Corporate

Highlights The Beige Book released on January 17 keeps the Fed on track to raise rates at least three times this year and highlights the impact of the tax bill on the economy. BCA's Big 5 Bank Lending Beige Book highlights several of the positive trends supporting our view of the economy, the tax bill and the Fed. The Tax Cut and Jobs Act of 2017 has the potential to generate significant supply-side benefits for consumers, shareholders and the broad economy. We decided to stay long the dollar after a lengthy internal debate, although we have revised down our view on the upside potential. Feature U.S. risk assets continued to outperform last week outside of the dollar, as S&P 500 firms started to report Q4 2017 results and provide guidance for Q1 2018 and beyond. BCA's Bank Lending Beige Book summarizes the most optimistic comments from the Big 5 banks. The Fed's Beige Book captured comments on the broad economy in December and early January that were equally ebullient. Both Beige books suggested that firms were planning to return their tax savings to shareholders in the New Year, and to continue to boost capex, which was stout even before the law was passed. Yet, despite the upbeat news, the dollar broke down last week, as the ECB sounded a hawkish note and the Japanese economy continued to improve. On balance, the Beige Book, the Q4 earnings season, the health of the U.S. economy (notably capital spending), all support BCA's stance on the U.S. stock-to-bond ratio, the Fed, duration and the dollar. However, the dollar has not behaved as we would have expected. Beige Book Barometer Bounces The Beige Book released on January 17 keeps the Fed on track to raise rates at least three times this year and highlights the impact of the tax bill on the economy. BCA's quantitative approach1 to the Beige Book's qualitative data points to underlying strength in GDP and a tighter labor market, but there is still a disconnect between the Beige Book's view of inflation and the market's stance. Moreover, references to the stronger dollar have disappeared from the Beige Book and business uncertainty is significantly reduced, reflecting the tax cut bill and President Trump's assault on regulation. Chart 1Latest Beige Book Supports##BR##The Fed's View On Rates, Economy Chart 1, panel 1 shows that at 66%, BCA's Beige Book Monitor stayed near its cycle highs in January, re-confirmation that the underlying economy was still upbeat in Q4 and early 2018. (The latest Beige Book covered the period from mid-November 2017 to January 8, 2018). The number of 'weak' words in the Beige Book returned to near four-year lows after ticking higher in the wake of last summer's hurricanes. Moreover, there were 12 mentions of the tax bill in the January Beige Book, up from only 3 in November (not shown). The tax bill was cast in a positive light in 75% of the remarks. In November, the references to either the tax bill (or tax reform) cited the consequent uncertainty as a constraint on growth. Based on the minimal references to a robust dollar in the past five Beige Books, the greenback should not be an issue in Q4 2017 or Q1 2018, which is in sharp contrast with 2015 and early 2016 when there was a surge in Beige Book mentions (Chart 1, panel 4). The last time that five consecutive Beige Books had so few remarks about a strong dollar was in late 2014. Business uncertainty over government policy (fiscal, regulatory and health) ticked up in the past few Beige Books as Congress debated the particulars of the tax bill. Nonetheless, comments of uncertainty in the Beige Book have dropped since Trump took office in early 2017. The implication is that the business community is correctly focused on policy and not politics in D.C. (Chart 1, panel 5). The disconnect with the Fed on inflation is evident in the Beige Book's number of inflation words (Chart 1, panel 3). Expressions regarding inflation rose to a four-month high in January and the disconnect persists between the still-elevated mentions of inflation and the soft readings on CPI and PCE. In the past, increased references to inflation have led measured inflation by a few months, suggesting that the CPI and core PCE may soon turn up. Bottom Line: The recent Beige Book backs BCA's view that the U.S. economy is poised to grow above its long-term potential in the first half of 2018. However, the Beige Book has done little to resolve the debate around why an economy growing above potential and a tightening labor market have not boosted inflation. Likewise, the latest Beige Book confirmed that at least initially, businesses and bankers across the U.S. welcomed the Tax Cut and Jobs Act. Bankers' Beige Book Returns Chart 2Banking System Shipshape BCA's Big 5 Bank Lending Beige Book highlights several of the positive trends supporting our view: Pristine credit quality, a positive U.S. credit impulse, loosening U.S. banking regulatory requirements, and pent up demand for shareholder friendly activities. We introduced the Big 5 Bank Lending Beige Book2 in early 2014 to interpret the health of the banking system based on comments from leaders of the Big Five banks during earnings season. Managements were upbeat on loan demand and credit quality as they unveiled Q4 results in the past two weeks, and most expressed optimism that the positive credit trends would continue to improve in 2018. Several bank executives shared their Fed rate hike expectations for this year, with most forecasting three or four increases. One institution planned for a flatter curve, while another noted that rising rates on both the short and long ends will benefit their operations. Chart 2 shows key banking related variables cited in the Bank Lending Beige Book. Appendix Table 1 shows the Big 5 Bank Lending Beige Book for Q4 2017. All five banks were uniformly upbeat in their assessments of the tax bill's impact on their operations, their customers' businesses or the overall economy. One bank noted that it took a repatriation charge in Q4, and another said it would return capital to shareholders via buybacks and dividends. A third said the bill will provide "immediate and ongoing benefit to our employees, customers, communities and our shareholders, as we invest a portion of our tax savings in each of these important constituencies." Bottom Line: The banking system is shipshape as 2018 begins and lenders are ready to extend credit to businesses and consumers to boost the economy despite higher rates. BCA's U.S. Equity strategists recommend an overweight position in the S&P 500's financial sector, with a high conviction overweight on banks.3 A Different Lens On Earnings Chart 3Corporate Health Has Improved##BR##Since Start Of 2017 The early December release of the U.S. flow of funds report allows us to update BCA's Corporate Health Monitor (CHM) (Chart 3). The CHM's level improved slightly between Q2 and Q3, but the overall reading remains in 'deteriorating health' territory. The marginal improvement in Q3 was driven by rising profit margins. In addition, profit growth surged while debt moved up modestly in Q3. The CHM is a reliable indicator of the trend in corporate bond spreads which supports our corporate bond overweight. Given that corporate balance sheets are declining, the sole supports for corporate spreads are low inflation and accommodative monetary policy. We anticipate spreads will start to widen later this year when inflation climbs and policy turns more restrictive. BCA's U.S. Bond strategists remain overweight the U.S. high-yield bond market.4 Although spreads appear a bit more attractive than for investment-grade corporates, there is still not much room for spread compression in high-yields. We calculate that if the high-yield index spread tightens by another 117 bps, then junk bonds will be the most expensive since 1995. In an optimistic scenario where the index spread tightens 100 bps, bringing it close to all-time expensive levels, then we would expect junk excess returns to be in the range of 600 bps (annualized). Nonetheless, in view of the trends in corporate leverage, it is unlikely that there will be another 100 bps of spread tightening. More realistically, we expect excess returns between 200 bps and 500 bps (annualized) between now and the end of the credit cycle. Bottom Line: BCA's indicators suggest that we are moving into the late stages of the credit cycle, but we retain an overweight cyclical stance on corporate bonds. A shift to a more restrictive monetary policy, tightening C&I bank lending standards and/or a continued uptrend in gross corporate leverage are the main catalysts we will monitor to gauge the end of the cycle. An abrupt end to the positive capex or earnings cycle would also be concerns for our upbeat view on credit. Repatriation Redux The Tax Cut and Jobs Act of 2017 has the potential to generate significant supply-side benefits for consumers, shareholders and the broad economy. There are several uses for corporate cash, including capital spending, M&A, increasing compensation to employees, paying down debt and returning capital to shareholders. Chart 4 shows that through Q3 2017, share buybacks and dividends ran slightly ahead of prior cycles, while capex was about average. Investors wonder how that mix may change under the new law. Corporate behavior in the wake of the 2004 overseas tax holiday5 provides some guidance. Chart 4Comparison Of Corporate Outlays Across Four Economic Expansion Phases Corporations used cash generated from the 2004 tax break to return capital to shareholders. However, we found scant evidence that firms who benefited from the tax holiday increased capital spending, raised wages or hired more workers. A study by the National Bureau of Economic Research (NBER) noted that a dollar increase in repatriations "was associated with an increase of almost $1 in payouts to shareholders."6 Moreover, a 2008 IRS paper7 concluded that nearly half of all the cash repatriated in 2004 and 2005 came from only the tech and pharma sectors. A Congressional Research Service (CRS) found that small firms tended to benefit less than large firms from the tax holiday.8 A paper9 by the left-leaning, U.S.-based think tank, the Center For Budget and Policy Priorities (CBPP), stated that several firms that benefitted the most from the 2004 law laid off workers soon after the tax law was enacted. In 2018, BCA expects firms to return capital to shareholders, boost capex and continue to bump up wages. Chart 5 shows that buybacks will probably augment S&P 500 EPS by around 2% this year, while panel 2 shows that there was a noticeable upswing to buyback announcements as 2017 ended. Aside from the post-recession bounce in buybacks in 2010, the last big swell in buyback announcements occurred in 2004 and 2005. That said, corporate balance sheets were in much better shape in 2004/2005 than they are today (Chart 3 again). The implication is that management teams may decide to pay down debt before returning the cash windfall back to shareholders. However, with rates still low, most firms will chose to distribute the cash to shareholders, despite high corporate debt levels. The positive reading on BCA's Capital Structure Preference Indicator supports our stance on buybacks (Chart 6, third panel). This Indicator is defined as the equity risk premium minus the default-adjusted yield in high-yield corporate bonds. When the indicator is above zero, there is financial incentive for firms to issue debt and buy back shares. Conversely, firms are incentivized to issue stock and retire debt when the indicator is below zero. The Indicator is currently positive, although not as high as it was in 2015. Moreover, Chart 7 shows that the dividend payout ratio rebounded from the 2007-2009 financial crisis, but has moved above its pre-crisis level. However, dividend distributions remain below their pre-crisis peak reached in the early 1990s. Chart 5Still Some Room##BR##To Run For Buybacks Chart 6Buybacks Adding Almost##BR##2 Percentage Points To EPS Growth Capital spending was already on a tear in late 2017, even before the tax bill passed. Industrial production, the PMI diffusion index and advanced-economy capital goods imports, all confirm strong underlying momentum in investment spending (Chart 8). Chart 7Corporations Poised To Return##BR##Capital To Shareholders Chart 8Capital Spending Helping##BR##To Drive Growth Both BCA's real and nominal capex models, driven by surging capital goods orders along with elevated ISM data, roaring global exports and soaring sentiment on business spending, indicate strong investment in plant and equipment in the next few quarters (Chart 9). CEO confidence soared to a 13-year high in Q4, according to the latest Duke's Fuqua School of Business/CFO Magazine Global Business Outlook (Chart 10, panel 1). Duke noted that "Among CFOs who responded to the survey after the Senate passed its version of the tax reform bill, optimism spiked to 73, which is the highest U.S. optimism ever recorded in the history of the survey."10 Chart 9Bright Outlook##BR##For Capital Spending Chart 10CEO Confidence And##BR##Capex Plans Surging Surveys by the Conference Board and Business Roundtable show a similar pattern. (panel 1 again). Notably, the soundings on all three surveys have climbed since Trump's election, but then retreated as his pro-business agenda stalled in the summer months. The dip in sentiment reflected the lack of legislative progress in Washington in the first 10 months of the Trump administration. The dip in CEO sentiment in Q2 and Q3 was in sharp contrast to the easing of policy concerns in the Fed's Beige Book (Chart 1, bottom panel). The upbeat numbers in the regional FRBs' surveys of capital spending intentions further support escalating capex spending in the next few quarters. The average readings from the New York, Philadelphia and Richmond Feds' capex survey plans are at an all-time high (Chart 10, panel 2). Moreover, the regional Feds' capex spending plans diffusion index is close to a cycle high, despite a modest pullback last summer (panel 3). Bottom Line: Stay overweight stocks versus bonds, and underweight duration. The tax bill will boost returns to shareholders via buybacks and dividends. In addition, rising capex will drive up GDP, employment and EPS in the coming quarters. Dollar View Revisited The dollar fell by 4% between mid-December and mid-January, amid a hawkish market interpretation of the ECB minutes, persistently strong growth in Japan and a key technical breakdown in the DXY index. The decline has some investors questioning BCA's bullish stance on the currency (Chart 11). We were correct on the direction of interest rate differentials vis-à-vis the other major economies, but this has not translated into a stronger dollar so far. We decided to stay long the dollar after a lengthy internal debate, although we have revised down our view on the upside potential. A lot of good news on the European and Japanese economies is now discounted and investors are quite pessimistic on the dollar (which is bullish the dollar from a contrary perspective) (Chart 12). Given this technical backdrop, we would expect at least a 5% rise in the trade-weighted dollar as expectations of Fed rate hikes rise this year. We are likely to exit our long dollar position if we get such an appreciation. Chart 11We Are Sticking With##BR##Our Long Dollar View Chart 12The Case For Crisis Era Monetary Stimulus##BR##In Europe And Japan Is Weakening Bottom Line: BCA's bullish dollar trade was initiated in October 2014 and although the DXY index is up 4% since that time, we are maintaining the trade. While downside risks remain, a unilateral decision by the Trump Administration to leave NAFTA will boost the U.S. dollar versus the Canadian dollar and the peso. Italy's upcoming spring Presidential election could prompt a rally in the dollar if the Eurosceptic parties outperform expectations. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Great Debate Continues", published on April 17, 2017. Available at usis.bcaresearch.com. 2 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Commitments", published January 20, 2014. Available at usis.bcaresearch.com. 3 Please see BCA Research's U.S. Investment Strategy Weekly Report, "High Conviction Calls", published November 27, 2017. Available at usis.bcaresearch.com. 4 Please see BCA Research's U.S. Bond Strategy Weekly Report, "January Effect", published January 9, 2018. Available at usbs.bcaresearch.com. 5 https://www.congress.gov/bill/108th-congress/house-bill/4520 6 http://www.nber.org/papers/w15023 7 https://www.irs.gov/pub/irs-soi/08codivdeductbul.pdf 8 https://fas.org/sgp/crs/misc/R40178.pdf 9 https://www.cbpp.org/research/tax-holiday-for-overseas-corporate-profits-would-increase-deficits-fail-to-boost-the 10 http://www.cfosurvey.org/2017q4/press-release.html Appendix: Bankers Beige Book

Special Report

Equities have melted up in recent weeks, celebrating the tax bill passage, synchronized upswing in global economic data, still quiescent inflation and near vanishing tail risk. On July 10th when we penned the "SPX 3,000?" report, the S&P 500 was close to 2400.1 Over the past six months stocks have been in an uninterrupted upleg, moving to within 10% of our SPX 3,000 target. Table 1 Stocks have run "too far too fast" for our liking and there are increasing odds of a healthy pullback, especially now that no pundits are talking of a correction. In addition, were the selloff in the bond markets to accelerate in a short time frame, at some point it will cause equity market consternation. But, bonds still remain extremely overvalued versus stocks (Chart 1). Late last year, we began to modestly de-risk the portfolio via booking impressive gains in tactical market-neutral trades, as our upbeat cyclical view remains intact.2 Our cyclical strategy is to "buy the dip", as we do not foresee a recession in the coming 9-12 months. Importantly, profits will dictate the S&P 500's direction and the cyclical path of least resistance is higher still. Our SPX profit model continues to forecast healthy EPS growth in 2018 (Chart 2) and as we posited in the last report of 2017, earnings will do the heavy lifting at the current juncture with the forward P/E multiple likely moving laterally (Chart 3). Chart 1Simple Bond Valuation Metric Says:##br## Bonds Are Overvalued Vs. Stocks Chart 2All ##br##Clear Chart 3EPS Will Do The##br## Heavy Lifting In 2018 A simple decomposition shows that equity returns could reasonably reach a low-to-mid double digit level this year. Our assumptions are the following: nominal GDP can grow near 5% (3% real plus 2% inflation) and thus we estimate organic EPS growth that typically mimics GDP at this stage of the cycle of ~5%, ~2% dividend yield, ~2% buyback yield, ~5% tax related boost to EPS and no multiple expansion. The above assumptions are based on four key drivers: energy and financials will command a larger slice of the earnings pie,3 synchronized global capex upcycle will boost EPS,4 delayed positive translation effects from the U.S. dollar will lift profits5 and easy fiscal policy will also act as a tonic to EPS.6 On this note, this White Paper officially introduces the U.S. Equity Strategy earnings models for the eleven GICS1 equity sectors. We have identified key macro earnings drivers for each sector and incorporated them into individual sector models. The objective is to forecast the direction of earnings growth. Beyond introducing our EPS models, the purpose of this White Paper is to also compare and contrast the cyclical readings of our equity sector models with sell-side analysts' profit growth (Charts 4 & 5) and margin expectations and help clients position portfolios for the rest of 2018. The earnings models carry the most weight in determining our sector positioning, with our macro overlay and our valuation and technical indicators rounding out our methodology. Currently, our earnings models are consistent with maintaining a mostly cyclically biased portfolio structure (top panel, Chart 6), and thus participating in the broad market's overshoot. Chart 4What EPS Are Priced In... Chart 5...Per Sector For 2018 Chart 6Continue To Prefer Cyclicals Over Defensives Encouragingly, an equal weight of the 10 GICS1 sector model outputs (we are excluding real estate due to lack of history), accurately forecasts the S&P 500's profit growth (bottom panel, Chart 6), and currently also confirms the broad market's upbeat four factor macro EPS model (Chart 2). Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Financials (Overweight) Our financials earnings growth model comprises bank credit growth, the U.S. dollar index and net earnings revisions. The U.S. credit impulse is gaining traction, indicating that the market has digested the almost doubling in long-term rates over the past 18 months. Bankers are willing extenders of C&I credit and, with the economy humming north of 3% in real GDP terms, the outlook for loan growth is excellent. Loosening U.S. banking regulatory requirements, and pent up demand for shareholder friendly activities are all welcome news for financials profitability. Tack on BCA's higher interest rate view in 2018 and net interest margins will also get a bump, further adding to the sector's EPS euphoria. Credit quality is the third key profit driver for bank profitability and pristine credit quality is a harbinger of increased profits. The unemployment rate is plumbing generational lows and suggests that non-performing loans as a percentage of total loans will remain on a downward trajectory. Our profit model is expanding at twice the current profit growth rate (second panel, Chart 7) and 10 percentage points above the Street's 12-month forward estimates (top panel, Chart 5). In fact, the latter have gone vertical of late playing catch up to our model's estimates. The S&P financials sector remains a core portfolio overweight and we reiterate our high-conviction overweight status in the heavyweight S&P banks index. Chart 7Financials (Overweight) Energy (Overweight) The three drivers behind the S&P energy sector EPS growth model are oil-related currencies, the U.S. oil & gas rig count and WTI crude oil prices. A depreciating greenback, whittling down OECD oil stocks and rising global oil demand are all boosting energy profitability. OPEC 2.0 cutbacks have not only helped stabilize oil markets, but also paved the way for a breakout in oil prices above the $62.50/bbl stiff resistance level. Sustained OPEC output restraint will counterbalance U.S. shale oil production increases and coupled with rising global demand likely continue to underpin oil prices. Our synchronized global capex upcycle theme included the basic resources following a multi-year drubbing in outlays. Energy capex cannot contract at double digit rates indefinitely. Already a V-shaped capex momentum recovery is in store, as 2018 capital spending budgets are on track to at least match 2017. Our EPS growth model (second panel, Chart 8) matches sell-side analyst optimism (third panel, Chart 5). Keep in mind that only recently did the energy space become profit positive, making a solid recovery from an extremely low base. Margins are only now renormalizing above the zero line and breakneck pace EPS growth should continue in 2018. Following a negative 2017 return, the S&P energy sector is the best performing sector year-to-date, and we reiterate the high-conviction overweight stance. Chart 8Energy (Overweight) Industrials (Overweight) Our S&P industrials EPS model comprises the ISM manufacturing survey, raw industrials commodity prices and interest rates. It has an excellent track record in forecasting industrials EPS momentum, and sports one of the highest explanatory powers amongst all sector EPS models. While industrials EPS growth has been bouncing off the zero line for the better part of the past five years, our profit model has spoken: forecast EPS are in a V-shaped recovery since the end of the recent manufacturing recession (second panel, Chart 9). Commodity prices are recovering and increasing final demand, coupled with a soft U.S. dollar suggest that more gains are in store. Tack on the global virtuous capex upcycle, and the stars are aligned for this deep cyclical sector to break out of its multi-year trading range funk on the back of a surge in profits. China is a wild card, but signs of stability are enough to sustain the upward trajectory in the commodity-levered complex, including industrials stocks. Our industrials sector EPS model suggests that industrials profits will easily surpass the low (and below the overall market) analysts' EPS growth hurdle (third panel, Chart 4). The late-cyclical S&P industrials sector remains an overweight. Chart 9Industrials (Overweight) Consumer Staples (Overweight) The S&P consumer staples EPS growth model key drivers are: food exports, non-discretionary retail sales and analysts' net earnings revision ratio. Overall industry exports are expanding at a healthy clip as a consequence of a softening U.S. dollar and robust European and rebounding emerging markets demand. Deflating raw food commodity prices are offsetting rising energy and labor input costs, heralding a sideways move to margins. Sell side analysts are also currently penciling in a lateral profit margin move (middle panel, Chart 10). Our model is expanding at a near double digit rate, and is in line with 12-month forward EPS growth estimates (second panel, Chart 4). Investors have been vehemently avoiding staples stocks during the board market's uninterrupted run up, and have put out positioning offside. However, in the context of our cyclical over defensive portfolio bent we refrain from putting all our eggs in one basket, and prefer to keep consumer staples as our sole defensive sector overweight. This small hedge will serve our portfolio well if we do indeed get a healthy Q1/2018 pullback, as we expect. Chart 10Consumer Staples (Overweight) Consumer Discretionary (Neutral - Downgrade Alert) Measures of consumer confidence, consumer discretionary exports and the net earnings revisions ratio comprise BCA's global consumer discretionary EPS growth model, which has an excellent track record in forecasting the path of consumer discretionary profits. Consumer confidence is rolling over, albeit from a nose-bleed level, signaling that, at the margin, discretionary consumer outlays will remain tame. Worrisomely, rising interest rates coupled with a breakout in crude oil prices are net negatives for consumer spending. Our consumer drag indicator captures these consumer headwinds and warns that the sector is not out of the woods yet (bottom panel, Chart 11). The Fed is on track to raise rate three more times in 2018 and continue to mop up liquidity via renormalizing its balance sheet. This