liquidity trap post-2008. The money multiplier remains high, loan growth has stayed strong, and inflation has remained perky. This means that the Norges Bank is in a better position to cyclically increase rates than the ECB. Chinese Yuan Chart 11Can The Yuan Weaken More? Can The Yuan Weaken More? Can The Yuan Weaken More? As commodity prices strengthened and Chinese productivity growth slowed, the strong upward bias to the yuan's long-term fair value paused in 2016 and may even fall a bit in 2017. Nonetheless, the CNY continuous fall has cheapened this currency considerably since 2015 (Chart 11). Does this mean that the CNY is a buy at this juncture? No. First, on a trade-weighted basis, the experience of the past 20 years has been that it bottoms at greater discounts to fair value. Moreover, while testing the current model, we also tried various productivity series for China. Depending on the one used, the yuan's discount to fair value would considerably shrink, implying a high degree of uncertainty around the actual cheapness of the RMB. Second, China continues to suffer from capital outflows, suggesting that domestic expected returns have yet to be equilibrated with those available in the rest of the world. A lower RMB would help generate this adjustment. Third, China is still an economy with too much capacity and too much debt that also intends to liberalize its internal markets and external accounts, even if slowly. Historically, this set of circumstances has most often come along with a weak currency, a key tool to alleviate the deflationary tendencies created by these forces. Fourth, and more specific to the dollar, the PBoC now targets a basket of currencies which means that when the DXY strengthens, USD/CNY also rallies. The dollar bull market will therefore continue to hurt the RMB versus the USD. Finally, Trump's protectionist rhetoric represents a big risk for China as exports to the U.S. represent 4% of China's GDP. A simple way to regain some of the competitiveness that would be lost to tariffs would be for the PBoC to let the CNY drift lower against the USD, though this would also aggravate the trade tensions. The Brazilian Real Chart 12Trouble In Rio Trouble In Rio Trouble In Rio Hampered by poor productivity trends, which weigh on the Brazilian current account balance, the fair value of the real remains quite depressed, even as commodity prices have sharply rebounded over the course of the past 12 months. In fact, the violent rally in the BRL over the same timeframe has made it one of the most expensive currencies tracked by our models (Chart 12). At current levels of overvaluation, the next 6 months return on the BRL has always been negative. The potential downside for BRL over the next 12-18 months is large. The rally reflected a general easing in EM financial conditions, fiscal stimulus in China, and the ejection of Dilma Rousseff, replaced by Michel Temer. While the change of government has depressed the geopolitical risk premium, any real improvement rests on the Temer administration's stated goal of slashing the size of the public sector. In the Mundell-Fleming model, the resulting destruction in domestic demand cuts local real rates, and therefore, the BRL's appeal to international investors. This a severe headwind to overcome, especially when coupled with as clear of a message as the one currently sent by valuations. Finally, the recent strength in the dollar along with the rise in DM global rates is creating a tightening of global and EM liquidity conditions, exactly as the Chinese fiscal stimulus wanes. This is a very poor risk profile for the BRL. The Mexican Peso Chart 13MXN Is Not Cheap Enough Yet MXN Is Not Cheap Enough Yet MXN Is Not Cheap Enough Yet Interestingly, despite the surge in USD/MXN in the wake of Trump's electoral victory, the MXN is not very cheap on a real trade-weighted basis (Chart 13). The peso's equilibrium rate has been pulled lower by the nation's persistent current account deficit which has continuously hurt its net international investment position. Conceptually, this is akin to a relative oversupply of Mexican assets to the rest of the world, depressing the peso's fair-value. The large stock of Mexican USD-denominated debt is a testament to this phenomenon. At this juncture, while PPP valuations suggest that the peso is attractive relative to the USD, Mexico's negative net international investment position and its large stock of U.S.-dollar debt warrant cautiousness. The Mexican economy is very exposed to a tightening in global liquidity conditions and the borrowing-costs squeeze represented by a higher dollar and higher U.S. rates. Hence, USD/MXN could have more upside from here on a 12-to-18 month basis. Compared to other EM currencies like the BRL, the RUB, or the CLP, however, the Mexican peso seems very attractively priced as all these currencies currently trade at large premia to their fair value. Additionally, a "Trump-protectionism" risk premium is already embedded in the Mexican peso, but the above currencies do not seem to suffer from the same handicap. While not as directly exposed to this risk as Mexico, these countries would nonetheless be affected by a trade war between the U.S. and Asia, and particularly between the U.S. and China. The Chilean Peso Chart 14The CLP Has Overshot The CLP Has Overshot The CLP Has Overshot The Chilean peso real effective exchange rate is driven by the country's productivity trend relative to its trading partners and the real price of copper - which proxies the Chilean terms-of-trade. As a result of the rally since the winter of 2015, the real CLP is at a 4-year high and is now in expensive territory (Chart 14). Global risks point to downside for the CLP, as copper is likely to underperform against other commodities. EM liquidity conditions should dry up due to the rising dollar, compounding potential problems created by China's efforts to crack down on real estate activity, the biggest source of copper consumption by a wide margin. The recent meteoric surge in copper prices will leave the red metal vulnerable to such dynamics. Domestic factors also don't bode well for the peso. The Chilean housing market is currently going through its biggest downturn since 2008 while economic activity remains anemic. Furthermore, the worker's strike in "La Escondida", the world's biggest copper mine, should cause strains on Chilean exports. All of these factors will be too great for the CLP to overcome. Thus, we remain short the peso. The Colombian Peso Chart 15COP Is A Cheap Oil Play COP Is A Cheap Oil Play COP Is A Cheap Oil Play The real COP is driven by Colombia's relative productivity trends and the price of oil, the country's main export. With oil prices having rebounded, the fair value has returned to 2014 levels. Nevertheless, the COP still undershoots its fundamentals (Chart 15). This reflects the premium demanded by investors to compensate for Colombia's large current account deficit equal to 6.3% of GDP. The outlook for the COP has brightened, especially against other commodity currencies. The OPEC deal to cut oil production seems to be on track so far, with 90% compliance amongst OPEC members. Furthermore, the potential for a strong economic performance in DM economies suggests that oil demand should remain firm. This should help the COP outperform currencies that