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Highlights A poor fundamental backdrop for high yield is being offset by easy monetary conditions. A prolonged shallow uptrend in corporate defaults - and therefore spreads - is most likely. The relative performance of equities versus corporate credit has not been distorted by monetary policy: the high-yield debt market will remain a reliable indicator for equity market vulnerability. A December rate hike will not be problematic for the residential real estate market. Plenty of pent-up demand for housing exists, and this will provide long-term support, so long as the labor market remains robust. Feature High-yield (HY) corporate bond spreads have dramatically narrowed throughout 2016 (Chart 1). This trend should not go unnoticed, since beyond being an important asset class in its own right, we have long viewed the high-yield debt market as an early warning system for equities. The current message suggests an all-clear for stocks. Chart 1Dramatic Spread Narrowing In 2016, But... bca.usis_wr_2016_10_31_c1 bca.usis_wr_2016_10_31_c1 We have had a cautious stance on U.S. high yield since August 2015, based on the view that corporate balance sheet health has deteriorated to the point where defaults would continue to rise on a cyclical basis. This week, we explore whether this remains the right strategy, and also whether junk bond spreads are still a relevant leading indicator for the equity market. Our answer to both questions is: Yes. In our view, the HY comeback can be explained by three main factors. First, the recovery in energy-related junk bonds has led the rally, as rising oil prices have helped diminish the default risks among U.S. shale issuers. Second, the 2015 spike in junk bond yields - mainly due to contagion from energy-sector bankruptcy fears - created tactical value in high-yield. Throughout most of 2016, we have seen an unwinding of these previously oversold positions. And third, the high-yield market benefits from an ongoing and intense search for yield in a world of unattractive higher-quality interest rates. Looking ahead, the first two forces are unlikely to play much of a role in the outcome for junk bonds. Oil prices are likely to trade in narrow range, allowing energy-related company fundamentals to stabilize. The rally in junk bonds over the past several months has removed any perceived value in this sector. Thus, it is only the search for yield/accommodative monetary policy that still supports a narrowing in spreads. Over time, we believe junk bond performance will once again be aligned with balance sheet fundamentals, i.e. high-yield spreads will gradually widen. A Review Of Our HY Indicators Our fixed income strategists have developed three key indicators to gauge major turning points in corporate spreads (Chart 2): Corporate Health Monitor (CHM): An aggregate indicator of non-financial corporate balance sheet health. The CHM deteriorated further in the second quarter, and has reached levels that historically tend to only be seen during recessions. Of the indicator's six components, most of the weakness has occurred in measures of corporate profitability (Chart 3). One caveat is that our measure of leverage in the CHM remains low, but this understates the risks because it measures total debt as a percent of market value of equity. Leverage looks decidedly worse if measured using net debt/book value. Chart 2Key Corporate Credit Indicators Key Corporate Credit Indicators Key Corporate Credit Indicators Chart 3Corporate Health Monitor Components Corporate Health Monitor Components Corporate Health Monitor Components C&I bank lending standards: A Fed survey that measures how easy/difficult it is for the corporate sector to access bank loans. According to this gauge, banks have already been tightening credit conditions for the past three quarters. Deviation in monetary conditions from equilibrium: We use our Monetary Conditions Index (MCI), which incorporates movements in both the dollar and interest rates. Due to a very accommodative Fed, monetary conditions remain very easy according to this measure. At present, two of these three indicators are sending negative signals for corporate spreads. Our corporate health monitor is decidedly bearish, as are lending standards. Indeed, focusing on corporate balance sheets and fundamental credit quality metrics would almost unanimously lead investors to recognize that the credit cycle is in its late stages and to expect spreads to move wider. After all, spreads have widened in every episode of deteriorating balance sheet health since the mid-1990s. Or to put it more simply, a default cycle - leading to spread widening - has occurred each time that year-on-year profit growth has gone negative since 1984 (Chart 4). Chart 4Profit Contraction Spells Trouble For Junk Bonds Profit Contraction Spells Trouble For Junk Bonds Profit Contraction Spells Trouble For Junk Bonds Our Bank Credit Analyst service came to the same conclusion earlier this year. In a Special Report, our colleagues analyzed financial ratios for 770 companies from across the industrial and quality spectrum. Their work uncovered that the corporate re-leveraging cycle is far more advanced than is widely believed and that key financial ratios and overall corporate health look only mildly better excluding the troubled energy and materials sectors. Of course, there is an important salve this cycle at work and it is captured in our third indicator - monetary policy. As shown in Chart 2, easy monetary conditions have never persisted for this long and low rates have driven a colossal search for yield, causing high-yield bonds to become ever more divorced from fundamentals. This divergence between corporate bond spreads and balance sheet fundamentals is likely to persist for as long as monetary conditions remain supportive. Adding it up, a poor fundamental backdrop for high-yield is being offset by easy monetary conditions. This combination argues for a cautious long-term bias toward lower-quality corporate credit because a prolonged shallow uptrend in corporate defaults (and spreads) is most likely. Nimble investors may look to tactically buy junk bonds when spreads overshoot our forecast of default losses, although such an opportunity is not present at the moment (Chart 5). The equity market is suffering from the same dynamic. Chart 5No Value Here No Value Here No Value Here Will Junk Bond Yields Still Warn Of Stock Bear Markets? Junk bond yields have long been one of our early warning indicators for equity bear markets. Since the 1980s, junk yields (shown inverted in Chart 6) have consistently broken out to new highs 3-6 months before stock bear markets take hold. This is because in a typical cycle, junk yields tend to respond more quickly to an erosion in corporate health fundamentals and/or a credit event. Chart 6Junk Bonds Provide Early Warning For Stocks Junk Bonds Provide Early Warning For Stocks Junk Bonds Provide Early Warning For Stocks Chart 7Typical Behavior Here bca.usis_wr_2016_10_31_c7 bca.usis_wr_2016_10_31_c7 But, as we note above, in the current cycle, the reaction to worsening corporate health fundamentals has been far more subdued than historical relationships would have predicted, due to the salve effect of easy monetary policy. If corporate bonds are in a "bubble", does it mean that the behavior of junk bond spreads will no longer be an early predictor of stocks returns? We believe corporate bonds will still be a useful timing tool for equities. If equities are experiencing the same divorcing from fundamentals, courtesy of central bank largesse, then it stands to reason that what pops the bond bubble will also burst the equity balloon. The search for yield has affected the behavior of investors, and therefore returns, in a fairly systematic way. Due to the current extended period of ultra-low interest rates and central bank asset purchases, government bond prices have been pushed sky high (yields have sunk to rock-bottom lows). As a shortage of government bonds has taken hold, investors have sought to invest in "Treasury-like" products, first seeking out the safest corporate bonds, but eventually reaching further out on the risk spectrum to include high-yield bonds and (dividend yielding) stocks. Indeed, asset prices of all stripes have been distorted by the search for yield, which has fueled a broad inflation in all asset classes. The behavior of stocks relative to corporate bonds is telling (Chart 7). Since 2010, and until very recently, stocks outperformed junk bonds on a total return basis. Junk bonds outperformed investment-grade bonds over roughly the same period (although junk underperformed investment-grade in most of 2015 due to the collapse in energy prices and related energy company defaults). This is exactly what has occurred during every recovery phase since the 1980s. Over the past forty years, investment-grade bonds tended to outperform junk bonds and equities during economic recessions. Junk bonds beat equities during the early phases of recovery (i.e. when economic growth turns positive) and for as long as companies continue to repair balance sheets. And equity returns trump both investment-grade and high-yield corporate bonds when our Corporate Health Monitor is deteriorating, i.e. in the latter half of the economic cycle, such as now. This suggests that the relative performance of equities versus corporate credit has not been distorted by monetary policy. One key takeaway is that, although very easy monetary conditions mean that corporate credit performance is becoming divorced from fundamentals, monetary policy has had a similar effect on equity prices (we have written at length in past reports about equity market performance diverging from profit indicators). As in past cycles, once the monetary cover fades, it is most likely that corporate credit markets will once again respond most quickly to balance sheet fundamentals. The bottom line is that we believe the high-yield debt market will remain a reliable indicator for equity market vulnerability. The current message is that a bear market in stocks will be averted, although as we have written in recent reports, earnings disappointments amid dollar strength represent a potential trigger for a near-term correction. Housing Outlook: Room To Expand Over the past quarter, residential real estate data has been slightly disappointing. September housing starts slipped to the bottom end of the range that has held this year and are only marginally above year-ago levels. House price inflation, as measured by the Case Shiller index, is negative on a 3-month basis. Despite this mild disappointment, we continue to believe the housing market is a relative bright light and will continue to be a significant positive contribution to GDP growth. Most indicators show that the housing market continues to recover along the typical path of the classic boom/bust real estate cycle (Chart 8). Chart 8Housing And Its History bca.usis_wr_2016_10_31_c8 bca.usis_wr_2016_10_31_c8 Chart 9First-Time Homebuyers Entering The Market First-Time Homebuyers Entering The Market First-Time Homebuyers Entering The Market Moreover, both supply and demand conditions are supportive of further construction activity and upward pressure on house prices over the next several quarters. On the demand side, household formation and a pick-up in interest from first-time buyers are the largest positives. Household formation: The number of households being formed is the most basic measure of marginal new demand for housing units. Household formation was suppressed during the Great Recession and early recovery years, because very poor job prospects and restricted access to credit sorely limited prospective new households from entering both the rental and ownership market. From 2007-2013, the annual household formation rate was 625,000, compared to over 1.1 million in the pre-crisis period.1 Now that the unemployment rate is at 5% and job security is improving, household formation rates are accelerating, particularly among young adults who have hitherto delayed moving out on their own. Monthly numbers are choppy, but household formation could easily run on average at 1.1 million per year for the next few years, simply to make up for muted rates post-housing crisis. First-time buyers: After years of putting off purchases, first-time buyers appear to be finally coming back to the housing market (Chart 9). According to the National Association of Realtors, the proportion of first-time homebuyers for existing home sales has reached its highest mark since July 2012 (34%). But there is still room for this share to improve, as prior to 2007, first-time homebuyers averaged about 40% of total purchases. Once again, persistent income gains and job security will be the driving factors behind first-time homebuyers' decisions. Could a Fed interest rate rise slow housing demand? We don't think so. Mortgage payments relative to income will remain well below their long-term average even if rates are increased by 200bps, an extreme case scenario. Even under this scenario, housing affordability would still be above average, conservatively assuming that income is held constant (Chart 10). Income and employment prospects will continue to trump mortgage rates for consumers making housing decisions; the current employment backdrop is positive for continued housing market activity. Chart 10December Rate Hike Won't Bother The Housing Market bca.usis_wr_2016_10_31_c10 bca.usis_wr_2016_10_31_c10 Chart 11Supply Is Tight bca.usis_wr_2016_10_31_c11 bca.usis_wr_2016_10_31_c11 From a supply perspective, conditions remain ripe for more robust construction activity. As Chart 11 shows, the supply of new homes remains low both in absolute, and in terms of months of supply. The bottom line is that we do not fear that a December rate hike will be particularly onerous for the residential real estate market. Plenty of pent-up demand for housing still exists, and this will provide long-term support, so long as the labor market remains robust, as we expect. The recent soft patch in housing will give way to stronger home building activity in the coming months, helping to boost real GDP growth in 2017. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 The State Of the Nation's Housing 2016, Joint Centre For Housing Studies of Harvard University http://jchs.harvard.edu/research/publications/state-nations-housing-2016

Highlights ECB Monetary Policy: Euro Area inflation will likely remain below the European Central Bank (ECB) 2% target for the next few years due to persistent excess capacity in Europe. The ECB will signal this at the December monetary policy meeting, providing the justification to extend their quantitative easing (QE) asset purchase program beyond the current March 2017 expiration date. ECB QE Changes: The constraints imposed on the ECB's bond purchases are self-imposed, and can be easily altered in the event of potential "shortages" of available debt for the QE program. Fears of a potential taper of ECB buying because of those constraints, which have bearish implications for Euro Area bond yields, are overstated. Country Allocation: Move to an above-benchmark stance on core European government debt, which are a low-beta safe haven in the current environment of a cyclical rise in global bond yields. Feature After spending the past couple of months fretting over the next move by the U.S. Federal Reserve or the Bank of Japan, investors' attention shifted to Europe last week. With the current European Central Bank (ECB) government bond quantitative easing (QE) program set to expire in March of next year, the markets were seeking any sort of guidance on whether the ECB will end the program as scheduled, or extend the program beyond March - perhaps with a reduction ("taper") in the size of the bond buying. ECB President Mario Draghi provided no new information at the post-meeting press conference last Thursday, leaving bond investors in limbo until the December meeting when the results of the ECB's assessment of their QE program will be published. Some alterations of the program will likely be announced, but it is too soon for the ECB to consider ending their QE program. With regards to the title of this Weekly Report - the most likely outcome is that the ECB will extend the QE program past March 2017, but will tinker with the rules of QE in an effort to pretend that the central bank is still following a prudent logic for its purchases. Fears of an early taper are overstated, and this makes core European government debt a potential oasis of safety while global bond yields remain in a bear phase. Plenty Of Reasons For The ECB Not To Taper This talk of a tapering of ECB asset purchases following the scheduled end of the current QE program seems premature. After all, neither the ECB's own economic forecasts, nor those of its Survey of Professional Forecasters, are calling for inflation to get close to the 2% target until at least 2018 (Chart of the Week). The ECB staff will prepare a new set of forecasts for the December policy meeting that will include projections for 2019 - perhaps these new estimates will have inflation finally reaching the 2% goal. But in the absence of a credible forecast of inflation returning to target, the ECB will be hard pressed to signal any move to a less-accommodative monetary policy. Headline Euro Area inflation is currently only 0.4%, despite a recent increase in the oil price denominated in Euros, which has been a reliable directional indicator for Euro Area inflation (Chart 2). Chart of the WeekNo Need For An ECB Taper bca.gfis_wr_2016_10_25_c1 bca.gfis_wr_2016_10_25_c1 Chart 2European Inflation Is Stubbornly Low bca.gfis_wr_2016_10_25_c2 bca.gfis_wr_2016_10_25_c2 The steady decline in the Euro Area unemployment rate over the past three years has coincided with a move higher in overall labor compensation, but this has been purely a "volume" effect resulting from steadily increasing employment growth. With the entire region not yet at full employment, there has been minimal upward pressure on wages or inflation in domestically focused sectors like services (bottom panel). In other words, the lack of Euro Area inflation is a direct function of the excess capacity in Euro Area product and labor markets. According to the IMF, the Euro Area output gap will not close until 2020, which will limit any rise in inflation over the rest of the decade (Chart 3). It will take a more prolonged period of above-trend economic growth to close the output gap, reducing the Euro Area unemployment rate below the full employment NAIRU level, before any recovery in wages or core inflation can take place (bottom panel). This lack of realized inflation is weighing on Euro Area inflation expectations and creating some potential credibility problems for the ECB. As we have discussed in earlier Weekly Reports, inflation expectations in much of the developed economies seem to follow an "adaptive" process, where expectations are formed in lagged response to actual inflation.1 If central banks are fully credible in their ability to use monetary policy to fight inflation (and demand) shortfalls, then those forward-looking expectations should eventually gravitate towards the central bank inflation target. However, if there is a large and persistent shock to realized inflation, then inflation expectations can deviate from the central bank target for an extended period. Using a 5-year moving average of realized headline CPI inflation as a proxy for inflation expectations is a reasonably good (albeit simple) approximation of this adaptive process (Chart 4). The current 60-month moving average for Euro Area headline inflation is 0.6%, not far from the 5-year Euro Area CPI swap rate of 0.9%. However, if the ECB's inflation forecasts for the next two years come to fruition (1.2% in 2017, 1.6% in 2018), then the 5-year moving average will continue to decline, as those higher inflation figures would not offset the sharp fall in inflation witnessed over the past few years. Chart 3Excess Capacity Holding Inflation Down bca.gfis_wr_2016_10_25_c3 bca.gfis_wr_2016_10_25_c3 Chart 4Inflation Expectations Will Stay Low bca.gfis_wr_2016_10_25_c4 bca.gfis_wr_2016_10_25_c4 Simply put, the ECB's current projections are not consistent with inflation expectations hitting the 2% target by 2018, and likely even beyond that. The ECB will be presenting new projections in December, but it would take a significant