dual tightening backdrop bodes ill for early cyclical discretionary stocks as we highlighted in the September 25th Weekly Report. Our consumer discretionary EPS growth model is making an effort to bounce, signaling that contracting earnings will likely reverse course and come out of their recent funk (second panel). But, analysts are overly optimistic penciling in a near double-digit profit growth backdrop for the consumer discretionary sector (fourth panel, Chart 5). Netting it all out, the anemic message from our profit model along with the ongoing Fed tightening cycle and spiking energy prices warrant a downgrade alert. Stay tuned. Chart 11Consumer Discretionary (Neutral-Downgrade Alert) Telecom Services (Neutral) Telecom pricing power and capital expenditures expectations comprise our S&P telecom services EPS growth model. Telecom capital expenditures have bounced off the zero line and are growing at 4% per annum while sector sales growth has been nil. This capital-intensive industry must continually invest to stay relevant. A push by telecom carriers into TV offerings as part of a quad-play (internet, wireline, wireless and TV) has rekindled an M&A boom, and capex is slated to increase. However, margins will suffer if increased investment fails to translate into new sales (bottom panel, Chart 12). Steeply contracting pricing power is a bad omen both for top and bottom line growth prospects (fourth panel). Hopefully, industry consolidation will lead to a better pricing backdrop, but the jury is still out. Our EPS model has sunk into the contraction zone (second panel). Analysts are a little bit more sanguine, penciling in low single-digit profit growth (bottom panel, Chart 4). Industry deflation is not alone as a headwind as the bond market selloff is weighing on the high dividend yielding telecom services stocks. Despite all the bearish news, near all-time lows in relative valuation and washed out technicals are keeping us on the sidelines. Chart 12Telecom Services (Neutral) Materials (Neutral) Materials EPS growth is a far cry from the near 100% year-over-year mark hit during the commodity super-cycle the mid-2000s and the reflex rebound following the Great Recession (second panel, Chart 13). Our S&P materials EPS model inputs include the U.S. currency, metals commodity prices and a measure of borrowing costs. The model has been steadily decelerating recently, and moving in the opposite direction compared with sell-side analysts' optimistic estimates (bottom panel, Chart 5). Consequently, there is scope for downward revisions. Materials stocks are reflationary beneficiaries and also high fixed cost high operating leverage deep cyclicals that benefit most during the later stages of the business cycle when a virtuous capex/EPS upcycle takes root. A number of both developed and developing central banks have recently embarked on tightening monetary policy following in the Fed's footsteps. Global liquidity is on the verge of getting mopped up as even the ECB and the BoJ have started to hint that they would remove some of their ultra-accommodative and unconventional policy measures. These opposing forces keep us at bay and we continue to recommend a benchmark allocation in the S&P materials index. Chart 13Materials (Neutral) Real Estate (Neutral) Commercial real estate loan demand, a labor market measure and the EUR/USD comprise our S&P real estate profit growth model (second panel, Chart 14). The 10-year Treasury yield and real estate relative performance have been nearly perfectly inversely correlated since the GFC as REITs sport a hefty dividend yield and thus are considered a fixed income proxy. BCA's higher interest rate 2018 theme suggests that more downside looms for this rate-sensitive sector. Similarly, a firming EUR/USD reflecting the nearly 100% domestic exposure of the sector weighs on real estate relative performance. Our EPS model has recently sunk into the contraction zone and is in sync with sell-side analysts' negative profit growth figures for calendar 2018 (second panel, Chart 5). While all this signals that an underweight stance is appropriate, we would rather stay on the sidelines for three reasons: First, sector pricing power (mostly rents) has not eroded yet, despite the surge in multi-family housing construction. Second, most of the bad news is likely already discounted in sinking valuations and extremely oversold technicals. Finally, we would rather concentrate our interest rate related underweight in the pure play fixed income proxy, the utilities sector (please see page 15). Stick with a benchmark allocation in the S&P real estate index. Chart 14Real Estate (Neutral) Health Care (Underweight) Our S&P health care EPS growth model consists of health care pricing power, labor costs and a measure of health care outlays. Health care demand is fairly inelastic, signaling that health care spending prospects remain upbeat, especially given the aging population. However, the industry's up-to-recently structurally robust pricing power backdrop is under intense scrutiny. Medical commodity cost inflation is melting and drug pricing power has nearly halved since early 2016. Democrats and Republicans alike, despise the pharmaceutical/biotech industry's pricing tactics and drug price containment is on nearly every legislator's agenda. Add on the generic drug inroads, and Big Pharma/biotech resilient profits appear vulnerable, weighing heavily on the sector's relative performance. From a secular perspective, there is scope for health care sector profit gains. Developing countries are only just starting to institute social "safety nets" that the developed world already has in place. Our profit model is decelerating (second panel, Chart 15) and forecasting single digit EPS growth, in line with the Street's 12-month forward profit estimates (fourth panel, Chart 4). The S&P health care sector is a core underweight portfolio holding and we reiterate the high-conviction underweight status in the heavy weight S&P pharma sub index. Chart 15Health Care (Underweight) Utilities (Underweight) Utilities pricing power, the yield curve and analysts' net earnings revisions are the key inputs in our S&P utilities EPS growth model (second panel, Chart 16). While natgas prices, the industry's marginal price setter, have been stuck in a trading range between $2.6 and $3.4/mmbtu over the past 18 months, they are currently contracting and weighing heavily on industry pricing power. The U.S. economy is firing on all cylinders (bottom panel, Chart 16) and a selloff in the 10-year Treasury market near 3% is BCA's base-case scenario for 2018. Under such a backdrop, fixed income proxied defensive equities lose their luster, and thus utilities stocks will likely remain under intense downward pressure, Our S&P utilities EPS growth model is expanding at a mid-single digit growth rate, broadly in line with sell-side analysts' forecasts (fifth panel, Chart 4) and roughly 700bps below the broad market. The S&P utilities sector is a high-conviction underweight. Chart 16Utilities (Underweight) Technology (Underweight - Upgrade Alert) Our three-factor global technology EPS growth model includes capex intentions, the trade-weighted U.S. dollar and sell-side analysts' net earnings revision ratio. While the tech sector is still largely considered a deep cyclical, we view it as more defensive. The majority of large capitalization tech companies are mature, cash rich, cash flow generating, dividend paying and high margin. Tech firms thrive in a deflationary backdrop as business models have been built to withstand the inherently disinflationary "creative destruction" process. BCA's interest rate view calls for an inflationary driven sell off in bonds for 2018, suggesting that investors avoid high-flying tech stocks. Weakness in basic resources explains most of the delta in cyclical capital outlays. Encouragingly, technology's share of the U.S. capex pie is making inroads rising to roughly 10% (bottom panel, Chart 17). Tech investment has been so abysmal for so long that it is hard to get any worse. In fact, it has started to improve both on an absolute and relative basis, as pent-up tech demand is being unleashed. Our synchronized global capex upcycle theme is gaining traction and the tech sector will continue to make gains at the expense of resource-related spending. Our global tech EPS model is forecasting modest double-digit growth in the coming quarters (second panel, Chart 17), largely aligned with sell-side analysts' profit growth expectations (fifth panel, Chart 5). On balance, we are putting the S&P tech sector on upgrade alert reflecting the capex tailwind offsetting the rising interest rate backdrop, and reiterate our capex-related high-conviction overweight in the S&P software sub-index. Chart 17Technology (Underweight-Upgrade Alert) 1 Please see BCA U.S. Equity Strategy Weekly Report, "SPX 3,000?," dated July 10, 2017, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "EPS And "Nothing Else Matters"," dated December 18, 2017, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Dissecting Profit Composition," dated July 24, 2017, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Weekly Report, "Invincible," dated November 6, 2017, available at uses.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Weekly Report, "Dollar The Great Reflator," dated September 18, 2017, available at uses.bcaresearch.com. 6 Please see BCA U.S. Equity Strategy Weekly Report, "Can Easy Fiscal Offset Tighter Monetary Policy?," dated October 9, 2017, available at uses.bcaresearch.com.

Highlights The consensus expects a 12% year-over-year increase in EPS in Q4 2017 versus Q4 2016, and 14% for 2018. The repercussions of the tax bill on operating conditions in 2018 will be a focus for corporate management teams and investors when discussing Q4 2017 results. The December readings on retail sales and CPI bolster the Fed's case for a rate hike in March. We expect a smooth transition in February for incoming FOMC Chair Powell, which will ensure a gradual normalization of monetary policy. However, Federal Reserve Board (FRB) vacancies, hawk/dove shifts and dissents are concerns. Feature U.S. equities continued their winning streak last week, as investors marked up expectations for both global growth and 2018 S&P 500 profits. The next section of this report offers a preview of the Q4 2017 earning season. There was even a hint of inflation in the air, as December's core CPI rose a stronger than expected 1.8% year-over-year. The overflow of Fed speakers did little to change the market's view that the next rate hike will occur at the March meeting. We discuss the composition of the FOMC in the final section of this week's report. The 10-year Treasury yield moved nearly 10 bps higher, ending the week at 2.56%. BCA's U.S. Bond Strategists put the 10-year fair value at 2.94%.1 Moreover, the 2-year Treasury yield touched 2% last Friday for the first time since 2008. S&P 500 Earnings: Q4 2017 The consensus expects a 12% year-over-year increase in EPS in Q4 2017 versus Q4 2016, and 15% for 2018. Energy, materials and technology shares will lead the way in earnings growth, while telecom and real estate earnings will languish. Excluding the energy sector, the consensus expects Q4 2017 EPS to rise by 10% year-over-year. The upbeat profit picture for the past quarter and 2018 reflects the rebound in oil prices, which are expected to boost energy sector EPS by an impressive 138% in Q4 (Chart 1). Energy-related capex and overall S&P 500 earnings are closely linked (Chart 1, panel 2). An improving global growth environment and still muted labor costs continued to drive a counter-cyclical rally in profit margins in Q4 and in early 2018. Moreover, the direct effect of the Tax Cut and Jobs Act of 2017, enacted late last year, will likely boost U.S. real GDP growth in 2018 by 0.2 to 0.3 percentage points. Hurricane reconstruction spending and a likely congressional agreement to raise the cap on federal discretionary spending could add another 0.2 points to the growth figure this year. However, much depends on the ability of tax changes and immediate capital expensing to further lift animal spirits in the business sector and bring forward investment spending. The repercussions of the tax bill on operating conditions in 2018 will be a focus for corporate management teams and investors when discussing Q4 2017 results. Specifically, corporations' use of cash via the benefit of lower tax rates and repatriating cash from overseas will be at the forefront. Chart 2 shows that through Q3 2017, share buybacks and dividends ran slightly ahead of prior cycles, while capex was about average. BCA will continue to monitor this mix. Improving economic conditions in Europe and the emerging markets (EM), the U.S. dollar, the sustainability of margins, and the aftermath of Hurricanes Harvey and Irma, all will likely be closely vetted during Q&A conference calls. Chart 1S&P 500 Sensitive To Oil Prices##BR##And Oil Driven Capex Chart 2Comparison Of Corporate Outlays##BR##Across Four Economic Expansion Phases Analysts may also fix their attention on rising interest rates and the shape of the yield curve. On January 12 the 10-year Treasury yield hit its highest point since March, reaching 2.56%. Moreover, in Q4 2017 the 10-year yield was 16 bps above Q3 2017 and 26 above Q4 2016. BCA expects the 2/10 yield curve to steepen in the next six months before flattening in the final half of the year. The curve and rising rates provide a boost to the financial sector of the S&P 500. BCA's U.S. Equity Strategy team remains overweight the Financials sector since May 2017.2 As always, guidance from corporate leaders on trends in Q1 2018 and beyond are more important than the actual Q4 results (Chart 3). Investors should guard against management over-optimism because earnings growth forecasts very often move lower over time. In Q4, as in the first three quarters of 2017, firms with elevated overseas sales should benefit from the improved growth profile in Europe, Japan and the EM. Chart 4 shows that the lofty ISM figures provide a favorable backdrop for earnings and sales in 2018. Moreover, Chart 5 indicates that industrial production (IP), a proxy for S&P 500 sales, is poised to advance in 2018 and lift corporate profits. Global GDP growth projections for this year and next have steadily perked up, in sharp contrast with prior years when forecasters relentlessly lowered GDP estimates (Chart 6). Chart 32018 Estimates Turned Higher After Tax Law Passed; '19 Likely To Move Lower Chart 4Favorable Macro Backdrop For Earnings And Sales In addition, BCA's U.S. Equity Strategy service notes3 that following a trough in 2015, the number of positive revenue revisions has steadily outpaced the number of positive earnings revisions, despite actual earnings growth vastly outpacing revenue growth. One plausible reason for the recent very positive revenue revisions is that firms are shifting some profits from 2017 into 2018 to capture the maximum benefit from tax reform. Chart 5ISM Components Suggest IP##BR##Poised To Accelerate Chart 6Global Growth Estimates##BR##Still Accelerating The U.S. dollar, which has been only a small drag on EPS in recent quarters, should become a modest plus in Q4; the dollar is down by 3% versus a year ago against a broad basket of currencies. Moreover, in the most recent Beige Book (November 29), mentions of a "strong dollar" declined by 8 compared with a year ago. This indicates that the stronger currency has faded as a primary concern of managements in recent months (Chart 7). Nonetheless, BCA's view is that the dollar will advance by 5% in the next 12 months. The appreciation would trim EPS growth by roughly 1 to 2 percentage points, although most of this would occur next year due to lagged effects. Another increase in the dollar, on its own, should not provide a substantial headwind for the stock market. Indeed, the dollar would only climb in the context of robust U.S. economic growth and an expanding corporate top line. Legislative progress on an infrastructure package in the U.S. and an improvement in U.S. business capital spending would boost the greenback's prospects. The effects of this past fall's major hurricanes on Q4 results will be muted for the S&P 500 and most sectors. Several weather-sensitive industries (insurance, airlines, chemicals, refining, leisure, etc.) saw significant disruptions to their Q3 results. These industries will probably see some snapback in their Q4 results. Investors are skeptical that margins can advance in Q4 2017 for the sixth consecutive quarter. BCA's view is that we are in a temporary sweet spot for margins, which should continue for the next couple of quarters, but the secular mean reversion of margins will resume beyond that time as wage pressures begin to percolate. The bottom line is that we expect the earnings backdrop will be supportive of equity prices in 2017Q4 and early in 2018. Beyond that, EPS growth will begin to decelerate in the second half of 2018 and will become more of a headwind for stock prices as we enter 2019 (Chart 8). Stay overweight stocks versus bonds. Chart 7The Dollar Should Not Be##BR##A Factor In Q4 Earnings Season Chart 8Strong S&P Growth Ahead,##BR##Will Start To Slow Soon Fed Leadership Transition: Smooth Sailing Ahead? Chart 9December's CPI Data Will Be Met##BR##With A Sigh Of Relief From The Fed Following a disappointing 0.1% m/m increase in November, core CPI posted a 0.3% m/m rebound in December (Chart 9). While welcomed news, there are a few counterpoints to note. First, the gain was concentrated in two subcomponents: housing and medical care. Shelter accounts for over 40% of core CPI and our models are pointing to a moderation ahead. Second, core services (ex-shelter and medical care) inflation remains anemic at sub-2% and core goods prices are still deflating. Third, annual core inflation is running at just 1.8%. Core CPI inflation of 2.4-2.5% is consistent with the Fed's 2% target for the core PCE deflator. December's retail sales report added to the upbeat tone of the economy as 2018 ended. The Atlanta Fed's GDPNow reading for Q4 2017 stood at 3.3% on January 12, up from 2.7% on January 5. U.S. inflation should gradually revert to target by year-end. In U.S. fixed income portfolios, investors should maintain below-benchmark duration and overweight TIPS versus nominal Treasuries. Rising inflation breakevens will also exert a steeping bias to the yield curve. The bounce in core CPI is certainly encouraging, but the Fed needs to see further firm prints to gain greater confidence that inflation is indeed heading back to target. With two more CPI reports ahead of the March FOMC meeting, the Fed may have the evidence it needs by then to hike rates again. We expect a smooth transition in February for incoming FOMC Chair Powell, which will ensure a gradual normalization of monetary policy. Powell will not want to create waves as the FOMC nudges the Fed funds rate closer to its projected terminal point of 2.75%.4 There are several reasons for our unequivocal view that there will be a smooth transition in FOMC leadership: Fed Chair Precedents: In previous FOMC leadership transitions, the monetary policy path remained continuous, on average about 13 months, before changing direction (Chart 10). For example, former Chair Bernanke continued to hike rates four more times after Greenspan retired (February 2006), with the tightening cycle peaking in June 2006. Yellen maintained a steady zero-interest rate policy (ZIRP) for almost two years following the departure of Bernanke in early 2014. Greenspan retained the tightening policy path initiated by Volcker, although it was temporarily interrupted to avert a credit crunch after the 1987 stock market crash. Thereafter, Chair Greenspan resumed hiking rates for a little more than one year. Chair Powell, known as a conforming centrist, will certainly follow the lead of his predecessors. U.S. monetary policy will remain unchanged from former Chair Yellen, unless there is an unforeseen shock to global growth or a sharp deviation from the expected path for inflation. Chart 10Fed Chair Precedents: Continuous Monetary Policy Path FOMC Composition Changes: Each year ushers in a different set of voters on the FOMC linked to the rotation of regional FRB presidents. More uncertainty has been created this year with the departures of several regional presidents and vacancies on the Board of Governors. The composition of voting FOMC members will be slightly more hawkish for 2018 relative to 2017 (Chart 11). The continuity and efficacy of monetary policy will be further promoted as the path for more rate hikes (at least two) are already discounted by forward markets and three more rate increases are expected in 2018. FRB Minneapolis President Kashkari and FRB Chicago President Evans depart this year as non-voting members. Kashkari is considered the most dovish; he will return as a voter in 2020 while Evans will come back in 2019. Chart 11Composition Of Voting FOMC Members 2017 Vs. 2018 In contrast, the arrival of FRB Presidents Mester (Cleveland), Williams (San Francisco) and Barkin (Richmond) tip the scale somewhat towards tighter policy. Most importantly, FRB's New York Dudley, a centrist, will leave about five months after Yellen's term expires next month. Board Governor Lael Brainard, an Obama-era appointee, will remain as the most dovish voter of the two existing doves in the mix. The FOMC's hawkish bias will no longer be a matter of perception but rather a matter of reality. The nomination of Marvin Goodfriend by President Trump to the Fed's Board should move matters towards neutrality (Goodfriend is not a definite hawk as he also cautious about fighting deflation) and ensure that the Fed operates with at least four governors in 2018. Goodfriend's successful confirmation would leave only three Board vacancies: the Vice-Chair and two governors. On the margin, the voting members of the FOMC skew more hawkish in 2018, but history suggests that new Fed Chairs favor gradual transitions over sudden shifts in policy. FRB Vacancies: The three outstanding Board vacancies should not prevent the smooth transition of leadership from Yellen to Powell next month. In recent years, the duration of FRB vacancies has been longer when compared with prior years. According to a recent report by the Bipartisan Policy Center,5 lengthy vacancies are most evident at the Fed among 13 independent financial regulatory agencies. From 1986 to the present, the 67% vacancy rate at the Fed was more than triple the percentage of 21% from 1947 to 1986 (Chart 12). The Center also calculated that since January 1, 2000, there has been at least one Federal Reserve Board vacancy more than 80% of the time, emphasizing that a "full Fed Board is as rare as a vacancy used to be." While the FOMC had a full Board most of the time (79%) from 1947 to 1986, in the past 30 years this occurred only one-third of the time (33%) (Chart 13). Therefore, even the structural shift in the FOMC's composition did not deter or unhinge the lift-off from a zero interest-rate policy in December 2015 (the first rate hike since June 2006) and the eventual debut of the Fed's balance sheet normalization last September. The implication for investors is that the FOMC has been operating in an era of a higher vacancy rate for some time, and therefore used to operating that way, and the vacancies should not play a major role in the Fed's policy path this year or in the transition from Yellen to Powell. Chart 12Vacancies Are Now The Norm Chart 13More Than One Vacancy Is Not Uncommon Too FOMC Dissents: Even with less than a full slate of governors on the Fed's Board, there has not been governor dissent since 2005 (Chart 14) We expect a somewhat similar frequency of dissents as in previous cycles. In 2017, all four dissents were registered by regional Fed presidents. Chair Yellen never expressed discord when she was a member of the Board of Governors nor when she was President of the FRB San Francisco. Notably, incoming Chair Powell has not dissented since joining the Board in 2012. Moreover, any opposition declared by Board members was usually for easier policy (78% for easier policy and 28% for tighter policy). For example, in the fall of 2015, prior to the first rate hike of the cycle, two dovish Fed governors opposed Chair Yellen. Governors Brainard and Tarullo wanted to delay boosting rates into 2016 because they believed that inflation was still too low. They contended that a "wait-and-see" approach was less risky than acting prematurely, arguing that the risks to global growth and U.S. inflation remained to the downside. One reason for this disagreement came from differing views on market-based inflation expectations. Given the tight link with oil prices, market-based, long-term inflation expectations had melted. Similarly in 2017, FRB Minneapolis President Kashkari and FRB Chicago President Evans disagreed, also citing inflation concerns. They made the case that the persistence of low inflation may not be entirely due to "transitory factors" as the FOMC Committee claimed. Chart 14Dissent By Reserve Bank Presidents And Fed Governors Bottom Line: The path of the economy and inflation, and not the composition of the Fed, will have the most significant impact on Fed policy in 2018. There was some support at the December 2017 FOMC meeting to study the use of inflation and/or nominal GDP targeting as policy framework, but the Fed will remain committed to its current policies. Meanwhile, incoming Chairman Powell will probably maintain the same gradual approach towards rate increases as his predecessor, even though there is a slightly more hawkish tilt to the makeup of the FOMC's voting members. The Board's vacancies at the start of 2018 are a risk, but past vacancies have not led to drastic policy changes. BCA expects three or four rate gains this year, but it is still too early to decrease risk in portfolios. Remain overweight equities relative to bonds. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com 1 Please see BCA Research's U.S. Bond Strategy Weekly Report "January Effect," published January 9, 2018. Available at usbs.bcaresearch.com. 2 Please see BCA Research's U.S. Equity Strategy Weekly Report "Girding For A Breakout," published on May 1, 2017. Available at uses.bcaresearch.com. 3 Please see BCA Research's U.S. Equity Strategy Insight "What's Up With SPX Revenue Vs. Profit Revisions," published on January 12, 2018. Available at uses.bcaresearch.com. 4 https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20171213.pdf 5 "Financial Regulators Struggling With Longer Vacancies At The Top", Schardin, Justin and Sheth, Ashmi, Bipartisan Policy Center, March 2017.