have a higher sensitivity to metals like the BRL and the ZAR. Domestic factors also paint a positive picture for the peso. The Colombian economic situation is more robust than in other EM economies. During the commodity boom years, Colombian banks were much more orthodox in their lending than their EM counterparts. Thus, this Andean country does not suffer from unsustainable debt dynamics, and therefore, if EM suffers a liquidity-induced slowdown, Colombia should withstand this shock better. The South African Rand Chart 16ZAR Has Outshined Gold, Higher Rates Will Be A Problem ZAR Has Outshined Gold, Higher Rates Will Be A Problem ZAR Has Outshined Gold, Higher Rates Will Be A Problem South Africa's dismal productivity trends continue to force a downtrend upon the rand's long-term fair value. The rally in commodity prices has nonetheless lifted the current fair value of the ZAR for early 2017 compared to estimates run last year. Despite this improvement, the rand's 6% rally in real terms has still overshot any justifiable fundamentals, leaving this currency overvalued (Chart 16). Furthermore, if commodity prices were to correct, not only would the fair value of the rand fall, but the current overshoot would also correct. This implies substantial downside risk to the ZAR. The ZAR may remain stable in the short term as the dollar's correction continues and gold prices enjoy a healthy bounce. However, the rand's copious handicaps will come back to haunt investors once the previous dollar strength is fully digested and the USD resumes its cyclical bull market. Moreover, such a move is likely to come hand-in-hand with rising U.S. rates, embracing both gold and the rand in an inescapable kiss of death. The Russian Ruble Chart 17RUB Has Fully Priced Any Russia-American Rapprochement RUB Has Fully Priced Any Russia-American Rapprochement RUB Has Fully Priced Any Russia-American Rapprochement Buoyed by both the perceived benefits to the Russian economy of OPEC oil production cuts and the fall in the geopolitical risk premium coming from the expected Trump/Putin rapprochement, the Ruble is now very expensive (Chart 17). While RUB was more expensive in the years prior to the 1998 Russian default, it still manages currently to trade at its highest premium in more than 18 years. Trump and Putin really need to get along famously well - and it is not clear that they will at the moment. As the RUB is massively expensive, we would not chase it higher from here. Not only is the upside to oil prices limited, since at current oil prices, shape of the oil curve, and financing costs, shale producers are once again investing in their oil fields, pointing to higher U.S. production in the coming quarters. Also, the civility between Trump and Putin is likely to prove ephemeral: Russia's commercial links are with Europe and China, not the U.S. If anything, the U.S.'s growing exports of energy products mean that both nations will soon compete in that market. We know how much Trump loves foreign competition. Thus, we prefer other petro currencies to the RUB. At the current juncture, buying CAD/RUB and NOK/RUB makes sense. Especially as the valuation disadvantage is clear enough to point to a large ruble-bearish move in both crosses. The Korean Won Chart 18No Big Discount In The KRW No Big Discount In The KRW No Big Discount In The KRW The fair value of the won is positively correlated with the nation's net international investment position, but shows a strong negative relationship with oil prices. This reflects the status of the nation as an oil importer, and thus lower oil prices constitute a positive terms-of-trade shock for Korea. Also, the real trade-weighted won is inversely correlated with EM spreads. This makes sense as the won is a very pro-cyclical currency reflecting the tech and manufacturing bias of the Korean economy. At the current juncture, the won is moderately cheap (Chart 18). The Korean won may be trading on the cheap side, but we worry that this good value may prove somewhat illusory. A strong U.S. dollar and rising DM real rates are likely to result in stresses for many EM borrowers, whether they borrow in USD, produce commodities, or even worse, do both. Such an event would put pressure on EM spreads and push down the fair value of the KRW. An additional problem for the won is Donald Trump. Korea has been one of the greatest beneficiaries of the expansion of globalization from 1980 to 2008, as its export growth was some of the strongest in the world. Today, if Trump's protectionist tendencies gather momentum, Korea is likely to end up on his line of sight. The passage of import-punishing tax reform, cancellation of the KORUS free trade agreement, or imposition of tariffs on that country would have two potential effects on the won. They could cause the country's current account to deteriorate, hurting the prospective path of Korea's net international position and dragging the KRW fair value lower. This would be a slower drag on the won. Or, the other path, which we judge more likely, market participants (probably helped by Korean monetary authorities) could embed a discount into the KRW's fair value equivalent to the expected impact of the tariffs. This discount would alleviate the pain of the tariff, and would materialize in swift fashion. The Indian Rupee Chart 19SGD Has Downside INR Real Equilibrium Keeps Rising, But Inflation Still Clouds The Outlook INR Real Equilibrium Keeps Rising, But Inflation Still Clouds The Outlook The fair value of the real trade-weighted INR is driven by India's productivity performance relative to its trading partners - the key factor behind the gentle upward slope in the equilibrium value for the rupee, its net international investment position, and Indian real interest rate differentials. However, the elevated level of inflation by global standards in India means that despite its long-term nominal downtrend, the INR is not cheap (Chart 19). Yet, while it will be difficult for this currency to rally against the USD if the dollar is in a broad-based uptrend, things are looking up for the INR relative to other EM currencies. The swift implementation of the currency reform last year was a bit of a debacle, but results are beginning to show through: deposit growth is improving. Thus, the constant shortage of loanable savings that has structurally hurt Indian capex and fomented elevated inflation in that country might begin to decrease. This means that over the long term, India's relative productivity performance might improve further and the country's stubborn inflation might decrease. This would lift the INR's fair value over time. The key to this positive outlook will be the RBI. With the personnel and political-administrative changes at its helm, it is hard to judge whether the Indian central bank will lift rates enough as capex perks up. That would limit future inflation and protect the value of the fiat currency and hence the long-term attractiveness of keeping money in Indian banks. We are optimistic, but await clearer proofs. The Philippine Peso Chart 20The Duterte Discount The Duterte Discount The Duterte Discount President Rodrigo Duterte's politics have been a source of fear for investors. As a result, PHP has depreciated against the USD and is now trading at a 10% discount (Chart 20). The fair value of the peso, driven by the