upgrade of their growth and inflation forecasts to "move the needle" on longer-term inflation expectations. Perhaps a move away from fiscal austerity across the Euro Area could trigger an upgrade on growth expectations, as that would imply a faster pace of growth and a more rapidly narrowing output gap. However, while the topic of greater fiscal spending has been heating up in the halls of governments in Washington, London and Tokyo, there has been little sign that Euro Area governments are about to open the fiscal spigots anytime soon (and certainly not before elections in Germany and France in 2017). Chart 5European Banks Getting More Cautious? European Banks Getting More Cautious? European Banks Getting More Cautious? ECB Still Needs To Support Loan Growth The state of Euro Area banks, and what it means for future lending activity, is another factor for the ECB to consider before contemplating any move to a less-accommodative monetary policy. The current growth rates of money and credit are showing no signs of significant deceleration (Chart 5). The latest ECB Euro Area bank lending survey, released last week, did show a modest decline in the net number of banks reporting easier lending standards to businesses, as well as a reduction in the number of banks reporting increasing loan demand from firms. The ongoing hit to European bank profitability from the current negative interest rate environment could be playing a role in the banks moving to a less easy environment for lending. As can be seen in the bottom panel of Chart 5, there is a reliable leading relationship between Euro Area bank equity prices and the growth in bank lending to businesses. The downturn in Euro Area bank stocks in 2016, which has been driven by declining profit expectations, could pose a risk to credit growth in the months ahead. According to a special question asked within the ECB's bank lending survey, a net 82% of respondents reported that the ECB's negative deposit rate has damaged banks' net interest income over the past six months.2 In that same survey, a net 12% of banks reported a boost to loan demand from the ECB's negative interest rate policy, and a net 15% of banks reported that the additional liquidity provided by the ECB bond purchases went towards extending loans to businesses. So while negative interest rates may be hurting bank profit margins, the impact of the ECB's QE is helping offset that to some degree by providing banks with capital gains on their bond portfolios that can be used to finance lending. So without any sign that inflation will soon approach the ECB's target, thus requiring a potential tapering of QE or even a move away from negative interest rates, the prudent course for the ECB to take to support Euro Area credit demand, and economic growth, is to continue with the QE program beyond the March 2017 expiration date. That will require some changes to the ECB's rules of the program, but, in the end, these are only self-imposed constraints. Bottom Line: Euro Area inflation will likely remain below the ECB 2% target over the next few years due to persistent excess capacity in Europe. The ECB will signal this at the December monetary policy meeting, providing the justification to extend their quantitative easing asset purchase program beyond the current March 2017 expiration date. The ECB Has Some Policy Options To Avoid A Taper Tantrum Core European bond yields have been depressed by the ECB's QE program, which have acted to push down both the future expected path of interest rates and the term premium (Chart 6). This has helped anchor real bond yields in negative territory, even with inflation expectations at such low levels. But any signs of potential slowing of the pace of QE buying could quickly unwind this effect, which makes the ECB's next steps so critical for the path of global bond yields. In Chart 7, we show the level and growth rate for the ECB's monetary base, along with five potential future scenarios: The ECB ends their QE program in March 2017, as currently planned; The ECB extends QE for six months to September 2017, at the current pace of €80bn in bond buying per month; The ECB extends QE program for twelve months to March 2018, at a pace of €80bn per month; The ECB extends QE to September 2017, but reduces the pace of purchases to €60bn per month; The ECB extends QE to March 2018, but cuts to €60bn per month. Chart 6ECB QE Still Holding Down Yields bca.gfis_wr_2016_10_25_c6 bca.gfis_wr_2016_10_25_c6 Chart 7ECB Needs To Keep The Monetary Base Growing bca.gfis_wr_2016_10_25_c7 bca.gfis_wr_2016_10_25_c7 As can be seen in the bottom panel of Chart 7, the growth rate of the ECB's monetary base (and the asset side of their balance sheet) will decelerate sharply in 2017 & 2018 if the ECB does end the QE program as scheduled next March. Extending the program, however, does push out the rapid deceleration phase for monetary base into 2018. This is of critical importance for the Euro Area bond market, as both the outright level and term premium component of German Bund yields have been broadly correlated with the growth rate of the monetary base (Chart 8). In other words, extending the ECB QE program into the future is most important to prevent a "taper tantrum" in European bonds, by signalling to the markets that the ECB wishes to maintain low interest rates for longer. The ECB could even announce a reduction in the pace of purchases, along with an extension, and bond yields should remain well-behaved. This will also help prevent an unwanted appreciation of the Euro, the value of which currently reflects the far easier monetary stance in Europe (Chart 9). Chart 8An ECB Taper Would Be Bad For Bunds An ECB Taper Would Be Bad For Bunds An ECB Taper Would Be Bad For Bunds Chart 9An Easy-For-Longer ECB Will Weigh On The Euro bca.gfis_wr_2016_10_25_c9 bca.gfis_wr_2016_10_25_c9 Given the persistent debates within the ECB (and between the ECB and some Euro Area governments) about the long-run merits of QE, the combination of both an extension and reduction in QE purchases could be the compromise option that satisfies all parties. Alternatively, the ECB could choose to maintain the pace of bond purchases but alter the selection rules governing the program. Given the recent concerns in bond markets that the ECB is "running out of bonds to buy", changing the rules of the QE program is a sensible way for the central bank to free itself from the self-imposed shackles on its bond purchases. There are three options that the ECB can consider: Moving away from strictly allocating the bond purchases according to the ECB "capital key", which essentially weights the bond purchases by the size of each economy; Raising the issuer limits on QE, which limits the ECB to holding no more than 33% of any single issuer or individual bond issue; Reducing the current yield floor on QE, which prevents the ECB from buying any bonds with yields below the ECB deposit rate, which is currently -0.4%; We think option 1 is the least likely to occur, as this would imply buying a greater share of countries with more problematic debt profiles, like Italy or Portugal. There is little chance of such a strategy being well received by the governments in Berlin and Brussels, and the ECB would likely wish to avoid a major political confrontation by allowing larger deviations from the capital key Option 2 is an easier solution to implement. The 33% issuer constraint was always an arbitrary level that was aimed more at bonds with so-called "collective action clauses", where a majority of bondholders can force a decision on all bondholders in the event of a debt restructuring. It is understandable why the ECB would not want to become to decision-making counterparty in the event of a future messy bond restructuring in Europe. However, the ECB's ownership percentages within each Euro Area country are nowhere near the 33% limit at the moment (Chart 10) and, at the current pace and composition of buying, that 33% limit will not even be reached for Germany anytime soon.3 There is room for the ECB to raise the issuer limits, as it has already done for some other parts of its asset purchase programs, like bonds issued by European Union supranationals.4 Chart 10ECB Holdings Are Far From The 33% Issuer Limit The ECB's Next Move: Extend & Pretend The ECB's Next Move: Extend & Pretend Chart 11Lowering The Yield Floor For QE Makes Sense The ECB's Next Move: Extend & Pretend The ECB's Next Move: Extend & Pretend Option 3 is the most binding constraint of all on the ECB purchases, as very large shares of the European government bond market are now trading below the ECB's -0.4% deposit rate (Chart 11). In the case of Germany, nearly 70% of all QE-eligible debt is trading below the ECB's yield floor, which has raised investor concerns that the ECB will soon be unable to buy enough German debt at the current pace of purchases. However, that yield floor constraint is completely arbitrary - there is nothing stopping the ECB from buying bonds trading at a yield below the deposit rate, other than (we suspect) a desire to impose some sort of price discipline on the QE buying to make the ECB appear more credible with its purchases. Chart 12The QE Yield Floor Can Be Changed The ECB's Next Move: Extend & Pretend The ECB's Next Move: Extend & Pretend If the ECB decided to lower the yield floor below the current -0.4% deposit rate, this would open up a greater share of the core European bond markets to QE buying (Chart 12). This would also change the current market narrative that the ECB will soon run out of German bonds to buy. In the end, the most likely path the ECB will take following its December re-assessment of its QE program is a combination of lowering the yield floor on QE bond purchases below -0.4% and raising the issuer limits above 33%. There appears to be plenty of leeway for the ECB to alter their purchases, but without necessarily reducing the monthly pace of buying. Combined with an extension of the end-date of the QE program beyond March, this should alleviate any concerns that the ECB will soon hit a wall with its asset purchases. Bottom Line: The constraints imposed on the ECB's bond purchases are self-imposed, and can be easily altered in the event of potential "shortages" of available debt for the QE program. Fears of a potential taper of ECB buying because of those constraints are overstated. Investment Implications: Move To An Above-Benchmark Stance On Core European Bonds With the ECB having no need to end its QE program early, the case for moving to an overweight stance on core Europe is a strong one. As we noted in our last Weekly Report, favoring bond markets of countries with the lowest inflation rates is a logical investment strategy in the current environment of a modest cyclical upturn in global growth and inflation.5 That justifies our current below-benchmark recommendation on U.S. and U.K. government debt, as both realized inflation and expected inflation are rising in both countries. That leaves the Euro Area and Japan as possible candidates to move to above-benchmark weightings, given their defensive properties as low-beta bond markets. Although with the Bank of Japan now pegging the Japanese government bond (JGB) yield curve with a 10-year yield at 0%, we do not see a compelling investment case for overweighting JGBs as a defensive trade. If an investor wants safety at a 0% yield - with no chance of a capital gain from a decline in yields - than owning T-bills, or even gold, is just as viable as owning JGBs. We recently upgraded Japan to neutral in our recommended portfolio allocation, and we see no reason to move from that. Thus, core European bonds stand out as the candidate to upgrade as a defensive trade during the current bond bear phase, which we expect will continue until at least December when the Fed is expected to deliver another rate hike in the U.S. We see a case for moving to above-benchmark for both Germany and France, but especially so in the latter. The beta of bond returns between France and both the U.S. (Chart 13) & U.S.(Chart 14) is very low, making French bonds a good market to favor at the expense of U.S. Treasuries and U.K. Gilts in currency-hedged bond portfolios. Chart 13French Bonds Are Low Beta To USTs... French Bonds Are Low Beta To USTs... French Bonds Are Low Beta To USTs... Chart 14...And To U.K. Gilts bca.gfis_wr_2016_10_25_c14 bca.gfis_wr_2016_10_25_c14 Bottom Line: Move to an above-benchmark stance on core European government debt, which are a low-beta safe haven in the current environment of a cyclical rise in global bond yields. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "Why Are Global Inflation Expectations Still So Low", dated March 1, 2016, available at gfis.bcaresearch.com. 2 The Q4 2016 ECB Euro Area Bank Lending Survey can be found at https://www.ecb.europa.eu/stats/pdf/blssurvey_201610.pdf. 3 Please note that the denominator in the percentages shown in Chart 10 include only bonds with maturities that are eligible for ECB QE purchases, omitting bonds that will mature in less than 2 year and more than 30 years. 4 For more details on that change to the supranational issuer limits, please see https://www.ecb.europa.eu/mopo/implement/omt/html/pspp-qa.en.html. 5 Please see BCA Global Fixed Income Strategy Weekly Report, "Return Of The Bond Vigilantes", dated October 18, 2016, available at gfis.bcaresearch.com. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index The ECB's Next Move: Extend & Pretend The ECB's Next Move: Extend & Pretend Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Duration: Treasury yields will continue to rise as a December Fed rate hike is priced in. A surge in bullish dollar sentiment between now and December would cause us to back away from our below-benchmark duration stance. Spread Product: Maintain a neutral allocation to spread product, favoring convexity over credit risk. A surge in bullish dollar sentiment between now and December would cause us to downgrade spread product relative to Treasuries. TIPS: The increased sensitivity of TIPS breakevens to core inflation argues for a continued overweight position in TIPS relative to nominal Treasuries. Sovereign Debt: Continue to favor U.S. corporate credit over USD-denominated sovereign government debt within a neutral allocation to spread product. Feature About one month ago, we outlined how we expected our investment strategy to evolve over the remainder of this year and into 2017.1 Our continued expectation that the Fed will lift rates in December leads us to maintain below-benchmark portfolio duration and a neutral allocation to spread product2 until a December rate hike has been fully discounted by the market. Chart 1Dollar Sentiment: A Key Indicator Dollar Sentiment: A Key Indicator Dollar Sentiment: A Key Indicator Beyond December, our investment strategy will depend largely on how the dollar responds to an upward re-rating of rate expectations. Strong dollar appreciation would likely cause us to reverse our below-benchmark duration stance and become even more cautious on spread product. Conversely, a tame dollar could mean that the sell-off in bonds and rally in spreads have further to run. The dollar has appreciated by close to +2% since early September and bullish sentiment toward the dollar has also edged higher (Chart 1). However, so far the increases appear muted compared to the rapid dollar appreciation that occurred in the run-up to last December's rate hike. The reason we care about the dollar is that a stronger currency represents a tightening of financial conditions that acts to depress expectations of future economic growth. This can spell trouble for risk assets and also lower the market-implied odds of future rate hikes. For example, spread product was performing well last year until rate hike expectations started to move higher in late October. As the market began to anticipate a December Fed rate hike, it did not take long for the combination of higher rate expectations and increasingly bullish dollar sentiment to weigh on risk assets (Chart 2). The Market Vane survey of bullish sentiment toward the dollar surged above 80% last December, and this tightening of financial conditions is what prompted the sell-off in spread product and sharp decline in Treasury yields that kicked off 2016. Chart 2More Bullish Dollar Sentiment Is A Risk For Spread Product More Bullish Dollar Sentiment Is A Risk For Spread Product More Bullish Dollar Sentiment Is A Risk For Spread Product With last year's example in mind, the relevant question for current investment strategy is: How much dollar appreciation can the market tolerate before Treasury yields reverse their uptrend and credit spreads start to widen? To answer that question we make an assessment of U.S. and global growth relative to this time last year. All else equal, if U.S. growth is improved compared to last year, then it should require a greater dollar appreciation to have a similar impact on yields and spreads. Relatedly, if the growth outlook outside of the U.S. is improved, then it would mean that the dollar's reaction to rising U.S. rate expectations might not be as strong. On this note, there is some evidence pointing toward a more resilient U.S. and global economy than at this time last year. In the U.S., our preferred leading indicators suggest that growth contributions from capital spending, housing, net exports, government spending and inventories should all move higher in the coming quarters (Chart 3). This should act to offset a likely moderation in consumer spending growth (Chart 4). All in all, the domestic U.S. growth outlook appears similar to - if not slightly better than - what was seen at this time last year. There is more cause for optimism in the global growth indicators. The aggregate global PMI and LEI are tracking close to levels seen last year, but rising diffusion indexes suggest that further increases are likely (Chart 5). Already, manufacturing PMIs in all the major economic blocs have entered clear uptrends (Chart 5, bottom two panels). This suggests that the global growth outlook is actually much brighter than at this time last year, and improved diffusion indexes suggest that the global recovery has also become more synchronized. Chart 3U.S. Growth Outlook Improving... bca.usbs_wr_2016_10_25_c3 bca.usbs_wr_2016_10_25_c3 Chart 4...Outside Of Consumer Spending bca.usbs_wr_2016_10_25_c4 bca.usbs_wr_2016_10_25_c4 Chart 5Global Growth On The Upswing Global Growth On The Upswing Global Growth On The Upswing The implication of a U.S. economic outlook that is broadly similar to last year and an improved outlook for global growth is that the U.S. dollar may not react as strongly to rising Fed rate hike expectations in 2016 as it did in 2015. If this turns out to be the case, then the performance of spread product should also be more resilient and the uptrend in Treasury yields is less likely to reverse. Bottom Line: We continue to track the dollar and dollar sentiment closely to inform our near-term investment strategy. While dollar sentiment has edged higher, it has not yet reached the elevated levels seen last year. A more synchronized global growth recovery makes such a spike in bullish dollar sentiment less likely this time around. What Is A High Pressure Economy? Chart 6What A "High Pressure Economy" Looks Like bca.usbs_wr_2016_10_25_c6 bca.usbs_wr_2016_10_25_c6 Fed Chair Janet Yellen introduced a new buzzword to the market two weeks ago when she suggested in a speech3 that "it might be possible to reverse the adverse supply-side effects [of the financial crisis] by temporarily running a 'high-pressure economy' with robust aggregate demand and a tight labor market." Some investors took this to mean that the Fed would be increasingly tolerant of inflation overshooting its 2% target. We think this interpretation is incorrect, although we do think that Yellen's description of a "high pressure economy" provides a lot of information about the Fed's reaction function. More than anything, Yellen's speech was a response to recent trends in the labor market. The downtrend in the unemployment rate started to abate late last year, even though the economy has continued to add jobs at an average pace of just under +200k per month. A sharp rebound in the labor force participation rate has prevented the unemployment rate from falling, despite robust job growth (Chart 6). It is this dynamic that Yellen refers to when she talks about a "high pressure economy". Essentially, her