Highlights The November jobs report keeps the Fed on track. Despite rising government debt levels, crowding out is not a significant threat. Capex as a share of GDP rises the year before a tax cut and falls in the year after. Holiday spending on track, boosted by tax bill. Feature Last week, investors assessed the ramifications of the OPEC meeting and the Senate's passage of the tax plan. The dollar was noticeably higher, and oil moved lower during the week, but other financial markets ended little changed. Chart 1 shows that the Trump trades are making a comeback, providing ample opportunity for investors who may have missed the trade the first time around. In this week's report, we examine the impact of the tax bill on the debt, deficit, and capital spending and more importantly on corporate balance sheets and financial markets. BCA's view is that the risk that rising government debt levels will crowd out private borrowing is low and that the tax cut will provide a tiny boost to an already robust capital spending environment. We also examine what signal the equity markets are sending about household spending in the holiday season. Chart 1Markets Responding To GOP Tax Plan Living In Paradise The November employment report, released last Friday, paints a Goldilocks-type macro environment for U.S. assets. Strong economic growth, muted inflation, and a go-slow Fed should prolong the bull market in U.S. equities. The economy added 228K in net new jobs, and the unemployment rate held steady at 4.1% in November. With the average work week rising by 0.1 hours, aggregate hours worked rose by a solid 0.5% m/m. Even if hours worked hold flat in December, the average for Q4 will be up 2.6% at an annualized rate from Q3. The November payroll data are easily consistent with about 3.5% GDP growth in Q4. BCA expects above-potential real GDP growth to persist well into 2018. Despite the strong growth and tight labor market, wage pressures remain contained. Average hourly earnings rose just 0.2% m/m in November, which followed a downwardly revised 0.1% m/m decline last month. Annual wage inflation is running at 2.5% (Chart 2). Last week's report will not dissuade the Fed from raising rates again next week. As long as GDP growth remains above trend and the labor market is tightening, the Fed will remain somewhat confident that wages will accelerate and inflation will gradually return to the target level. However, there is no reason yet for the Fed to turn more aggressive for fear of falling behind the curve. Chart 2November Jobs Report Keeps Fed On Track It's Getting Mighty Crowded The recently passed U.S. Senate tax reform bill has to be reconciled with the House bill, but it appears that the Republicans may meet their Christmas deadline after all. BCA's Geopolitical Strategy service has consistently expected a tax package to pass by the end of Q1 2018 at the latest.1 Although some technical differences between the two versions remain, the two bills are close enough that compromise should not be difficult. The Republicans are under pressure to deliver a "win" ahead of the 2018 mid-term elections. Most of the tax adjustments will occur early next year, except for a reduction in the corporate tax rate that may be delayed until 2019. The Senate version, if passed, would decrease individual taxes by about $680 billion over 10 years, trim small business taxes by just under $400 billion, and reduce corporate taxes by roughly the same amount (including the offsetting tax on currently untaxed foreign profits). The direct effect of all the tax cuts will probably boost real GDP growth in 2018 by 0.2 to 0.3 percentage points. However, much depends on the ability of the tax changes and immediate capital expensing to lift animal spirits in the business sector and bring forward investment spending. The total impact - at this stage - is difficult to estimate. According to the Joint Committee on Taxation (JCT), by the end of 2027 the legislation will add $1 trillion to the debt, including the effects of dynamic scoring. Without the boost from faster economic activity due to the tax changes, the deficit is expected to be $1.4 trillion higher than the CBO's baseline projection for 2027. While nominal economic growth would increase under the plan, the debt-to-GDP ratio would climb to 95% of GDP by 2027, up from 91% under current law (Chart 3). Chart 3Federal Debt As A Share Of GDP Set To Rise Sharply In Coming Decades So far, the Treasury market has shown little reaction to the passage of the Senate bill. Fixed-income investors do not appear to be overly concerned about the implications of the size of the public debt and do not believe that the tax changes alter the Fed's calculations. BCA is also not concerned about the size of public debt in the near term but thinks the tax changes will alter the Fed's forecasts. Nonetheless, more government red ink is likely to raise equilibrium bond yields in the long term. The Fed estimates that the equilibrium 10-year bond yield would rise on a structural basis by 3-4 basis points for each percentage point increase in the Federal government's debt-to-GDP ratio, and by 25 basis points for every percentage point increase in the deficit-to-GDP ratio.2 The implication is that if the GOP plan becomes law, then the 10-year yield will be 12-16 bps higher than under current legislation. Nonetheless, there is only a modest risk that mounting U.S. government debt will crowd out private borrowing and choke off investment on a 12-month horizon. Crowding out occurs when soaring government debt sparks competition between the public and private sectors for available savings. Increased demand for private credit, a narrowing output gap, and elevated interest payments as a percentage of GDP, are all preconditions for crowding out. While the output gap has closed, demand for private credit is mixed, at best, and federal interest payments will remain in check. Private credit demand has rebounded from the recession, but it is still tepid. At 2% of corporate sales, nonfinancial corporate borrowing is at the lower end of its post-crisis range and has downshifted since 2015 (Chart 4). Before the 2007-2009 financial crisis, there was a tight relationship between corporate demand for funds and Treasury yields. Since 2009, the link has weakened; credit demand snapped back, but Treasury yields stayed low. Soft C&I loan demand also indicates less of a risk for crowding out (panel 3). Interest payments on the Federal debt are expected to climb, but remain well below all-time highs set in the early 1990s (Chart 5). The CBO's baseline projects that interest payments on the debt as a share of nominal GDP will more than double from 1.4% in 2017 to 2.9% in 2027. These payments will triple in absolute terms from $300 billion in 2017 to more than $800 billion in 2027. The GOP tax plan will boost the 2027 projection, but the CBO has not yet released a new estimate. In a study prepared prior to the passage of the tax bill, the OECD forecast that the federal government's interest payments would climb to 2.9% by 2019. Chart 4Private Credit Demand Has Rebounded,##BR##But Remains Tepid Chart 5Gradual Rise in Net Interest Payments##BR##Not A Crowding Out Threat Moreover, the Tax Policy Center, a center-left think tank, also concluded that interest costs will move up under the new tax law.3 On balance, interest payments on federal debt obligations as a share of the economy are expected to escalate in the next 10 years to 2.5-3%. This reading is in line with the average in the past 20 years, but is still below the 4-4.5% average reached in the late 1980s and early 1990s, and the 3.5-4% range observed from 1970-2000. If nothing else changes, higher federal interest payments would absorb funds that could instead be used for areas that add to the productive capacity of the economy, such as education, training and technical innovation. That said, the impact on long-term growth from "crowding out" may only represent a partial offset to the supply-side benefits of the fiscal package to the extent that the business sector lifts capex spending as a result of a lower corporate tax rate and immediate expensing (see below). Bottom Line: Tax cuts are bond bearish but support our overweight stance on equities on the surface. The effective corporate tax rate could decline by about two percentage points, which would boost after-tax cash flows by roughly 2½%. While this is not trivial, much of the good news already appears to be discounted in the S&P 500. Moreover, to the extent that faster growth in 2018 may bring forward hikes in the Fed funds rate, the equity market will have to contend with rising bond yields next year. Investors are also wondering about the tax plan's potential impact on capital spending and corporate balance sheets. Tiny Steps As discussed above, the fiscal package has the potential to generate significant supply side benefits, to the extent that the business sector turns on the capex taps. The JCT estimates that the tax bill will boost U.S. capital stock by 1.1% in 2027, an increase of about 0.1% a year. However, it is uncertain if corporations will permanently boost capex due to increased allowances for capital spending or if the tax shift will merely bring forward future spending. BCA's view is closer to the latter. We expect higher budget and trade deficits in the coming decade as a result of the Senate plan. These deficits will limit the ability of domestic saving to fund needed capital spending projects. Foreign saving will fill the gap. U.S. domestic saving is below the low end its 1960-2008 range (Chart 6). Chart 7 shows that since 1960, there have been four distinct periods of expanding net saving by foreigners. Nominal 10-year Treasury yields rose in three of the four intervals. However, real yields declined in the 1960s, rose in the mid-1970s and early 1980s as foreign saving increased, and then fell in the 1990s and 2000s. Moreover, a rise in the share of foreign saving led to higher capex in the mid-1960s and 1980s, but lower business expenditures in the 1990s (Chart 8). Chart 6Foreigners Will Finance Capex As##BR##Domestic Saving Declines Chart 7Interest Rates As##BR##Foreign Saving Rises Setting aside who will finance the spending, history suggests that business capital spending tends to climb faster in the 12 months prior to a period of rising fiscal thrust than it does in the 12 months following (Chart 9 and Tables 1 and 2). Note that our analysis shows that recessions occurred in five of the seven episodes of pro-cyclical fiscal policy. Chart 8Capex And Rising Foreign Saving Chart 9Capex During Periods Of Fiscal Stimulus In addition, as fiscal thrust escalates, stocks in the industrial and technology sectors underperform the broad market. Small caps generally beat large caps. Since 2000, the fed funds rate fell during periods of fiscal stimulus. Prior to that, the Fed both eased and tightened policy during these episodes (not shown). Table 1Business Spending 12 Months Before Pro-Cyclical Fiscal Policy Table 2Capex In The Year After Stimulative Fiscal Policy Is Enacted BCA's Corporate Health Monitor (CHM) has a tendency to improve during phases of increased fiscal thrust; Chart 10 shows that the CHM improved in five of the seven periods. Free cash flow and return on capital are the best performers during these intervals. In contrast, corporate leverage is apt to shoot up as fiscal policy takes hold. Chart 10Stimulative Fiscal Policy And The Corporate Health Monitor Our fiscal thrust measure includes both personal and corporate tax cuts, and along with increases in government spending. We use fiscal thrust as a proxy because there are a very limited number (just 3 since 1970) of corporate tax cuts to analyze. The paragraphs below covers the impact of corporate tax cuts on capital spending, capital spending-related financial metrics and corporate balance sheets. Capital spending is inclined to rise faster in the 12 months before a corporate tax cut than in the year afterward. The caveat is that there have been only 3 corporate tax cuts in the past 50 years. Charts 11 and 12 and Tables 3 and 4 examine the impact of previous corporate tax reductions on nonresidential fixed investment (and its components) as a share of GDP and on several capex-related metrics in the financial market. Chart 11Corporate Tax Cuts And Capital Spending Chart 12Corporate Tax Cuts And Financial Markets Moreover, industrial stocks underperform the broad market after a tax cut, while tech stocks outperform (Chart 12 again). Small-cap performance is mixed. Both the Fed funds rate and the 10-year Treasury yield rise after corporate tax decreases take effect. Table 3Capex The Year Before A Corporate Tax Cut Table 4Capex In The Year After A Corporate Tax Cut Corporate health weakens in the year before a business tax cut is enacted, but then it improves modestly in the ensuing year. Chart 13 and Tables 5 and 6 examine the significance of previous corporate tax cuts on BCA's Corporate Health Monitor (CHM) and several of its components. The interest coverage ratio deteriorates, on average, both before and after a corporate tax reduction, but leverage increases substantially in the 12 months following a corporate tax cut. Free cash flow deteriorates in the year prior to a drop in the business tax rate, but is little changed in the subsequent year. Chart 12Corporate Tax Cuts And Financial Markets Chart 13Corporate Tax Cuts And The Corporate Health Monitor Bottom Line: Business capital spending was already on the upswing and the output gap was already closed before the tax cut was passed. Accelerated depreciation allowance may pull capex ahead, but not materially change its trajectory over the long term. Corporate tax cuts and fiscal stimulus, in general, boost capex and corporate health, and support BCA's view that credit will outperform Treasuries in 2018. Table 5BCA's Corporate Health Monitor A Year Before A Corporate Tax Cut... Table 6...And In The 12 Months After Boxing Day The critical holiday spending season is in full bloom. Holiday retail sales make up the bulk of total consumer spending, representing about 20% to 30% of total annual retail sales (and about 40% of total personal consumption expenditures). Moreover, according to the National Retail Federation (NRF), although 54% of consumers surveyed expect to spend the same amount in this year's holiday season as in 2016, 24% are prepared to spend more. The NRF forecasts that holiday sales will increase between 3.6% and 4.0%, exceeding last year's 3.6% rate and the 5-year average forecast of 3.5%. Holiday retail sales have faded in nominal and real terms from an average of 4.9% in the 1993-1999 period to 3.7% pre-2008 (2000-2007) and to an average of 3.3% post-2008 GFC (2009-2016). However, the baseline trend, based on average annual growth rates, remains stable at 3%, with upside potential of as much as 6% during robust economic growth phases(mid 2000s) and downside risk to as low as -4% in recessions (2008) (Chart 14). Chart 14Holiday Sales: Strong Tailwinds Intact Holiday sales this season may just get an unexpected boost from stout consumer finances. The implication is that U.S. economic growth should remain above potential well into 2018. Solid consumer balance sheets remain a tailwind even at this late stage of the business cycle. Household balance sheets have been repaired in an optimal way and household net worth continues to soar to new highs. The implication is that households are much less likely to forego holiday spending this season than in periods where household net worth is under downward pressure. Furthermore, stock market returns for the U.S. consumer discretionary sector, measured between the mid-September to mid-December period, are well correlated with holiday spending trends (Chart 15). The 8.6% rise in the consumer discretionary sector since mid-September heralds another healthy holiday spending season. However, global consumer discretionary retailers are a better predictor of holiday sales than domestic consumer discretionary retailers. Prices here are up 6.6% since mid-September. Chart 15Trends Of Holiday Sales And Equity Returns Furthermore, expectations of tax reform legislation becoming law by the end of the year will incentivize low income households to spend more this holiday season. This cohort is apt to pay for holiday purchases with cash. The NRF has likened the benefit of the tax plan to a "free Christmas".4 The NRF suggests that the cumulative savings from the tax package for an average household will offset the $967.13 projected to be spent this year by the average household in the holiday season. Moreover, a 2016 Fed study finds that the financing for holiday spending varies by income. Low income households have a tendency to source holiday spending from savings/income rather than borrowing, and if access to credit is not readily available, they simply will not spend on holiday shopping.5 To ensure that a majority of U.S. households contribute towards a robust holiday spending season, strong employment growth alongside stable wage growth (and higher real income expectations) and sturdy consumer confidence is required. With an already tight labor market and the underemployment rate (U-6) close to pre-recession lows, solid consumer fundamentals remain intact. Bottom Line: A robust holiday shopping season is likely in 2017, supported by stout consumer balance sheets, the new tax bill, and rising wages and incomes. The 8.6% run up in consumer discretionary stocks also suggests that a happy holiday for retailers is in prospect. BCA's U.S. Equity Strategy service has a neutral rating on the Consumer Discretionary sector, but recommends an overweight the advertising, home improvement retail and leisure products industry groups. Additionally, BCA maintains an overweight to the holiday-sensitive Air Freight and logistics industry within the Industrial sector.6 Strong personal spending will support above potential GDP growth in Q4 and into 2018, eliminate the output gap, push the unemployment rate further below NAIRU and push up inflation and ultimately bond yields. Stay short duration. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com 1 Please see BCA Research's Geopolitical Strategy Weekly Report, "Xi Jinping: Chairman Of Everything," October 25, 2017. Available at gps.bcaresearch.com. 2 "New Evidence on the Interest Rate Effects of Budget Deficits and Debt", Thomas Laubach, Board of Governors of the Federal Reserve System, May 2003. https://www.federalreserve.gov/pubs/feds/2003/200312/200312pap.pdf 3 http://www.taxpolicycenter.org/sites/default/files/publication/148841/2001606-macroeconomic-analysis-of-the-tax-cuts-and-jobs-act-as-passed-by-the-house-of-representatives_1.pdf 4 https://nrf.com/media/press-releases/retailers-say-senate-passage-of-tax-reform-could-give-shoppers-free-christmas 5 https://www.federalreserve.gov/econresdata/notes/feds-notes/2016/holiday-spending-and-financing-decisions-in-2015-survey-of-household-economics-and-decisionmaking-20161201.html 6 https://uses.bcaresearch.com/trades/recommendations

Special Report

Highlights Junk & The Yield Curve: The flat yield curve increases the risk of a sell-off in junk bonds. The most likely scenario is that higher inflation steepens the curve and mitigates this risk, but if inflation fails to respond then spreads will probably gap wider in the near-term. Ultimately, this would be a buying opportunity and not the end of the cycle. Junk & Corporate Health: Net debt-to-EBITDA should move lower during the next few quarters, driven by strong profit growth, but this is already in the price. Further increases in net debt-to-EBITDA would bring the end of the credit cycle closer, and this measure bears close monitoring. Junk & Fund Flows: Outflows from open-ended bond funds - especially those that invest in illiquid securities - can exacerbate periods of spread widening much in the same way as the use of leverage. Feature Anxiety in appropriate intensity makes humans intelligent - Anna Freud The remarkable run of junk bond outperformance suffered a setback last week, and it is very likely that excess returns will be negative in November for only the fourth month since spreads peaked in February 2016 (Chart 1). Chart 1A Buying Opportunity? We are inclined to view the recent price action as a temporary blip, and continue to believe that higher inflation and a more restrictive central bank reaction function are pre-conditions for a sustained period of spread widening.1 Nonetheless, if inflation trends higher as we expect, our pre-conditions for the end of the credit cycle could be in place by the middle of next year. In other words, we are much closer to the end of the credit cycle than the beginning and investors should be constantly re-assessing the risk/reward trade-off of staying invested. To aid in this process, this week we consider five reasons why investors might be nervous about their high-yield allocations and discuss how to think about each reason in the context of making a portfolio allocation decision. Reason 1: Spreads Are Tight Undoubtedly, the number one reason most people fret about high-yield bond performance is that valuation is extremely stretched. Even after last week's sell-off the average option-adjusted spread on the junk index is still 362 basis points, only 38 bps above the mid-2014 cycle lows (Chart 2). A more refined valuation measure, the 12-month breakeven spread for each credit tier, paints a similar picture.2 Chart 3 shows that valuation has been more expensive for Ba-rated securities only 23% of the time. B-rated securities have been more expensive only 39% of the time, and Caa-rated securities only 44% of the time. Chart 2Bouncing Off The Lows Chart 3Junk Bond Valuation Further, we calculate that if Ba-rated spreads tighten another 97 bps they will reach all-time expensive levels. This represents only 3 months of average spread tightening. The same calculation shows that B-rated spreads can tighten another 179 bps (4 months of average tightening) and Caa-rated spreads can tighten another 378 bps (5 months of average tightening). The message is quite clear. Spreads are close to all-time expensive levels and it would be unwise to hinge an investment decision on the expectation of significant capital gains. Junk is a carry trade at this point in the cycle, and the important question is how much longer we can pick up the carry before a sustained period of spread widening takes hold. However, we must also remember that valuation is not a market timing tool. Spreads can stay at low levels for extended periods, especially in the late stages of the credit cycle. Valuation is only important because it allows us to formulate expected return projections, and lower expected returns make the prospect of trying to time the exact end of the credit cycle less appealing. With that in mind, our base case scenario assumes that default losses will total 1.02% during the next 12 months. This means we should expect excess returns of 260 bps in a scenario where spreads remain flat. Even if spreads tighten another 100 bps from current levels high-yield excess returns will only reach 651 bps. That would represent a very optimistic scenario for junk returns. More realistically investors should expect excess returns between 200 bps and 500 bps (annualized) between now and the end of the credit cycle. Reason 2: The Yield Curve Is Flat The relentless flattening of the yield curve also presents a risk for junk bonds because it is a signal that monetary policy is becoming too restrictive. Restrictive monetary policy, along with deteriorating corporate health and tightening bank lending standards, is one of our three main credit cycle indicators (Chart 4). Typically we need a signal from all three of our indicators before a bear market in junk bonds kicks in. We already see such a signal from deteriorating corporate health, but accommodative Fed policy and easing bank lending standards continue to support spreads. Chart 4Credit Cycle Indicators That being said, during the past nine months the combination of disappointing inflation and two Fed rate hikes has caused the 2/10 Treasury slope to flatten all the way down to 62 bps. An inverted yield curve is a signal that the credit cycle is over and a slope of 62 bps is close enough to zero that market participants are jittery. We think a slope at these levels makes a near-term sell off in junk bonds more likely because investors will be inclined to view any negative news as a signal that the credit cycle is about to turn. They would be less inclined to do so if the curve was steeper. While such a flat yield curve poses a near-term risk to spreads, we have argued forcefully in recent reports that it will soon steepen.3 The most likely scenario is that