cumulative current account and commodity prices, is on an uptrend. This will likely continue as a strong USD should depress commodity prices, improving the Philippines' trade balance and terms of trade. Additionally, improving DM economies will likely generate higher remittances to the Philippines, boosting the current account balance, domestic consumption, and the PHP's long-term value. These dynamics underpin our bullish long-term view on the PHP. However, potential political risks still loom large for the economy. So far Duterte has allowed technocrats to run economic policy, but if he takes a greater personal interest in this area it is likely to be unfriendly to foreign investors, potentially endangering broader FDI inflows. This could erode the PHP long-term equilibrium value over time. Relations with the Trump administration do not have any clarity yet but potentially offer substantial downside risks. Tempering our fear for now, Duterte is taking a reasonable approach to economic management and opening the way for new investment from China, suggesting political risks to foreign investment remain contained. The Singapore Dollar Chart 21INR Real Equilibrium Keeps Rising, But Inflation Still Clouds The Outlook SGD Has Downside SGD Has Downside Our model points to a relatively stable long-term valuation of the Singaporean Dollar. The currency displays little statistical significance with economic factors, with its relationship with commodities being one of indirect statistical coincidence. This is because the Monetary Authority of Singapore (MAS) utilizes the currency as its main monetary policy tool, underpinning the SGD's cyclical nature. As inflation has only just stepped back into positive territory in December 2016, and retail prices remain weak, MAS is unlikely to deviate from its current policy stance and will remain accommodative. Therefore, SGD is likely to depreciate from its current 3.6% overvaluation (Chart 21). This strong mean-reverting characteristic warrants a short position on the SGD. Last September, we suggested selling SGD against USD over JPY, a recommendation we stick to, since a dollar bull market will add additional pressure onto the SGD. The Hong Kong Dollar Chart 22HKD Is Expensive But The Peg Will Survive HKD Is Expensive But The Peg Will Survive HKD Is Expensive But The Peg Will Survive While USD/HKD is pegged, the real trade-weighted Hong-Kong dollar can still experience wild swings. Since 2011, its real appreciation has been driven by a wave of EM currency weakness and higher inflation in HK than the U.S. Also, the strength in USD/CNY since January 2014 has added to the HKD's surge. Thanks to this combination, the Hong Kong dollar remains more expensive than it was in 1997, on the eve of the Asian Crisis (Chart 22). This does not mean that HKD is about to depreciate. In fact, we expect the Hong Kong Monetary Authority to keep the peg alive as it has been a pillar of stability since its introduction in 1983. With reserves of 114% of GDP, not only does the HKMA have the financial fire-power to support the HKD, but also Hong Kong continues to sport a current account surplus of 4%. While it is possible that USD/HKD will appreciate toward 7.85, the upper range of the target zone, any depreciation in the real HKD will be a consequence of deepening deflation. This suggests that HK real estate prices will suffer more, especially as they remain significantly overvalued. The Saudi Riyal Chart 23Saudi Needs Higher Oil Prices Or An Internal Devaluation Will Rage For Years To Come Saudi Needs Higher Oil Prices Or An Internal Devaluation Will Rage For Years To Come Saudi Needs Higher Oil Prices Or An Internal Devaluation Will Rage For Years To Come The Saudi Riyal shares two attributes with the HKD: It is a pegged currency and a prohibitively expensive one (Chart 23). Moreover, the very poor productivity performance of the Saudi economy necessitates a perpetually falling real effective exchange rate. Like the HKMA, SAMA will continue to defend its exchange rate for now, as it holds reserves of US$538 billion to protect its currency. Also, Saudi budget deficits can be curtailed further and the Saudi government can continue to borrow in the debt market. Finally, the production-cut agreements between OPEC and Russia have put a floor under oil prices for the time being, exactly as the market was already moving into deficit. They give SAMA even more time. However, one cannot forget that following the 1986 oil collapse, USD/SAR rose by 11%. Therefore, if oil prices relapse as U.S. shale production picks up anew or as the broad USD rallies further, the probability of a SAR surprise devaluation grows. Moreover, selling SAR could also act as insurance against further trouble in the Middle East, especially if Trump follows through on his demand that America's allies pay more for their own defense. At the current juncture, a small long USD/SAR position within a portfolio is equivalent to owning an instrument with a deep out-of-the-money option-like payoff: It costs little, has a small probability of being exercised, but if it does, it will pay great rewards. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Haaris Aziz, Research Assistant haarisa@bcaresearch.com Juan Manuel Correa, Research Assistant juanc@bcaresearch.com 1 For a more detailed discussion of the various variables incorporated in the models, please see Foreign Exchange Strategy Special Report, "Assessing Fair Value In FX Markets," dated February 26, 2016, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Duration: Growth, inflation & investor risk-seeking behavior remain bond-bearish in both the U.S. & the Euro Area. Market technicals, both in terms of oversold momentum and heavy short positioning, are the biggest headwind to higher yields in the near-term. USTs vs. Bunds: U.S. Treasury yields will remain under upward pressure from a hawkish Fed with the U.S. economy operating at full employment. The opposite is true in Europe, at least until Euro Area inflation is much higher. Stay overweight core Europe versus the U.S. in global hedged bond portfolios Feature Chart of the WeekCan The Bond Selloff Continue? Can The Bond Selloff Continue? Can The Bond Selloff Continue? Last week brought the first serious test of the bond bear phase that has been in place since last July. The 10-year U.S. Treasury yield dipped as low as 2.33% after a benign January U.S. Payrolls report that substantially reduced the odds of a March Fed rate hike. German Bund yields also dipped as renewed worries about the upcoming French election triggered a flight to quality out of French and Peripheral sovereign debt. Even the chartists got in on the act, talking of an imminent breakdown below the "head & shoulders neckline" on the 10-year U.S. Treasury that would herald a 25bp decline in yields. Adding to the growing sense of nervousness among investors is a fear that the "Trumpflation" trade could soon run out of gas, with a correction of both elevated equity prices and bond yields likely in the absence of concrete economic news from the White House. Yet all it took was for Trump to simply mention that a "phenomenal" announcement on his tax plan was coming in the next few weeks to restart the Trump trades, pushing equity indices to new highs and driving up bond yields. Given all the conflicting forces at play