theory suggests that, despite the low unemployment rate, the economy might be able to continue to add jobs without inflation spiking higher. Put differently, the unemployment rate might be less useful as an input to the Fed's forecast of future inflation than in past cycles. The key implication for investors is that if the Fed doesn't trust the unemployment rate to provide a signal about future inflation, then it is forced to rely on the actual inflation data for guidance. In our view, core PCE and core CPI inflation are now the two most important inputs to the Fed's reaction function. On that note, while last week's September core CPI release was soft, both core CPI and core PCE remain in uptrends that began in early 2015. Further, diffusion indexes suggest that these uptrends will persist (Chart 7). The Fed's increased focus on core inflation also has implications for our TIPS call. The sensitivity of TIPS breakevens to realized core inflation has shifted higher since the Great Recession (Chart 8). In our view, this has occurred because of how the zero-lower-bound on interest rates has constrained the Fed's ability to influence investor expectations. Chart 7The Inflation Uptrend Is Intact bca.usbs_wr_2016_10_25_c7 bca.usbs_wr_2016_10_25_c7 Chart 8TIPS Breakevens & Core Inflation TIPS Breakevens & Core Inflation TIPS Breakevens & Core Inflation When the fed funds rate was well above the zero-lower-bound, investors could reasonably assume that the Fed would act to offset any temporary price shocks. As such, long-maturity TIPS breakevens remained in a relatively narrow range and were mostly influenced by perceptions about the stance of Fed policy. In a zero-lower-bound world, investors can reasonably question whether the Fed has the ability to offset a deflationary price shock. As such, inflation expectations are increasingly driven by the actual inflation data rather than the Fed. With the Fed and the market both increasingly taking their cues from the actual inflation data, it means that the Fed will likely remain sufficiently accommodative for core PCE to return to target and also that TIPS breakevens will move higher alongside the trend in realized inflation. Bottom Line: The increased sensitivity of TIPS breakevens to core inflation argues for a continued overweight position in TIPS relative to nominal Treasuries. Sovereign Credit: A Dollar Story Chart 9Sovereign Debt & The Dollar Sovereign Debt & The Dollar Sovereign Debt & The Dollar As noted above, in the current environment the path of the U.S. dollar takes on increased importance for our entire portfolio strategy. However, there is one sector of the fixed income market where the dollar is always paramount - USD-denominated sovereign debt. Specifically, we refer to the Barclays Sovereign index which consists of the U.S. dollar denominated debt of foreign governments, mostly emerging markets.4 In the long-run, the performance of sovereign debt relative to equivalently-rated and duration-matched U.S. corporate credit tends to track movements in the dollar and bullish sentiment toward the dollar (Chart 9). When the dollar appreciates it makes USD-denominated debt more expensive to service from the perspective of a foreign issuer, and therefore causes sovereign debt to underperform domestic alternatives. As stated above, we do not anticipate a near-term spike in the dollar, like what was witnessed near the end of last year. However, given that the Fed is much further along in its tightening cycle than other major central banks, the long-run bull market in the U.S. dollar should remain intact. This will continue to be a major headwind for sovereign debt. Further, the recent performance of sovereign debt relative to U.S. credit has bucked its traditional correlations with the dollar. Notice that the beta between sovereign excess returns and the dollar has moved into positive territory (Chart 9, bottom two panels). Historically, the correlation does not remain at these levels for long and sovereign debt should underperform as the more typical negative correlation is re-established. At present, there is not even an attractive valuation argument for sovereign debt relative to U.S. credit. The spread differential between the Sovereign index and an equivalently-rated, duration-matched U.S. credit index is well below zero (Chart 10), and only the USD-debt of Hungary, South Africa, Colombia and Uruguay offer spreads that appear attractive relative to the U.S. Credit index (Chart 11). Chart 10No Spread Pick-Up In Sovereigns No Spread Pick-Up In Sovereigns No Spread Pick-Up In Sovereigns Chart 11USD-Denominated Sovereign Debt By Issuing Country Dollar Watching: An Update Dollar Watching: An Update Bottom Line: Continue to favor U.S. corporate credit over USD-denominated sovereign government debt within a neutral allocation to spread product. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching", dated September 13, 2016, available at usbs.bcaresearch.com 2 We favor negatively convex assets (MBS) over credit within a neutral allocation to spread product, on the view that negatively convex assets will outperform as yields head higher in advance of a December rate hike. In anticipation of a December Fed rate hike we are also maintain a short position in the December 2017 Eurodollar futures contract as well as positions in 2/10 and 10/30 curve flatteners. The three trades have returned: +20bps, -23bps and +4bps respectively. 3 http://www.federalreserve.gov/newsevents/speech/yellen20161014a.htm 4 The largest issuers in the Barclays Sovereign Index are: Mexico (22%), Philippines (14%) and Colombia (11%). Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Portfolio Strategy Boost restaurant stocks to neutral, as same-store sales should improve next year. A further upgrade requires evidence of top-line traction. The exodus from health care stocks represents an overreaction rather than a downshift in fundamental forces. Stay long. Recent Changes S&P Restaurants Index - Upgrade to neutral for a profit of 9%. Table 1 Profits: Is Less Bad Good Enough? Profits: Is Less Bad Good Enough? Feature Equity market buoyancy remains a liquidity rather than an earnings story. Fed commentary and the trend in global bond yields, a reflection of the global central bank narrative, continue to exert an outsize influence on short-term price action and momentum. In the background, earnings are a wildcard. Companies may be surpassing beaten down third quarter estimates, but the path of profits over the next several quarters is by no means assured and will determine the durability of any stock market advance. Even excluding the persistent drag from narrowing profit margins, courtesy of falling productivity and increasing unit labor costs, it is dangerous to look at the corporate profit outlook through rose colored glasses. The low level of economic growth, both at home and abroad, represents a major hurdle to the corporate sector. Total business sales have climbed back up to zero, but it is premature to forecast meaningful growth ahead based on moribund global export growth (Chart 1), and/or leading economic indicators. After all, sales growth has been virtually non-existent for years, reinforcing that earnings per share have been driven by cost cutting and buybacks. While measured consumer price inflation has crept higher, corporate sector pricing power remains virtually non-existent. The producer price index is still deflating, despite the rally in oil prices. U.S. import prices are very weak (Chart 1). The negative global credit impulse warns that there is still no impetus to reinvigorate final demand, and by extension, global profits (Chart 1). It is hard to envision an economic reacceleration as long as the corporate sector is more inclined to retrench than expand, as heralded by stressed balance sheets and weak durable goods orders (Chart 2). Chart 3 shows BCA's two U.S. profit models. The first one is based on reflationary variables, such as the dollar, bond yields and oil prices. It is designed to predict the trend in forward earnings momentum. This model has troughed, but is not signaling any upside ahead in already exuberant analyst earnings estimates (Chart 3, second panel). Chart 1Without Sales Growth... bca.uses_wr_2016_10_24_c1 bca.uses_wr_2016_10_24_c1 Chart 2... And Rising Costs... bca.uses_wr_2016_10_24_c2 bca.uses_wr_2016_10_24_c2 Chart 3... How Much Can Profits Improve? ... How Much Can Profits Improve? ... How Much Can Profits Improve? The second model looks at macro data such as new orders, labor costs and productivity growth to forecast the trend in actual operating earnings. This model is slightly more optimistic (Chart 3, bottom panel), and signals a decisive end to the profit contraction, albeit not a growth rate sufficient to satisfy double-digit analysts forecasts or rich valuations. The U.S. dollar is a major wildcard, as any sustained strength would compromise earnings. Typically, major profit expansions only occur after the currency begins to depreciate and labor cost inflation ebbs (Chart 2). The late-1990s was an exception, as profits climbed alongside the currency and amidst rising wage inflation (Chart 2). However, that was during an economic and credit boom, two key factors that are conspicuously absent at the moment. Nevertheless, as discussed in past Weekly Reports, the flood of central bank liquidity could sustain the overshoot in equity prices for a while longer. Investors have demonstrated a willingness to look through soggy profits as long as the liquidity taps remain open. Despite the possibility of a stubbornly resilient broad market, we do not recommend interpreting it as a sign of economic vitality, and consider it high risk. Our portfolio strategy is based on expected sectoral earnings trends, as liquidity is subject to the whims of central bankers. We recommend a largely defensive sector portfolio, with some exceptions, as discussed in last week's Special Report. Our cyclical exposure remains confined to consumption-oriented plays; this week we are lifting our view on restaurants. Restaurants: Buying Into Weakness Investors have gravitated toward washed out deep cyclical sectors rather than consumption-oriented plays in recent months. However, we doubt this trend has staying power, as outlined in our Special Report last week. Consequently, it is time to revisit the outlook for shunned consumer sectors, such as restaurants. This year's exodus from casual dining stocks has been justified on the basis of overvaluation and deteriorating industry performance. The National Association of Restaurants (NAR) survey of current performance has dipped into negative territory (Chart 4), as restaurant operators have reported a decrease in traffic. One of the major drags on restaurant same-store sales has been the gap in restaurant inflation compared with the cost of food inflation for eating at home. Relative inflation has soared (Chart 5). That has caused relative spending growth at restaurants vs. at home dining to drop sharply, in real (volumes) terms. However, next year could be different. If the inflation gap falls, as predicted by the decline in relative spending (Chart 5), then restaurant traffic should stabilize. Importantly, the odds of budgets for dining out being pruned even further are low. As long as wages and salaries growth is decent and consumer income expectations are firm, consumers should still allocate a rising share to restaurants relative to eating at home (Chart 5). There is plenty of scope for relative restaurant spending to rise on a secular basis (Chart 5, bottom panel). Clearly, if relative spending were to reaccelerate too quickly, then the inflation gap would stay wide, and same-store sales growth would stay punk. That is a risk to an optimistic view of future restaurant traffic. But the good news is that cost structures are being realigned to a more subdued sales run rate. The NAR survey shows that staffing plans are on the wane. That leads restaurant labor cost inflation (Chart 4). As the largest source of expenses, any decline in headcount would be welcome given that minimum wages in a number of states are set to climb next year. In any case, the most potent profit elixir would be a recovery in top-line growth, sourced both domestically and from abroad. Restaurant sales growth has been unimpressive for the past several years. Subdued pricing power gains, and until recently, lackluster income growth among lower income consumers have weighed on revenue growth. The good news is that consumer confidence among low income earners is on the upswing (Chart 6), which bodes well for casual dining out in the coming quarters. If our bearish view on refiners and gasoline prices continues to pan out, then a windfall from lower fuel prices may further bolster the outlook. Chart 4Expenses Set To Ease bca.uses_wr_2016_10_24_c4 bca.uses_wr_2016_10_24_c4 Chart 5Inflation Gap Should Narrow bca.uses_wr_2016_10_24_c5 bca.uses_wr_2016_10_24_c5 Chart 6Sales Set To Stabilize... bca.uses_wr_2016_10_24_c6 bca.uses_wr_2016_10_24_c6 In addition, restaurant retail sales often follow the trend in the wealth effect (Chart 7). The latter has pulled back this year, owing to the equity market consolidation and house price correction. However, financial wealth gains are rebounding, and provided the stock market does not suffer a sustained swoon, consumers' feeling of affluence may soon be bolstered. Even marginal improvements in store traffic should be impactful to same-store sales. Restaurant chains have been in retrenchment mode since the Great Recession. Construction activity is historically low, which implies limited capacity expansion (Chart 7). Contribution from abroad may become less of a drag. The industry garners roughly 67% of sales from overseas. The strong U.S. dollar, particularly against emerging market currencies, has deprived the industry of sales strength. Moreover, even in domestic currency terms, emerging markets consumption has been through a difficult period, as the Asian Hotel and Restaurant Activity Proxy spent most of the last year in negative territory (Chart 8). But EM currencies have stabilized and Asian restaurant activity has climbed back into positive territory in recent months. The upshot is that foreign revenue could make up any lingering domestic sales slack. All of this suggests that leaning into share price weakness in anticipation of improved prospects next year makes sense. Nevertheless, the S&P restaurants index does not warrant a full shift from underweight to overweight. There could still be earnings/headline risk given lackluster readings in coincident activity indicators, despite McDonald's earnings beat last week. Valuations are not cheap. On a normalized basis, the relative forward P/E ratio has dropped below its average, but still trades at a premium to the broad market. A return to above average levels is possible if operating margins expand on the back of sales improvement (Chart 9), thereby sparking higher return on equity, but it may be too soon to position for such an outcome. Chart 7... Or Even Improve In 2017 bca.uses_wr_2016_10_24_c7 bca.uses_wr_2016_10_24_c7 Chart 8End Of Foreign Drag bca.uses_wr_2016_10_24_c8 bca.uses_wr_2016_10_24_c8 Chart 9Still Not Dirt Cheap bca.uses_wr_2016_10_24_c9 bca.uses_wr_2016_10_24_c9 Bottom Line: Lift the S&P restaurant index (BLBG: S5REST - MCD, SBUX, YUM, CMG, DRI) to neutral from underweight, locking in a profit of 9% since our underweight recommendation last November. Health Care Crunch: Buying Opportunity Or Trend Change? The speed at which the health care sector has sunk toward the bottom end of this year's trading range has unnerved many investors. In fact, the sector has dropped back down to the levels where we added it to our high conviction overweight list. The question now is whether our positive views still hold, and whether would we add here if we weren't long already, or if something more sinister is at work? The hit to health care stocks reflects a rise in risk premiums related to concerns that the U.S. government will exert more control over price setting if the Democrats win the election rather than any immediate downshift in relative forward earnings drivers. While it is impossible to forecast with any precision to what extent pricing models may or may not change, the political appetite may be low for another overhaul of the sector so soon after the Affordable Care Act was implemented. Regardless, several observations suggest that the sector may already be undershooting, i.e. a Democratic victory is already discounted. Relative performance has experienced a clear uptrend over the last forty years, with cyclical swings oscillating around its upward sloping trend-line (Chart 10). It would be extremely rare for a bull phase to peak prior to hitting at least one standard deviation above trend. Instead, the price ratio hit trend and is now not far above one standard deviation below trend, a level one would normally equate with an economic boom when capital flowed to high-beta sectors. Cyclical technical measures also point to an undershoot. Our Technical Indicator has hit an oversold extreme (Chart 11), signaling that the sell-off is in the late stages. Our relative advance/decline line has also stayed firm, suggesting that the decline in the overall sector has not been broad-based (Chart 11). Chart 10Time To Buy, Not Sell bca.uses_wr_2016_10_24_c10 bca.uses_wr_2016_10_24_c10 Chart 11Buying Opportunity Buying Opportunity Buying Opportunity Whether a wholesale flight from the sector, and all defensives in general, looms is largely contingent on the path of inflation expectations, which have been in a multiyear decline. This trend reflects anemic global final demand and the repercussions from over-indebtedness. Lately, inflation expectations have firmed, but that may largely reflect the rebound in oil prices courtesy of hopes for an OPEC production cut, given the lack of confirming indicators of growth acceleration and renewed strength in the U.S. dollar. The latter is testing the top end of its recent range (Chart 11, shown inverted, bottom panel), and it would be highly unusual for inflation expectations to rise concurrent with the U.S. dollar. In a world of zero interest rates and limited aggregate demand strength, a strong currency is deflationary, especially for corporate profits. Those conditions keep bond yields low, and push capital into long duration sectors. Once the election is over, attention will refocus on the relative forward earnings outlook. Our Indicators suggest that earnings momentum will stay positive. Our health care sector pricing power proxy has rebounded after cooling from red-hot levels, and is still much stronger than overall corporate sector pricing (Chart 12, second panel). That is confirmed by the pharmaceuticals producer price index, and employment cost index for health insurance, i.e. pricing strength is broad-based. There is still scant evidence of a downshift in consumer spending patterns in reaction to rising health care sector inflation. Real (volumes) personal spending on health care goods and services continues to grow at a mid-single digit rate, well in excess of the rate of overall consumption (Chart 12). That is consistent with ongoing earnings outperformance. As noted in past research, the time to forecast negative relative earnings momentum is when consumers balk at higher prices. So far, a few high profile cases of exorbitant drug price increases have grabbed the spotlight, but in aggregate, consumers are not voting with their wallets. The biggest tangible negative for the health care sector may be that shares outstanding are no longer falling (Chart 13). That mirrors overall buyback activity, which has cooled markedly on the back of balance sheet deterioration and waning free cash flow. We doubt the supply of health care stocks is going to rise much, however, because the sector is in good financial shape, earning healthy returns and is not dependent on external financing. Chart 12Demand Driven Pricing Power Gains Demand Driven Pricing Power Gains Demand Driven Pricing Power Gains Chart 13Buybacks Are Dwindling bca.uses_wr_2016_10_24_c13 bca.uses_wr_2016_10_24_c13 Bottom Line: Health care sector risk premiums have climbed in response to polling results, but an apolitical check on relative earnings drivers and valuations points to a buying opportunity. Current Recommendations Current Trades Size And Style Views Favor small over large caps and growth over value.