inflation will start to trend higher, and this will steepen the curve while still allowing the Fed to deliver a pace of rate hikes close to its median projection. But even in a scenario where inflation fails to rise, we would still expect the curve to steepen as the Fed capitulates on its projected rate hike path. The key risk for junk spreads is a scenario where inflation fails to rise but the Fed does not react and instead continues to lift rates. This scenario would certainly lead to a risk-off episode in credit markets. At that point, however, the Fed would take note of the tightening in financial conditions and adopt a more dovish policy stance to support the recovery. In other words, while the Fed might be slow to renege on its rate hike projections in the face of low inflation, it has a strong track record of responding to shifts in financial conditions. This is because the Fed rightly understands that financial conditions lead GDP growth (Chart 5), and above-trend growth must be maintained in order for inflation to move back to target. Chart 5Financial Conditions Lead Growth Bottom Line: The flat yield curve increases the risk of a sell-off in junk bonds. The most likely scenario is that higher inflation steepens the curve and mitigates this risk, but if inflation fails to respond then spreads will probably gap wider in the near-term. Ultimately, this would be a buying opportunity and not the end of the cycle. Reason 3: Corporate Health Is Weak As was noted in the prior section, corporate balance sheet health is weak but this is only one of the three conditions that need to be met before defaults start to pick up and spreads start to widen. We also need to see more restrictive monetary policy and banks that are less inclined to extend credit. But it is also logical that weaker balance sheets should cause investors to demand greater compensation to hold high-yield bonds, and in general we do observe a strong correlation between junk spreads and net debt-to-EBITDA for the non-financial corporate sector as a whole (Chart 6). Worryingly, spreads have diverged from this measure since early 2016, but net debt-to-EBITDA did tick lower in Q2 and we anticipate further improvement in the coming quarters as the outlook for profit growth appears strong.4 It is important to note that any future improvement in net debt-to-EBITDA is already priced in, but further deterioration would speed up the time until the end of the credit cycle. That is, if the measure of net debt-to-EBITDA shown in the top panel of Chart 6 moves higher in the coming quarters then we will have to be quicker to shift to an underweight stance on high-yield (and investment grade) corporate bonds at the first sign of inflation. The other important issue related to corporate health is that we have seen a great deal of bond issuance during the past few years, but almost none of that issuance has been required to finance capital investment. Chart 7 shows that the financing gap - firms' capital expenditures less retained earnings - has only recently turned positive. It follows that the proceeds from most of this cycle's bond issuance must have been returned to shareholders in the form of stock buybacks. Chart 6Leverage Bears Monitoring Chart 7Less Equity, More Debt This observation does not help us figure out when the credit cycle will end, but if corporate capital structures have less of an equity cushion then it should lead to lower recovery rates when corporate defaults finally start to occur. In the bottom two panels of Chart 7 we show aggregated bottom-up data from a sample of junk rated non-financial firms. We see that the debt-to-equity ratio of the median company in the sample is much higher than during the last recession, but at similar levels to what was seen during the 2001 recession. The bottom panel of Chart 7 shows the percent of firms in our sample with a debt-to-equity ratio above 300%, and it sends a similar message. Bottom Line: Net debt-to-EBITDA should move lower during the next few quarters, driven by strong profit growth, but this is already in the price. Further increases in net debt-to-EBITDA would bring the end of the credit cycle closer, and this measure bears close monitoring. Additionally, corporate capital structures have less of an equity cushion than during the last recession but look similar to the late 1990s/early 2000s. This has more of a bearing on recovery rates during the next downturn than on the timing of the turn in the credit cycle. Reason 4: Volatility Is Low VIX and junk spreads are practically tied at the hip (Chart 8), that much is well known. The question is whether the very low reading from the VIX poses an additional risk to junk bonds beyond what is already reflected in tight spreads. For the most part we think that it does not. The low VIX appears to be driven by the same factors that cause junk spreads to tighten - stronger corporate balance sheets, accommodative monetary policy and easing bank lending standards (Chart 9). Chart 8VIX Also At Cycle Lows Chart 9VIX Fair Value Is Biased Higher There is one possible exception and that relates to leverage in the banking system. It has been shown that financial intermediaries manage their Value-at-Risk (VaR) so that the ratio of VaR-to-equity is stable. Since lower volatility leads to a lower calculated VaR, it suggests that banks can take on more leverage and still keep their ratio of VaR-to-equity stable.5 If low volatility mechanically leads to higher banking sector leverage, then that presents the additional risk that banks will face greater losses when spreads eventually widen. This would cause lending standards to tighten even more quickly, and exacerbate the spread widening. So while low volatility could potentially lead to a wider end-point for junk spreads once the cycle turns, it does not help us determine when that widening will occur. Also, stricter post-crisis bank capital regulations may have mitigated this risk to a certain extent, though it is difficult to know until the default cycle actually takes hold. Reason 5: Open-Ended Fund Flows Another risk that has been flagged by many investors is the ever-growing presence of open-ended mutual funds and ETFs in the corporate bond market. According to second quarter Flow of Funds data, 19% of corporate and foreign bonds were held in mutual funds or ETFs (Chart 10). This is a big change from past cycles. In a speech from 2014, then Fed Governor Jeremy Stein elucidated why this might pose a risk:6 When investor i exits [the fund] on day t, does the net asset value at the end of the day that defines investor i's exit price fully reflect the ultimate price effect of the sales created by his exit? If not, those investors who stay behind are hurt, which is what creates run incentives. And, if run incentives are strong enough, then a credit-oriented bond fund starts looking pretty bank-like. The fact that its liabilities are not technically debt claims is not all that helpful in this case - they are still demandable, and hence investors can pull out very rapidly if the terms of exit create a penalty for being last out the door. Essentially, outflows from open-ended bond funds - especially those that invest in illiquid securities - can exacerbate periods of spread widening much in the same way as the use of leverage. If fund outflows drive a gap between the price of the fund and its net asset value, then investors may be incentivized to quickly exit the fund before the gap widens even further. And in fact, even since the beginning of 2016 we have seen that periods of junk spread widening have coincided on occasion with a gap opening up between the price of the popular SPDR junk ETF and its net asset value (Chart 11). So far the effect has not been dramatic, but potentially the shock has simply not yet been large enough for the dynamic described by Stein to play out more fully. Chart 10Growing Fund Presence In Corporate Bond Market Chart 11A Run On Bond Funds? Much like with the risk from low volatility, the large presence of open-ended funds in the corporate bond market does not help us determine when the credit cycle is about to end. However, it does potentially increase the risk that once spreads start to widen they will widen much further than they would have otherwise. Investment Recommendations We continue to hold the view that we must first see stronger inflation and a more restrictive monetary policy before the credit cycle can end. We are therefore inclined to remain overweight high-yield bonds and would view last week's spread widening as a buying opportunity. That being said, if inflation starts to trend higher as we expect, then the credit cycle could come to an end as early as the middle of next year. Our first signal will be when long-maturity TIPS breakeven inflation rates return to the 2.4% to 2.5% range that has historically been consistent with inflation anchored around the Fed's target. In the meantime, the flat yield curve increases the risk of near-term spread widening. We think this risk will be mitigated as higher inflation steepens the curve, but until then investors should be on guard. Ultimately, any spread widening that occurs before inflationary pressures are more pronounced will be a buying opportunity, not the end of the credit cycle. Additionally, net debt-to-EBITDA must continue to trend lower as profit growth recovers. If it fails to do so then we will be quicker to adopt an underweight allocation to junk. Investors should also be mindful of the potential risks posed by low volatility and the large presence of open-ended funds in the corporate bond market. Both of those factors could exacerbate any spread widening once the credit cycle turns, though they do not help us determine when that turn will occur. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended," dated June 27, 2017, available at usbs.bcaresearch.com 2 Looking at each credit tier individually controls for the changing average credit rating of the overall index. The 12-month breakeven spread is used in place of the option-adjusted spread to control for the changing duration of each index. 3 Please see U.S. Bond Strategy Weekly Report, "The Fed Will Fall Behind The Curve," dated October 24 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Won't Back Down," dated September 26, 2017, available at usbs.bcaresearch.com 5 Tobias Adrian and Hyun Song Shin, "Procyclical Leverage and Value-at-Risk," Federal Reserve Bank of New York Staff Report No. 338. July 2008. 6 https://www.federalreserve.gov/newsevents/speech/stein20140228a.htm

Highlights Global credit markets have endured a surprising bit of turbulence over the past month. Credit spreads in a variety of markets, from U.S. High-Yield (HY) to Euro Area Investment Grade (IG) to Emerging Markets (EM) corporate debt, have widened for the first time since August. Outflows from dedicated corporate bond funds helped fuel the sell-off, with a reported $6.8 billion pulled from U.S. high-yield mutual funds and ETFs over the past week according to Reuters.1 Feature This volatility in credit markets spooked other asset classes last week, triggering a few days of equity market weakness. That is no surprise given the reliable and well-known leading relationship between corporate bond spreads and equity values. For markets that are priced for perfection, with tight credit spreads and elevated equity market valuations at a time when global central banks are inching towards a less accommodative policy stance, it may not take much to prompt some nervous selling by investors. Was this risk-off move justified by any renewed deterioration in credit fundamentals? Or was it just a correction in a market that was very overdue for one? To try and answer this, we think this is an ideal time to present an update of our Corporate Health Monitor (CHM) Chartbook. Chart 1Credit Markets Priced For Perfection Our CHMs are composite indicators of balance sheet and income statement ratios designed to assess the financial well-being of the overall non-financial corporate sectors in the U.S., Europe and Emerging Markets (EM). We have developed both top-down (based on profit data from national income/GDP accounts) and bottom-up (based on actual reported financial data of individual companies) versions of the CHM. While there are differences in methodology between the two measures due to data availability and coverage (see Appendix 1 on Page 13 for details), we have found that both are useful in providing a more complete and comprehensive assessment of the state of corporate finances. The broad conclusion from the latest readings on our Developed Markets CHMs paint a mixed picture (Chart 1): Medium-term credit quality in the U.S. continues to deteriorate, especially for high-yield borrowers, although there has been some cyclical improvement on the back of the solid cyclical performance of U.S. profit growth. Euro Area corporate health remains in good shape, supported in no small part by the hyper-accommodative policy stance of the European Central Bank (ECB) that includes corporate bond purchases. Although returns on capital remain poor and leverage has increased in the Peripheral economies. U.K. corporates are enjoying very strong liquidity positions that are boosting overall credit quality despite mediocre underlying earnings performance. With the global economy enjoying a coordinated cyclical upturn that is supporting solid earnings growth, combined with global monetary policy settings that still accommodative, corporate health is not the primary driver of credit market returns at the moment. Yet if the BCA view on global growth, inflation and interest rates plays out in 2018 - all moving higher, especially in the U.S. - then the story is likely to change. Investors who have been piling into credit because of low risk-free interest rates (and spillovers from global central bank asset purchases) will begin to worry more about credit fundamentals than simply chasing higher yields, to the detriment of credit market performance. U.S. Corporate Health Monitors: Still Deteriorating Our top-down CHM for the U.S. has now been in the "deteriorating health" region for thirteen consecutive quarters dating back to the middle of 2014 (Chart 2). The current U.S. economic expansion has boosted corporate earnings growth on a cyclical basis. This has only acted to slow the modest decline in top-down profit margins, and much larger fall in return on capital, since the peak in both ratios three years ago. The reading on the latter from the 2nd quarter of 2017 (the last data available) is only 6%, not far from the lows seen during the past two recessions. The low return on capital during the current cycle is a disturbing development, as it suggests that there has is a surplus of capital on U.S. balance sheets that is largely unproductive and not boosting profits (the numerator in the ratio). This can also be seen in the run-up in corporate borrowing in recent years that has been used strictly to do share buy-backs. If the best investment idea that a company can have is to take on debt to repurchase its own stock, rather than borrow to invest in its own business, then the internal rate of return on that investment (i.e. the return on capital) must indeed be quite low, which is a longer-term problem for corporate health. Short-term liquidity remains in good shape for U.S. companies, but interest coverage remains near the low end of the historical range of this ratio. This combination suggests that U.S. companies are not facing an imminent cash crunch that could raise downgrade/default risk, but there is less room for error than in years when interest coverage was at higher levels. This can also be seen in the bottom-up versions of the U.S. CHMs for IG corporates (Chart 3) and HY companies (Chart 4). Interest coverage is at historically depressed levels for the U.S. HY names in our indicator, and has fallen back to just slightly above the levels seen prior to the 2009 recession. Leverage levels are much higher in HY - around 180% debt/equity (at book value) compared to around 100% for IG - with profit margins that are ½ as wide as those of the IG names in our CHM universe. Thus, it is no surprise to see a far worse interest coverage ratio within our HY CHM where most components are near historically "bad" levels for credit quality. Chart 2Top-Down U.S. CHM:##BR##Still Deteriorating Chart 3Bottom-Up U.S. Investment Grade CHM:##BR##Still Deteriorating What is rather worrying is the fact that U.S. IG interest coverage has fallen in recent years, despite high profit margins and historically low corporate borrowing rates. This suggests that the stock of debt has now grown so much after the rapid run-up in leverage (i.e. record bond issuance) that the interest expense required to service that debt is eating up a greater share of corporate earnings, even at a time when profit growth is robust. This will raise downgrade risk if corporate borrowing rates were to rise significantly or the U.S. experiences a major economic downturn, as interest costs would rise while earnings deteriorate. Given our views on the likelihood of additional Fed rate hikes and higher Treasury yields in 2018, with even a possibility of a Fed-induced recession in 2019 if policy is tightened too aggressively to combat rising inflation, the risks to U.S. corporate debt performance (both IG and HY) will grow over the course of next year. For now, we are still recommending playing the growth phase of the business cycle by staying overweight U.S. corporate debt within global fixed income portfolios (Chart 5). The time to scale back positions will come after there is more decisive evidence that rising realized inflation is boosting inflation expectations, which will give the Fed confidence to tighten policy more aggressively. This will dampen future corporate profit expectations and likely raise risk premiums on U.S. corporate bonds. Chart 4Bottom-Up U.S. High-Yield CHM:##BR##Modest Cyclical Improvement, From Very Bad Levels Chart 5Credit Rally##BR##Losing Momentum? One final point on the U.S. CHMs - in this version of the CHM Chartbook, we are adding some additional charts showing the bottom-up CHMs for some selected corporate bond sectors. These can be found in Appendix 2 on Page 13. We are only showing the charts this time, but we do plan on doing deeper dives on some individual sectors in future Weekly Reports and CHM Chartbooks. Euro Area CHMs: Still O.K., But With Some Mixed Signals Our top-down Euro Area CHM remains in "improving health" territory as it has for the entire period since the Global Financial Crisis. The direction is turning a bit more worrisome, though, as the indicator is now the closest it's been to the zero line since 2013 (Chart 6). By construction, the CHM shows deviations of the indicator from recent trends, in order to more quickly capture turning points in credit quality. Looked in that light, the steady worsening of the top-down CHM is a function of recent declines in profit margins, return on capital and debt coverage. This is offsetting the high and rising levels of short-term liquidity levels and interest coverage. The latter two points are directly related to the easy money policies of the ECB. The combination of zero (and even negative) short-term interest rates, specific liquidity programs aimed to prompt low-cost bank lending, and outright ECB asset purchases of Euro Area corporate debt have all helped drive borrowing rates to record low levels. Perhaps surprisingly, the low return on capital in the Euro Area, around 8%, is still above the return on capital from the U.S. top-down CHM of 6%. This is also confirmed by the bottom-up versions of the Euro Area CHMs for IG corporates (Chart 7) and HY corporates (Chart 8). Return on capital for Euro Area IG issuers (both domestic issuers and foreign issuers in the European bond market) is between 8-10%, a healthy number by any measure and similar to the level in the bottom-up U.S. IG CHM. Even Euro Area HY shows a return on capital of 4-6%, similar to that of U.S. HY. Chart 6Top-Down Euro Area CHM:##BR##Trending In A Bad Direction Chart 7Bottom-Up Euro Area##BR##Investment Grade CHMs: Improving Within the countries of the Euro Area, our bottom-up CHMs show that the credit metrics look better for the Core versus the Periphery (Chart 9). The biggest difference comes from a cyclical improvement in profit margins and interest coverage in the Core that is not being matched in the Periphery. Chart 8Bottom-Up Euro Area##BR##High-Yield CHMs: Looking Much Better Chart 9Bottom-Up Euro Area##BR##IG CHMs: Core Vs. Periphery More broadly, European corporate health seems to be improving when looking at our bottom-up CHMs. This goes against the trend we are seeing in the top-down CHM, although the latter is still in the "improving health" zone. Declining leverage, especially among the HY issuers in our bottom-up universe, appears to be the biggest source of the HY CHM improvement - again, a bit of a surprising result given how low the cost of debt finance currently is in Europe. Looking ahead, the outlook for Euro Area corporate credit looks positive in the near term, but murkier after that. The current powerful cyclical upturn in the European economy is likely to continue in 2018, as is the ECB's highly accommodative monetary policy. But at some point in the middle of next year, the ECB will be having the same discussion with the markets that was conducted over the past few months, regarding the future of the central bank's asset purchase program. This time, we think the growth and inflation data will give the ECB no choice but to announce a full tapering of its bond-buying program by the end of 2018. Interest rate hikes will come after that, but with a lag of at least one full year. European government bond yields will rise as the ECB eventually stops its asset purchases and the market pulls forward the timing of the next ECB rate hiking cycle. This also applies to corporate debt, where the ECB has become a massive buyer over the past three years. As the pace of ECB buying diminishes, Euro Area corporate bond yields should begin to rise and credit spreads will widen (Chart 10). The underlying improvements in our bottom-up Euro Area CHMs suggests that the repricing of European credit post-ECB tapering may be relatively contained. We still prefer to own U.S. corporate credit over Euro Area equivalents at this time, though. The gap between our top-down CHMs for the U.S. and Europe has proven to be an excellent directional indicator for the relative performance of U.S. credit vs. Europe (Chart 11). That CHM gap continues to favor U.S. credit, although of late only U.S. IG corporates have outperformed Euro Area corporates. European HY has been outperforming in 2018 (in excess return terms), which may be a sign that investors are seeing the better European credit health that our bottom-up CHM is showing. Chart 10European Credit##BR##Looks Fully Valued Chart 11Relative Top-Down CHMs##BR##Still Favor The U.S. Over Europe U.K. Corporate Health Monitor: No Major Causes For Concern The top-down U.K. CHM has been in the "improving health" zone for the past two years, led by cyclical improvements in profit margins and interest coverage, combined with very strong short-term liquidity (Chart 12). Return on capital is low relative to its history, which is consistent with the trends seen in the U.S. and Euro Area and likely reflects the global low productivity backdrop (although at levels not far off those seen in the U.S. and Europe). U.K. credit has enjoyed the same global liquidity tailwind that other corporate bond markets have enjoyed. This is doubly so because of the specific easy monetary policies of the Bank of England (BoE) after the 2016 Brexit vote. The BoE has already reversed the post-Brexit interest rate cut, although additional hikes are highly unlikely given muddled growth momentum and the lingering uncertainties over the Brexit negotiations. The post-Brexit weakness in the British pound has stabilized, with the trade-weighted exchange rate now in positive territory on a year-over-year basis. This will result in slower inflation rates in the coming months and a BoE that is likely to sit on its hands for a while. An environment of mushy domestic growth and a stand-pat central bank would typically be good for risk assets like corporate credit. Yet at current low yield and spread levels, it is difficult to paint a scenario of additional outperformance of U.K. credit without a catalyst like accelerating growth or monetary easing. The combination of accommodative monetary policy and a solid credit backdrop, as indicated by our U.K. CHM, leads us to maintain our current neutral allocation to U.K. corporate debt, even though valuations do not look particularly cheap (Chart 13). Chart 