in developed bond markets - accelerating growth, rising inflation, fiscal and political uncertainties, bearish bond investor positioning - we believe it is important to stay grounded by focusing only on the most relevant factors while trying to sift out the signal from the noise. This week, we are introducing a new "Duration Checklist" for both U.S. Treasuries and German Bunds, highlighting the key economic and market indicators that we are watching to assess whether we should maintain our current below-benchmark portfolio duration stance. From this checklist, we can confirm that the bond-bearish backdrop remains intact, with more indicators pointing to higher yields in the U.S. relative to core Europe. Describing The Elements Of Our Checklist The individual components of bond yields that we typically monitor - term premia, inflation expectations and shifts in the market-implied path of policy rates - have all contributed to the rise in U.S. and European bond yields since last July (Chart of the Week). Some of the factors that have driven yields higher are global in nature, like faster economic growth and rising energy prices, while others are more country-specific, like rising wage inflation in the U.S. To account for those different factors, we need to include a variety of indicators in our new GFIS Duration Checklist. The goal of list is to answer the specific question: "what should we watch to maintain a below-benchmark duration stance in the U.S. and core Europe?" The items in the Checklist are shown in Table 1, broken down into the following groupings: Table 1Stay Bearish On Treasuries & Bunds A Duration Checklist For U.S. Treasuries & German Bunds A Duration Checklist For U.S. Treasuries & German Bunds Accelerating Global Growth: Here, we are looking at indicators that are pointing to a quickening pace of global economic growth that would put upward pressure on all developed market bond yields. Specifically, we are looking to see if: a) the annual growth in the global leading economic indicator (LEI) is accelerating; b) our diffusion index for the global LEI is above 50 (suggesting a majority of countries with an expanding LEI) and rising; c) the global ZEW economic sentiment index is increasing; d) the global data surprise index is moving higher; and e) our measure of the global credit impulse (the 6-month change in credit growth among the major economies, one of BCA's favorite leading economic signals) is expanding. These global indicators are all shown in Chart 2. The global LEI growth rate, the global ZEW index and global data surprises are all moving higher, consistent with upward pressure on bond yields, and thus warrant a "check" in our GFIS Duration Checklist. The LEI diffusion index is well above 50, but has hooked down slightly in the past few months, as has the global credit impulse. These moves are relatively modest, and it is not yet certain whether they represent a change in trend in these series. For now, we are giving these indicators a "check", but with a question mark attached. If we see additional declines in the diffusion index and the global credit impulse in the next few months, we would interpret that as a sign that the cyclical global upturn is in danger of losing momentum, thus reducing the upward pressure on bond yields. Accelerating Domestic Growth: These are economic data that are specific to each country that would be consistent with higher yields; a) manufacturing purchasing managers' indices (PMIs) that are above 50 and rising; b) expanding consumer confidence; c) rising business confidence; d) faster growth in corporate profits. The relevant data for the U.S. are shown in Chart 3, which shows that all elements are increasing in a fashion that is bearish for U.S. Treasuries. The popular perception is that the recent surge in business confidence (both for corporate CEOs and small business owners) is simply a "Trump effect" from the new president's pro-business economic platform. However, the acceleration in corporate profit growth, which our own models are suggesting will continue in the coming quarters, is a sign that there is a more fundamental reason for firms to feel more optimistic. Chart 2Global Growth Still Pointing To Higher Yields Global Growth Still Pointing To Higher Yields Global Growth Still Pointing To Higher Yields Chart 3U.S. Domestic Upturn Is Solid U.S. Domestic Upturn Is Solid U.S. Domestic Upturn Is Solid We give all the U.S. domestic growth indicators a "check" pointing to a need to stay below-benchmark U.S. duration. The specific Euro Area growth data is shown in Chart 4. Similar to the U.S., all the indicators are moving higher in a bond-bearish direction, warranting a "check" on the Euro Area Duration Checklist. The political tensions stemming from the busy election calendar in Europe this year represent a potential negative shock to confidence. As we discussed in our Special Report published last week, however, we do not foresee a populist election shock in France akin to Brexit or Trump that would derail the Euro Area economic expansion.1 Rising Domestic Inflation Pressures: These are data that are specific to each country that would be consistent with faster inflation and higher yields: a) the annual growth in the oil price, in local currency terms, is accelerating; b) wage inflation is rising; c) the unemployment gap (the difference between the unemployment rate and the full employment NAIRU rate) is closed or nearly closed; The U.S. inflation data is shown in Chart 5, with all the indicators warranting a bond-bearish "check" in our U.S. Duration Checklist. The rising trend in oil prices continues to put upward pressure on headline U.S. inflation, even with the strong U.S. dollar. Meanwhile, the unemployment gap is now closed and U.S. wage inflation is grinding higher. This should be consistent with additional modest gains in core inflation that will put upward pressure on the inflation expectations component of U.S. Treasury yields (bottom panel). Chart 4Euro Area Domestic Upturn Is Solid Euro Area Domestic Upturn Is Solid Euro Area Domestic Upturn Is Solid Chart 5U.S. Inflation Trends Still Bearish For USTs U.S. Inflation Trends Still Bearish For USTs U.S. Inflation Trends Still Bearish For USTs It is a different story in the Euro Area, as can be seen in Chart 6. While the rapid acceleration in the Euro-denominated price of oil is starting to feed through into faster headline inflation, there still exists a positive unemployment gap that is helping keep wage growth, and core inflation, muted. A continuation of the recent economic upturn will likely put more downward pressure on Euro Area unemployment, but, for now, only the oil price acceleration justifies a "check" in the Euro Area Duration Checklist. Chart 6Euro Area Inflation Is A Mixed Bag Euro Area Inflation Is A Mixed Bag Euro Area Inflation Is A Mixed Bag Central Bank Policy Stance: Here, we are not including any charts, but are only stating whether the central bank has a bias to tighten monetary policy. That is certainly the case in the U.S., where the Fed has already delivered a 25bp hike in December and continues to signal that up to three more hikes will occur in 2017 if the FOMC growth forecasts are realized. So we put a "check" in this box on the U.S. side of the checklist. The European Central Bank (ECB) continues to maintain