Highlights The path of the least resistance for the U.S. dollar is up; this has far-reaching implications for monetary policy, global growth dynamics and asset prices. Dollar strength reinforces our view to overweight defensives vs. cyclicals and is a headwind to overall S&P 500 profits. Most of the gap between core CPI and core PCE can be explained by the medical care component. Overall, core PCE is likely to reach 2% over the next several months; a strong dollar means core goods PCE deflation will be sustained, but rising wage costs will put upward pressure on service sector inflation. Feature Amid the ongoing U.S. elections and Q3 earnings uncertainty, one of our higher conviction views is the likelihood of U.S. dollar appreciation. Our reasoning is straightforward: interest-rate differentials are the strongest 12-18 month predictor of currency trends,1 and relative economic performance between the U.S. and the rest of the world suggests that the gap between U.S. monetary policy and elsewhere will stay wide, and perhaps even widen (Chart 1). Chart 1Interest Rates And The Dollar Interest Rates And The Dollar Interest Rates And The Dollar Moreover, as we showed last week, the trade-weighted dollar provides good insurance against a variety of downside equity risks, even when a financial calamity occurs on U.S. soil. We remain dollar bulls. However, that does not mean that the outlook is without risk. The implications of further dollar strength are wide-ranging: How does dollar strength impact inflation expectations and monetary policy? How does the rest of the world cope with a rising U.S. dollar? How does the S&P 500 stand up to further dollar appreciation? Monetary Policy And The Dollar We have discussed the ramifications of the Fed Policy Loop, the interplay between Fed policy and financial conditions, since September 2015 (Chart 2). Since last year, each hawkish move from the Fed has been met by a sharp upward adjustment in the trade-weighted dollar and a sell-off in equities and credit spreads. Tighter-than-expected financial conditions have then forced the Fed to lower its outlook for future economic growth and adopt a more dovish policy stance. A more dovish Fed then caused financial conditions to ease and the dollar to fall, and this easing eventually emboldened Fed policymakers to move in a more hawkish direction. The loop then repeats itself. The reason this loop has been in place is because U.S. monetary policy is so far in advance of other central banks. For example, the ECB and BoJ continue to try to find ways to stimulate their economies, while the Fed is gearing up for a second rate hike. The point is that this feedback mechanism means that monetary conditions tighten in the form of a rising dollar, even without the Fed hiking interest rates by very much (Chart 3). The implication for investors is also clear: for equities, even though overall monetary conditions can tighten, rate-sensitive, domestically-exposed sectors such as telecoms can still perform well, because the tightening is coming mainly through the currency, rather than interest rates. For bonds, the policy loop means that sell-offs are likely to happen in fits and starts: the Fed knows that the process of normalizing interest rates will trigger bouts of volatility, because their actions are being exaggerated by movements in the dollar. This is one reason why we are not more eager to move aggressively underweight duration. Chart 2The Fed Policy Loop USD Strength: Betting Dollars To Donuts USD Strength: Betting Dollars To Donuts Chart 3Dollar To Do The Fed's Lifting? bca.usis_wr_2016_10_24_c3 bca.usis_wr_2016_10_24_c3 ROW And The Dollar Dollar strength, in the context of a robust U.S. economy, can be a good thing for some parts of the world. For example, a strong dollar means that European and Japanese exports will be more competitive. In this benign context, currency strength acts a growth re-distributor, taking growth away from the U.S., but transferring it to others, where the currency has been devalued. Our concerns focus squarely on emerging markets. Since the early 1980s, there have been no periods when EM share prices rallied amid strength in the real broad trade-weighted U.S. dollar (Chart 4). Chart 4EM Stocks Don't Like Dollar Strength EM Stocks Don't Like Dollar Strength EM Stocks Don't Like Dollar Strength It is significant that financial markets panicked in August, 2015 when the RMB was devalued by 2% ahead of the Fed's warning about a rate rise, and amid broad based U.S. dollar strength. True, the RMB has weakened periodically since then, without any real fallout for risk assets. Nonetheless, it is hard to say that the global economy - and China for that matter - is in significantly better shape than when the Fed began televising the last rate hike. We do not offer a forecast on the likelihood of further RMB devaluation. However, recent history is a reminder that dollar strength risks creating volatility in global markets. The latter would be especially true if worries about the EM credit cycle resurface. S&P 500 And The Dollar In the last major dollar bull market (1994-2002), U.S. stocks strengthened alongside the rise in the currency, offering some historical support that dollar strength does not necessarily hinder stock market performance. However, the global backdrop during that era was distinctly different from today. During the last half of the 1990s, the entire global economy experienced a supply-side, disinflationary expansion and credit binge. The U.S. was at the forefront of that expansion, and pulled the rest of the world (ROW) along for the ride. In other words, the U.S. and ROW were all moving broadly in the same direction. Today, the global economic backdrop is starkly different. Europe, Japan and China are all battling deflation and the major distinguishing trait of this business cycle is deficient demand and the need to de-lever. As we highlighted above, the U.S. has embarked on a gradual rate hike path, but most other central banks are trying new ways to reflate. In this world, currency movements act to re-distribute growth: a stronger currency can become a headwind to externally sourced profits, rather than a reflection of strong domestic demand. Indeed, the S&P 500 may become even more vulnerable to dollar strength: globally sourced profits as a share of overall S&P 500 profits has been in a steady climb over the past twenty years. Chart 5 shows that net earnings revisions are especially sensitive to currency moves, suggesting that further dollar appreciation would undermine already very lofty earnings expectations and would be a headwind for the broad market. Chart 5Beware The Dollar Drag Beware The Dollar Drag Beware The Dollar Drag From a sector perspective, dollar strength has already become problematic and is a main reason why we continue to advocate for defensive stocks relative to cyclical plays. Our U.S. Equity Strategy service published a Special Report on this topic last week.2 The Report outlined a seven item checklist of factors needed before tilting positions in favor of cyclicals. The first item on the list is dollar weakness. The full checklist is here: Chart 6Stick With Defensives Stick With Defensives Stick With Defensives Broad-based U.S. dollar weakness, particularly against emerging market currencies in countries with large current account deficits. An end to Chinese manufacturing sector deflation. A decisive upturn in global manufacturing purchasing manager's indexes. A return to growth in global export volumes and prices. A resynchronization in global profitability such that U.S. profits were not the only locomotive. A rebound in global inflation expectations. China credibly addressing banking sector weakness to the point where economic growth can reaccelerate rather than move laterally. Most of the items remain unfulfilled and our U.S. equity strategists believe that over the past several weeks, a technical adjustment has occurred in equity markets, rather than a fundamentally-driven trend change. In fact, the cyclical vs. defensive share price ratio appears to now be overshooting after having undershot. We expect leadership to revert back to non-cyclical sectors once the current rotational correction has run its course, given the lack of confirmation from the bulk of the macro variables on our checklist (Chart 6). The bottom line is that the U.S. dollar's path of least resistance is to trend higher. Dollar strength has already become restrictive for some U.S. industries, and unlike the late 1990s, we are concerned that further currency appreciation will act to restrain profit growth, rather than be reflective of a stellar domestic backdrop. Still, the Fed and other central banks' actions have proven to so far be a powerful antidote to earnings concerns: as long as the liquidity taps remain open, investors are willing to look through profit disappointment. We continue to recommend benchmark weightings to equities, but are highly attuned to this profit risk. What Is The True Inflation Rate? The Fed's target is 2% inflation. Core CPI has been above this rate for eleven months, implying that if the Fed's target was based on this measure, policymakers would have been much more aggressive in hiking interest rates. But the Fed's preferred measure, core PCE, is still stuck below the target. The CPI and PCE usually move together. The correlation between the two series is about 98% and divergences tend to be short-lived (Chart 7). Thus, the choice between the two series is often irrelevant, although the recent gap raises an issue for the Fed and the bond market: which measure is currently telling the right story? First, there are many alternative measures of inflation and in Chart 8, we show a selection of them. The median CPI uses the middle or median price change as its estimate of the underlying rate of inflation, irrespective of its share of the overall basket. The trimmed mean CPI removes the most volatile components of the index. The market-based PCE measure of inflation addresses concerns about using "imputed" prices (such as financial services furnished without payment) by leaving them out. Incidentally, this latter series, which is currently somewhat weaker than core PCE, is giving a similar inflation signal to our corporate price deflator. Together, these two measures suggest that the business sector is faced with a much tougher pricing backdrop than the core PCE and core CPI suggest. Chart 7Core CPI And Core PCE Usually Say The Same Thing bca.usis_wr_2016_10_24_c7 bca.usis_wr_2016_10_24_c7 Chart 8Various Alternative Measures Various Alternative Measures Various Alternative Measures Unfortunately, none of these alternative measures offer reliable leading information and do not help in understanding the divergence between core CPI or core PCE. However, understanding how the indexes are constructed does uncover important differences. Core CPI And Core PCE Explained The core CPI is a fixed-weight index while the personal consumption expenditure is chain-weighted. A fixed-weight index uses a constant basket of goods and tries to determine how much more an individual pays for an identical basket today versus a base year. A chain-type index measures how much it costs to a constantly evolving basket. The latter should be more representative of consumers' evolving buying habits. Historically, the different weighting methodology explains most of the gap between CPI and PCE inflation rates. The remainder of the gap is accounted for largely by the difference in the size of the weights used for the medical and housing components. Housing accounts for 40% of core CPI and only 17% of core PCE. Medical care accounts for 7% of core CPI versus 18% of core PCE. Currently, the gap between core PCE and core CPI is mostly explained by the medical care component (both the relative weights, but also the underlying prices used). In the CPI, only the portion that consumers spend on health care is taken into account, but the PCE also includes the amount that government agencies spend on consumers' behalf. The pricing information on the government funded portion is estimated from the PPI, which sometimes gives a different signal than the data supplied to the CPI from the consumer expenditure survey. The gap between medical care PCE and CPI has become particularly pronounced in the past few years. There is a lot of confusion about what is driving the spike in CPI medical care costs, with some pundits trying to find a political angle. Some blame higher insurance rates, while others blame drug costs. In fact, as Chart 9 shows, all elements of medical care CPI have contributed to the surge. Meanwhile, core PCE shows that medical care inflation has in fact been contained, some say, due to the enactment of the Affordable Care Act (a.k.a. Obamacare). It is not clear that this is the full story and forecasting future rates of inflation specifically in this sector is beyond the scope of this report. Over the next six to twelve months, we would expect some convergence between the two inflation gauges, as CPI medical care inflation peaks. More specifically, we would not be surprised to see the core PCE move slightly above 2%, but we think it is unlikely that much of an overshoot of the Fed's target can occur. Chart 10 shows the major components of CPI and we note the following: Chart 9Medical Care##br## Inflation Is Tricky bca.usis_wr_2016_10_24_c9 bca.usis_wr_2016_10_24_c9 Chart 10Major Components Of##br## Inflation At Crosscurrents Major Components Of Inflation At Crosscurrents Major Components Of Inflation At Crosscurrents Goods prices continue to fall. If our strong dollar view proves correct, deflation in this sector may persist for years. Recall that throughout the economic recovery in the first half of the previous decade, core goods price deflation persisted; that was during a dollar bear market. This time, dollar strength is likely to keep an even tighter lid on imported prices. Non-shelter service price inflation appears to be rolling over, after a surge earlier this year. The key for core service price inflation is wage pressures, since labor costs are the most significant input cost to U.S. service businesses. For core service price inflation to sustainably break above 3%, i.e. to return to the pre-Great Recession range, recent wage trends will need to be sustained, if not accelerate. Shelter prices are the most difficult segment to forecast. Our model for shelter inflation has flattened out, owing to a decline in market-tightness in multi-family properties. A reasonable working assumption is that shelter inflation stays around 3%, which is roughly the rate of shelter inflation that persisted prior to the housing bubble of the previous decade. Adding it up, core inflation is likely to drift gradually up: service sector inflation will likely trend higher with wage growth, but deflation in the goods sector will provide somewhat of an offset. The Fed has initiated interest rate hikes in the past when core PCE was under 1.5%, so there is historic precedent for policymakers to hike rates before the 2% target is achieved. Of course, this cycle is very different and there has been much talk of the need for policymakers to err on the side of ease for even longer, i.e. allow inflation to run much higher than 2%. Recent Fed communication suggests that a December rate hike is most likely, unless the data significantly worsen in the meantime. Thereafter, if our inflation view is correct, the Fed will find little reason to hike more than twice in 2017. Note: Last week, I had the pleasure of participating in our Geopolitical Strategy service's webcast on the upcoming U.S. Elections. In addition to a well-rounded debate on the U.S. political situation, we also discussed the present economic and investment landscape. To listen to the replay, please go here: www.bcaresearch.com/webcasts/index/131 Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report "Dollar: The Great Redistributor", dated October 7, 2016, available at fes.bcaresearch.com 2 Please see U.S. Equity Strategy Special Report "Defensive Dominance Has Bent, But Will Not Break", dated October 17, 2016, available at uses.bcaresearch.com Appendix Monthly Asset Allocation Model Update Our Asset Allocation (AA) model provides an objective assessment of the outlook for relative returns across equities, Treasuries and cash. It combines valuation, cyclical, monetary and technical indicators. The model was constructed as a capital preservation tool, and has historically outperformed the benchmark in large part by avoiding major equity bear markets. Please note that our official cyclical asset allocation recommendations deviate at times from the model's recommendation. The model is just one input to our decision process. The model's recommended weightings for the major asset classes remained unchanged this month: neutral equity exposure at 60% (benchmark 60%), slightly overweight Treasury allocation at 40% (benchmark 30%) and underweight cash at 0% (benchmark 10%). The neutral portfolio recommendation for equities is in line with our qualitative defensive stance, in place since August 2015. Although the technical and monetary components of the equity model are still favorable, the earnings-driven component continues to warn that profits are likely to remain lackluster, especially relative to expectations. The allocation for a slight overweight in Treasuries continues to be supported by all three components of the bond model: valuation, cyclical and technical. While the valuation component continues trending towards expensive territory, a "buy signal" still exists for now. The cyclical and technical components of the bond model have retraced some of their bullish signals, but both still maintain a preference for Treasuries, especially relative to cash. Chart 11Portfolio Total Returns Portfolio Total Returns Portfolio Total Returns Chart 12Current Model Recommendations Current Model Recommendations Current Model Recommendations Note: The asset allocation model is not necessarily consistent with the weighting recommendations of the Cyclical Investment Stance. For further information, please see our Special Report "Presenting Our U.S. Asset Allocation Model", February 6, 2009. Market Calls