12U.K. Corporate Health Monitor:##BR##Credit Quality Still Improving Chart 13U.K. Credit Rally Starting##BR##To Lose Steam Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 https://www.reuters.com/article/us-markets-flows-baml/investors-yank-6-8-billion-from-high-yield-bonds-third-largest-outflows-baml-idUSKBN1DH1G8 Appendix 1: An Overview Of The BCA Corporate Health Monitors The BCA Corporate Health Monitor (CHM) is a composite indicator designed to assess the underlying financial strength of the corporate sector for a country. The Monitor is an average of six financial ratios inspired by those used by credit rating agencies to evaluate individual companies. However, we calculate our ratios using top-down (national accounts) data for profits, interest expense, debt levels, etc. The idea is to treat the entire corporate sector as if it were one big company, and then look at the credit metrics that would be used to assign a credit rating to it. Importantly, only data for the non-financial corporate sector is used in the CHM, as the measures that would be used to measure the underlying health of banks and other financial firms are different than those for the typical company. The six ratios used in the CHM are shown in Table 1 below. To construct the CHM, the individual ratios are standardized, added together, and then shown as a deviation from the medium-term trend. That last part is important, as it introduces more cyclicality into the CHM and allows it to better capture major turning points in corporate well-being. Largely because of this construction, the CHM has a very good track record at heralding trend changes in corporate credit spreads (both for Investment Grade and High-Yield) over many cycles. Table 1Definitions Of Ratios That Go Into The CHMs Top-down CHMs are now available for the U.S., Euro Area and U.K. The CHM methodology was extended in 2016 to look at corporate health by industry and by credit quality.2 The financial data of a broad set of individual U.S. and Euro Area companies was used to construct individual "bottom-up" CHMs using the same procedure as the more familiar top-down CHM. Some of the ratios differ from those used in the top-down CHM (see Table 1), largely due to definitional differences in data presented in national income accounts versus those from actual individual company financial statements. The bottom-up CHMs analyze the health of individual sectors, and can be aggregated up into broad CHMs for Investment Grade and High-Yield groupings to compare with credit spreads. An EM version of the bottom-up CHM was introduced by the BCA Emerging Markets Strategy team in September 2016, which extends the CHM analysis to EM hard-currency corporate debt.3 2 Please see Section II of The Bank Credit Analyst, "U.S. Corporate Health Gets A Failing Grade", dated February 2016, available at bca.bcaresearch.com. 3 Please see BCA Emerging Markets Strategy Special Report, "EM Corporate Health Is Flashing Red" dated September 14 2016, available at ems.bcaresearch.com. Appendix 2: U.S. Bottom-Up CHMs For Selected Sectors Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The BCA earnings model shows that S&P 500 EPS growth is peaking and should decelerate through 2018. Synchronous global growth remains in place in 2017 and will persist into 2018, providing a tailwind for U.S. growth, equity markets and, ultimately, inflation. The labor market continues to tighten, which suggests that wage pressures should accelerate soon. Is another "Great Moderation" at hand? Feature Uncertainty around the GOP tax plan led to a weaker dollar last week, but U.S. equities and Treasuries were little changed. The tax plan could fail if enough Republican voters turn against it. BCA's Geopolitical Strategy team notes1 that as long as President Trump remains more popular with Republican voters than his Republican peers in Congress, he will be able to force the tax plan through both the Senate and the House. Moreover, we could even see some Democrats in the Senate supporting these tax changes. Ahead of the OPEC meeting on November 30, the weaker dollar along with the ongoing political turmoil boosted oil prices. Closer to home, corporate profits for Q3 2017 and guidance for Q4 2017 and beyond remains supportive for risk assets, although BCA expects S&P 500 earnings growth to peak in the next couple of quarters on a 4-quarter moving average basis. Global growth remains supportive for S&P 500, U.S. economic growth, and ultimately, higher inflation. Meanwhile, investors are still asking when price and wage inflation will turn higher toward the Fed's 2% forecast. BCA's answer: Be patient. In the final section of this week's report, we examine whether the recent period of low economic and financial market volatility will persist and herald a return to the Great Moderation. Q3 Earnings Season: Margins Still Expanding EPS and sales growth in Q3 ran well ahead of consensus expectations as forecasted in our October 2 preview. Moreover, the counter-trend rally in profit margins is still in place. Over 90% of companies have reported results so far, with 72% beating consensus EPS projections, just above the long-term average of 69%. Furthermore, 67% have posted Q3 revenues that topped expectations, which exceeded the long-term average of 55%. The surprise factor for year-over-year results in Q3 stands at 5% for EPS and 1% for sales. These compare favorably with the average EPS (4%) and sales (1%) in the past five years. We anticipate the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning early in 2018. Margins tend to peak halfway through late-cycle periods.2 Nonetheless, the results imply that Q3 will be another quarter of margin expansion. Earnings growth (Q3 2017 versus Q3 2016) is solid at 8%, and in revenues, 5%. Strength in earnings and revenues is broad based (Table 1). Earnings per share increased in Q3 2017 versus Q3 2016 in 8 of the 11 sectors. The 7.3% year-over-year drop in the financial sector is attributed to the impact of the hurricanes on the insurance and reinsurance industries. Excluding those industries, financial EPS is up by 6% from a year ago. EPS results are particularly impressive in energy (162%), and strong in technology (24%), healthcare (8%), and materials (7%). These sectors likewise experienced significant sales gains (17%, 10%, 4%, and 9%, respectively). Corporate managements are more focused on the message in Washington than on the President (Chart 1). Trump's name was mentioned only twice in the Q3 earnings calls held through November 10, doubling the total in Q2. CEOs and CFOs have cited Trump's name at least once in each earnings season since Q2 2016. The zenith in mentions occurred immediately after Trump took office in early 2017. Table 1S&P 500:##BR##Q3 2017 Results* Chart 1Managements Focused On The Message##BR##Not The Man In DC In contrast, "tax" and "reform" have appeared 13 times so far in Q3 conference calls, most often in a positive light. There were only five mentions in Q2 when investors were skeptical that a tax plan would pass this year. In the Q4 2016 reporting season following the November election, tax and reform were cited 16 times. BCA's Geopolitical Strategy service has consistently expected a tax package to pass by the end of Q1 2018.3 We are encouraged by the upward trajectory of EPS estimates for 2017 and 2018 (Chart 2). It is odd that the recent downtick in 2017 EPS is mirrored by an uptick in the 2018 projection. The divergence can be explained by the effect of the hurricanes on the financial sector's earnings in 2017 and the probable snapback in early 2018. Analysts expect 2019 EPS growth to slow from the anticipated 2018 clip, which matches BCA's view. However, unlike estimates for 2017 and 2018, we anticipate that EPS estimates for 2019 will move lower throughout 2018 and 2019, ahead of a recession in late 2019.4 Bottom Line: The BCA earnings model shows that S&P 500 EPS growth is peaking and should decelerate through 2018 to a level commensurate with 3 ½-4% nominal GDP growth (Chart 3). Margins will crest in 2018. Accordingly, BCA believes that the earnings backdrop will remain a tailwind for the equity market, albeit a smaller tailwind. This forecast excludes any encouraging effect on growth from tax cuts, which would be positive for EPS and the S&P 500 price index in the short term, but would bring forward Fed rate hikes. BCA expects growth outside the U.S. to remain robust, an additional support for EPS growth in the coming quarters. Chart 2Stability In '17 & '18 EPS Estimates, But '19 Likely To Move Lower Chart 3Strong EPS Growth Ahead,##BR##Will Start To Slow Soon Global Growth Update Synchronous global growth remains in place in 2017 and will persist into 2018,5 providing a tailwind for U.S. growth, equity markets and, ultimately, inflation. Global real GDP estimates continue to move higher, a welcome departure from the past when estimates slid relentlessly lower (Chart 4). Since the start of 2017, GDP estimates for this year have increased from 2.6% to 3.2%, while 2018 forecasts have accelerated from 2.8% to 3%. The 2019 growth projection is steady at 2.9%. This upward trajectory for 2017 and 2018 has occurred despite a recalibration by many major central banks away from accommodative policies. The improving growth forecasts could be short-circuited by aggressive central bank actions, a worldwide trade war, or escalating tensions in Northeast Asia (or a combination of all three). Falling oil prices would also challenge a quickening of world growth, but BCA's stance is that oil prices will move up significantly in the coming year.6 Chart 4Global Growth Estimates Accelerating Global leading indicators are on the upswing. The most recent update of our Global Leading Indicator (excluding the U.S.) was the strongest since 2010 when it slowed after a sharp rebound from the 2007-2009 financial crisis. Moreover, the global LEI diffusion index turned positive after a worrisome dip below 50% earlier this year. It will be a warning sign for wide-reaching growth if the diffusion index moves back below 50% (Chart 5). Industrial production (IP) overseas is expanding at nearly three times the U.S. rate (Chart 6). This suggests that U.S. economic activity will be pulled up by foreign demand. Additionally, G3 capital goods orders are climbing at the fastest pace since 2014. A stronger dollar may dampen U.S. exports and earnings, but this will be a modest offset, rather than something that derails the recovery in U.S. industrial production. Chart 5Global LEI's Pointing Higher Chart 6Supports For Global Growth In Place Global growth is important to large cap U.S. equities because 43% of S&P 500 sales in 2016 came from outside the U.S. (Table 2). Remarkably, this figure moved lower in the past 5 years and 10 years. In 2012, 47% of S&P 500 sales came from outside the U.S.; in 2007, it was only 1% less. The drop in overseas sales since 2012 masks shifts by region. In 2016, 8% of S&P 500 sales were to Asia, up 100 bps from 2012. Europe, excluding the U.K., accounted for 6% sales in 2016 and the U.K., a mere 1%. These numbers dropped from the 2012 figures of 10% and 2% respectively. While Standard and Poor's does not separate out sales to China, that country represents a large portion of sales to Asia, which makes China and Europe the two most important regions for overseas sales. In contrast, only 3% of S&P 500 sales are made in Canada and Mexico. Table 2Most S&P 500 Sales Go To Asia And Europe While BCA's European strategists remain upbeat about growth prospects in the Eurozone,7 our outlook on China is more sanguine. BCA's Geopolitical Strategy service notes that Chinese politics have shifted from tailwind to headwind for global growth in the wake of China's 19th National Party Congress.8 Meanwhile, BCA's China Investment Strategy states that the weak external demand environment faced by China in 2015 was a function of severe dislocations in the commodity and currency markets that probably will not recur in the coming 6-12 months. While Chinese export growth will moderate in the coming year, the absence of these shocks is an important factor supporting a gradual deceleration.9 Moreover, China's economic momentum is on the upswing. Real-time measures of economic activity such as electricity production, excavator sales, and railway freight traffic, all are expanding at double-digit rates, albeit down from recent peaks (Chart 7). Various price indexes also show a broadly based pickup in inflation to levels that will unnerve the authorities. Nonetheless, economic growth will slow in 2018 as policymakers continue to pare back stimulus. BCA does not foresee a substantial downturn in growth next year, but it could be hard on base metals prices. Bottom Line: Improving economic activity outside the U.S. is a tailwind for both domestic economic growth and profits of U.S. firms with significant foreign business. Moreover, surging world growth is a precondition for higher inflation. BCA's Global Fixed Income Strategy service notes10 that 68% of OECD nations have unemployment rates under the organization's assessment of "global NAIRU", which has not occurred since before the Great Recession when inflation expanded in both the goods and service sectors (Chart 8). Solid foreign demand will help the economy hit the Fed's GDP target and support the central bank's additional but gradual tightening stance. Stay overweight U.S. equities and remain short duration. BCA's view that inflation is poised to turn higher also supports our duration call. Chart 7China: Healthy Growth Indicators Chart 8NAIRU Is Not Dead Yet Still Waiting For Wage Inflation Table 3Inflation Reacts With A Lag The labor market continues to tighten, which suggests that wage pressures should accelerate soon. Given that inflation is a lagging indicator, investors must remain patient. Table 311 illustrates the time lag from when full employment is reached to the turning point for consumer price inflation. During long expansions, the gap is 26 months. The U.S. unemployment rate dipped below NAIRU 12 months ago in November 2016. The implication is that investors (and the Fed) are too eager as they wait for inflation's inflection point. BCA approaches wage growth - or the lack of it - in another way. Like inflation, wage growth takes time to materialize in protracted recoveries. Charts 9 and 10 provide updates on inflation and its leading indicators that we published in August 2017. These charts reiterate that price pressures take time to emerge in "slow burn" expansions. Chart 11 shows that the ECI has trended higher since 2009, matching increases in quit rates, NFIB compensation plans, and the Conference Board's measure of jobs hard to get less jobs easy to get. Moreover, the top panel of Chart 11 shows that the ECI gains are widespread and at 73%, the percentage of states reporting unemployment rates below NAIRU suggests that wage gains are imminent (Chart 12). Chart 9In the 80s And 90s Wage Growth Did Not##BR##Provide And Early Warning On Inflation Chart 10Patience Is Required On##BR##Inflation In Long Cycles Chart 11Labor Market Is Tight Enough##BR##To Push Up Inflation Chart 1270%+ Of States Have Unemployment Rates Below NAIRU The Atlanta Fed Wage Tracker,12 which is not compromised by compositional shifts in the labor market, stabilized in the past few months after rolling over in the spring and early summer. Moreover, the Tracker remains in a distinct uptrend; at 3.6% year-over-year, it is at the lower end of the 3.3% to 4.3% year-over-year range in place before the global financial crisis (Chart 13, panel 2). Chart 13Wage Pressures Mounting Bottom Line: Wage inflation is on the upswing as the output gap turns positive for the first time in a decade and the unemployment rate moves even further below NAIRU. A persistent buildup in wages will allow the Fed to bump up rates in December and three times again next year. This supports BCA's underweight stance on duration. That said, a sudden surge in consumer price or wage inflation would trigger a more aggressive response from the Fed, and a signal of "the beginning of the end" for the recent return of the Great Moderation. Great Moderation, Interrupted? The Great Recession was eight years ago, but investors are now ruminating about the return of the Great Moderation era (mid-1980s to mid-2007), when subdued macroeconomic volatility often coincided with low market volatility. Then, as now, inflation was muted and stable, but unlike today, economic growth was much faster in a long expansion phase with two mild recessions (Chart 14). There have been many studies rationalizing the Great Moderation, which was observed in most advanced economies (G7 countries and Australia) roughly at the same time though not fully synchronized (Chart 15).The phenomenon13 was initially forged in 2002 by Stock and Watson and then publicized by former Fed Chair Bernanke14 in a 2004 speech.15 Chart 14Return Of The Great Moderation? Chart 15The Great Moderation: A Global Phenomenon Too! Three main causes were identified: Structural changes in the economy: improvement in inventory management as the U.S. moved away from a manufacturing-based economy towards a service-based economy, the latter less volatile. Financial innovations, for example, increased credit availability to households through the rise of securitization, allowing consumption to be more balanced; Higher efficacy of monetary policy: increased transparency and predictability of FOMC actions, which augmented the Fed's credibility to tame inflation (price stability) and foster full employment; Good Luck (smaller shocks): post mid-1980s (and up to the global financial crisis-GFC), the economy did not experience outsized shocks such as the surge in oil prices in the 1960s and the 1970s. Most investors and/or economists agree that structural changes and better monetary policy were significant drivers of the decline in macroeconomic volatility. Good luck also seems to have been a factor and there is empirical research to support it. The persistence and length of the current expansion is an indication that good luck still plays a role, with investors taking on risk and becoming complacent. That said, there does not seem to be a consensus on the single most important driver of the "Great Moderation". Interestingly, complacency in the financial markets creates vulnerability at the late stage in this expansion. It has caught the Fed's attention as evidenced in the September 19-20 FOMC minutes: "Broad U.S. equity price indexes increased over the intermeeting period. One-month-ahead option-implied volatility of the S&P 500 index - the VIX - remained at historically low levels despite brief spikes associated with increased investor concerns about geopolitical tensions and political uncertainties." Since Chair Yellen took office in February 2014, this is the most direct reference about low volatility and therefore, complacency in the financial markets. Chart 16Back To Low Correlations Among Stocks The November 2017 Bank Credit Analyst Monthly Report16 discussed complacency in the context of a return of the Great Moderation. BCA believes significant complacency is signaled by the good news already discounted in equity prices, the depressed level of the VIX and the decline this year in risk asset correlations. Moreover, large institutional investors are reportedly selling volatility and thus, dampening implied volatility across asset classes. The "Great Moderation" in macro volatility is also contributing to low correlations among stocks (Chart 16). The idea is that low perceived macroeconomic volatility during the "Great Moderation" had diminished the dispersion of growth and inflation forecasts, thereby trimming the variance of interest rate projections. This allowed equity investors to focus on alpha rather than beta, given less uncertainty about the macro outlook. The focus on alpha contributed to the decline in stock price correlation. Today, dispersion in the outlooks for growth and interest rates have returned to pre-Lehman levels, helping to explain the low levels of implied volatility and correlation in the equity market (Chart 17). Some of the reduced dispersion can be justified by the fundamentals. The onset of a broadly based global expansion has calmed lingering fears that the world economy is constantly teetering on the edge of the abyss. Investor uncertainty regarding economic policy has also moderated (bottom panel). Historically, implied volatility tended to fall when global industrial production was strong and global earnings were rising in a broad swath of countries (Chart 18). Our U.S. Equity Sector Strategy service points out that, during the later stages of the cycle, equity sector correlations tend to drop. The lower correlations occur as earnings fundamentals become more important performance drivers, and sector differentiation generates alpha.17 Similarly, the VIX can fluctuate at low levels for an extended time when global growth is broadly based. Chart 17A Less Uncertain Macro Outlook? Chart 18Broad-Based Growth Lowers Implied Volatility Still, the current readings of equity market correlation and the VIX are unnerving given a plethora of potential geopolitical crises and the pending unwinding of the Fed's balance sheet. Moreover, any meaningful pickup in inflation would upset the 'low vol' applecart. Table 4 shows the drop in the S&P 500 index during non-recessionary periods when the VIX surges by more than 10% in a 13-week period. The equity price index fell by an average of 7% during those nine episodes, with a range of -3.6 to -18.1%. Table 4Episodes When VIX Spiked Bottom Line: Longer expansions and shorter recessions, alongside the decline in market volatility, may stay for a while, the result of the perceived return to the Great Moderation. Risk assets are thus vulnerable because a lot of good news is discounted. Nonetheless, we would view any pullback in equities as a healthy correction rather than the beginning of a bear market. If the next recession is not expected before 2019 (our base case), then it is too early for the equity market to begin to discount the next bear market because profits will continue to expand well into 2018. Stay overweight stocks versus bonds in the next 12 months. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com 1 Please see BCA Research's Geopolitical Strategy Weekly Report, "Tax Cuts Are Here... So Much for Populism," November 8, 2017. Available at gps.bcaresearch.com. 2 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Late Cycle View," October 16, 2017. Available at usis.bcaresearch.com. 3 Please see BCA Research's Geopolitical Strategy Weekly Report, "Xi Jinping: Chairman Of Everything," October 25, 2017. Available at gps.bcaresearch.com. 4 Please see BCA Research's Global Investment Strategy Weekly Report, "Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear," October 4, 2017. Available at gis.bcaresearch.com. 5 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Synchronicity," September 25, 2017. Available at usis.bcaresearch.com. 6 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Still Some Upside In The Nickel Market," November 2, 2017. Available at ces.bcaresearch.com. 7 Please see BCA Research's European Investment Strategy Weekly Report, "The Great Resynchronization," September 21, 2017. Available at eis.bcaresearch.com 2017. 8 Please see BCA Research's Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?," November 1, 2017. Available at gps.bcaresearch.com. 9 Please see BCA Research's China Investment Strategy Weekly Report, "China's Economy - 2015 Vs. Today (Part I): Trade," October 26, 2017. Available at cis.bcaresearch.com. 10 Please see BCA Research's Global Fixed Income Strategy Weekly Report, "Have Bond Yields Peaked For The Cycle? No," September 12, 2017. Available at gfis.bcaresearch.com. 11 Please see The Bank Credit Analyst Monthly Report, November 2017. Available at bca.bcaresearch.com. 12 https://www.frbatlanta.org/chcs/wage-growth-tracker.aspx?panel=1 13 Peter M. Summers, "What Caused the Great Moderation" Some Cross-Country Evidence", 2005, Federal Reserve Bank of Kansas City www.kansascityfed.org/ROkYZ/OcgaZ/Publicat/econrev/PDF/3q05summ.pdf 14 James H. Stock and Mark W. Watson, "Has the Business Cycle Changed? Evidence and Explanations", August 2003 https://www.kansascityfed.org/publicat/sympos/2003/pdf/Stockwatson2003.pdf 15 Governor Ben S. Bernanke, "The Great Moderation," Washington, DC, February 20, 2004, https://www.federalreserve.gov/boarddocs/speeches/2004/20040220/ 16 Please see The Bank Credit Analyst Monthly Report, November 2017. Available at bca.bcaresearch.com. 17 Please see BCA Research's U.S. Equity Strategy Weekly Report, "Later Cycle Dynamics," published October 23, 2017. Available at uses.bcaresearch.com.