an unusually accommodative monetary stance, using a combination of asset purchases, negative policy rates and dovish forward guidance. We continue to see a potential shift away from this super-easy policy bias in the latter half of the year - in response to the upturn in economic growth and acceleration of Euro Area inflation towards the ECB's 2% target - as the biggest risk for both Euro Area bonds, in particular, and global bonds, in general. For now, however, the ECB is signaling no imminent shift to a more hawkish stance, so we are placing an "x" in the central bank portion of the Euro Area checklist. Risk-Seeking Behavior In Financial Markets: Here, we are checking to see if pro-growth, pro-risk asset classes are outperforming and whether market volatilities are rising. Risk asset outperformance and stable vol suggests that investors are less interested in risk-free government bonds: a) the domestic equity index is rising but is not yet 10% above the 200-day moving average (a level that has coincided with post-crisis equity market and bond yield peaks); b) domestic corporate bond spreads are either flat or falling rapidly; c) domestic equity market volatility is low and falling rapidly. The U.S. indicators are shown in Chart 7, while the Euro Area data is shown in Chart 8. The story is the same in both regions, with equity markets in a bullish trend but not yet at a fully-stretched extreme, credit spreads (both for Investment Grade and High-Yield) tight, and equity market volatility at multi-year lows. We view these indicators as signs that investors are less interested in owning U.S. Treasuries and German Bunds than owning equities and corporate debt. This will help bond yields drift higher on the margin as economic growth and inflation rise in the coming months. Thus, we place a "check" on all three elements in both the U.S. and Euro Area Duration Checklists. Chart 7Risk-Seeking Behavior In The U.S. Risk-Seeking Behavior In The U.S. Risk-Seeking Behavior In The U.S. Chart 8Risk-Seeking Behavior In Europe Risk-Seeking Behavior In Europe Risk-Seeking Behavior In Europe Contrarians may look at those same charts and say that this is more of a sign that investors are too optimistic and are now exposed to any negative growth shock, potentially representing a trigger for a selloff of risk assets and a move into government debt. We prefer to view the bullish performance of growth-sensitive assets as a sign of underlying investor risk appetite. Domestic Bond Market Technicals: Here, we are simply looking at measures of price momentum and market positioning in government bonds, to assess if there is room for additional yield increases as investors reduce exposure: a) the domestic 10-year bond yield is not stretched to the upside versus the 200-day moving average; b) the domestic Treasury index total return momentum (26-week rate of change) is not stretched to the downside; c) bond investor positioning is not already short. The 10-year U.S. Treasury technicals are shown in Chart 9, while the German Bund technicals are shown in Chart 10. The story is quite simple here - the rapid run-up in global bond yields late last year has led to stretched, oversold conditions on both sides of the Atlantic. Sentiment remains bearish in U.S. Treasuries, with massive net shorts in bond futures, suggesting that an overhang of positions remains a major headwind to higher yields. While we do not have positioning data for Euro Area bond investors, the momentum charts for German Bunds look very similar to the U.S. Treasury charts. Clearly, we must place an "x" in all these boxes on both Duration Checklists. Chart 9Stretched Technicals In U.S. Treasuries... Stretched Technicals In U.S. Treasuries... Stretched Technicals In U.S. Treasuries... Chart 10...And In German Bunds ...And In German Bunds ...And In German Bunds So What Are The Checklists Telling Us? Adding it all up, and the vast majority of the indicators in both checklists are pointing to continued upward pressure on bond yields, justifying a below-benchmark duration stance. The lack of core inflation pressure in the Euro Area, however, suggests that there is less upward pressure on German Bund yields relative to U.S. Treasuries, thus we continue to recommend an overweight stance on Bunds versus Treasuries in global hedged bond portfolios. Oversold conditions suggest that yields will have a tough time rising quickly from here while the market continues to consolidate the late 2016 bond selloff. However, a major bond market reversal is unlikely given the solid upturn in global growth. Bottom Line: Growth, inflation & investor risk-seeking behavior remain bond-bearish in both the U.S. & the Euro Area. Market technicals, both in terms of oversold momentum and heavy short positioning, are the biggest headwind to higher yields in the near-term. Maintain a below-benchmark portfolio duration stance in the near term, favoring German Bunds over U.S. Treasuries. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Special Report, "Our View On French Government Bonds", dated February 7, 2016, available at gfis.bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index A Duration Checklist For U.S. Treasuries & German Bunds A Duration Checklist For U.S. Treasuries & German Bunds Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Chart I-1No Recovery In Domestic Demand A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Feature Today we are publishing charts on cyclical economic conditions within developing economies. The aim of this report is to aid investors in gauging the business cycle profiles of these individual emerging economies. Global trade and manufacturing have recovered, driven by an acceleration in U.S. and euro area demand. Chinese imports have also recovered, supporting global trade amelioration. Although there has been improvement in EM manufacturing PMIs (diffusion indexes), "hard" EM economic data have not recovered (Chart I-1). This is especially true for EM domestic demand measures such as consumer spending and real gross fixed capital formation. Given the still-lingering credit excesses in many EM countries, credit growth is likely to decelerate further, leaving little chance of domestic demand recovering. Bottom Line: Continue underweighting EM equities and credit markets versus their DM peers. China Chart I-2, Chart I-3, Chart I-4, Chart I-5, Chart I-6, Chart I-7 Chart I-2C2 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-3C3 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-4C4 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-5C5 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-6C6 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-7C7 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Korea Chart I-8, Chart I-9, Chart I-10, Chart I-11 Chart I-8C8 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-9C9 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-10C10 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-11C11 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Taiwan Chart I-12, Chart I-13 Chart I-12C12 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-13C13 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies India Chart I-14, Chart I-15, Chart I-16, Chart I-17 Chart I-14C14 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-15C15 