Highlights The U.S. is not yet a "high-pressure" economy, but slack is dissipating. U.S. growth, while not torrid, will remain high enough to push interest rates higher. The euro area continues to exhibit tepid domestic demand growth, and slack there remains higher than in the U.S. Monetary divergences will grow, weighing on EUR/USD. The Canadian economy displays underlying weaknesses which will prevent the BoC from hiking for an extended period of time. Stay long USD/CAD, but favor the CAD to the AUD and the NZD on a USD rally. Feature Following Janet Yellen's Boston speech last week, a new phrase has entered the lexicon of investors: "high-pressure economy". The speech was originally interpreted as a clarion call to let the economy overheat in order to absorb the slack created by the shock of 2008. However, Yellen still sees some slack in the economy. In her eyes, an easy monetary stance, at this point, will not cause an overheating, it will only bring back to the marketplace workers that had left the labor force. Chart I-1Drying Global Liquidity bca.fes_wr_2016_10_21_s1_c1 bca.fes_wr_2016_10_21_s1_c1 We have sympathy toward this view, especially when put in an international context where global capacity utilization remains depressed. Also, countries like China, Saudi Arabia, and Mexico have been intervening in the FX markets to preempt or limit downside to their currencies, tightening global liquidity conditions (Chart I-1). Nonetheless, the Fed Chair also highlighted that the FOMC did not want the U.S. economy to overheat as the domestic slack gets absorbed. Doing so would raise the risk that the Fed will have to then overcompensate by tightening rates very aggressively. This would prompt another recession. U.S.: Not High Pressure Yet, But... No indicator suggests that there is a burning need to quickly ratchet U.S. rates higher. However, domestic economic conditions are falling into place to justify a slow move toward higher rates. Our aggregate U.S. capacity utilization gauge is showing a dissipation of U.S. economic slack (Chart I-2, top panel). This is a side-effect of the tepid growth in the capital stock of U.S. businesses this cycle, which limits the expansion of the supply-side of the economy (Chart I-2, bottom panel). Meanwhile, household consumption should remain robust. Not only did 2015 register the strongest growth in the median household's real income since 1967, consumption is unlikely to slow much. In fact, vehicle-miles traveled and the Federal income tax receipts are both pointing toward healthy consumption (Chart I-3). Despite punky construction starts, housing activity shows signs of improvement. Housing inventories are near record lows and construction has underperformed household formation. Moreover, building permits are hooking upward, while housing affordability remains generous (Chart I-4). Additionally, the NAHB survey also points toward a rising share of residential activity in the economy (Chart I-4, bottom panel). Finally, capex intentions are slowly recovering. Moreover, the BCA House view is that the U.S. profit contraction is past its nadir. Going forward, capex and inventories are unlikely to subtract as much from growth as they did in 2015 and 2016. They may even become accretive to GDP growth. Chart I-2Vanishing U.S. Slack Vanishing U.S. Slack Vanishing U.S. Slack Chart I-3Positive Signs For The U.S. Consumer bca.fes_wr_2016_10_21_s1_c3 bca.fes_wr_2016_10_21_s1_c3 Chart I-4Residential Investment Will Improve bca.fes_wr_2016_10_21_s1_c4 bca.fes_wr_2016_10_21_s1_c4 Limited slack and a continued economic expansion imply a high likelihood of a Fed hike this year, and maybe two more next year if no shocks to financial conditions emerge. With markets currently pricing in 65 basis points of rate hikes by the end of 2019, this should lift rates across the curve. Higher interest rates on U.S. assets should drive private inflows into the country, pushing the U.S. dollar higher (Chart I-5). From a technical perspective, the U.S. capitulation index is breaking out to the upside following a pattern of lower highs. Since 2008, such breakouts have been followed by a significant rally in the broad trade-weighted dollar (Chart I-6). Thus, we continue to position ourselves for additional dollar strength this cycle. Chart I-5Flows Into The U.S. ##br##Are Set To Grow bca.fes_wr_2016_10_21_s1_c5 bca.fes_wr_2016_10_21_s1_c5 Chart I-6Favorable Technical ##br##Backdrop For The Greenback bca.fes_wr_2016_10_21_s1_c6 bca.fes_wr_2016_10_21_s1_c6 Bottom Line: The household sector remains healthy, and U.S. economic slack is dissipating. Hence, the Fed will try, rightfully or wrongly, to push rates higher this year and next, lifting the dollar in the process. Euro Area: Less Pressure A dollar rally could be painful for the euro. Yet, the euro is cheap and supported by a current account surplus of 3.3% of GDP (Chart I-7). What to do with this conflicting picture? For a currency to embark on a durable bull market, productivity growth needs to be stronger than that of its trading partners. A strong currency makes the tradeable-goods sector less competitive, hampering growth. A positive terms-of-trade shock, like that undergone by commodity producers during the previous decade can also do the trick. Neither of these statements currently describe the euro area. Another avenue for a country to withstand a strong currency is for growth to be domestically driven. If household consumption is the main locomotive, exporters' loss of market share do not hurt activity as much. This is true until the domestic economy enters a recession, an event usually driven by higher policy rates. This is why when the share of salaries in the U.S. economy expands, the dollar undergoes cyclical bull markets (Chart I-8). More salaries in the national income means more consumption. Chart I-7Euro ##br##Supports Euro Supports Euro Supports Chart I-8Domestically-Driven Growth##br## Is Good For A Currency Domestically-Driven Growth Is Good For A Currency Domestically-Driven Growth Is Good For A Currency In the euro area, GDP growth is above trend, but, in recent quarters, final private domestic demand has been weak (Chart I-9). In fact, last quarter, net exports were the main contributor to growth. This could explain why, since 2015, stronger European business surveys vis-à-vis the U.S. were unable to boost EUR/USD (Chart I-10). Chart I-9European Consumption##br## Isn't Strong Relative Pressures And Monetary Divergences Relative Pressures And Monetary Divergences Chart I-10If EUR/USD Could Not ##br##Rally Then, When Will It? bca.fes_wr_2016_10_21_s1_c10 bca.fes_wr_2016_10_21_s1_c10 We do expect eurozone final domestic demand to remain tepid. Yes, the credit impulse has improved, but this amelioration will prove temporary. The previous rebound in credit flows reflected the movement from a large contraction to a small expansion. Today, the dismal performance of euro area bank stocks - which have been a good leading indicator of European loan growth - points to slowing credit growth (Chart I-11). Fiscal policy is also moving from a small positive to a small negative. Work by the ECB staff shows that the cyclically adjusted budget balance in Europe fell by 0.3%, from -1.7% to -2.0% of GDP in 2016. Aggregate cyclically-adjusted budget balances are forecasted to improve to -1.8% and -1.6% of GDP in 2017 and 2018, respectively, representing a 0.2% fiscal drag each year. While a small number, we have to keep in mind that euro area trend growth is between 0.5% and 1%. This suggests that the European economy remains ill-equipped to handle a stronger euro. Moreover, the European economy exhibits much more slack than the U.S. economy. While total hours worked in the U.S. are 14% above Q1 2010 levels, in Europe, they are only 1.5% above such levels (Chart I-12), a gap much greater than demographics alone would have suggested. This means that monetary divergence will continue between Europe and the U.S. Chart I-11Euro Area Credit Impulse Will Weaken bca.fes_wr_2016_10_21_s1_c11 bca.fes_wr_2016_10_21_s1_c11 Chart I-12Less Capacity Pressures In Europe Less Capacity Pressures In Europe Less Capacity Pressures In Europe In fact, this week, the ECB did little to dispel this notion. Beyond trying to squash ideas of a sudden end to the QE program or any imminent tapering, president Draghi communicated that December will be the month when the real action occurs. Based on current trends, we expect the ECB to extend its QE program beyond March, but to hint at a tapering of purchases later in 2017. The ECB will also make it very clear that rates will remain as low as they currently are for an extremely long time. Thus, while the ECB might be slowly moving away from its hyper-stimulative stance, it will not do so as fast as the Fed. Therefore, policy divergences should continue to weigh on EUR/USD. Technicals are also pointing toward a lower euro. Not only has EUR/USD broken down its 1-year old series of higher lows, the euro's capitulation index, the intermediate-term momentum indicator, and the euro's A/D line are forming negative divergences with EUR/USD (Chart I-13). An interesting way to play the euro's weakness is to go short EUR/CZK, a position championed by our Emerging Market Strategy service.1 A floor at 27 has been set under EUR/CZK since November 2013. Yet, this floor looks increasingly untenable. Speculators are beginning to pile in. This week, 2-year Czech yields temporarily dipped below those of Swiss 2-year bonds, the current holder of the world's lowest yield. To fight appreciation pressures, the Czech National Bank (CNB) is accumulating a lot of reserves by buying euros, which is fueling a surge in the money supply (Chart I-14, top panel). Chart I-13Worrying Euro ##br##Technicals Worrying Euro Technicals Worrying Euro Technicals Chart I-14CZK: Reserves Expansion##br## Leading To Inflation bca.fes_wr_2016_10_21_s1_c14 bca.fes_wr_2016_10_21_s1_c14 This accumulation of reserves, in turn, is fanning inflationary forces in the Czech economy. The output gap is closing and core inflation already is increasing at a rate of 1.8% p.a. Easy financial conditions and expanding credit growth are likely to boost already-accelerating unit labor costs and wages (Chart I-14, bottom panel). This means that the 2% inflation target is likely to be hit as early as Q2 2017 according to the CNB. We expect this goal to be handily surpassed if the floor stays in place. Thus, we expect the CNB to abandon the floor within the next twelve months and we are shorting EUR/CZK. Finally, while we are bearish EUR/USD, we do believe that the euro will outperform the pound and commodity currencies. Moreover, despite poorer fundamentals, the euro could also temporarily outperform the SEK and the NOK if the dollar strengthens. The latter two are more sensitive to the USD than the euro is. Bottom Line: EUR/USD is at risk from the broad dollar rally. It is also likely to suffer from the tepid state of the euro area's final domestic demand, fueling monetary-policy divergences with the U.S. A speculative opportunity to short EUR/CZK is emerging, as the CNB's peg is outliving its usefulness. Canada: Falling Pressure USD/CAD has become more correlated with movements in rate differentials than with the vagaries of oil prices (Chart I-15). This puts the actions of the Bank of Canada in sharper focus. As expected, this week, the BoC left policy rates unchanged at 0.5%. More interesting was the quarterly monetary report. The economy has rebounded from the slump induced by the Q2 Alberta wildfires, and many key gauges of the Canadian economy have improved (Chart I-16). Yet, the BoC is looking the other way. Chart I-15CAD: Now More Rates Than Oil bca.fes_wr_2016_10_21_s1_c15 bca.fes_wr_2016_10_21_s1_c15 Chart I-16The BoC Is Looking The Other Way... bca.fes_wr_2016_10_21_s1_c16 bca.fes_wr_2016_10_21_s1_c16 The BoC is now forecasting the Canadian output gap to close in mid-2018; in July, this was expected to happen in the second half of 2017. This is because the BoC cut the expected Canadian growth rate by a cumulative 0.5% over the next two years. There have been some worrying developments warranting a more cautious forecast. While the Trudeau government's new childcare benefits are currently being rolled out and new infrastructure spending is to be implemented in 2017, the Canadian private sector's finances are increasingly shaky. The aggregate debt-servicing costs of the non-financial private sector is at record highs, with generous contributions from both households and the corporate sector (Chart I-17). The aggregate credit impulse has responded to this handicap, contracting by 7% of potential GDP, a move driven by the corporate sector (Chart I-18). While not as dramatic, the pace of debt accumulation by the household sector has also weakened. Recent administrative measures to cool the housing market - put in place by various provincial entities as well as the federal government - could accentuate this trend. Chart I-17...Rightfully So bca.fes_wr_2016_10_21_s1_c17 bca.fes_wr_2016_10_21_s1_c17 Chart I-18Collapsing Canadian Credit Impulse Collapsing Canadian Credit Impulse Collapsing Canadian Credit Impulse Another problem for Canada has been its loss of competitiveness. Non-oil Canadian exports have not responded as expected to the fall in the CAD. This is because many Canadian manufacturers have set up factories in Mexico and other EMs, or are competing with firms operating out of these nations. With these countries' currencies witnessing devaluations as deep as, or deeper than the loonie's, it is no wonder that Canada has lost market shares in the U.S. (Chart I-19). This means that Canadian rates will remain low for longer, making Canada another contributor to global monetary divergences vis-a-vis the U.S. The BoC is right to be worried that the Canadian economy will take longer than anticipated to close its output gap. With the pass-through to inflation of a lower CAD dissipating, the BoC expects Canadian core inflation to remain well contained for the next two years. We see little cause to disagree. This means that despite trading at a premium to PPP, USD/CAD has upside. Moreover, the Canadian dollar's A/D line is rolling over, another factor pointing to upside for USD/CAD (Chart I-20). At this point, the biggest risk to our view is oil. If WTI can breakout above $52 - perhaps in response to an as-yet negotiated OPEC/Russia oil-production cut or freeze - this could mitigate the downside for the CAD. Thus, while we like USD/CAD, we think the CAD has upside against the AUD and the NZD, especially as the loonie is less sensitive to the USD and EM spreads than the two antipodean currencies. Chart I-19Canada Is Losing Competitiveness Relative Pressures And Monetary Divergences Relative Pressures And Monetary Divergences Chart I-20Falling CAD A/D Line Falling CAD A/D Line Falling CAD A/D Line Bottom Line: The Canadian economy is showing surprising signs of underlying weakness. With the CAD having recently been more correlated to rate differentials than to oil, USD/CAD could rally on monetary divergences. That being said, on the back of a strong USD, CAD is likely to outperform the AUD and NZD. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report, "Central European Strategy: Two Currency Trades", dated September 28, 2016, available at ems.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 bca.fes_wr_2016_10_21_s2_c1 bca.fes_wr_2016_10_21_s2_c1 Chart II-2USD Technicals 2 bca.fes_wr_2016_10_21_s2_c2 bca.fes_wr_2016_10_21_s2_c2 Policy Commentary: "The risks have changed in terms of overshooting what I think is full employment with implications for potential imbalances...Those imbalances might result in a reaction by the Fed that we end up having to tighten more quickly than I would like" - FOMC Voting Member Eric Rosengren (October 17, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 The Euro Chart II-3EUR Technicals 1 bca.fes_wr_2016_10_21_s2_c3 bca.fes_wr_2016_10_21_s2_c3 Chart II-4EUR Technicals 2 bca.fes_wr_2016_10_21_s2_c4 bca.fes_wr_2016_10_21_s2_c4 Policy Commentary: "An abrupt ending to bond purchases, I think, is unlikely...We remain committed to preserving a very substantial degree of monetary accommodation" - ECB President Mario Draghi (October 20, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 The Yen Chart II-5JPY Technicals 1 bca.fes_wr_2016_10_21_s2_c5 bca.fes_wr_2016_10_21_s2_c5 Chart II-6JPY Technicals 2 bca.fes_wr_2016_10_21_s2_c6 bca.fes_wr_2016_10_21_s2_c6 Policy Commentary: "Since the employment situation has continued to improve, no further easing of monetary policy may be necessary... at any rate, I would like to discuss this thoroughly with other board members at our monetary policy meeting" - BoJ Board Member Yutaka Harada (October 12, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 British Pound Chart II-7GBP Technicals 1 bca.fes_wr_2016_10_21_s2_c7 bca.fes_wr_2016_10_21_s2_c7 Chart II-8GBP Technicals 2 bca.fes_wr_2016_10_21_s2_c8 bca.fes_wr_2016_10_21_s2_c8 Policy Commentary: "Our judgment in the summer was that we could have seen another 400,000-500,000 people unemployed over the course of the next few years...So we're willing to tolerate a bit of overshoot in inflation over the course of the next few years in order to avoid that situation, to cushion the blow" - BOE Governor Mark Carney (October 14, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9AUD Technicals 1 bca.fes_wr_2016_10_21_s2_c9 bca.fes_wr_2016_10_21_s2_c9 Chart II-10AUD Technicals 2 bca.fes_wr_2016_10_21_s2_c10 bca.fes_wr_2016_10_21_s2_c10 Policy Commentary: "We have never thought of our job as keeping the year-ended rate of inflation between 2 and 3 percent at all times...Given the uncertainties in the world, something more prescriptive and mechanical is neither possible nor desirable" - RBA Governor Philip Lowe (October 17, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 bca.fes_wr_2016_10_21_s2_c11 bca.fes_wr_2016_10_21_s2_c11 Chart II-12NZD Technicals 2 bca.fes_wr_2016_10_21_s2_c12 bca.fes_wr_2016_10_21_s2_c12 Policy Commentary: "There are several reasons for low inflation - both here and abroad. In New Zealand, tradable inflation, which accounts for almost half of the CPI regimen, has been negative for the past four years. Much of the weakness in inflation can be attributed to global developments that have been reflected in the high New Zealand dollar and low inflation in our import prices" - RBNZ Assistant Governor John McDermott (October 11, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 bca.fes_wr_2016_10_21_s2_c13 bca.fes_wr_2016_10_21_s2_c13 Chart II-14CAD Technicals 2 bca.fes_wr_2016_10_21_s2_c14 bca.fes_wr_2016_10_21_s2_c14 Policy Commentary: "Given the downgrade to our outlook, Governing Council actively discussed the possibility of adding more monetary stimulus at this time, in order to speed up the return of the economy to full capacity" - BoC Governor Stephen Poloz (October 19, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swiss Franc Chart II-15CHF Technicals 1 bca.fes_wr_2016_10_21_s2_c15 bca.fes_wr_2016_10_21_s2_c15 Chart II-16CHF Technicals 2 bca.fes_wr_2016_10_21_s2_c16 bca.fes_wr_2016_10_21_s2_c16 Policy Commentary: "[On the effects of low interest rates on the housing market]...If you look at the recent past, the dynamics have been a bit more reassuring...