Highlights Powell's nomination will not change the Fed's gradual rate hike path, but open Board seats are a worry. Household debt growth is slower than usual, but auto debt levels are a concern. Stocks will beat bonds and oil will rise after EPS growth peaks next year. Funding liquidity should remain adequate as the Fed unwinds its balance sheet. Feature Last week was an extraordinarily busy week for U.S. financial markets, but BCA's view on the economy, the Fed and asset class returns remains the same. President Trump named Jerome Powell to replace Janet Yellen as Fed Chair and the GOP released additional details of their tax plan. The October readings on employment, manufacturing, and wage growth fell short of expectations. However, data on consumer confidence, non-manufacturing ISM and vehicle sales for October exceeded expectations. The Q3 Employment Cost Index will give Fed policymakers confidence that the Phillips curve is not dead, but the persistent weakness in unit labor costs (the Q3 data was released last week) will concern the FOMC. The Fed remains on track to raise rates by 0.25% in December and three more times in 2018, matching their dot plot. While average hourly earnings disappointed in October, the impacts of Hurricanes Harvey and Irma make the data difficult to interpret. Nonetheless, the year-over-year growth in the 3-month moving average of average hourly earnings was 2.6% in October, up from 2.5% in July, before Harvey made landfall in Texas. Moreover, real GDP is growing faster than the economy's long term potential (1.8% per the Fed), and at 4.1%, the unemployment rate is well below the Fed's measure of full employment (4.6%) (Chart 1). Jerome Powell will continue to pursue the gradual rate hikes preferred by his predecessor. However, Powell is the first Fed Chair since G. William Miller (1978-79) to not have a PhD in economics. He is not known as a policy hawk or a dove, and this lack of conviction in his own policy suggests that he will rely on more on his Board colleagues for direction than recent chairs. The potential power shift from the chair to the committee may make FOMC communications more difficult to interpret. After Yellen departs the Fed early next year, the seven-member board will be down to just four, providing Trump the opportunity to further shape monetary policy. Table 1 provides Powell's comments on key aspects of the economy, monetary and regulatory policy. Chart 1Labor Market Conditions Tightening##BR##And Support More Rate Hikes Table 1Powell On Monetary Policy, The Economy And Regulation BCA expects that Powell, a Republican, will be confirmed by the Senate and preside over the FOMC meeting in March 2018. Powell already sits on the Fed Board. In 2012 President Obama appointed Powell to the Fed to fill an unexpired term. The Senate voted 74-21 to confirm. Two years later, Powell was confirmed 67-21 for a full term (14 years) as a governor. Fifty-one votes are required for confirmation. BCA's Chief Economist, Martin Barnes, wrote about the potential for change at Federal Reserve Board earlier this year.1 The bottom line is that looming changes in the composition of the Fed's Board of Governors are important, but we doubt that the overall integrity of the Fed will be seriously compromised by bad appointments. However, at this stage, it is futile to guess who the Administration will choose. Regardless of who controls the Fed, there always will be the potential for errors because their economic models (along with everybody else's) are imprecise, data can be unreliable, and the policy tools are crude. Some uptick in inflation is likely and would even be desirable, but it will not be allowed to get out of control. The bigger uncertainty is what will happen after the next economic downturn because even the most hawkish policymakers may be forced to embrace inflationary policies that will make the past cycle's actions pale by comparison. Subprime Auto Sector Signals Household deleveraging has ended, but consumers are reticent to take on new debt despite an improving labor market and record household net worth. Household debt is growing at under 2% a year, less than half the pre-crisis pace. Moreover, household debt relative to disposable income remains well below a decade ago, but the household indebtedness profile is not uniform. While the debt-to-disposable income ratio of mortgage and revolving consumer credit has moved lower, the ratio of non-revolving credit (which includes both auto and student loan debt) has moved up since 2010 and surpassed the 15.8% pre-crisis peak in 2012 (Chart 2). Chart 2Household Debt By Sector In 2016, 34% of U.S. families had vehicle loans, up from a low of 30% in 2010. In 2004-2007, more than one-third of U.S. families carried auto debt (Chart 3). The median value of households' auto loans is $13,000 (in 2016 dollars), up from $11,000 in 2010, but still below the 2004-2007 peak of $14,000 (Chart 4). However, delinquency rates are on the rise in those areas where consumers have been adding debt (credit cards, auto loans and student loans) (Chart 5). Chart 3Rise In % Of Families With Auto Loan Debt... Chart 4...But Auto Debt Levels Are Manageable In particular, default rates in auto and student loans are above their mid-2000s readings, but are below their 2010-2012 zenith. Lending standards for vehicle loans were easy at the start of the decade, became less so recently and then turned restrictive in mid-2016. In the mid-2000s, borrowing guidelines for student loans and credit cards (data on bank lending standards for auto loans began in 2011) were easy in 2004-2007. Banks are taking a cautious approach to consumer lending in this cycle. The gradual tightening of lending criteria between 2010 and 2016 led to a drop in the average FICO score for new auto loans. However, as standards tightened in 2016 and into the first quarter of 2017, the average FICO escalated. FICO scores for new vehicle loans moved sharply lower in Q2; it may be a new trend or perhaps a blip in the data. Even with the latest dip, the FICO for new auto loans (698) is well above the 675-685 range that prevailed in 2004-2006 (Chart 6, bottom panel). Chart 5Consumer Loan Metrics Chart 6ABS Market Overview Subprime auto loans as a percentage of all auto loans remain well below pre-crisis levels and should limit a wave of subprime auto defaults in the years ahead. Only 22% of the $148 billion in new vehicle loans recorded in Q2 2017 were issued to borrowers with FICO scores below 620. The latest reading is in the middle of the range that has been in effect since 2010 (18-25%). Between 2004 and 2007, the share of auto loans issued to subprime borrowers was as high as 32% in 2006 and averaged 28%. The FOMC has elevated financial stability in its recent deliberations2 and is watching for imbalances. The September 20-21 FOMC meeting minutes noted that "Subprime auto loan balances have declined so far this year, partly reflecting the tighter lending standards, and the average credit score of all borrowers who obtained an auto loan in the second quarter remained near the upper end of its range of the past few years." We expect the Fed to remain vigilant on this issue. Bottom Line: Household debt ratios are well below the pre-2007 peak, but consumers are piling on more auto debt. While delinquency rates for auto debt are rising, banks are tightening lending requirements and have not extended auto credit to subprime borrowers outside of historical norms. If household incomes, the stock market and housing prices rise, and banks and regulators remain vigilant, then the subprime auto sector would not pose a systemic risk to the U.S. economy or financial system.3 BCA's U.S. Bond Strategy service prefers Aaa-rated credit card ABS over Aaa-rated auto loan ABS (Chart 6). Investment Direction After EPS Peak Chart 7Strong EPS Growth Ahead,##BR##Will Start To Slow Soon The BCA earnings model shows that S&P 500 EPS growth is peaking and should slow through 2018 toward a level commensurate with 3½-4% nominal GDP growth (Chart 7). Accordingly, BCA believes that the earnings backdrop will remain a tailwind for the equity market, albeit a smaller force. This forecast excludes any positive effects on growth from tax cuts that would encourage EPS and the S&P 500 index in the short term, although this would also bring forward Fed rate hikes. We will provide an update on the Q3 earnings reporting season in next week's report. Investors are questioning what will happen to risk assets after earnings growth peaks, but before it slips below zero (Table 2). BCA has identified seven episodes between 1973 and 2015 when S&P 500 EPS growth reached a top and subsequently dipped below zero. Four of the seven periods (1973-75, 1976-80, 1988-1991, and 1993-2001) partially overlapped with recessions. The U.S. economy was in recession during the entire 1973-75 period but the recession occurred at or near the end in the other three occurrences. U.S. stocks, Treasuries and oil behave consistently during these periods. The performance of gold, the dollar, small caps (relative to large) and high yield (relative to Treasuries) is not consistent, and investment-grade corporate debt underperformed Treasuries in six of the seven intervals. On average, stocks beat bonds by 3,000 bps after earnings decelerate, but before they turn negative. Oil (+8,310 basis points) and gold (+6,950 bps) are the standouts; both commodities beat stocks) as earnings growth fades. Small caps barely outperform large, and the dollar, on average, is flat across all seven periods. Investment-grade corporate debt underperforms Treasuries by an average of 50 bps during these episodes. Table 2U.S. Asset Class Performance As EPS Growth Slows The three occasions when EPS growth crested and then slowed to zero, but the economy avoided a recession, were in the mid-1980s, the mid-2000s and the early part of the current decade. These mid-cycle slowdowns were triggered by Fed rate hikes in the mid-1990s and mid-2000s; in the early 2010s, there were similar fears of a rate increase, coupled with a stronger dollar and a collapse in oil prices. The performance of risk assets during these mid-cycle earnings corrections was similar to the entire sample, although the magnitude of the asset class performances shifted. Oil (+12,560 bps) and gold (+8,400 bps) were standouts; equity and Treasury prices both rose, but equities beat Treasuries by nearly 10,000 bps, easily surpassing the 3,000 bps outperformance in all periods. Small caps underperformed large caps and the dollar climbed (Chart 8). Chart 8U.S. Asset Class Performance As EPS Growth Slows Bottom Line: S&P 500 earnings growth will peak in 2018. Stocks will outperform bonds as profit growth slows, which matches BCA's stance for the next 12 months. Gold and oil have both outpaced equities as earnings abate; this supports BCA's bullish position and above-consensus view of oil for 2018. BCA's modestly bullish stance on the dollar in the next 12-18 months aligns with the historical achievements of the dollar as earnings moderate, but BCA's bullish view on small caps runs counter to history after EPS growth crests. The Great Balance Sheet Unwind Given that the era of quantitative easing has been a positive one for risk assets, it is unsurprising that investors are concerned about the looming unwind of the Fed's massive balance sheet. For example, Chart 9 demonstrates the correlation between the change in G4 balances sheets and both the stock market and excess returns in the U.S. high-yield market. In an October 2017 Special Report,4 the Bank Credit Analyst outlines how the pending shrinkage of the Fed's balance sheet could affect overall liquidity conditions. Liquidity falls into four categories: monetary, balance sheet, financial market transaction liquidity, and funding liquidity. Overall liquidity conditions are reasonably constructive for risk assets at the moment. Financial market and balance sheet liquidity are adequate. Monetary policy is extremely easy, although the low level of money and credit growth underscores that the credit channel of monetary policy is still somewhat impaired and/or constrained relative to the pre-Lehman years. Funding liquidity is as important as monetary liquidity for financial markets. It has recovered from the Great Financial Crisis (GFC) lows, but it is far from frothy. More intense regulation means that funding liquidity will probably never again be as favorable for risk assets as it was before the crisis. But, hopefully, efforts by the authorities to reduce perceived systemic risk mean that funding liquidity may not be as quick to dry up as was the case in 2008, in the event of another negative shock. Unwinding the Fed's balance sheet represents a risk to investors because QE played such an important role in reducing risk premia in financial markets. The unwind should not affect transactions liquidity or balance sheet liquidity. It should not affect the broad monetary aggregates either. Chart 10 presents our forecast for how quickly the Fed's balance sheet will contract. Following the September 19-20 FOMC meeting we learned that balance sheet reduction will begin October 1. For the first three months the Fed will allow a maximum of $6 billion in Treasuries and $4 billion in MBS to run off each month. Those caps will increase in steps of $6 billion and $4 billion, respectively, every three months until they level off at $30 billion per month for Treasuries and $20 billion per month for MBS. Chart 9G4 Central Bank Balance Sheets Chart 10Fed Balance Sheet We have received no official guidance on the level of bank reserves the Fed will target for the end of the run-off process. However, New York Fed President William Dudley recently recommended that this level should be higher than during the pre-QE period, and should probably fall in the $400 billion to $1 trillion range.5 In our forecasts we assume that bank reserves will level-off once they reach $650 billion. In that scenario, the Fed's balance sheet will shrink by roughly $1.4 trillion by 2021. The level of excess reserves in the banking system will decline by a somewhat larger amount ($1.75 trillion). The technical impact of balance sheet unwind on the inner workings of the credit market is very complicated and difficult to forecast. Asset sales could lead to a shortage of short-term high quality assets. However, this is more a problem in terms of the Fed's ability to raise interest rates than for funding liquidity. A smaller balance sheet could, in fact, improve funding liquidity to the extent that it frees up space on banks' balance sheets. In terms of asset prices, some investors believe that when the excess reserves were created, a portion of it found its way out of the banking system and was used to buy assets directly. That is not the case. The excess reserves were left idle, sitting on deposit at the Fed. They did not "leak" out and were not used to purchase assets. Thus, fewer excess bank reserves do not imply any forced selling. Nonetheless, the QE program certainly affected asset prices indirectly via the portfolio balance effect. The risk is that the portfolio balance effect goes into reverse as the Fed unwinds the asset purchases. The negative impact on risk assets will depend importantly on the bond market's response. The bond market's reaction will be far more important than balance sheet shrinkage. Empirical estimates suggest that the Fed's shedding of Treasuries could boost the 10-year yield by about 80 basis points because the private sector will require a higher term premium to absorb the higher flow of bonds. However, the impact on yields is likely to be tempered by two factors: Banks are required by regulators to hold more high-quality assets than they did in the pre-Lehman years in order to meet the new Liquidity Coverage Ratio; As the FOMC dials back monetary stimulus it will be concerned with overall monetary conditions, including short-term rates, long-term rates and the dollar. If long-term rates and/or the dollar rise too quickly, policymakers will moderate the pace of rate hikes and use forward guidance to talk down the long end of the curve so as to avoid allowing financial conditions to tighten too quickly. The bottom line is that the impact on monetary liquidity of a smaller Fed balance sheet should be minimal, although long-term bond yields will be marginally higher as a result. As long as the Fed can limit the bond market damage via forward guidance, then funding liquidity should remain adequate and risk assets should take the Fed's unwind in stride. However, it will be a whole different story if inflation lurches higher. If the core PCE inflation rate were to suddenly shift up to the 2% target or above, then bond prices will be hit hard, the VIX will surge and risk assets will sustain some damage. The prospect of a more aggressive pace of monetary tightening would undermine funding liquidity, compounding the negative impact on risk assets. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com 1 Please see The Bank Credit Analyst Special Report, "Should You Fear Looming Changes At The Federal Reserve?", September 21, 2017. Available at bca.bcaresearch.com. 2 Please see BCA's U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate," July 24, 2017. Available at usis.bcaresearch.com. 3 Please see BCA's U.S. Bond Strategy Portfolio Allocation Summary, "Return Of The Trump Trade," October 3, 2017. Available at usbs.bcaresearch.com. 4 Please see The Bank Credit Analyst Special Report, "Liquidity And The Great Balance Sheet Unwind," In the October Monthly Report. Available at bca.bcaresearch.com. 5 William C. Dudley, "The U.S. Economic Outlook and the Implications for Monetary Policy," Federal Reserve Bank of New York (September 07, 2017).

Highlights Risk assets are responding well to better data and rising rates. Q3 EPS results beating lowered expectations, but growth earnings will peak soon. The conditions are in place for robust capital spending. Financial assets are adhering to the post-Hurricane playbook, with a few notable exceptions. Feature Chart 1Risk Assets Higher Despite Higher Rates Risk assets rose last week for the 6th week in a row (Chart 1). A solid start to Q3 earnings season, more legislative progress on the GOP's tax plan and a narrowing of President Trump's choice for Fed Chair (Jerome Powell, John Taylor and incumbent Janet Yellen) all added to the positive backdrop. The 4 bps rise in the 10 year Treasury yield last week (and 37 bps since early September) was not an impediment to higher equity and oil prices, and gains for small caps and high yield bonds. The positive reaction likely reflected the fact that yields rose more because of increased growth expectations than higher inflation expectations. Despite the impact of Hurricanes Harvey and Irma, Q3 GDP posted an impressive 3% gain. The composition of the Q3 readings suggests an even stronger report in Q4 (Chart 2). At 2.3%, the year-over-year change in real GDP is close to the Fed's 2017 forecast (2.4%) and above the long run forecast (1.8%). The implication for investors is that because U.S. economic growth is faster than its long-term potential, the labor market is tightening and inflation is poised to move higher. Accordingly, market odds for a Fed hike in December are near 90% and participants expect 51 bps more hikes in the next 12 months (Chart 1, panel 3). BCA's view is that U.S. economic growth is set to accelerate in the coming quarters aided by a post hurricane rebound in housing. The Fed will raise rates in December and three more times next year as inflation returns to 2% and perhaps beyond. Corporate profit growth will peak in the next few quarters, but remain supportive of higher stock prices for now. The rise in the Economic Surprise Index will continue for another few months, and provide another lift for risk assets. A surge in capital spending adds to the upbeat tone. Chart 2GDP Growth Remains Below Average, But Above Fed's Long Run Target Capital Spending Blasts Off Business capital spending is on the upswing. The robust readings in September on core durable goods orders (7.8% year-over-year) and shipments reported last week were paybacks for the Hurricane-weakened August report. Nonetheless, the impressive soundings on the three -month change in both orders and shipments were not distorted by the storms. Moreover, the durable goods report was one of the latest in a series of data points brightening capex's outlook (Chart 3). Both BCA's real and nominal capex models, driven by surging capital goods orders along with elevated ISM readings and soaring sentiment on business spending, indicate strong investment in plant and equipment in the next few quarters. CEO confidence soared to a 13-year high in Q1 according to the latest Duke University/CFO Magazine Business Outlook, but retreated modestly in Q2 and Q3 (Chart 4). Surveys by the Conference Board and Business Roundtable show a similar pattern. Notably, readings on all three surveys have climbed since Trump's election in November 2016, but then retreated as his pro-business agenda stalled. The drop in sentiment reflects the lack of legislative progress in Washington (Chart 5). The dip in CEO sentiment in Q2 and Q3 is in sharp contrast with the easing of policy concerns in the Beige Book. Chart 3Bright Outlook For Capital Spending Chart 4Capital Spending Plans Upbeat Chart 5Managements Remain Upbeat The upbeat numbers in the regional Federal Reserve Banks' surveys of capital spending intentions further support rising capex spending in the next few quarters. The average readings from the New York, Philadelphia and Richmond Feds' capex survey plans are close to cycle highs, despite a modest pullback in the summer months. Moreover, the regional Feds' capex spending plans diffusion index hit an eight-year high in October (Chart 5, panel 3). Bottom Line: Stay overweight stocks versus bonds, and underweight duration. Rising capex will drive up GDP, employment and EPS in the coming quarters. Q3 Earnings Beating Lowered Expectations The Q3 earnings reporting season is off to a strong start, with both EPS and sales growth well ahead of consensus expectations as we forecast in our October 2 preview. Moreover, the counter-trend rally in profit margins is still in place. Just under 55% of companies have reported results so far, with 74% beating consensus EPS projections just above the long-term average of 55%. Furthermore, 67% have posted Q3 revenues that topped expectations, which exceeded the LT average of 69%. The surprise factor for Q3 stands at 5% for EPS and 2% for sales. These compare favorably with the average EPS (4.2%) and sales (1.2%) in the past five years. We anticipate the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning early in 2018. Nonetheless, initial results imply that Q2 will be another quarter of margin expansion. Average earnings growth (Q3 2017 versus Q3 2016) is solid at 7% with revenue growth at 5%. Strength in earnings and revenues is broad based (Table 1). Earnings per share increased in Q3 2017 versus Q3 2016 in eight of the 11 sectors. The 7.3% year-over-year drop in the financial sector is linked to the impact of the hurricanes on the insurance and reinsurance industries. Excluding those industries, financial EPS is up 4.7% from a year ago. EPS results are particularly stout in energy (164%), technology (18%) and healthcare (7%). Those sectors likewise experienced significant sales gains (16%, 9% and 5% respectively). Corporate managements are more focused on the message in Washington than on the President (Chart 6). Trump's name was mentioned just once in the Q3 earnings calls held through October 27, matching Q2's reporting period. CEOs and CFOs have cited Trump's name at least once in each earnings season since Q2 2016. The peak in mentions occurred immediately after Trump took office in early 2017. Table 1S&P 500:##BR##Q3 2017 Results* Chart 6Managements Focused On##BR##The Message Out Of DC In contrast, the words "tax" and "reform" have appeared 39 times thus far in Q3 conference calls, most often in a positive light. There were only five mentions in Q2, when there was skepticism that a tax plan would pass this year. In the Q4 2016 reporting season following the November election, tax and reform were cited 16 times. BCA's Geopolitical Strategy service has consistently expected a tax package to pass by the end of Q1 2018.1 We are encouraged by the upward trajectory of EPS estimates for 2017 and 2018 (Chart 7). It is odd that the recent downtick in 2017 EPS is mirrored by an uptick in the 2018 figure. That said, the divergence can be explained by the impact of the hurricanes on the financial sector's earnings in 2017 and probable snapback in early 2018. Analysts expect 2019 EPS growth to slow from 2018's clip, which matches BCA's view. However, unlike estimates for 2017 and 2018, we anticipate that EPS estimates for 2019 will move lower throughout 2018 and 2019, ahead of a recession in late 2019.2 Bottom Line: The BCA earnings model shows that S&P 500 EPS growth is peaking and should decelerate through 2018 toward a level commensurate with 3 ½-4% nominal GDP growth (Chart 8). Accordingly, BCA believes that the earnings backdrop will remain a tailwind for the equity market, albeit a smaller tailwind. This forecast excludes any positive effect on growth from tax cuts, which would be positive for EPS and the S&P 500 price index in the short term, although this would also bring forward Fed rate hikes. The entire Treasury curve has readjusted to reflect this view. Chart 7Stability In '17 & '18 EPS Estimates,##BR##But '19 Likely To Move Lower Chart 8Strong EPS Growth Ahead,##BR##Will Start To Slow Soon 10-Year Treasury Update BCA's view is that the 10-year Treasury yield will head higher in the coming months. However, is the move from 2.03% in early September to 2.43% last week sustainable? BCA's fair value model for the 10-year Treasury yield (based on Global PMI and dollar sentiment) places fair value at 2.65% (Chart 9, panel 1). Moreover, BCA's three-factor version of the model (that includes the Global Economic Policy Uncertainty Index), puts fair value slightly higher at 2.63% (Chart 9, panel 3). Investors should continue to position for a steeper curve by favoring the 5-year bullet versus a duration-matched 2/10 barbell. Chart 9Treasury Fair Value Models BCA's U.S. Bond Strategy service will publish updated fair models after the November 1 release of October's global PMI data. The latest readings on Citi's Economic Surprise index also support BCA's stance on rates. How Long Can The Economic Surprise Index Stay Positive? The Citi Economic Surprise Index crossed into positive territory on October 2nd, remaining above zero for 20 business days, and risk assets are responding (Chart 10). Since 2010, once the Index turns positive, it continues to rise for 46 days. The implication for investors is that the economic data will continue to be remarkable for another two months. Table 2 shows that risk assets outperform as the economic surprise index rises from zero toward its zenith. Risk assets have also outperformed since the June bottom in economic surprises, matching the historical performance.3 Oil (+17%), small caps and investment grade corporates are all standouts and the gains may not be over. The track record of risk assets as the Economic Surprise Index climbs suggests that additional increases are in prospect for risk assets. On average, equities (relative to treasuries) and oil are the best performers during these intervals. Chart 10May Still Be Room To Run On Economic Surprise Table 2Risk Assets Perform Well As Economic Surprise Rises Post-Hurricane Macro Backdrop The strength of the Citi Economic Surprise Index following the hurricanes duplicates the historical trend and supports the rise in risk assets. The Index moves higher for the first month post-storm, and then remains above zero for an additional three weeks (Chart 11, panel 4). This bolsters BCA's stance that the direction of the Index will continue to lift risk assets in the next few months. Financial assets are also adhering to the post-Hurricane playbook,4 with a few notable exceptions (Chart 12). The stock-to-bond ratio moved higher and the VIX has declined since Hurricane Harvey, matching the typical post-storm performance. However, the 10-year Treasury yield, the S&P 500 and the Fed funds rate, all have bucked historical trends. The S&P 500 rose by 5.6% since late August; stocks typically drift lower in the first few months after a major storm. In addition, the 10-year Treasury yield climbed but it usually moves down in the two months following a hurricane. Post- storm, the Fed typically continues to do whatever it was doing prior to the storm. Accordingly, we expect the Fed to hike rates at its December meeting. Chart 11Major Hurricane Impact##BR##On Activity Data Chart 12Major Hurricane Impact On##BR##Financial Markets And The Fed The economic, inflation and sentiment data are also mixed. Housing data frequently lags in the wake of a storm, but both new and existing home sales moved up in the month after Harvey and Irma; housing starts declined in recent months which is counter to the historical pattern (Chart 13). Both IP and employment plunged after the storms, however, these indicators tend to rise after major weather. Initial claims for unemployment insurance were typically volatile in the six weeks since Harvey hit Texas, but have resumed their downtrend. Average hourly earnings in inflation climbed after Harvey and Irma, while consumer confidence dipped, matching history. However, the bump in gasoline prices since late August runs counter to historical precedent. Gasoline prices tend to decline after major storms (Chart 14). Chart 13Major Hurricane Impact##BR##On Housing Data Chart 14Major Hurricane Impact On##BR##Sentiment And Inflation Data Investment Conclusions: The macro backdrop remains bullish for risk assets, especially since synchronized growth has reduced fears of secular stagnation. Bond yields will rise, but won't be a headwind for stocks yet.5 Rising bond yields because of growth, without rising inflation, are bullish for risk assets, but this will change as inflation reaches 2% and inflation expectations start to rise. At that point, the Fed will be behind the curve. This will lead to faster Fed rate hikes, historically a headwind for equities. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA's Geopolitical Strategy Weekly Report, "Xi Jinping: Chairman Of Everything," October 25, 2017. Available at gps.bcaresearch.com. 2 Please see BCA's Global Investment Strategy Weekly Report, "Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear," October 4, 2017. Available at gis.bcaresearch.com. 3 Please see BCA's U.S. Investment Strategy Weekly Report, "Global Monetary Policy Recalibration," April 17, 2017. Available at usis.bcaresearch.com. 4 Please see BCA's U.S. Investment Strategy Weekly Report, "Shelter From The Storm," September 5, 2017. Available at usis.bcaresearch.com. 5 Please see BCA's U.S. Investment Strategy Weekly Report, "Still In The Sweet Spot" June 19, 2017. Available at usis.bcaresearch.com.