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-16C16 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-17C17 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Indonesia Chart I-18, Chart I-19 Chart I-18C18 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-19C19 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Malaysia Chart I-20, Chart I-21 Chart I-20C20 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-21C21 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Thailand Chart I-22, Chart I-23, Chart I-24 Chart I-22C22 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-24C24 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-23C23 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Philippines Chart I-25, Chart I-26 Chart I-25C25 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-26C26 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Brazil Chart I-27, Chart I-28, Chart I-29, Chart I-30, Chart I-31, Chart I-32 Chart I-27C27 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-28C28 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-29C29 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-30C30 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-31C31 C31 C31 Chart I-32C32 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Mexico Chart I-33, Chart I-34, Chart I-35, Chart I-36, Chart I-37 Chart I-33C33 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-34C34 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-35C35 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-36C36 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-37C37 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Colombia Chart I-38, Chart I-39, Chart I-40, Chart I-41 Chart I-38C38 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-39C39 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-40C40 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-41C41 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Peru Chart I-42, Chart I-43, Chart I-44 Chart I-42C42 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-43C43 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-44C44 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chile Chart I-45, Chart I-46, Chart I-47, Chart I-48 Chart I-45C45 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-46C46 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-47C47 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-48C48 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Argentina Chart I-49, Chart I-50, Chart I-51, Chart I-52, Chart I-53 Chart I-49C49 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-50C50 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-51C51 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-52C52 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-53C53 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Russia Chart I-54, Chart I-55 Chart I-54C54 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-55C55 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Turkey Chart I-56, Chart I-57, Chart I-58, Chart I-59 Chart I-56C56 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-57C57 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-58C58 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-59C59 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies South Africa Chart I-60, Chart I-61, Chart I-62, Chart I-63 Chart I-60C60 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-61C61 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-62C62 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-63C63 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Central Europe Chart I-64, Chart I-65 Chart I-64C64 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-65C65 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Key Portfolio Highlights Improved world economic growth and rising inflation expectations have buoyed global equities (Chart 1). The downside is that financial conditions are tightening and U.S. dollar-based liquidity is contracting, which is growth restrictive (Chart 2). The massive outperformance of the financials and industrials sectors since the U.S. election implies that U.S. markets have been largely politically-motivated. Positive economic surprises remain mostly sentiment/confidence driven, rather than from upside in hard economic data (Chart 3). That unusually large gap implies that a big jump in 'hard data' surprises is already discounted and represents a latent risk, as it did in the spring of 2011 just before the summertime equity market swoon. Federal income tax receipts are contracting, suggesting that an economic boom is not forthcoming (Chart 4). In fact, there has never been a contraction in tax receipts without a corresponding slump in employment growth. Corporate sector pricing power gains have not been evenly distributed. Deep cyclicals gains came off a low base and may already be experiencing a relapse. Conversely, defensive and interest rate-sensitive sectors are demonstrating the most strength (Chart 5). Our macro models are not signaling that investors should position as if robust and self-reinforcing economic growth lies ahead. Our Deep Cyclical indicators are the weakest, while defensive and interest rate-sensitive models are grinding higher (Chart 6). Deep cyclical sectors are very overvalued and overbought, while defensives are deeply undervalued and oversold (Charts 7 and 8). Mean reversion is an apt theme for the next few months. The most attractive combination of macro, valuation and technical readings are in the consumer staples, health care sectors. The financials sector is a close second, but it is overbought. The least attractive combinations are in energy, materials and industrials. Prospects for elevated market volatility, stronger economic growth in developed vs developing economies, a tighter Fed and expensive U.S. dollar are consistent with maintaining a largely defensive portfolio structure (Charts 9-12). Chart 1Pricing Power Revival... Pricing Power Revival... Pricing Power Revival... Chart 2... But A Liquidity Drain ... But A Liquidity Drain ... But A Liquidity Drain Chart 3Show Me The Money Show Me The Money Show Me The Money Chart 4Yellow Flag Yellow Flag Yellow Flag Chart 5Pricing Recovery Is Not Broad Based Pricing Recovery Is Not Broad Based Pricing Recovery Is Not Broad Based Chart 6Indicator Snapshot Indicator Snapshot Indicator Snapshot Chart 7Focus On Value Focus On Value Focus On Value Chart 8Mean Reversion Ahead Mean Reversion Ahead Mean Reversion Ahead Chart 9Fundamentals Favor Defensives... Fundamentals Favor Defensives... Fundamentals Favor Defensives... Chart 10... As Do Market Signals ... As Do Market Signals ... As Do Market Signals Chart 1112-Month Performance After Fed Hikes Cyclical Indicator Update Cyclical Indicator Update Chart 1224-Month Performance After Fed Hikes Cyclical Indicator Update Cyclical Indicator Update Chart 13Staples Will Cushion A Volatility Resurgence Staples Will Cushion A Volatility Resurgence Staples Will Cushion A Volatility Resurgence Chart 14Media Stocks Like A Strong Currency Media Stocks Like A Strong Currency Media Stocks Like A Strong Currency Chart 15Unduly Punished Unduly Punished Unduly Punished Chart 16Strong Fundamental Support Strong Fundamental Support Strong Fundamental Support Chart 17Less Production... Less Production... Less Production... Chart 18... Means