[still]let's not forget, this disequilibrium that we have achieved remains very high" - SNB Vice-President Fritz Zurbruegg (October 12, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 bca.fes_wr_2016_10_21_s2_c17 bca.fes_wr_2016_10_21_s2_c17 Chart II-18NOK Technicals 2 bca.fes_wr_2016_10_21_s2_c18 bca.fes_wr_2016_10_21_s2_c18 Policy Commentary: "A period of low interest rates can engender financial imbalances. The risk that growth in property prices and debt will become unsustainably high over time is increasing. With high debt ratios, households are more vulnerable to cyclical downturns" - Norges Bank Governor Oystein Olsen (October 11, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 bca.fes_wr_2016_10_21_s2_c19 bca.fes_wr_2016_10_21_s2_c19 Chart II-20SEK Technicals 2 bca.fes_wr_2016_10_21_s2_c20 bca.fes_wr_2016_10_21_s2_c20 Policy Commentary: "[On Sweden's financial stability]...it remains an issue because we are mismanaging out housing market. Our housing market isn't under control in my view" - Riksbank Governor Stefan Ingves (October 27, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Dazed And Confused - July 1, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Muni Credit Cycle: The reading from our Municipal Health Monitor supports low Muni/Treasury yield ratios for now, but will become less supportive near the end of 2017. This is consistent with historical lags between the muni and corporate credit cycles. Issuance: State & local government investment spending will increase in 2017, as will muni issuance for new capital. Pensions: The pension funding problem will only get worse in the coming years. Credit ratings do not adequately reflect the risk from under-funded pensions. Election: Muni/Treasury yield ratios have not yet discounted Donald Trump's recent plunge in the polls. Maintain an overweight allocation to municipal bonds for the time being, but stand prepared to gradually reduce exposure as the muni credit cycle starts to turn in late 2017. Feature The financial crisis marked a major inflection point in the municipal bond market. Not only did the economic fall-out from the housing crash lead to historically large state & local government budget gaps, but the end of bond insurance and a growing realization that municipal default is possible have focused investor attention on credit quality more than ever before. In this Special Report we zero-in on the Municipal/Treasury (M/T) yield ratio.1 We identify its major short-run and long-run drivers, and assess where it is headed in the context of the municipal bond credit cycle. The Longer-Run Outlook For Yield Ratios An important input to our understanding of the municipal credit cycle is our Muni Health Monitor (MHM). The MHM is a composite of eight indicators of state & local government budget health. Full details of the indicator and its components can be found in the Appendix to this report. The MHM has an excellent track record of signaling the major inflection points in muni ratings migration (Chart 1). We observe that the MHM bottomed in 2006, one year before the previous trough in ratings migration. The MHM also crossed into "deteriorating health" territory six months before municipal downgrades started to outpace upgrades in 2008. More recently, the MHM crossed back into "improving health" territory in Q4 2012. Muni ratings migration also peaked in Q4 2012 and upgrades began outpacing downgrades in Q4 2014. Chart 1The Municipal Health Monitor Leads Ratings bca.usbs_sr_2016_10_18_c1 bca.usbs_sr_2016_10_18_c1 We pay attention to the trends in muni ratings because ratings and state & local government net borrowing explain more than 50% of the variation in the average M/T yield ratio since 1997 (Chart 2). Further, increased investor focus on the creditworthiness of municipal issues has made the yield ratio even more responsive to ratings and net borrowing since the Great Recession. So where are we currently situated in the muni credit cycle? The MHM remains in "improving health" territory, but appears to have entered an extended bottoming-out phase. Given the re-leveraging that has already occurred in the corporate sector, it would be extremely unusual for the MHM to improve further during this cycle. In fact, our Corporate Health Monitor tends to lead the MHM by about two years (Chart 3). This squares with what we know about the behavior of state & local governments throughout the economic cycle. Chart 2The Muni Credit Cycle Illustrated I bca.usbs_sr_2016_10_18_c2 bca.usbs_sr_2016_10_18_c2 Chart 3The Muni Credit Cycle Illustrated II The Muni Credit Cycle Illustrated II The Muni Credit Cycle Illustrated II Typically, the corporate sector will increase debt loads when times are good and will then be forced to de-lever when the economy enters recession, profits contract and those debt loads become unsustainable. State & local government budget gaps, on the other hand, will tend to narrow during an economic recovery as rapid income growth translates into increased tax revenue. It is only during a recession that state & local government budget gaps widen, since tax revenue plummets while expenditure growth - particularly for social benefits - remains firm. The end result is that the municipal credit cycle tends to lag the corporate credit cycle. This is also apparent in the ratings data (Chart 3, bottom panel), which suggest that we should expect to see muni downgrades (and hence yield ratios) head higher near the end of next year. The typical lag between the corporate credit cycle and the municipal credit cycle suggests that M/T yield ratios should remain well behaved until late-2017, and then begin to move higher. However, the extraordinary length of the current economic recovery gives us some cause to believe that the lags in this cycle may be somewhat longer. We turn to a macro analysis of net state & local government borrowing to shed some further light on this issue. Net borrowing is simply the difference between revenues and expenditures. On the revenue side of the ledger, state & local governments have already seen a significant deceleration in tax receipts during the past year (Chart 4). Every source of tax revenue - except for property taxes - has slowed alongside what has been disappointing overall economic growth so far in 2016. While a return to the 10% revenue growth that was seen in the mid-2000s is unlikely, we expect most of the recent deceleration will soon be reversed. Aggregate weekly hours bounced sharply in September (Chart 5), and federal income tax withholdings also continue to grow rapidly. Both indicators suggest that income growth will be stronger during the next few months, which will support state & local tax receipts. On the expenditures side, while spending on social benefit programs has increased, state & local governments have largely dealt with budget gaps by cutting back severely on discretionary spending (Chart 6). Investment spending has also collapsed and, as a result, gross municipal bond issuance has been dominated by refinancing (Chart 6, bottom two panels). Chart 4S&L Government Revenue S&L Government Revenue S&L Government Revenue Chart 5Income Growth Will Rebound bca.usbs_sr_2016_10_18_c5 bca.usbs_sr_2016_10_18_c5 Chart 6S&L Government Expenditures bca.usbs_sr_2016_10_18_c6 bca.usbs_sr_2016_10_18_c6 This could all be about to change. Both U.S. Presidential candidates have prioritized infrastructure spending as part of their platforms. Hillary Clinton plans to increase infrastructure spending by $500 billion. This consists of $250 billion of federal infrastructure spending over the next five years and $25 billion of seed money to create a national infrastructure bank. The bank would also accept an additional $225 billion in direct loans. Clinton's plan would also bring back the Build America Bonds (BABs) program. Donald Trump has also expressed a desire to invest heavily in infrastructure, and has floated figures in the range of $1 trillion, although he has been less specific about the details. Historically, about 70% of public investment has occurred at the state & local government level (Chart 7). This suggests that if infrastructure spending became a priority it would lead to a large increase in state & local government investment and hence municipal bond issuance. However, with Clinton's plan it is still unclear whether the bulk of infrastructure spending would be financed through the Treasury market or the muni market. Certainly, to the extent that increased spending is financed through the BABs program, then tax-exempt muni issuance would not be impacted. In our view, state & local government investment spending will head higher in 2017 even without any support from the new President. The need for state & local governments to invest in infrastructure has been evident for some time, but only recently have budgets become healthy enough for governments to consider it. There is a strong correlation between state & local government investment spending and the net percentage of states with a total balance (general fund plus rainy day fund) that exceeds 5% of expenditures (Chart 8). This figure has just recently moved into positive territory and, not coincidentally, more than $200 billion worth of infrastructure spending will be on ballots requesting voter approval in November.2 Chart 7State & Local Government ##br##Drives Investment bca.usbs_sr_2016_10_18_c7 bca.usbs_sr_2016_10_18_c7 Chart 8Healthy Enough##br## To Invest bca.usbs_sr_2016_10_18_c8 bca.usbs_sr_2016_10_18_c8 The combination of resilient, but not surging, revenue growth and increased investment spending in 2017 is consistent with the idea that the muni credit cycle will follow the lead of the corporate cycle and start to turn near the end of next year. Bottom Line: The reading from our Municipal Health Monitor supports low Muni/Treasury yield ratios for now, but will become less supportive near the end of 2017. This is consistent with historical lags between the muni and corporate credit cycles. The Pension Problem Of course, the elephant in the room with regards to the long-run outlook for municipal credit quality is pensions. So far pensions have only entered our discussion of the muni credit cycle tangentially, since the pension funded ratio is a component of the MHM (see Appendix). However, large unfunded pension liabilities - should they persist - have the potential to be severely destabilizing for the muni market at some point in the future. According to the U.S. National Accounts, aggregate defined benefit pension entitlements at the state & local government level total $5.6 trillion, only 65% of which are currently funded by assets. However, this aggregate figure masks large divergences between a few municipalities with unsustainable pension liabilities and the majority of municipalities where pension liabilities are probably manageable. Chart 9Low Returns Put Pressure On Pensions Low Returns Put Pressure On Pensions Low Returns Put Pressure On Pensions In a recent report,3 the Center for Retirement Research at Boston College found that 36 states should be able to fund their existing liabilities by making annual payments that total less than 15% of revenue. However, five states - Illinois, New Jersey, Connecticut, Hawaii and Kentucky - require annual payments in excess of 25% of revenue. The breakdown is found to be similar at the city level, where pension costs were found to be manageable for the majority of cities, although Chicago, Detroit, San Jose, Miami, Houston, Baltimore, Wichita and Portland all face annual pension costs that exceed 40% of revenue. Unfortunately, while the pension situations of most municipalities are currently manageable, they are only likely to get worse. Changes in the aggregate pension funded ratio closely track returns from a portfolio that is 50% invested in the S&P 500 and 50% invested in the Barclays Treasury index (Chart 9). Based on current equity valuations, it is probably only reasonable to expect 6% annual nominal returns from the equity market during the next 10 years,4 and the 10-year Treasury yield suggests that 1.8% is a reasonable expectation for annual nominal Treasury returns. Taken together, annual nominal investment returns from a 50/50 portfolio during the next decade could be close to 4%, far below the historical average of 8.9% and also below the 7.6% average return assumed by state & local pension plans in 2014. The two main points are that: The pension problem is likely to get worse, not better Given that large under-funded pensions are concentrated in only a few states, inter-state muni allocations are very important On this second point, we observe that states with lower pension funded ratios have higher General Obligation (GO) bond yields (Chart 10), and also that not all of the difference is reflected in credit ratings. We ran a cross-sectional regression of GO bond yields against credit rating and found that a correlation remains between the residual from that regression and the pension funded ratio (Chart 11). In other words, credit rating does not adequately control for the risk presented by under-funded pensions. Chart 10Municipal Bond Yields Vs. Pension Funded Ratios Trading The Municipal Credit Cycle Trading The Municipal Credit Cycle Chart 11Municipal Bond Yields Vs. Pension Funded Ratios: Controlling For Credit Rating Trading The Municipal Credit Cycle Trading The Municipal Credit Cycle Bottom Line: The pension funding problem will only get worse in the coming years. Credit ratings do not adequately reflect the risk from under-funded pensions. The Short-Run Outlook For Yield Ratios So far we have discussed the muni credit cycle and noted that M/T yield ratios should begin to move higher on a sustained basis at some point near the end of 2017. However, the near-term drivers of M/T yield ratios suggest that an overweight allocation to municipal bonds remains appropriate for the time being. We have found that the bulk of near-term volatility in M/T ratios can be explained by four factors (Chart 12): The Global Policy Uncertainty Index5 Gross municipal bond issuance Net municipal mutual fund flows Ratings migration The Brexit shock to policy uncertainty has now mostly been reversed. Meanwhile, our Muni Excess Supply Indicator (Chart 12, panel 4) shows that gross issuance has been outpacing fund inflows of late. This should put upward pressure on yield ratios, although this pressure has been largely offset by still supportive ratings migration (Chart 12, bottom panel). Considering all factors, this short-term model shows that the average M/T yield ratio is close to fair value. A reading close to fair value is consistent with muni returns that should exceed those from duration-equivalent Treasuries most of the time (Table 1), even before adjusting for the muni tax advantage. In fact, Table 1 shows that the odds of muni underperformance only really increase once the M/T ratio appears more than one half standard deviation expensive on our model. Chart 12A Short-Term Muni Model A Short-Term Muni Model A Short-Term Muni Model Table 1Municipal Bond Excess Returns* Based On Fair Value Model** Residual: 2010 - 2016 Trading The Municipal Credit Cycle Trading The Municipal Credit Cycle The other near-term factor that supports a continued overweight allocation to municipal debt is the prospect of a Clinton victory in next month's election. Since the beginning of the year, the average M/T ratio has closely tracked the probability of a Trump election victory (Chart 13). The reasoning is entirely logical. Trump has promised large tax cuts for the highest earners. Such tax cuts would significantly de-value the tax advantage of municipal bonds and pressure yield ratios higher. In contrast, Clinton promises to raise taxes on high income individuals. This would make the tax advantage of municipal debt more valuable, and pressure yield ratios lower. Chart 13Trump Is Bad For Yield Ratios Trump Is Bad For Yield Ratios Trump Is Bad For Yield Ratios The average M/T yield ratio has not yet discounted Trump's recent plunge in the polls. This argues for the maintenance of an overweight allocation to municipal debt in the near term. Bottom Line: M/T yield ratios appear fairly valued in the near-term, and have not yet discounted Donald Trump's recent plunge in the polls. Maintain an overweight allocation to municipal bonds for the time being, but stand prepared to gradually reduce exposure as the muni credit cycle starts to turn in late 2017. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com Appendix: The BCA Municipal Health Monitor The BCA Municipal Health Monitor is an equal-weighted composite of eight indicators meant to quantify trends in state & local government budget gaps and debt service capability. The components consist entirely of data that are publicly available from the Bureau of Economic Analysis, Federal Reserve, Bureau of Labor Statistics and the National Association of State Budget Officers. The eight components are described below, and shown graphically in Charts A1 & A2. Chart A1Muni Health Monitor Components I Muni Health Monitor Components I Muni Health Monitor Components I Chart A2Muni Health Monitor Components II bca.usbs_sr_2016_10_18_c15 bca.usbs_sr_2016_10_18_c15 Leverage: The ratio of total state & local government liabilities (excluding unfunded pension liabilities) to total financial assets. Interest Coverage: State & local government current budget surplus (excluding interest expenditures) divided by interest expenditures. The current surplus is calculated as the difference between current revenues and current expenditures (i.e. investment spending is excluded). Pension Funded Ratio: Total assets of state & local government pension funds divided by total pension liabilities. Revenue: State & local government current revenue in nominal terms, as a deviation from its 18-quarter trend. Surplus Margin: State & local government current budget surplus as a % of current revenue. Liquidity: State & local government total financial assets less short-term liabilities, as a % of total financial assets. Employment Growth: Year-over-year % change in state and local government employment. Total Balance: Aggregate state government total year-end balance. The total balance is the general fund balance plus the rainy day fund, as a % of total expenditures. 1 The average M/T yield ratio shown in this report is calculated by taking an equal-weighted average of M/T yield ratios for 2-year, 5-year, 10-year and 30-year maturities. For each maturity point the yield ratio is calculated as the ratio between the Bloomberg Fair Value Aaa Municipal bond yield and the Federal Reserve's constant maturity Treasury yield. 2 http://www.bloomberg.com/news/articles/2016-09-13/mega-deals-lead-ballo… 3 http://crr.bc.edu/briefs/will-pensions-and-opebs-break-state-and-local-… 4 Please see Global Investment Strategy Special Report, "Global Equity Valuations: Risks And Opportunities", dated July 1, 2016, available at gis.bcaresearch.com 5 The index was created by Professors Scott Baker, Nick Bloom and Steven Davis and is driven by the number of times terms related to economic and policy uncertainty are found in newspaper articles. Full details of the methodology are available at www.policyuncertainty.com