Bank Credit Analyst

Highlights The macro environment remains positive for risk assets. Nonetheless, the shadow of the '87 stock market crash is a reminder that major market corrections can occur even when the earnings and economic growth backdrop is upbeat. Our base case remains that global growth will stay reasonably firm in 2018, although the composition of that growth will shift towards the U.S. thanks to the lagged effects of easier financial conditions and the likelihood of some fiscal stimulus next year. Positive U.S. economic growth surprises and the disappearing output gap will allow the Fed to raise rates more than is discounted by the markets, providing a lift to the dollar and widening U.S. yield spreads relative to its trading partners. The momentum in profit growth, however, will favor Japan relative to the U.S. and Europe. Investors should overweight Japanese equities and hedge the currency risk. There is still more upside for oil prices, but we are not playing the rally in base metals. The Chinese economy is performing well at the moment, but ample base metal supply and a rising dollar argue against a substantial price rise from current levels. Emerging market equities should underperform the developed markets due to a rising U.S. dollar and the largely sideways path for base metals. Our macro and profit views are consistent with cyclicals outperforming defensive stocks. Investors should also continue to bet on higher inflation expectations and be overweight corporate bonds (relative to governments). High-yield relative value is decent after accounting for the favorable default outlook. It is too early to fully retreat from risk assets and prepare for the next recession. Nonetheless, the market has entered a late cycle phase. Investors appear to have shed fears of secular stagnation, and have embraced a return to a lackluster-growth version of the Great Moderation. The risk of disappointment is therefore elevated. Low levels of market correlation and implied volatility can perhaps be justified, but only if there are no financial accidents on the horizon and any rise in inflation is gradual enough to keep the bond vigilantes at bay. Investors with less tolerance for risk should maintain an extra cash buffer to protect against swoons and provide dry powder to boost exposure after the correction. Feature The October anniversary of the '87 stock market crash was a reminder to investors that major market corrections can arrive out of the blue. With hindsight, there were some warning signs evident before the crash. Nonetheless, the speed and viciousness of the correction caught the vast majority of investors by surprise, in large part because the economy was performing well (outside of some yawning imbalances such as the U.S. current account deficit). Many worried that the 20% drop in the S&P 500 would trigger a recession, but the economy did not skip a beat and it was not long before the equity market recouped the losses. We view the '87 crash as a correction rather than a bear market. BCA's definition of a bear market is a combination of magnitude (at least a 15% decline) and duration (lasting at least for six months). Bear markets are usually associated with economic recessions. Corrections tend to be short-lived because they are not associated with an economic downturn. None of our forward-looking indicators suggest that a recession is in the cards in the near term for any of the major economies. Even the risk of a financial accident or economic pothole in China has diminished in our view. As discussed below, the global economy is firing on almost all cylinders. Chart I-1Valuation Today Is Very Stretched Vs. 1987 Nonetheless, there are some parallels today with the mid-1980s. A Special Report sent to all BCA clients in October provides a retrospective on the '87 crash.1 One concern is that the proliferation of financial computer algorithms and derivatives is a parallel to the popularity of portfolio insurance in the 1980s, which was blamed for turbocharging the selling pressure when the market downturn gathered pace in October. My colleague Doug Peta downplays the risks inherent in the ETF market in the Special Report, but argues that automatic selling will again reinforce the fall in prices once it starts. It is also worrying that equity valuation is much more stretched than was the case in the summer of 1987 based on the cyclically-adjusted P/E ratio (CAPE, Chart I-1). The CAPE is currently at levels only previously reached ahead of the 1929 and 2000 peaks. In contrast, the CAPE was close to its long-term average in 1987. Quantitative easing and extremely low interest rates have pulled forward much of the bond and stock markets' future returns. It has also contributed to today's extremely low readings on implied volatility. The fact that the Fed is slowly taking away the punchbowl and that the ECB is dialing back its asset purchase program only add to the risk of a sharp correction. The Good News For now though, investors are focusing on the improving global growth backdrop and the still-solid earnings picture. While the S&P 500 again made new highs in October, it was the Nikkei that stole the show among the major countries. Impressively, the surge in the Japanese stock market was not on the back of a significantly weaker yen. As we highlighted last month, risk assets are being supported by the three legged stool of robust earnings growth, low volatility and yield levels in government bonds, and the view that inflation will remain quiescent for the foreseeable future. The fact that the global growth impulse is broadly-based is icing on the cake because it reduces lingering fears of secular stagnation. Even emerging economies have joined the growth party, while a weak U.S. dollar has tempered fears of a financial accident in this space. Our forward-looking growth indicators are upbeat (Chart I-2). Our demand indicators in the major economies remain quite bullish, especially for capital spending (not shown). Animal spirits are beginning to stir. Moreover, financial conditions remain growth-friendly, especially in the U.S., and subdued inflation is allowing central banks to proceed cautiously for those that are tightening or tapering. The global PMI broke to a new high in October, and the economic surprise index for the major economies has surged in recent months. Our global LEI remains in a strong uptrend and its diffusion index shifted back into positive territory, having experiencing a worrisome dip into negative territory earlier this year. We expect the global growth upturn will persist for at least the next year. The U.S. will be the first major economy to enter the next recession, although this should not occur until 2019. It is thus too early to expect the equity market to begin to anticipate the associated downturn in profit growth. Earnings: Japan A Star Performer It is still early days in the Q3 earnings season, but the mini cyclical rebound from the 2015/16 profit recession in the major economies is still playing out. The bright spots at the global level outside of energy are industrials, materials, technology and consumer staples (Chart I-3). All four are benefitting from strengthening top line growth and rising operating margins. Chart I-2Upbeat Global Economic Indicators Chart I-3Global Earnings By Sector The U.S. is further advanced in the mini-cycle and EPS growth is near its peak on a 4-quarter moving total basis. The expected topping out in profit growth is more a reflection of challenging year-on-year comparisons than a deterioration in the underlying fundamentals. The hurricanes will take a bite out of third quarter earnings, but this effect will be temporary. Moreover, oil prices are turbocharging earnings in the energy patch and we expect this to continue. Our commodity strategists recently lifted their 2018 target price for both Brent and WTI to $65/bbl and $63/bbl, respectively. The global uptick in GDP growth, along with continued production discipline from OPEC 2.0 are the principal drivers of our revised outlook. We expect the fortuitous combination of fundamentals to accelerate the drawdown in oil inventories globally, which also will be supportive for prices. While U.S. financials stocks have cheered the prospects that Congress may pass a tax bill sometime in early 2018, sell-side analysts have been brutally downgrading financial sector EPS estimates. This has dealt a blow to net earnings revisions in the sector. Expected hurricane-related losses are probably the main culprit, especially in the insurance sector. Nonetheless, our equity sector strategists argue that such indiscriminate downgrades are unwarranted, and we would lean against such pessimism.2 Recent profit results corroborate our positive sector bias, although we are still early in the earnings season. European profits will suffer to some extent in the third quarter due to the lagged effects of previous euro strength. The same will be true in the fourth quarter, although we expect this headwind to diminish early in 2018. That leaves Japan as the star profit performer among the majors in the near term. The recent surge in foreign flows into the Japanese market suggests that global investors are beginning to embrace the upbeat EPS story. Abe's election win in October means that the current monetary stance will remain in place. The ruling LDP's shift away from austerity (e.g. abandoning the primary balance target) may also be lifting growth expectations. A Return To The Great Moderation? Chart I-4Market Correlation And The ERP A lot of the good news is already discounted in equity prices. The depressed level of the VIX and the drop in risk asset correlations this year signal significant complacency. Large institutional investors are reportedly selling volatility and thus dampening vol across asset classes. But there is surely more to it. It appears that investors believe we have returned to the pre-Lehman period between 1995 and 2006 when the Great Moderation in macro volatility contributed to low correlations among stocks within the equity market (Chart I-4). The idea is that low perceived macroeconomic volatility during that period had diminished the dispersion of growth and inflation forecasts, thereby trimming the variance of interest rate projections. This allowed equity investors to focus on alpha rather than beta, given less uncertainty about the macro outlook. Of course, the Great Recession and financial market crisis brought the Great Moderation to a crashing end. Correlations rocketed up and investors demanded a higher equity risk premium to hold stocks. Today, dispersion in the outlooks for growth and interest rates have fallen back to pre-Lehman levels, helping to explain the low levels of implied volatility and correlation in the equity market (Chart I-5). Some of this can be justified by fundamentals. The onset of a broadly-based global expansion phase has likely calmed lingering fears that the global economy is constantly teetering on the edge of the abyss. Investor uncertainty regarding economic policy has moderated as well (bottom panel). Historically, implied volatility tended to fall during previous periods when global industrial production was strong and global earnings were rising across a broad swath of countries (Chart I-6). Our U.S. Equity Sector Strategy service points out that, during the later stages of the cycle, equity sector correlations tend to fall as earnings fundamentals become more important performance drivers and sector differentiation generates alpha, as the broad market enters the last stage of the bull market. Similarly, the VIX can fluctuate at low levels for an extended period when global growth is broadly based. Chart I-5A Less Uncertain Macro Outlook? Chart I-6Broad-Based Growth Lower Implied Volatility Still, current levels of equity market correlation and the VIX are unnerving given a plethora of potential geopolitical crises and the pending unwinding of the Fed's balance sheet. Moreover, any meaningful pickup in inflation would upset the 'low vol' applecart. Table I-1 shows the drop in the S&P 500 index during non-recession periods when the VIX surges by more than 10% in a 13-week period. The equity price index fell by an average of 7% during the nine episodes, with a range of -3.6 to -18.1%. Table I-1Episodes When VIX Spiked The Equity Risk Premium Chart I-7Still Some Value In High-Yield On a positive note, the equity risk premium (ERP) is not overly depressed. There are many ways to define the ERP, but we present it as the 12-month forward earnings yield minus the 10-year Treasury yield in Chart I-4. It has fallen from about 760 basis points in 2011 to 310 basis points today. We do not believe that the ERP can return to the extremely low levels of 1990-2000. At best, the ERP may converge with the level that prevailed during the last equity bull market, from 2003-2007 (about 200 basis points). The current forward earnings yield is 550 basis points and the 10-year Treasury yield is 2.4%. The ERP would need to fall by 110 basis points to get back to the 2% equilibrium. This convergence can occur through some combination of a lower earnings yield or higher bond yield. If the 10-year yield is assumed to peak in this cycle at about 3% (our base case), then this leaves room for the earnings yield to fall by 50 basis points. This would boost the forward earnings multiple from 18 to 20. However, a rise in the 10-year yield to 3½% would leave no room for multiple expansion. We are not betting on any further multiple expansion but the point is that stocks at least have some padding in the event that bond yields adjust higher in a gradual way. It is the same story for speculative-grade bonds, which are not as expensive as they seem on the surface. The average index OAS is currently 326 bps, only about 100 bps above its all-time low. However, junk value appears much more attractive once the low default rate is taken into account. Chart I-7 presents the ex-post default-adjusted spreads, along with our forecast based on unchanged spreads and our projection for net default losses over the next year. The spread padding offered by the high-yield sector is actually reasonably good by historical standards, assuming there is no recession over the next year. We are not banking on much spread tightening from here, which means that high-yield is largely a carry trade now. Nonetheless, given a forecast for the default and recovery rate, we expect U.S. high-yield excess returns to be in the range of 2% and 5% (annualized) over the next 6-12 months. The bottom line is that the positive growth backdrop does not rule out a correction in risk assets, especially given rich valuations. But at least the profit, default and growth figures will remain a tailwind in the near term. The main risk is a breakout in inflation, which financial markets are not priced for. Inflation And Hidden Slack The September CPI report did little to buttress the FOMC's view that this year's inflation pullback is temporary. The report disappointed expectations again with core CPI rising only 0.13% month-over-month. For context, an environment where inflation is well anchored around the Fed's target would be consistent with core CPI prints of 0.2% every month, roughly 2.4% annualized. The inflation debate continues to rage inside and outside the Fed as to whether the previous relationship between inflation and growth have permanently changed, whether low inflation simply reflects long lags, or whether it will require tighter labor markets in this business cycle to fuel wage and price pressures. We back the latter two of these three explanations but, admittedly, predicting exactly when inflation will pick up is extremely difficult and we must keep an open mind. A Special Report in the October IMF World Economic Outlook sheds some light on this vexing issue.3 Their work suggests that the deceleration in wage growth in the post-Lehman period in the OECD countries can largely be explained by traditional macro factors: weak productivity growth, lower inflation expectations and labor market slack. The disappointing productivity figures alone account for two-thirds of the drop in wage growth. However, a key point of the research is that the headline unemployment figures are not as good a measure of labor market slack as they once were. This is because declining unemployment rates partly reflect workers that have been forced into part-time jobs, referred to as involuntary part-time employment (IPT). The rise in IPT employment could be associated with automation, the growing importance of the service sector, and a diminished and more uncertain growth outlook that is keeping firms cautious. The IMF's statistical analysis suggests that the number of involuntary part-time workers as a share of total employment (IPT ratio) is an important measure of slack that adds information when explaining the decline in wage growth. Historically, each one percentage point rise in the IPT ratio trimmed wage growth by 0.3 percentage points. Chart I-8 and Chart I-9 compare the unemployment rate gap (unemployment rate less the full-employment estimate) with the deviation in the IPT ratio from its 2007 level. The fact that the IPT ratio has had an upward trend since 2000 in many countries makes it difficult to identify a level that is consistent with full employment. Nonetheless, the change in this ratio since 2007 provides a sense of how much "hidden slack" the Great Recession generated due to forced part-time employment. Chart I-8Measures Of Labor Market Slack (I) Chart I-9Measures Of Labor Market Slack (II) For the OECD as a whole, labor market slack has been fully absorbed based on the unemployment gap. However, the IPT ratio was still elevated at the end of 2016 (latest data available), helping to explain why wage growth has remained so depressed across most countries. The IPT ratio is still above its 2007 level in three-quarters of the OECD countries. Of course, there is dispersion across countries. Japan has no labor market slack by either measure. In the U.S., the unemployment gap has fallen into negative territory, but only about half of the post-2007 rise in the IPT ratio has been unwound. For the Eurozone, the U.K. and Canada, the unemployment gap is close to zero (or well into negative territory in the U.K.). Nonetheless, little of the under-employment problem in these economies has been absorbed based on the IPT ratio. Our discussion in last month's report highlighted the importance of the global output gap in driving inflation in individual countries. Consistent with this, the IMF finds that there have been important spillover effects related to labor market slack, especially since 2007. This means that wage growth can be held down even in countries where slack has disappeared because of the existence of a surplus of available labor in their trading partners. Phillips Curve Is Not Dead That said, we still believe that the U.S. is at a point in the cycle when inflationary pressures should begin to build, even in the face of persisting labor market slack at the global level. Chart I-10 shows the ECI and the Atlanta Fed wage tracker, which are the best measures of wages because they are less affected by composition effects. Both have moved higher along with measures of labor market tightness. Wage and consumer price inflation have ebbed this year, but when we step back and look at it over a longer timeframe, the Phillips curve still appears to be broadly operating. Moreover, inflation is a lagging indicator. Table I-2 splits the post-war U.S. business cycles into short, medium, and long buckets based on the length of the expansion phase. It presents the number of months from when full employment was reached to the turning point for consumer price inflation in each expansion. There was a wide variation in this lag in the short- and medium-length expansions, but the lags were short on average. Chart I-10Phillips Curve Still (Weakly) Operating Table I-2Inflation Reacts With A Lag It is a different story for long expansions, where the lag averaged more than two years. We have pointed out in the past that it takes longer for inflation pressures to reveal themselves when the economy approaches full employment gradually, in contrast to shorter expansions when momentum is so strong the demand crashes into supply constraints. The fact that U.S. unemployment rate has only been below the estimate of full employment for eight months in this expansion suggests that perhaps we and the Fed are just being too impatient in waiting for the inflection point. Turning to Europe, the IPT ratio confirms the ECB's view that there is an abundance of under-employment, despite the relatively low unemployment rate. This suggests that the Eurozone remains behind the U.S. in the economic cycle. As expected, the ECB announced a tapering in its asset purchase program to take place next year. While policymakers are backing away from QE in the face of healthy growth and a shrinking pool of bonds to purchase, they will continue to emphasize that rate hikes are a long way off in order to avoid a surge in the euro and an associated tightening in financial conditions. U.S./Eurozone bond yield spreads are still quite wide by historical standards and thus it is popular to bet on spread narrowing and a stronger euro/weaker dollar. However, some narrowing in short-term rate spreads is already discounted based on the OIS forward curve (Chart I-11). The real 5-year, 5-year forward OIS spread - the market's expectation of how much higher U.S. real 5-year rates will be in five years' time relative to the euro area - stands at about 70 basis points. This spread is not wide by historical standards, and thus has room to widen again if market expectations for the fed funds rate moves up toward the Fed's 'dot plot' over the next 6-12 months. While market pricing for the ECB policy rate path appears about right in our view, market expectations for rate hikes in the U.S. are too complacent. This implies that long-term spreads could widen in favor of the U.S. dollar over the coming months, especially if U.S. growth accelerates while euro area growth cools off a bit. The fact the U.S. economic surprise index has turned positive is early evidence that this process may have already begun. Moreover, the starting point is that the dollar has been weaker than interest rate differentials warrant, such that there is some room for the dollar to 'catch up', even if interest rate differentials do not move (Chart I-12). We see EUR/USD falling to 1.15 by the end of the year. Chart I-11Room For U.S./Eurozone Spreads To Widen... Chart I-12...Giving The Dollar A Lift A New Fed Chair? Our forecast for yield spreads and currencies is not overly affected by the choice of Fed Chair for next year. President Trump's meeting with academic John Taylor reportedly went well, but we think the President will prefer someone with a less hawkish bent. Keeping Chair Yellen is an option, but she has strong views on financial sector regulation that Trump does not like. The prevailing wisdom is that Jerome Powell is a moderate who is only slightly more hawkish than Yellen. But the truth is that we don't really know where he stands because he has no academic publication record and has generally steered clear of taking bold views on monetary policy. In any event, the organizational structure of the Fed makes it impossible for the chair to run roughshod over other FOMC members. This suggests that no matter who is selected, the general thrust of monetary policy will not change radically next year. As discussed above, uncertainty is elevated, but our base case sees inflation rising enough in the coming months for the Fed to maintain their 'dot plot' forecast. The market and the Fed are correct to 'look through' the near-term growth hit from the hurricanes, to the rebound that always follows the destruction. The U.S. housing sector is a little more worrying because some softness was evident even before the hurricanes hit. Since the early 1960s, a crest in housing led the broader economic downturn by an average of seven quarters. Nonetheless, we continue to expect that the housing soft patch does not represent a peak for this cycle. Residential investment should provide fuel to the economy for at least the next two years as pent up demand is worked off, related to depressed household formation since the 2008 financial crisis. Affordability will still be favorable even if mortgage rates were to rise by another 100 basis points (Chart I-13). Robust sentiment in the homebuilder sector in October confirms