More Rigs ... Means More Rigs ... Means More Rigs Chart 19End Of Sugar High End Of Sugar High End Of Sugar High Chart 20A Toxic Mix A Toxic Mix A Toxic Mix Chart 21Tech Stocks Don't Like Inflation Tech Stocks Don't Like Inflation Tech Stocks Don't Like Inflation Chart 22Time To Disconnect Time To Disconnect Time To Disconnect Feature S&P Consumer Staples (Overweight - High Conviction) The Cyclical Macro Indicator (CMI) has been grinding higher for several months, even climbing through last year's share price shellacking. The CMI has been supported by the uptrend in relative consumer spending on essential items and consumer preference for saving vs. spending. More recently, a pricing power recovery in a number of groups has provided an assist as has a rebound in staples export growth. Booming consumer confidence and business confidence have held the CMI in check. The strong U.S. currency, particularly bilaterally against China, also implies a reduction in the cost of imported goods sold, and has also been an indication of relative valuation expansion because it often signals increased financial market volatility (Chart 13 on page 6). The attractive valuation starting point this cycle, and historic outperformance when the Fed raises interest rates (Chart 13 on page 6), were key factors behind our upgrade to high conviction status in January. Technical conditions are completely washed out. Sector breadth and momentum have reached oversold extremes. That signals widespread bearishness, which is positive from a contrary perspective. Chart 23 S&P Consumer Staples S&P Consumer Staples S&P Consumer Discretionary (Overweight) Our CMI is forming a tentative trough, supported by rebounding relative outlays on media services, low prices at the pump, a budding recovery in mortgage equity withdrawal and firming wage growth. The biggest drags over the past few months have come from higher Treasury yields and consumers increased propensity to save. However, rising job certainty and a vibrant residential real estate market suggest that consumers should loosen their purse strings. The VI has deflated toward the neutral zone, although remains moderately expensive from a long-term perspective. Our TI started to rebound from oversold levels. History shows that a recovery in the TI from one standard deviation below the mean has heralded a playable relative performance rally. Overweight positions should remain concentrated in housing-related equities and the media space, both of which benefit from U.S. dollar appreciation (Chart 14 on page 6). Chart 24 S&P Consumer Discretionary S&P Consumer Discretionary S&P REITs (Overweight - High Conviction) Our new REIT CMI has ticked lower, but the share price ratio has over-exaggerated this small move down. REITs have traded as if the back up in global bond yields will persist indefinitely, and that they are the only factor that drives relative performance. Improving cash flows and cheap valuations suggest that REITs can decouple from bond yields. Banks have tightened standards on commercial real estate loans, but this appears more likely to limit supply growth than create a slowdown. Commercial property prices are hitting new highs and our REIT Demand Indicator (RDI) has climbed into positive territory, signaling higher rental inflation. The latter is already outpacing overall CPI by a wide margin (Chart 15 on page 7). While REITs are back to fair value from a long-term perspective, on a shorter term basis the sector is very undervalued (Chart 15 on page 7), particularly with Treasury yields now in undervalued territory. Our REIT TI is extremely oversold, at a point which forward relative returns typically shine on a 12 and 24 month basis, even excluding the dividend yield kicker. Chart 25 S&P Real Estate S&P Real Estate S&P Health Care (Overweight) Our CMI continues to grind higher, opening a massive divergence with relative performance. This gap can be explained by the political attack on the pharmaceutical industry, the sector's heavyweight, rather than by a downturn in relative earnings drivers. Pharmaceutical shipments are hitting new highs and pricing power continues to grow at a robust mid-single digit rate. Future pricing gains may slow if government gets more heavily involved in setting prices, but this is already discounted. Pricing power in the rest of the sector remains strong, while wage inflation is tame. Health care spending is still growing as a share of total spending, but the pace is decelerating. Typically, this backdrop signals outperformance for health care insurers, who may also receive a risk premium reduction from a potential revamp of the Affordable Care Act, albeit the timing will likely be drawn out. Relative valuations are very attractive. The sector has been used as a source of capital to fund purchases in areas expected to benefit from increased fiscal stimulus. That is an overreaction, and flows should be restored to reflect the sector's appealing investment profile, particularly given the sector's track record during Fed tightening cycles (Chart 16 on page 7). The TI is deeply oversold. Breadth measures are beginning to recover from completely washed out levels. These conditions reinforce that an exploitable undershoot has occurred. Chart 26 S&P Health Care S&P Health Care S&P Financials (Neutral) Our Financial CMI has surged, underscoring that the advance in relative performance reflects more than just a reaction to anticipated sector deregulation by the Trump Administration. Leading indicators of capital formation, such as the stock-to-bond ratio, have jumped sharply. Moreover, the yield curve has steepened in recent months, bolstering the CMI. An improvement in overall profit growth and the tight labor market suggest that the credit cycle may not become a profit drag until the economy begins to cool. While not yet evident, the restrictive move in oil, the dollar and bond yields warn that disappoint may emerge in the coming months. It is notable that bank loan growth has dropped to nil over the last 3 months. C&I loan growth is contracting over that time period. Banks are hiring more aggressively, yet are tightening lending standards, suggesting productivity disappointment ahead. Despite the share price jump, value remains attractive after 8 years of financial repression. Our TI is overbought and breadth is beginning to recede, which is often a precursor to a consolidation phase. We are not willing to move beyond a market weight allocation at this juncture. Chart 27 S&P Financials S&P Financials S&P Energy (Neutral) Our CMI has plunged, probing all-time lows. Rising oil inventories and spiking wage inflation are exerting severe gravitational pull on the CMI, more than offsetting the budding recovery in domestic production. Refining margins are probing six year lows as the Brent/WTI spread has evaporated. Nevertheless, OPEC is finally curtailing production, joining non-OPEC producers (Chart 17 on page 8), which should ultimately help eat into excess global oil supply. History shows that once supply growth peaks, the rig count typically firms. That is a plus for energy services (Chart 18 on page 8), even though rising oil production will prove self-limiting for oil prices. High yield spreads have narrowed significantly from nosebleed levels, but industry balance sheets remain bruised. Net debt is historically elevated, EBITDA has yet to return to its glory days, and interest coverage remains anemic and vulnerable to any downside energy price surprises. The surge in our VI reflects depressed cash flow, and is overstating the degree of overvaluation. The TI has returned to the neutral zone, and will need to hold at current levels otherwise a relapse in the share price ratio toward previous lows is probable. Selectivity is still warranted in the energy complex. We remain underweight refiners and overweight the energy services index. Chart 28 S&P Energy S&P Energy S&P Utilities (Neutral) Our utilities sector CMI is stabilizing. That is a surprise, given the rebound in inflation expectations and firming global leading economic indicators, which are typically bearish for this defensive, fixed-income proxy. The latter negative exogenous factors are being offset by falling wage inflation, better pricing power and rising electricity output growth. Power demand is linked with manufacturing activity, underscoring that there is an element of cyclicality to sector profits. The share price ratio has held up better than most other defensive sectors since the U.S. election, perhaps on the hope that an overhaul of the tax code will benefit this domestic sector. Regardless, valuations have retreated from the extremely expensive zone where we took profits and downgraded to neutral last summer, but are not yet at a level that warrants re-establishing overweight positions. An upgrade could occur once our TI becomes fully washed out, provided that occurs within the context of additional CMI strength and a peak in global growth and inflation momentum. Chart 29 S&P Utilities S&P Utilities S&P Industrials (Underweight - High Conviction) The CMI has edged lower after a modest recovery in recent months. The strong U.S. dollar, relapse in short-term pricing power measures and sector productivity contraction are offsetting improvement in global PMI surveys. The lack of confirmation of an industrial sector revival from emerging markets is also holding back the CMI. There continues to be a deflationary undercurrent in the form of more rapid capacity than industrial sector output growth, suggesting that durable pricing power gains may remain elusive (Chart 19 on page 9). The post-election surge in share prices is slowly being unwound, as the sector was quick to discount expectations for massive domestic fiscal stimulus. Our valuation gauge is not at an extreme, although a number of individual groups are trading at historically rich multiples, such as machinery and railroads. Participation is beginning to fray around the edges, as our relative advance/decline line has rolled over, as has breadth. Our TI is pulling back from overbought levels, warning that a further correction in the share price ratio looms. It would be nearly unprecedented for the share price ratio to trough before our TI hits oversold levels. Industrials fare poorly when the Fed tightens. Chart 30 S&P Industrials S&P Industrials S&P Materials (Underweight) The CMI has nosedived, reflecting China's diminishing fiscal thrust and the recent tightening in monetary policy. Commodity price inflation peaked in mid-December concurrent with the Fed raising rates, signaling that emerging markets end-demand, in general and Chinese in particular, is likely past its prime. The nascent rebound in EM currencies represents a positive offset, but not by enough to turn around the CMI. Select heavyweight EM manufacturing PMIs are still below the boom/bust line. Relative valuations are becoming extended according to our VI, and stretched technical conditions are waving a red flag. Keep in mind the materials sector has an abysmal performance history after the Fed starts tightening (Chart 20 on page 9). The heavyweight chemical index (75% of the sector) bears the brunt of the downside risks owing to excess capacity (Chart 20 on page 9). On the flipside, overweight exposure in gold mining (via the GDX:US ETF) and the niche containers & packaging sub-indexes is recommended. Chart 31 S&P Materials S&P Materials S&P Technology (Underweight) The CMI has rolled over, driven lower by contracting relative pricing power, decelerating new orders-to-inventories growth, lack of capital expenditure traction and the appreciating greenback. Tech stocks thrive in a disinflationary/deflationary environment and suffer during inflationary periods (Chart 21 on page 10). Inflation is making a comeback, so it will be an uphill battle for tech companies to successfully raise selling prices at a fast enough pace to keep profits on a par with the broad corporate sector. While a capital spending cycle would be a welcome development, the narrowing gap between the return on and cost of capital warns against extrapolating improvement in business sentiment just yet. Our S&P technology operating profit model warns that tech profits are likely to trail the broad market as the year progresses, a far cry from what is embedded in analysts' forecasts. The good news is that valuations are not demanding nor are technical conditions overbought, which should cushion the magnitude and sharpness of downside risks. Chart 32 S&P Technology S&P Technology S&P Telecom Services (Underweight) Our CMI for telecom services has gained ground of late, primarily on the back of a sharp decline in wage inflation. However, we recently downgraded exposure to underweight, because of a frail spending backdrop. Our telecom services sales model is extremely weak (Chart 22 on page 10). Softening outlays on telecom services have reinvigorated the industry price war, and our pricing power gauge is sinking like a stone (Chart 22 on page 10). Telecom carrier capital expenditures have been running at a healthy clip, which could further pressure profit margins. Undervaluation exists, but this has been a chronic feature for the sector over the past decade, and does not foretell of cyclical upside or downside risks. Our TI has plunged into the sell zone, but remains above levels that would signal that a countertrend rally is imminent. Chart 33 S&P Telecommunication Services S&P Telecommunication Services Size Indicator (Overweight Small Vs. Large Caps) The small/large cap ratio is correcting short-term overbought conditions. The dip in the U.S. dollar has provided a fundamental reason for corrective action in this domestically-oriented asset class. However, we doubt a trend change is at hand. Our style CMI is climbing steadily. Small company business optimism has soared, partly because of an increase in planned price hikes, but also from an anticipated reduction in the regulatory burden. If small company price hikes persist, then rising labor costs will be more easily absorbed. That is critical to narrowing the profit margin gap between small and large firms. A stronger domestic vs. global economy and the potential for trade barriers is also unambiguously positive for small firms that do the bulk of their business at home. Despite the surge in the share price ratio post-U.S. election, our valuation gauge is not yet at an overvalued extreme. The lack of extreme overvaluation suggests that positive momentum will persist, perhaps similar to the 2004-2006 period, when the share price ratio stayed in overbought territory for years. Chart 34 Size Indicator (Small Vs. Large Caps) Size Indicator (Small Vs. Large Caps)