Highlights Our protector portfolio is a combination of assets that have a low or negative correlation with equities that give investors some downside protection. Replacing cash and/or Treasuries with our protector portfolio in 60-30-10 or 60-40 benchmark portfolios would have produced superior returns since 2011. We continue to advocate allocating investments to our protector portfolio in the near term as it represents an effective hedge against immediate risks such as a negative market reaction to the upcoming elections and/or disappointing third quarter profits. Feature Both equities and bonds are under pressure, as a higher likelihood of a December interest rate hike is beginning to be priced in at the same time as nervousness about Q3 earnings results has intensified. This confluence of factors - less liquidity and earnings disappointment - has been the central argument of our defensive portfolio stance for some time: any handoff from liquidity to growth would be shaky, and potentially premature. Indeed, as we wrote in the September 26 Weekly Report, liquidity conditions will largely remain favorable for risk assets for some time because even with a December rate hike, interest rates are well below equilibrium, i.e. are not restrictive. However, equity investors will suffer through bouts of earnings disappointments, similar to the chronic disappointment in GDP growth. As we show in Chart 1, throughout the economic recovery, expectations for economic growth have been revised lower and are only now finally in line with what we expect is close to reality. As highlighted in last week's report, investors' expectations about earnings are most likely to undergo the same fate because profit margins will remain a lasting headwind: investors have not yet adjusted to this new reality (Chart 2). That will hold equity gains to low single digits, at best. Chart 1Years Of One-Way (Down) Revisions bca.usis_wr_2016_10_17_c1 bca.usis_wr_2016_10_17_c1 Chart 2Earnings Set To Disappoint? bca.usis_wr_2016_10_17_c2 bca.usis_wr_2016_10_17_c2 Overall, our view is that the economic backdrop is stable as there are low odds of a recession-inducing monetary tightening occurring, and we do not see any other negative shocks that are concerning enough to trigger a recession. Still, above and beyond our worry about profit disappointments, many client queries are currently focused on U.S. election risks. On September 26, we warned of market volatility leading up to the election, since investors may continue to assign too low odds of a Trump Presidential win. However, we would expect markets to quickly recover - at least until Trump reveals his true policy colors. We took a page from the market reaction to Brexit as a possible guideline to the outcome of Trump winning the election, i.e. the election is ultimately won by a non-status quo candidate. Investors will recall that the post-vote U.K. equity market reaction to Brexit was short-lived but savage. However, the uncertainty around the upheaval of institutions and structures in the euro area and the U.K. are far greater than the election of a non-conformist U.S. President within an institutionally sound system with checks and balances. All of that said, we recognize that we could be wrong and that the U.S. election has taken over the pole position on investors' list of concerns. More specifically, investors are worried about negative financial market fallout from a Trump win.1 So, how should investors hedge the downside risk of these election results? And for that matter, what about other near-term risks? Protector Portfolio Explained This publication has been advocating for some time that investors hold some portion of their capital in a protector portfolio (currently a combination of TIPS, gold and the U.S. dollar). The goal is to find assets with a low or negative correlation to U.S. equities and offer a measure of protection against a steep selloff in stocks. As Chart 3 shows, a portfolio of 60/30/10, where 10% is placed in the protector portfolio, would have outperformed a traditional 60/30/10 allocation in which the 10% is held in straight cash since 2011 (in a ZIRP world). A 60/40 allocation where 40% is placed in the protector portfolio also beats a 60/40 stock/Treasury allocation since 2011. Chart 3Protector Portfolio Enhances Performance ##br## Since 2011 Protector Portfolio Enhances Performance Since 2011 Protector Portfolio Enhances Performance Since 2011 Chart 4Protector Components Are ##br## Negatively Correlated With S&P 500 bca.usis_wr_2016_10_17_c4 bca.usis_wr_2016_10_17_c4 The three assets included in our protector portfolio were chosen with specific risks in mind: USD: As the main global reserve currency, the U.S. dollar benefits when global risk aversion is on the rise. Admittedly, when fears have emanated from U.S. soil, the dollar has performed less well compared to other safe-haven assets, such as the Swiss franc and/or Swiss bonds. Nonetheless, for U.S. investors, investing in one's home currency can provide a natural hedge/advantage. In Chart 4, we show the one-year correlation between USD and S&P 500 equity returns. Since 2009, the correlation has been negative and the implication is that by holding USD, investors are already implicitly defensive. Gold: Gold traditionally does well in times of extreme geopolitical uncertainty and also as a hedge against inflation. More recently, gold has done less well as a hedge because the negative correlation between equity prices and gold broke down from 2011 until earlier this year (Chart 4). Gold has once again become negatively correlated with equity prices and we believe it will be an effective safe-haven asset should inflation become a concern. TIPS: Both 10-year TIPS and nominal Treasuries are negatively correlated with U.S. equity returns and both provide some measure of insurance in risk-off periods/phases of economic disappointment. Nonetheless, we prefer TIPS at the moment since they offer a measure of protection against a back-up in inflation expectations (also Chart 4). In sum, our protector portfolio is a combination of assets that are uncorrelated enough with equities to give investors some protection against a range of downside risks. Protector Portfolio: But Beware Buy And Hold Chart 5Protector Buy And Hold Will Not Work bca.usis_wr_2016_10_17_c5 bca.usis_wr_2016_10_17_c5 As Chart 2 has shown, our protector portfolio has outperformed both a 60-30-10 and 60-40 portfolio in recent years. However, longer -term performance has been less outstanding (Chart 5). Indeed, adding a constant proportion of safe-haven assets to a balanced portfolio over an extended period underperforms the balanced portfolio benchmark for long stretches of time: there are non-negligible costs associated with holding safe-haven assets over prolonged periods. The bottom line is that timing plays a critical part in investing in safe-haven assets. Owning a fixed share of protector portfolio assets over long horizons will not beat a traditional buy and hold strategy, although superior returns over cash offer a compelling case in a NIRP world. We continue to recommend that investors hedge against downside risk in the form of the protector portfolio - or simply by choosing the safe haven that most closely corresponds as a hedge to the specific risk at hand. However, it is important to know that safe-haven assets fall in and out of favor through time and the protector portfolio will at some point no longer be justified, and/or its components will need to be adjusted. For example, only after 2000 did Treasuries start providing a good hedge against equity corrections. The contrary is true for gold - it acted as one of the most secure investments during corrections until that time, but then became correlated with S&P 500 total returns from 2012-early 2016. That said, gold's coefficient has turned negative again, and it should be viewed as an all-weather safe haven, especially if deflation risks begin to dissipate. The Most Relevant Safe Haven In Case Of A Policy Mistake Chart 6Fed Policy Mistake? Buy Protector Portfolio bca.usis_wr_2016_10_17_c6 bca.usis_wr_2016_10_17_c6 As we wrote above, our base investment case is that the prospect of less liquidity and the risk of an earnings disappointment mean that investors should keep a defensive portfolio stance and be prepared for pullbacks in equities in the single digits. However, the Minutes of the latest FOMC meeting highlight that a fairly low threshold has been set for a December interest rate rise. If financial market participants interpret incoming economic information more bearishly than the Fed, then a December rate hike risks being perceived by investors as a policy mistake. Under this scenario, risk assets could be set for a much greater fall, buoying the case for further portfolio insurance. Which safe havens will outperform? We take our cue from the market reaction to the December, 2015 rate hike. In that episode, equity prices fell 12%. The protector portfolio in its current configuration2 increased 10%. The bulk of the appreciation was due to a strong run in gold prices (surely helped in part by massive woes in China) and TIPS (Chart 6). We believe that this basket of assets would once again offer an important buffer against equity losses associated with a policy mistake. The Most Relevant Safe Haven For A Trump Win If a Trump win triggers a correction in risk assets, we would expect the U.S. dollar to rally due to Trump policy uncertainty and heightened geopolitical risk. We noted above that USD does not always rally when a stress event occurs on U.S. soil. However, in the past several weeks, the performance of the dollar as well as Treasury yields has been linked to Trump's probability of winning the election. Whenever the odds of a Trump presidency rise, these risk-off assets have appreciated. And The Most Relevant Lessons From The Election Cycle This month's Geopolitical Strategy Special Report 3 provides a final forecast and implications for the elections. As we note above, we agree that a Trump win is a red herring in terms of the key issues investors face. But we also agree with our geopolitical strategists that there are several important lessons from the election cycle that may have long term ramifications for investors. Below, we highlight the most relevant for financial market participants: The median voter has moved to the left on economic policy. Trump's victory over an army of seasoned, relatively orthodox GOP contenders in the primary exposed the fact that the party's grassroots voters no longer care deeply about fiscal austerity and no longer wish to tolerate the corporate incentive for importing cheap labor. Similarly, demographic trends favoring millennials and minorities (who tend to vote left on economic policies), portends a shift by which the GOP attempts to capture left-leaning voters. Fiscal conservatism (and social conservatism, for that matter) will have less to show by way of official party machinery. The 2016 election campaign has amplified the notion that the news media works in narratives. These narratives work as a filter that preempts and distorts the presentation and, to some extent, reception of facts. This phenomenon was influential in Trump's rise - the first "Twitter" candidacy - as well as his recent decline. Investors cannot be too wary of what the mainstream press or financial "smart money" says about any particular political trend or event. It is essential to separate the wheat from the chaff by using empirics and looking at macro and structural factors to identify the constraints rather than the preferences of candidates or politicians. U.S. Economy: Neither Hot Nor Cold The NFIB survey of small business survey ranks as one of our preferred indicators of U.S. business confidence. The employment related indicators serve as a key input into our payroll model; questions about the pricing environment often provide a good leading/coincident gauge about inflation trends, and; as Chart 7 shows, the labor cost versus pricing series provides an excellent leading indicator for the profit margin outlook. The latter remains in a downtrend, reinforcing our message that profit margins will remain a headwind to earnings growth for still some time. Overall, small business optimism has been generally flat this year, after peaking in late 2014. It is somewhat discouraging that "demand" as a most important problem is no longer falling. Consumption has been one of the more robust areas of growth in the past several years and we expect consumption to continue to outshine other areas of the economy. However, even here, the data should be monitored closely. Chart 7Small Business Concerns (Part 1) bca.usis_wr_2016_10_17_c7 bca.usis_wr_2016_10_17_c7 Chart 8Small Business Concerns (Part 2) bca.usis_wr_2016_10_17_c8 bca.usis_wr_2016_10_17_c8 Retail sales (excluding gasoline and autos) growth has been slowing throughout 2016 and September data did not buck this trend (Chart 8). Results among retailers varied substantially, with growth strongest at building supply stores, sporting goods stores, vehicle dealers and furniture stores. Laggards include electronics and appliance stores - segments that are still under siege from falling prices. The bottom line is that in aggregate, consumption is holding up reasonably well and should continue to do so, as long as employment gains and modest wage growth remain intact. Stay tuned. Lenka Martinek Vice President, U.S. Investment Strategy lenka@bcaresearch.com 1 Our Geopolitical Strategy service concurs that a Trump win is a red herring, i.e. is unlikely to occur and is a distraction from more relevant issues. For more insight, please see Geopolitical Strategy Monthly Report "King Dollar: The Agent Of Righteous Retribution", dated October, 2016, available at gps.bcaresearch.com 2 At the time, the protector portfolio performed slightly less well, as 30-year government bonds were used instead of TIPS. 3 Please see Geopolitical Strategy Special Report "U.S. Election: Final Forecast & Implications", dated October 12, 2016, available at gps.bcaresearch.com Market Calls

Highlights Recent U.S. economic data have surprised to the upside, raising the odds of a December rate hike. U.S. GDP growth is likely to accelerate further in 2017 on the back of stronger business capex, a turn in the inventory cycle, and a pickup in government spending. Faster wage growth should also support consumption. The real broad trade-weighted dollar will appreciate by 10% over the next 12 months, as the market prices in more Fed tightening. The stronger dollar will pose a headache for U.S. multinationals, as well as emerging markets and commodity producers. However, it will be a boon for Europe and Japan. Global equities are vulnerable to a near-term correction, but the longer-term outlook for developed market stocks outside the U.S. looks reasonably good. Investors should overweight euro area and Japanese equities in currency-hedged terms. Feature Why The Fed Hit The Pause Button When the FOMC decided to hike rates last December, it signaled to investors via its "dot plot" that rates would likely rise four times this year. Ten months later, the fed funds rate remains unchanged. What caused the Fed to stand down? External factors certainly played a role: Fears of a hard landing in China permeated the markets at the start of the year. And just as these worries were beginning to recede, the Brexit vote sent investors into a hurried panic. However, the more important reason for the Fed's decision to hit the pause button is that U.S. domestic activity slowed sharply, with real GDP growing by just 0.9% in Q4 of 2015 and by an average of 1.1% in the first half of 2016. Rays Of Light Fortunately, recent data suggest that the growth drought may be ending (Chart 1): Chart 1Some Bright Spots In the U.S. Data Some Bright Spots In the U.S. Data Some Bright Spots In the U.S. Data The ISM non-manufacturing index jumped 5.7 points in September, the largest monthly increase on record. The ISM manufacturing index also surprised to the upside, with the new orders index jumping six points to 55.1. Factory orders increased by 0.2% in August, against consensus expectations for a modest decline. Initial unemployment claims continue to decline, with the four-week average falling to a 42-year low this week. The Conference's Board's consumer confidence index hit a nine-year high in September. The University of Michigan's index also rose. The key question for investors is whether the recent spate of good data is just noise or the start of a more lasting improvement in underlying demand growth. We think it's the latter. As we expand upon below, the adverse lagged effects on growth from the dollar's appreciation between mid-2014 and early this year should dissipate, pushing aggregate demand higher. Energy sector capex appears to be stabilizing after plunging nearly 70% since its peak in 2014. Stronger wage growth should also keep consumption demand elevated, even as employment growth continues to decelerate. In addition, fiscal policy is likely to loosen somewhat regardless of who wins the presidential election. Lastly, the inventory cycle appears to be turning, following five straight quarters in which falling inventory investment subtracted from growth. To what extent will better U.S. growth translate into a stronger dollar? To answer this question, we proceed in three steps: First, we estimate the magnitude by which U.S. growth will exceed its trend rate if the Fed takes no action to tighten financial conditions. Our answer is "by around one percentage point in 2017," which we think is considerably above market expectations. Second, we assess the degree to which the Fed will need to tighten financial conditions - via higher interest rates and a stronger dollar - in order to keep inflation from significantly overshooting its target. Third, we consider how developments abroad will affect the dollar. Our conclusion is that the real trade-weighted dollar will likely rise by around 10% over the next 12 months. How Quickly Will Aggregate Demand Grow If The Fed Does Not Raise Rates? As detailed below, a bottom-up analysis of the various components of GDP suggests that real GDP growth could reach 2.5% in the second half of 2016 and accelerate to 2.8% in 2017 if financial conditions remain unchanged from current levels. This would represent a significant step up in growth from the average pace of 1.6% experienced between Q1 of 2015 and Q2 of 2016. While growth of 2.8% next year might sound implausibly high, keep in mind that real final sales to private domestic purchasers - the cleanest measure of underlying private-sector demand - has grown by an average of 3% since Q3 of 2014 and increased by 3.2% in Q2 of this year, the last quarter for which data is available. Consumption Assuming that interest rates and the dollar remain unchanged, we project that real personal consumption will grow by an average of 2.7% in Q4 of this year and over the course of 2017. This is equivalent to the average growth rate of real PCE between Q1 of 2015 and Q2 of 2016, but below the 3% pace recorded in the first half of this year. Granted, employment growth is likely to slow over the coming quarters, as labor market slack is absorbed. Nevertheless, real income growth should remain reasonably robust, as real wages accelerate in response to a tighter labor market. A rough rule of thumb is that a 1% increase in real wage growth boosts real household income by the equivalent of 120,000 extra jobs per month over one full year. Thus, it would not take much of a pickup in wage growth to ensure that consumption keeps rising at a fairly solid pace. In fact, one could see a virtuous circle emerging, where accelerating wage growth pushes up consumption, leading to a tighter labor market, and even faster wage growth. At some point the Fed would raise rates by enough to cool the economy, but not before the dollar had moved sharply higher. This may explain why there is such a strikingly strong correlation between the dollar and labor's share of national income (Chart 2). Households may also end up spending a bit more of their incomes. Faster wage growth, rising consumer confidence, continued home price appreciation, and negative real deposit rates have all given households even more incentive to spend freely. While we do not expect the savings rate to fall anywhere close to the rock-bottom levels seen before the financial crisis, even a 0.5 percentage point decline from the current level of 5.7%, spread out over six quarters, would add 0.4% to GDP growth. Residential Investment Real residential investment dropped 7.7% in Q2 after growing by an average of nearly 12% over the preceding six quarters. The Q2 dip was mainly due to the warm winter, which pulled forward home-improvement spending. Housing activity has recovered since then, with new home sales, single-family housing starts, and the NAHB homebuilders index all at or near post-crisis highs (Chart 3). Chart 2The Dollar Is Redistributing Income bca.gis_wr_2016_10_14_c2 bca.gis_wr_2016_10_14_c2 Chart 3U.S. Housing Remains Robust U.S. Housing Remains Robust U.S. Housing Remains Robust The underpinnings for housing continue to look good. The ratio of household debt-to-GDP has declined nearly 20 points from its 2008 high - the lowest figure since 2003 - while the debt- service ratio is back to where it was in the early 1980s (Chart 4). Excess inventories have also been absorbed. The homeowner vacancy rate has fallen to 1.7%, completely reversing the spike experienced during the Great Recession (Chart 5). With household formation picking up and housing starts still 20%-to-25% below most estimates of how much construction is necessary to keep up with population growth, it is likely that housing activity can increase at a reasonably brisk pace over the next two years. We assume that real residential investment will expand by 4% in both Q4 and 2017. Chart 4Household Debt Burdens Have Declined bca.gis_wr_2016_10_14_c4 bca.gis_wr_2016_10_14_c4 Chart 5The Excess Supply In Housing Has Cleared bca.gis_wr_2016_10_14_c5 bca.gis_wr_2016_10_14_c5 Business Capex Growth in business capital spending has been falling since mid-2014 and turned negative on a year-over-year basis in the first quarter of this year. Initially, the deceleration in capital spending was largely confined to the energy sector. Since late last year, however, non-energy capex has also weakened sharply (Chart 6). Chart 6Easing In Energy Sector Retrenchment Better U.S. Economic Data Will Cause The Dollar To Strengthen Better U.S. Economic Data Will Cause The Dollar To Strengthen The recent slowdown in business capex reflects three factors. First, the disaggregated data on corporate investment spending indicate that lower energy prices generated a second-round effect on businesses that are not officially classified as being part of the energy space, but that are nonetheless major suppliers to the sector. Second, the stronger dollar hurt the manufacturing sector more broadly, leading to a lagged decline in capital spending. Third, the backup in corporate borrowing spreads that began in May 2014 and the associated tightening in bank lending standards put further downward pressure on business capex. All three of these headwinds have waned over the past few months (Chart 7). The oil rig count has started to recover, suggesting that energy capex should stabilize and perhaps even improve. The dollar and corporate credit spreads have also come down, while loan growth remains robust (Chart 8). Reflecting these developments, core capital goods orders have risen for the past three months. Corporate capex intentions have also perked up (Chart 9). We project that real business capex will increase by 2.5% in Q4 and 3.5% in 2017 if the dollar and interest rates remain unchanged. Chart 7Borrowing Costs Have Fallen bca.gis_wr_2016_10_14_c7 bca.gis_wr_2016_10_14_c7 Chart 8Solid Loan Growth bca.gis_wr_2016_10_14_c8 bca.gis_wr_2016_10_14_c8 Chart 9Recent Signs Of Improving Corporate Capex Spending Intentions bca.gis_wr_2016_10_14_c9 bca.gis_wr_2016_10_14_c9 Inventories Lower inventory investment shaved 1.2 percentage points off Q2 growth. This marked the fifth consecutive quarter that inventories have been a drag on growth - the first time this has happened since 1956. Real inventory levels fell by $9.5 billion at a seasonally-adjusted annualized pace in the second quarter and are likely to be flat-to-slightly down again in Q3. However, since it is the change in inventory investment that affects growth, this should translate into a modestly positive contribution to Q3 GDP growth. Looking further out, firms are likely to start slowly rebuilding inventories as we head into 2017. The economy wide inventory-to-sales ratio is now back near its trend level (Chart 10). Durable goods inventories excluding the volatile aircraft component rose in the third quarter, as did the inventory component of the ISM manufacturing index (Chart 11). We expect inventory restocking to boost growth by 0.1 percentage points in Q4 and 2017, a big improvement over the drag of -0.6 percentage points between Q2 of 2015 and Q2 of 2016. Chart 10Room To Stock Up Better U.S. Economic Data Will Cause The Dollar To Strengthen Better U.S. Economic Data Will Cause The Dollar To Strengthen Chart 11Inventory Rebuilding Has Commenced Inventory Rebuilding Has Commenced Inventory Rebuilding Has Commenced Government Spending Real government consumption and investment declined by 1.7% in Q2 on the back of lower state and local spending and continued weakness in defense expenditures. The drop at the state and local levels should be reversed, given that tax revenues are trending higher. Federal government spending should also pick up regardless of who wins the presidency. There is now bipartisan support for removing the sequester and increasing infrastructure spending. We are penciling in growth in real government expenditures of 1.5% in Q4 and 2.5% in 2017. Net Exports Net exports shaved 0.8 percentage points off growth in the five quarters spanning Q4 of 2014 to Q4 of 2015. Net exports made a slight positive contribution to growth in the first half of this year. Unfortunately, this was mainly a consequence of sluggish import growth against a backdrop of decelerating domestic demand. Looking out, assuming no change in the dollar index, a rebound in import demand will lead to a modest widening in the trade deficit, which will translate into a 0.2 percentage-point drag from net exports over the remainder of this year and 2017. Putting It All Together The analysis above suggests that the U.S. economy will grow by around 2.5% in Q4 - close to the pace that Q3 growth is currently tracking at - with growth accelerating to 2.8% in 2017. This is a point above the Fed's estimate of long-term real potential GDP growth based on the latest Summary of Economic Projections. How Will The Fed React To Faster Growth? We tend to agree with most FOMC officials who think that the economy is now close to full employment. We also concur that the relationship between inflation and spare capacity is not linear. When spare capacity is high, even large declines in unemployment have little effect on inflation. In contrast, when the labor market becomes quite tight, modest declines in the unemployment rate can cause inflation to rise appreciably. As Chart 12 illustrates, the existence of such a "kinked" Phillips Curve is consistent with the data. Where this publication's view differs with the Fed's is over the question of how much of an inflation overshoot should be tolerated. Considering that the Fed has undershot its inflation target by a cumulative 4% since 2009, a strong case can be made that it should aim for a sizable overshoot in order to bring the price level back to its pre-crisis trend. Most FOMC members do not see it that way, however. This point was reinforced by Chair Yellen at her September press conference when she said that "We don't want the economy to overheat and significantly overshoot our 2 percent inflation objective."1 Chart 13 shows that many measures of core inflation are already above 2%. This suggests that the Fed is unlikely to stand pat if aggregate demand growth looks set to accelerate to nearly 3% next year, as our analysis suggests it will. Chart 12The Phillips Curve Appears To Be Non-Linear Better U.S. Economic Data Will Cause The Dollar To Strengthen Better U.S. Economic Data Will Cause The Dollar To Strengthen Chart 13Some Measures Of U.S. Core Inflation Are Already Above 2% Some Measures Of U.S. Core Inflation Are Already Above 2% Some Measures Of U.S. Core Inflation Are Already Above 2% How high will rates go? This is a tricky question to answer because it requires us to know the value of the so-called neutral rate - the short-term interest rate consistent with full employment. Complicating the matter is the fact that changes in interest rate expectations will affect the value of the dollar, and that changes in the value of the greenback, in turn, will affect the level of the neutral rate. This is because a stronger dollar means a larger trade deficit, which necessitates a lower interest rate to keep the economy at full employment. It is a "joint estimation" problem, as economists call it. One key point to keep in mind is that currencies tend to be more sensitive to changes in interest rate differentials when those differentials are expected to persist for a long time. Chart 14 makes this point using a visual example.2 The implication is that most of the tightening in financial conditions that the Fed will need to engineer is likely to occur through a stronger dollar rather than through higher interest rate expectations. Chart 14The Longer The Interest Rate Gap Persists, The Bigger The Exchange Rate Overshoot Better U.S. Economic Data Will Cause The Dollar To Strengthen Better U.S. Economic Data Will Cause The Dollar To Strengthen A back-of-the-envelope calculation suggests that the level of aggregate demand would exceed the economy's supply-side potential by 2% of GDP by end-2019 in the absence of any effort by the Fed to tighten financial conditions.3 We estimate that in order to keep the output gap at zero, the real trade-weighted dollar would need to appreciate by 10% and the fed funds rate would need to rise to 2% in nominal terms, or 0% in real terms. Despite this month's rally, the real broad trade-weighted dollar is still down more than 2% from its January high. Thus, a 10% appreciation would leave the dollar index less than 8% above where it was earlier this year, and well below past peaks (Chart 15). Chart 15Still Far From Past Peaks Still Far From Past Peaks Still Far From Past Peaks In terms of timing, a reasonable baseline is that the Fed will raise rates in December and twice more in 2017. This would represent a more rapid pace of rate hikes than what is currently discounted by markets, but would only be roughly half as fast as in past tightening cycles. How quickly the dollar strengthens will depend on how fast market expectations about the future path of short-term rates adjust. In past episodes such as the "taper tantrum," they have moved quite rapidly. This suggests that the dollar could also rise at a fairly fast clip. The Impact From Abroad Chart 16A Stronger Dollar Could Push Up EM Spreads A Stronger Dollar Could Push Up EM Spreads A Stronger Dollar Could Push Up EM Spreads Exchange rates are nothing more than relative prices. This means that developments abroad have just as much of an effect on currencies as developments at home. Given the size of the U.S. economy, better U.S. growth would likely benefit the rest of the world. Could this impart a tightening bias on other central banks that cancels out some of the upward pressure on the dollar? For the most part, the answer is no. Both the euro area and Japan have more of a problem with deflation than the U.S. The neutral rate is also lower in both economies. This implies that neither the ECB nor the BoJ are likely to raise rates anytime soon. Thus, to the extent that stronger U.S. growth buoys these economies, this will translate into somewhat higher inflation expectations and thus, lower real rates in the euro area and Japan. This is bearish for their currencies. The possibility that the ECB will start tapering asset purchases next March, as many have speculated, would not alter our bullish view on the dollar to any great degree. Granted, if the ECB did take such a step without introducing any offsetting measures to ease monetary policy, this would cause European bond yields to rise, putting upward pressure on the euro. However, anything that strengthens the euro would weaken the dollar, giving the U.S. a competitive boost. This, in turn, would prompt the Fed to raise rates even more than it otherwise would. The final outcome would be that the dollar would still appreciate, although not quite as much as if the ECB kept its asset purchases unchanged. As far as emerging markets are concerned, a hawkish Fed is generally bad news. Tighter U.S. monetary policy will reduce the pool of global liquidity that has pushed down EM borrowing costs (Chart 16). And given that 80% of EM foreign-currency debt is denominated in dollars, a stronger greenback could cause distress among some over-leveraged borrowers. To make matters worse, a stronger dollar has typically hurt commodities - the lifeblood for many emerging economies. All of this is likely to translate into weaker EM currencies, and hence, a stronger dollar. Investment Conclusions Today's market climate is similar to the one around this time last year. Back then, the Fed was also gearing up to hike rates. Initially, stocks held their ground even as bond yields edged higher. But then, shortly after the Fed raised rates, the floodgates opened and the S&P 500 fell 13% within the course of six weeks (Chart 17). We are nearing such a precipice again. And, in contrast to earlier this year when the 10-year Treasury yield fell by 70 basis points, there is less scope for the bond market to generate an easing in financial conditions in response to plunging equity prices. The 10-year Treasury yield stood at 2.30% on December 29, just before the stock market began to sell off. Today it stands at 1.74%. Investors should position for an equity correction that sends the S&P 500 down 10% from current levels. Looking out, if U.S. growth does begin to accelerate, that should provide some support to stocks. Nevertheless, a stronger dollar and faster wage growth will weigh on corporate earnings, while stretched valuation levels will limit any further expansion in P/E multiples (Chart 18). Investors should underweight U.S. stocks relative to their global peers, at least in local-currency terms. Chart 17Beware Of A Replay Of The Last Correction Beware Of A Replay Of The Last Correction Beware Of A Replay Of The Last Correction Chart 18U.S. P/E Ratios: High, Very High U.S. P/E Ratios: High, Very High U.S. P/E Ratios: High, Very High Turning to bonds, while an equity market correction would not cause Treasurys to rally as much as they did in January, the 10-year yield could still touch 1.5% if risk sentiment were to deteriorate. Once the dust settles, however, bond yields will resume their upward grind. Lastly, a stronger dollar will pose a significant headwind for commodities. That said, as we discussed in last week's Fourth Quarter Strategy Outlook, recent cuts to capital spending are likely to generate supply shortages in some corners of the commodity complex.4 BCA's commodity strategists prefer energy over metals and are particularly bullish on U.S. natural gas heading into 2017. Peter Berezin, Senior Vice President peterb@bcaresearch.com 1 Please see "Transcript of Chair Yellen's Press Conference September 21, 2016," Federal Reserve, September 21, 2016. 2 To understand this concept in words, consider two countries: Country A and Country B. Suppose rates in both countries are initially the same, but that Country A's central bank then proceeds to raise rates by one percentage point and pledges to keep them at this higher level for five years. Why would anyone buy Country B's short-term debt given that Country A's debt yields one percent more? The answer is that people would be indifferent between investing in Country A and Country B if they thought Country A's currency would depreciate by 1% per year over the next five years. To generate the expectation of a depreciation, however, Country A's currency would first have to appreciate by 5%. Now modify the example with the only difference being that Country A's central bank pledges to keep rates higher for ten years, rather than five. For interest rate parity to hold, Country A's currency would now have to overshoot its fair value by 10%. The implication is that the longer interest rates in Country A are expected to exceed those in Country B, the more "expensive" Country A's currency must first become. 3 For the purposes of this calculation, we assume that the output gap this year will be -0.5% of GDP and that aggregate demand growth will exceed potential GDP growth by 1% in both 2017 and 2018, with the gap between demand and supply growth falling to 0.5% in 2019 and stabilizing at zero thereafter. The New York Fed's trade model suggests that a 10% appreciation in the dollar would reduce the level of real GDP by a cumulative 1.2 percentage points over a two-year period. A slightly modified Taylor Rule equation implies that an 80 basis-point increase in interest rates on average across the yield curve would reduce the level of real GDP by 0.8 percentage points after several years. We assume that Fed tightening would lead to a flatter yield curve so that short-term rates rise more than long-term yields. 4 Please see Global Investment Strategy Strategy Outlook, "Fourth Quarter 2016: Supply Constraints Resurface," dated October 7, 2016, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Consumer products stocks are likely to move to an even larger valuation premium before the cyclical outperformance phase ends.