that the hurricane setback in housing starts is temporary. China And Base Metals Turning to China, economic momentum is on the upswing. Real-time measures of economic activity such as electricity production, excavator sales, and railway freight traffic are all growing at double-digit rates, albeit down from recent peak levels (Chart I-14). Various price indexes also reveal a fairly broadly-based inflation pickup to levels that will unnerve the authorities. Growth will likely slow in 2018 as policymakers continue to pare back stimulus. We do not foresee a substantial growth dip next year, but it could be hard on base metals prices. Chart I-13Housing Affordability Outlook Housing ##br##Affordability Under Various Rate Assumptions Chart I-14China: Healthy ##br##Growth Indicators Policy shifts discussed in Chinese President Xi's speech in October to the Party Congress are also negative for metals prices in the medium term. The speech provided a broad outline of goals to be followed by concrete policy initiatives at the National People's Congress (NPC) in March 2018. He emphasized that policy will tackle inequality, high debt levels, overcapacity and pollution. Globalization will also remain a priority of the government. The supply side reforms required to meet these goals will be positive in the long run, but negative for growth in the short run. Restructuring industry, deleveraging the financial sector and fighting smog will all have growth ramifications. The government could use fiscal stimulus to offset the short-term hit to growth. However, while overall growth may not slow much, the shift away from an investment-heavy, deeply polluting growth model, will undermine the demand for base metals. Our commodity strategists also highlight the supply backdrop for most base metals is not supportive of an extended rally in prices. The implication is that investors who are long base metals should treat it as a trade rather than a strategic position. Despite our expectation that policy will continue to tighten, we believe that investors should overweight Chinese stocks relative to other EM markets. Investment Conclusions: Our base case remains that global growth will stay reasonably firm in 2018, although the composition of that growth will shift towards the U.S. thanks to the lagged effects of the easing in U.S. financial conditions that has taken place this year and the likelihood of some fiscal stimulus next year. The U.S. Congress has drawn closer to approving a budget resolution for fiscal 2018 that would pave the way for tax legislation to reach President Donald Trump's desk by the end of the first quarter of next year. Surveys show that investors have all but given up on the prospect of tax cuts, which means that it will be a positive surprise if it finally arrives (as we expect). Positive U.S. economic growth surprises and the disappearing output gap will allow the Fed to raise rates more than is discounted by the markets, providing a lift to the dollar and widening U.S. yield spreads relative to its trading partners. The momentum in profit growth, however, will favor Japan relative to the U.S. and Europe. Investors should favor Japanese equities and hedge the currency risk. There is still more upside for oil prices, but we are not playing the rally in base metals. The Chinese economy is performing well at the moment, but ample base metal supply and a rising dollar argue against a substantial price rise from current levels. Emerging market equities should underperform the developed markets due to a rising U.S. dollar and the largely sideways path for base metals. Our macro and profit views are consistent with cyclicals outperforming defensive stocks. Investors should also continue to bet on higher inflation expectations and be overweight corporate bonds (relative to governments) in the major developed fixed-income markets. Our base-case outlook implies that it is too early to fully retreat from risk assets and prepare for the next recession. Nonetheless, the market has entered a late-cycle phase. Calm macro readings and still-easy monetary policy have generated signs of froth. Investors appear to have shed fears of secular stagnation, and have embraced a return to a lackluster-growth version of the Great Moderation. Low levels of market correlation and implied volatility can perhaps be justified, but only if there are no financial accidents on the horizon and any rise in inflation is gradual enough to keep the bond vigilantes at bay. Upside inflation surprises would destabilize the three-legged stool supporting risk assets, especially at a time when the Fed is shrinking its balance sheet. Black Monday is a reminder that major market pullbacks can occur even when the economic outlook is bright. Thus, investors with less tolerance for risk should maintain an extra cash buffer to protect against swoons, and to ensure that they have dry powder to exploit them when they materialize. Mark McClellan Senior Vice President The Bank Credit Analyst October 26, 2017 Next Report: November 20, 2017 1 Please see BCA Special Report, "Black Monday, Thirty Years On: Revisiting The First Modern Global Financial Crisis," October 19, 2017, available at bca.bcaresearch.com 2 Please see BCA U.S. Equity Strategy Weekly Report, "Banks Hold The Key," October 24, 2017, available at uses.bcaresearch.com 3 Recent Wage Dynamics In Advanced Economies: Drivers And Implications. Chapter 2, IMF World Economic Outlook. October 2017. II. Three Demographic Megatrends Dear Client, This month's Special Report is written by my colleague, Peter Berezin, Chief Global Strategist. Peter highlights three key demographic trends that will shape financial markets in the coming decades. His non-consensus conclusions include the idea that demographic trends will be negative for both bonds and equities over the long haul, in part because the trends are inflationary. Moreover, continuing social fragmentation will not be good for business. Mark McClellan Megatrend #1: Population Aging. Aging has been deflationary over the past few decades, but will become inflationary over the coming years. Megatrend #2: Global Migration. International migration has the potential to lift millions out of poverty while boosting global productivity. However, if left unmanaged, it poses serious risks to economic stability. Megatrend #3: Social Fragmentation. Rising inequality, cultural self-segregation, and political polarization are imperilling democracy and threatening free-market institutions. On balance, these trends are likely to be negative for both bonds and equities over the long haul. In today's increasingly short-term oriented world, it is easy to lose track of megatrends that are slowly shifting the ground under investors' feet. In this report, we tackle three key social/demographic trends. Chart II-1Our Aging World Megatrend #1: Population Aging Fertility rates have fallen below replacement levels across much of the planet. This has resulted in aging populations and slower labor force growth (Chart II-1). In the standard neoclassical growth model, a decline in labor force growth pushes down the real neutral rate of interest, r*. This happens because slower labor force growth causes the capital stock to increase relative to the number of workers, resulting in a lower rate of return on capital.1 The problem with this model is that it treats the saving rate as fixed.2 In reality, the saving rate is likely to adjust to changes in the age composition of the workforce. Initially, as the median age of the population rises, aggregate savings will increase as more people move into their peak saving years (ages 30 to 50). This will put even further downward pressure on the neutral rate of interest. Eventually, however, savings will fall as these very same people enter retirement. This, in turn, will lead to a higher neutral rate of interest. If central banks drag their feet in raising policy rates in response to an increase in r*, monetary policy will end up being too stimulative. As economies overheat, inflation will pick up, leading to higher long-term nominal bond yields. Contrary to popular belief, spending actually increases later in life once health care costs are included in the tally (Chart II-2). And despite all the happy talk about how people will work much longer in the future, the unfortunate fact is that the percentage of American 65 year-olds who are unable to lead active lives because of health care problems has risen from 8.8% to 12.5% over the past 10 years (Chart II-3). Cognitive skills among 65 year-olds have also declined over this period. We are approaching the inflection point where demographic trends will morph from being deflationary to being inflationary. Globally, the ratio of workers-to-consumers - the so-called "support ratio" - has peaked after a forty-year ascent (Chart II-4). As the support ratio declines, global savings will fall. To say that global saving rates will decline is the same as saying that there will be more spending for every dollar of income. Since global income must sum to global GDP, this implies that global spending will rise relative to production. That is likely to be inflationary. Chart II-2Savings Over The Life Cycle Chart II-3Climbing Those Stairs Is ##br##Getting More And More Difficult Chart II-4The Ratio Of Workers To ##br##Consumers Has Peaked The projected evolution of support ratios varies across countries. The most dramatic change will happen in China. China's support ratio peaked a few years ago and will fall sharply during the coming decade. Nearly one billion Chinese workers entered the global labor force during the 1980s and 1990s as the country opened up to the rest of the world. According to the UN, China will lose over 400 million workers over the remainder of the century (Chart II-5). If the addition of millions of Chinese workers to the global labor force was deflationary in the past, their withdrawal will be inflationary in the future. The fabled "Chinese savings glut" will eventually dry up. Chart II-5China On Course To Lose More ##br##Than 400 Million Workers Rising female labor force participation rates have blunted the effect of population aging in Europe and Japan. This has allowed the share of the population that is employed to increase over the past few decades. However, as female participation stabilizes and more people enter retirement, both regions will also see a rapid decline in saving rates. This could lead to a deterioration in their current account balances, with potential negative implications for the yen and the euro. Population aging is generally bad news for equities. The slower expansion in the labor force will reduce the trend GDP growth. This will curb revenue growth, and by extension, earnings growth. To make matter worse, to the extent that lower savings rates lead to higher real interest rates, population aging could reduce the price-earnings multiple at which stocks trade. This could be further exacerbated by the need for households to run down their wealth as they age, which presumably would include the sale of equities. Megatrend #2: Global Migration Economist Michael Clemens once characterized the free movement of people across national boundaries as a "trillion-dollar bill" just waiting to be picked up from the sidewalk.3 Millions of workers toil away in poor countries where corruption is rife and opportunities for gainful employment are limited. Global productivity levels would rise if they could move to rich countries where they could better utilize their talents. Academic studies suggest that less restrictive immigration policies would do much more to raise global output than freer trade policies. In fact, several studies have concluded that the removal of all barriers to labor mobility would more than double global GDP (Table II-1). The problem is that many migrants today are poorly skilled. While they can produce more in rich countries than they can back home, they still tend to be less productive than the average native-born worker. This can be especially detrimental to less-skilled workers in rich countries who have to face greater competition - and ultimately, lower wages - for their labor. Chart II-6 shows that the share of U.S. income accruing to the top one percent of households has closely tracked the foreign-born share of the population. Table II-1Economic Benefits Of Open Borders Chart II-6Immigration Versus Income Distribution Low-skilled migration can also place significant strains on social safety nets. These concerns are especially pronounced in Europe. The employment rate among immigrants in a number of European countries is substantially lower than for the native-born population (Chart II-7). For example, in Sweden, the employment rate for immigrant men is about 10 percentage points lower than for native-born men. For women, the gap is 17 points. The OECD reckons that a typical 21-year old immigrant to Europe will contribute €87,000 less to public coffers in the form of lower taxes and higher welfare benefits than a non-immigrant of the same age (Chart II-8). Chart II-7Low Levels Of Immigrant Labor Participation In Parts Of Europe Chart II-8Immigration Is Straining Generous ##br##European Welfare States All of this would matter little if the children of today's immigrants converged towards the national average in terms of income and educational attainment, as has usually occurred with past immigration waves. However, the evidence that this is happening is mixed. While there is a huge amount of variation within specific immigrant communities, on average, some groups have fared better than others. The children of Asian immigrants to the U.S. have tended to excel in school, whereas college completion rates among third-generation-and-higher, self-identified Hispanics are still only half that of native-born non-Hispanic whites (Chart II-9). Across the OECD, second generation immigrant children tend to lag behind non-immigrant students, often by substantial margins (Chart II-10). Chart II-9Hispanic Educational Attainment Lags Behind Chart II-10Worries About Immigrant Assimilation Immigration policies that place emphasis on attracting skilled migrants would mitigate these concerns. While such policies have been adopted in a number of countries, they have often been opposed by right-leaning business groups that benefit from cheap and abundant labor and left-leaning political parties that want the votes that immigrants and their descendants provide. Humanitarian concerns also make it difficult to curtail migration, especially when it is coming from war-torn regions. Chart II-11The Projected Expansion ##br##In Sub-Saharan Population Europe's migration crisis has ebbed in recent months but could flare up at any time. In 2004, the United Nations estimated that sub-Saharan Africa's population will increase to 2 billion by the end of the century, up from one billion at present. In its 2017 revision, the UN doubled its projection to 4 billion. Nigeria's population is expected to rise to nearly 800 million by 2100; Congo's will soar to 370 million; Ethiopia's will hit 250 million (Chart II-11). And even that may be too conservative because the UN assumes that the average number of births per woman in sub-Saharan Africa will fall from 5.1 to 2.2 over this period. For investors, the possibility that migration flows could become disorderly raises significant risks. For one, low-skill migration could also cause fiscal balances to deteriorate, leading to higher interest rates. Moreover, as we discuss in greater detail below, it could propel more populist parties into power. This is a particularly significant worry for Europe, where populist parties have often pursued business-sceptic, anti-EU agendas. Megatrend #3: Social Fragmentation In his book "Bowling Alone," Harvard sociologist Robert Putnam documented the breakdown of social capital across America, famously exemplified by the decline in bowling leagues.4 There is no single explanation for why communal ties appear to be fraying. Those on the left cite rising income and wealth inequality. Those on the right blame the welfare state and government policies that prioritize multiculturalism over assimilation. Conservative commentators also argue that today's cultural elites are no longer interested in instilling the rest of society with middle-class values. As a result, behaviours that were once only associated with the underclass have gone mainstream.5 Technological trends are exacerbating social fragmentation. Instead of bringing people together, the internet has allowed like-minded people to self-segregate into echo chambers where members of the community simply reinforce what others already believe. It is thus no surprise that political polarization has grown by leaps and bounds (Chart II-12). When people can no longer see eye to eye, established institutions lose legitimacy. Chart II-13 shows that trust in the media has collapsed, especially among right-leaning voters. Perhaps most worrying, support for democracy itself has dwindled around the world (Chart II-14). Chart II-12U.S. Political Polarization: Growing Apart Chart II-13The Erosion Of Trust In Media It would be naïve to think that the public's rejection of the political establishment will not be mirrored in a loss of support for the business establishment. The Democrats "Better Deal" moves the party to the left on many economic issues. Nearly three-quarters of Democratic voters believe that corporations make "too much profit," up from about 60% in the 1990s (Chart II-15). Chart II-14Who Needs Democracy When You Have Tinder? Chart II-15People Versus Companies The share of Republican voters who think corporations are undertaxed has stayed stable in the low-40s, but this may not last much longer. Wall Street, Silicon Valley, and the rest of the corporate establishment tend to lean liberal on social issues and conservative on economic ones - the exact opposite of a typical Trump voter. If Trump voters abandon corporate America, this will leave the U.S. without any major party actively pushing a pro-business agenda. That can't be good for profit margins. The fact that social fragmentation is on the rise casts doubt on much of the boilerplate, feel-good commentary written about the "sharing economy." For starters, the term is absurd. Uber drivers are not sharing their vehicles. They are using them to make money. Both passengers and drivers can see one another's ratings before they meet. This reduces the need for trust. As trust falls, crime rises. The U.S. homicide rate surged by 20% between 2014 and 2016 according to a recent FBI report.6 In Chicago, the murder rate jumped by 86%. In Baltimore, it spiked by 52%. Chart II-16 shows that violent crime in Baltimore has remained elevated ever since riots gripped the city in April 2015. The number of homicides in New York, whose residents tend to support more liberal policing standards for cities other than their own, has remained flat, but that is unlikely to stay the case if crime is rising elsewhere. The multi-century decline in European homicide rates also appears to have ended (Table II-2). Much has been written about how millennials are flocking to cities to enjoy the benefits of urban life. But this trend emerged during a period when urban crime rates were falling. If that era has ended, urban real estate prices could suffer tremendously. It is perhaps not surprising that the increase in crime rates starting in the 1960s was mirrored in rising inflation (Chart II-17). If governments cannot even maintain law and order, how can they be trusted to do what it takes to preserve the value of fiat money? The implication is that greater social instability in the future is likely to lead to lower bond prices and a higher equity risk premium. Chart II-16Do You Still Want To Move Downtown? Table II-2Crime Rates Are Creeping Higher In Europe Chart II-17Homicides And Inflation Peter Berezin Chief Global Strategist Global Investment Strategy 2 Another problem with the neoclassical model is that it assumes perfectly flexible wages and prices. This ensures that the economy is always at full employment. Thus, if the saving rate rises, investment is assumed to increase to fully fill the void left by the decline in consumption. In the real world, the opposite tends to happen: When households reduce consumption, firms invest less, not more, in new capacity. One of the advantages of the traditional Keynesian framework is that it captures this reality. And interestingly, it also predicts that aging will be deflationary at first, but will eventually become inflationary. Initially, slower population growth reduces the need for firm to expand capacity, causing investment demand to fall. Aggregate savings also rises, as more people move into their peak saving years. Globally, savings must equal investment. If desired investment falls and desired savings rises, real rates will increase. At the margin, higher real rates will discourage investment and encourage saving, thus ensuring that the global savings-investment identity is satisfied. As savings ultimately begins to decline as more people retire, the equilibrium real rate of interest will rise again. 3 Michael A. Clemens, "Economics and Emigration: Trillion-Dollar Bills on the Sidewalk?" Journal of Economic Perspectives Vol. 25, no.3, pp. 83-106 (Summer 2011). 4 Robert D. Putnam, "Bowling Alone: The Collapse And Revival Of American Community," Simon and Schuster, 2001. 5 Charles Murray has been a leading proponent of this argument. Please see "Coming Apart: The State Of White America, 1960-2010," Three Rivers Press, 2013. 6 Federal Bureau of Investigation, "Crime In The United States 2016" (Accessed October 25, 2017). III. Indicators And Reference Charts Global equity markets partied in October on solid earnings and economic growth figures, and the rising chances of a tax cut in the U.S. among other bullish developments. The Nikkei has been particularly strong in local currency terms following the re-election of Abe. Our equity indicators remain upbeat on the whole, although the rally is looking stretched by some measures. The BCA monetary indicator is hovering at a benign level. Implied equity volatility is very low, investor sentiment is frothy and our Speculation Indicator is elevated. These suggest that a lot of good news is already discounted. Our valuation indicator is also closing in on the threshold of overvaluation at one standard deviation. Our technical indicator is rolling over, although it needs to fall below the zero line to send a 'sell' signal. On a constructive note, the solid rise in earnings-per-share is likely to continue in the near term, based on positive earnings surprises and the net revisions ratio. Moreover, our new Revealed Preference Indicator (RPI) continued on its bullish equity signal in September for the third consecutive month. We introduced the RPI in the July report. It combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Our Willingness-to-Pay (WTP) indicators are also bullish on stocks in the U.S., Europe and Japan. These indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. The U.S. and European WTPs rose in October after a brief sideways move in previous months, suggesting that equity flows have turned more constructive. But the Japanese WTP is outshining the others. Given that the Japanese WTP is rising from a low level, it suggests that there is more 'dry powder' available to purchase Japanese stocks, especially relative to the U.S. market. We favor Japanese stocks relative to the other two markets in local currency terms, as highlighted in the Overview section. Oversold conditions for the U.S. dollar have now been absorbed based on our technical indicator, but there is plenty of upside for the currency before technical headwinds begin to bite. The greenback looks expensive based on PPP, but is less so on other measures. We are positive in the near term. Our composite technical indicator for U.S. Treasurys has moved above the zero line, but has not reached oversold territory. Bond valuation is close to fair value based on our long-standing valuation model. These factors suggest that yields have more upside potential before meeting resistance. Other models that specifically incorporate global economic factors suggest that the 10-year Treasury is still about 20 basis points on the expensive side. Stay below benchmark in duration. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market ##br##And Earnings: Relative Performance Chart III-8Global Stock Market ##br##And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst