Developed Countries

Overweight Since the beginning of February, the S&P air freight & logistics group has been waylaid by reports that Amazon was exploring its own logistics network. This is not new news; in fact, we wrote about this the last time a media outlet flagged Amazon's growing logistics efforts in October of last year.1 In that report, we noted three reasons (all of which are still valid) why the reaction in the index was an overreaction: First, Amazon represents approximately 3% of FDX' North American volume and 7% of UPS, according to Moody's, implying relatively small top line impacts from an Amazon shift. Second, those volumes come at extremely low margins and the companies may be able to replace them more profitably. Last, it is highly unlikely that Amazon could replace FDX and UPS completely, with their unmatched 'last mile' infrastructure, nor does this move signal that this is the intention. We think investors should stay focused on the fundamentals; air freight volumes move hand-in-hand with U.S. sales (second panel) and resilient global growth; the current message is unambiguously positive. Further, any Amazon effects have been ignored in sell side estimates which are currently pointing to a solid earnings recovery (third panel). Despite the positive backdrop, sentiment has taken the index's valuation to its lowest point in the last 15 years (bottom panel). This looks like as good an entry point as one could expect; stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5AIRF - UPS, FDX, CHRW, EXPD. 1 Please see BCA U.S. Equity Strategy Insight Report, “Is Amazon Moving Vertical?” dated October 6, 2017, available at uses.bcaresearch.com.

Neutral (Downgrade Alert) Comcast shareholders were surprised earlier this week with the announcement that they were making an offer to purchase British satellite broadcaster Sky, besting an offer from 21st Century Fox for the 61% it doesn't already own. The announcement raises the specter of both an expensive bidding war for these assets as well as a potential bidding war for 21st Century Fox which is itself subject to a pending takeover from Disney. Overall, it appears that media distribution assets are being consolidated at high (and rising) valuations. Such consolidation is logical for U.S. media interests; pricing power has been negative for the past year (second panel) and relative EPS growth has flat lined (third panel). These conditions have been partially reflected in valuation multiples which are already well below normal (bottom panel). Should a bidding war emerge, balance sheets will get stretched resulting in higher risk premiums and deteriorating EPS, both of which mean valuations sink further. Altogether, we are adding a downgrade alert to our neutral rating on media stocks. The ticker symbols for the stocks in the movies & entertainment and cable & satellite indexes (collectively the media indexes) are BLBG: DIS, TWX, FOXA, FOX, VIAB and BLBG: S5CBST - CMCSA, CHTR, DISH, respectively.

Dear Client, I am travelling this week meeting clients in Asia, so this report has been written by my colleagues, Billy Zicheng Huang and Sophie McGrath. Greece, the epicentre of the euro debt crisis, is finally recovering. Declining net NPLs, an upturn in investor confidence and improving employment are encouraging. But there is a risk that growth will lose some momentum amid the country's exit from the third economic adjustment program. Hence, we are recommending a neutral weighting in the Greek equity market as a whole comprising four overweight ideas counterbalanced by four underweight ideas. We expect companies with essential product focus, low debt levels and strong asset health to outperform non-essential product providers, highly leveraged players and weak asset-quality counterparts. Dhaval Joshi Best Overweight And Underweight Ideas Table I-1Single-Stock Statistics On Select Greek Companies* Greece: The Long Road To Recovery Macro indicators in Greece have improved and investors have become more confident. This is highlighted by the recent upgrade of Greece's long-term sovereign credit rating to B and an oversubscribed seven-year bond sale, confirming high investor demand. Nevertheless, there is a risk that growth will lose some momentum amid the country's exit from the third economic adjustment program. Listing the improvements, economic sentiment is approaching previous peaks (Chart I-1), the unemployment rate has dropped to its lowest level since 2011 (Chart I-2) and the youth unemployment rate has fallen around 20 percentage points from its high (Chart I-3). Chart I-1Economic Sentiment Has Improved Chart I-2Unemployment Is Down... Chart I-3...Youth Unemployment Even More So Furthermore, the most intense headwinds from fiscal drag are over. In the depths of the debt crisis, fiscal drag reached 7% of annual GDP. While Greece is not set to receive a sustained fiscal 'thrust' in the medium term, it appears the worst is over on the austerity front (Chart I-4). The most promising indicator is competitiveness. Greece appears to have made the necessary adjustments to unit labor costs and is no longer a euro area outlier (Chart I-5). Chart I-4Peak Fiscal Drag##br## Is Over Chart I-5Unit Labour Costs Are Now In Line ##br##With Euro Area Counterparts Recent developments in the banking system are also encouraging. Bank liquidity has improved, and the use of ECB Emergency Liquidity Assistance (ELA) has significantly diminished (Chart I-6). Net NPLs have declined sharply and are now covered by bank equity capital (Chart I-7). An unprecedented legal foundation is now in place to address the NPL stockpile. These measures include the introduction of electronic auctions to recover claims, the simplification of the out-of-court settlement process and reducing the liability of individuals involved. If net NPLs continue to fall, we can expect a healthier banking sector to support the economy, as witnessed in Spain, Ireland, and more recently in Italy. Chart I-6Banks Are No Longer Reliant ##br##On Emergency Funding Chart I-7Bank Equity Capital Finally ##br##Exceeds Net NPLs Despite these encouraging signs, the consumption recovery is fragile as households continue to delever (Chart I-8). Additionally, retail sales have dipped again recently (Chart I-9). Chart I-8Households Continue To Delever Chart I-9Retail Sales Have Dipped Regarding the bailout exit and debt sustainability, markets have seemingly priced in the wrapping up of the third review later this year, with the Eurogroup meeting on January 22 having recorded progress. However, what is more uncertain is whether this will take the form of a 'clean' or 'dirty' exit. The level of post-bailout monitoring that is agreed upon will ultimately dictate the pace of Greece's return to capital market normalcy. Considering the uncertainties in the overall picture, we recommend a market neutral portfolio in Greece with an overall beta of 0.15, consisting of four overweight companies versus four underweight counterparts from the consumer discretionary, telecoms, real estate, banking, consumer staples and energy sectors (Table I-2). Through our selection process we focused on companies with better growth profiles in essential sectors of the Greek economy. Table I-2Select Companies And 12-Month Beta Vs. MSCI EM Sector Specifics/Dynamics Our overweight (OW) basket performance over the past three years has been exceptionally strong relative to the underweight (UW) names. The OW basket has outperformed by 59% (Chart I-10A). However, this was primarily due to a selloff in Piraeus Bank (UW) in the second half of 2015. On a short-term horizon we see a different picture. Looking at one-year performance, the OW basket has actually just closed the underperformance gap over the past two months (Chart I-10B). Chart I-10AThree-Year Performance: ##br##Overweight Vs. Underweight Basket Chart I-10BOne-Year Performance: ##br##Overweight Vs. Underweight Basket Valuations favor the OW basket, especially from the second half of 2017 on, when OW and UW share prices began to diverge. Compared to historical valuations, OW names are currently trading close to their three-year average P/E, while their UW counterparts are trading at one standard deviation above historical P/E (Chart I-11A, Chart I-11B, and Chart I-11C). Chart I-11AOW Basket Displays Appealing Valuations##br## Relative To UW Basket... Chart I-11B...And Its Own ##br##Historical Average... Chart I-11C...While UW Basket Is Trading One Standard##br## Deviation Above Mean Non-bank OW companies display stronger operating margin dynamics, despite a recent dip, while the OW bank demonstrates superior net interest margins. Both margin trends are translating into solid profitability (Chart I-12A and Chart I-12B). Chart I-12ARobust Operational Level Performance... Chart I-12B...Feeds Into Solid Profitability Additionally, the OW basket displays more favorable debt dynamics, with debt remaining at low levels and trending down, whereas the debt ratio in the UW basket is already at an elevated level and continues to climb (Chart I-13). Meanwhile, free cash flow yield has favored UW players since mid-2016 when banks are excluded (Chart I-14). Chart I-13Debt Levels Remain ##br##Low In OW Companies Chart I-14Free Cash Flow Yield Favors ##br##UW Non-bank Names Specifically for banks, Alpha Bank (OW) enjoys a much healthier asset quality profile compared to Piraeus Bank (UW), with a combination of a lower NPL ratio and a higher tier-1 ratio (Chart I-15). Please also note that EPS growth is not shown as we normally do in our reports due to abrupt volatility in both baskets, which prevents us from drawing comparative conclusions. Dividend yield is also omitted due to the fact that most companies we have selected do not pay dividends. Chart I-15Alpha Bank Illustrates Healthier Asset Quality The Overweight Basket Jumbo (BELA GA) Jumbo (BELA GA) (Chart I-16) Chart I-16Performance Since February 2017: ##br##Jumbo Vs. MSCI EM Jumbo reported financial results for the fiscal 2017 year on October 12. Revenue increased by 7% year over year. Despite a difficult year in Greece, sales were compensated largely by organic growth in Romania and Bulgaria, with one new store open in each country respectively. EBITDA grew by 6% year over year, on the back of an effective cost management effort, while EBITDA margin remained virtually flat at 25.2%. As a result, the bottom line expanded by 8% year over year, with profit margin up 20 basis points to 19.2% Jumbo is currently trading at a forward P/E of 15.5x, while the market is forecasting an EPS CAGR of 6.3% over the next three years. The company is expected to continue its strong expansion drive in Eastern Europe, with one more store open in Romania in November 2017 (the 9th store) and one more store to be open next year in Bulgaria. At the same time, a drop in unemployment and a pick-up in household consumption will help Jumbo's recovery in the Greek market, signaling upside potential for the share price. Hellenic Telecom (HTO GA) Hellenic Telecom (HTO GA) (Chart I-17) Chart I-17Performance Since February 2017: ##br##Hellenic Telecom Vs. MSCI EM Hellenic Telecom (OTE) reported full-year 2017 results on February 22. Revenues declined slightly year over year by 1.3% to €3857 million, dragged down mainly by mobile operations in Albania, where revenues declined by 11.8%. Mobile operations in Romania remained positive, aided by a strong fourth-quarter performance which saw revenues increase by 14.4% year over year. Revenue growth in Greece remained solid in both mobile and fixed line, increasing by 0.7% and 1% year over year respectively. EBITDA shrank by 1.3% year over year, while EBITDA margin remained flat at 33.8%. As a result of muted top line growth on an annual basis as well as elevated operating costs, the bottom line contracted by 20% year over year, in line with market expectations. Hellenic Telecom is currently trading at a forward P/E of 86x, while the market is forecasting an EPS CAGR of 6.9% over the next three years. Management guidance indicates that free cash flow (FCF) and adjusted capex will start to return to normal levels in 2018 after heavy investments in both its fixed and mobile network capabilities in 2017. Additionally, growing confidence in the company's outlook is signalled by its announcement of a new shareholder return policy, where 100% of the FCF will be distributed through a combination of a dividend payout and share buybacks. We expect that its recent investment in mobile and fixed capabilities and an improving Greek economy should drive a positive performance in 2018. Grivalia Properties (GRIV GA) Grivalia Properties (GRIV GA) (Chart I-18) Chart I-18Performance Since February 2017: ##br##Grivalia Properties Vs. MSCI EM Grivalia Properties reported stellar full-year 2017 financial results on January 31. The top line displayed solid results, with rental income advancing 7% year over year. Furthermore, the company realized a strong net gain of EUR18.8 million from fair value adjustments on investment property, compared to a EUR13.6 million loss in 2016. This was mainly driven by new property investments. As a result, operating profit surged by 102% year over year. All this translated into 139% year-over-year net income growth. Due to loan growth, the loan-to-value ratio grew by 8 percentage points to 14%, while NAV per share expanded by 5% year over year. Grivalia Properties is trading at a forward P/E of 15x, while the market is forecasting an EPS contraction of 1% over the next three years. The company announced in February the acquisition of office space in Maroussi, which has already been leased out to multinational companies. Two more properties were acquired in Greece in the same month. We believe a stabilizing property market leaves ample room for recovery, which is expected to support Grivalia's overweight Greek real estate portfolio and its risk diversification. Alpha Bank (APLHA GA) Alpha Bank (APLHA GA) (Chart I-19) Chart I-19Performance Since February 2017: ##br##Alpha Bank Vs. MSCI EM Alpha Bank reported solid third-quarter 2017 financial results on November 30. Net interest income improved by 2% year over year, with net interest margin growing 20 basis points to 2.9%. However, on a quarter-over-quarter basis, growth was negative. Fee income depicted a similar picture, up 2% year over year but down 7% quarter over quarter. On the positive side, operating expenses were under control, declining by 3% year over year, effectively pushing down the cost/income ratio. With the help of a decline in impairment losses, net income surged by 386% year over year. Asset quality showed a pattern of recovery: The NPL ratio went down by 7.4 percentage points to 33.2% year over year, while the tier-1 ratio improved by 1 percentage point to 17.8%. Moreover, ELA has trended down year to date. The market is forecasting an EPS CAGR of 53.6% over the next three years. Despite uncertainty regarding stress testing and the overall trajectory of Greek economic growth, Alpha Bank has demonstrated a solid pace of recovery in terms of a better asset-liability mix, improved liquidity and steady disengagement with the ELA. As guided by management, ELA funding is expected to be further replaced by strong deposit inflows, deleveraging initiatives and an increase in interbank lending. The Underweight Basket Intralot (INLOT GA) Intralot (INLOT GA) (Chart I-20) Chart I-20Performance Since February 2017:##br## Intralot Vs. MSCI EM Intralot reported mixed third-quarter financial results on November 27. Top-line growth was solid, up 10% year over year, mainly boosted by licensed operations in Jamaica, Azerbaijan and Poland. This also drove up gross margin by 2.8 percentage points to 18.1% year over year. However, a cost hike took a bite out of profits, with operating expenses expanding by 8%. Along with a 49% surge in R&D costs, the bottom line was still in negative territory. On a year-to-date basis, cash flow grew by 23%. However, this was mainly boosted by financing activities, with operating cash flow almost unchanged. Meanwhile, long-term debt has grown by over 50% year over year, which has prompted questions on solvency and the ability to further carry the interest payment burden. The market is forecasting negative EPS over the next three years. We believe the 80% share sale of the company's Peruvian operations reflects its need for cash inflow and raises concerns on balance sheet health. Coca-Cola HBC (EEE GA) Coca-Cola HBC (EEE GA) (Chart I-21) Chart I-21Performance Since February 2017:##br## Coca-Cola HBC Vs. MSCI EM Coca-Cola HBC reported solid full-year 2017 financial results on February 14. Revenues came in strong, growing by 5% year over year. Sales volume in developed markets, developing markets and emerging markets went up 1%, 7%, and 7% respectively. Looking at product lines, Sparkling was the best seller, driven by new flavor launches (such as lime, lemon, and cucumber). Stripping out foreign exchange effects, FX-neutral revenue grew by 6% year over year. Cost of sales ticked up by 4% year over year. EBITDA expanded by 10% year over year, while EBITDA margin added 60 basis points to 14.3%. As a result, the bottom line expanded by 24% year over year, beating market expectations. Coca-Cola HBC is currently trading at a forward P/E of 20x, while the market is forecasting an EPS CAGR of 11% over the next three years. The stock price rallied in the second half of 2017 following the company's announcement that it was acquiring 54.5% of Coca-Cola Beverages Africa (CCBA), indicating market complacency toward a strong synergy effect the deal could bring. However, given its weak profitability, CCBA is not expected to be as accretive as many investors believe. With the acquisition news priced in, CCHBC's year-to-date stock price has begun reverting to its true fundamentals. Hellenic Petroleum (ELPE GA) Hellenic Petroleum (ELPE GA) (Chart I-22) Chart I-22Performance Since February 2017:##br## Hellenic Petroleum Vs. MSCI EM Hellenic Petroleum reported full-year 2017 financial results on February 22. Revenue increased by 21% year over year, driven by higher volumes (exports +12% and +14% in domestic net sales, mainly helped by aviation and bunkering) in the refining division and improved average selling prices. However, this result was offset by higher cost of sales, up 23% year over year, driven by increased input prices, sending gross margin 160 basis points lower to 13.6%. Operating income was 4.7% higher year over year, helped by lower operating expenses. EBITDA was up 14% year over year, while EBITDA margin was 200 basis points lower, finishing at 10.6%. The company secured bottom line growth of 15.7%, but came in below the market expectation by 4.5%. Hellenic Petroleum is currently trading at a forward P/E of 6.5x, while the market is forecasting an EPS CAGR of 4.6% over the next three years. The reopening of the Elefsina refinery will enable Hellenic Petroleum to return to normal capacity in 2018. However, continued maintenance work expected to end in March 2018 and higher crude prices will continue to place pressure on margins. We expect weak domestic demand to continue to impact carbon revenue, despite strong sales growth from increased tourism. Piraeus Bank (TPEIR GA) Piraeus Bank (TPEIR GA) (Chart I-23) Chart I-23Performance Since February 2017: ##br##Piraeus Bank Vs. MSCI EM Piraeus Bank delivered disappointing third-quarter 2017 financial results on November 9. Net interest income came in weak, sliding 3% year over year, with net interest margin remaining virtually flat at 2.7%. On the positive side, net fee income displayed strong growth, up 24% year over year. Operating expenses contracted by 5% year over year, pushing down the cost/income ratio by 5 percentage points to 51%. Despite robust pre-provisional income, the impairment on loans dragged down net income into negative territory, compared to a positive bottom line during the same period last year. Asset quality was a mixed bag: The NPL ratio went down by 2.6 percentage points to 48.3%, but is still the highest among its peers. The loan-to-deposit ratio declined, with ELA loan exposure trending slightly down year-to-date. The market is forecasting an EPS contraction of 8.8% over the next three years. Piraeus Bank has shown little signs of operational recovery, with most cost-savings efforts achieved through branch reductions (-8% year to date) and employee layoffs (-7% year to date). We believe the bank is still a long way away from a real turning point and prefer to monitor on the sidelines. How To Trade? The EMES team recommends gaining exposure to the sector through a basket of the listed stocks below, which would consist of overweight positions in four select Greek companies and underweight positions in the other four. The main goal is active alpha generation by excluding laggards and including out-of-benchmark plays, to avoid passive index-hugging via an ETF. Direct: Equity access through the tickers (Bloomberg): Jumbo (BELA GA) vs. Intralot (INLOT GA) Hellenic Telecom (HTO GA) vs. Coca-Cola HBC (EEE GA) Grivalia Properties (GRIV GA) vs. Hellenic Petroleum (ELPE GA) Alpha Bank (ALPHA GA) vs. Piraeus Bank (TPEIR GA) ETFs: There are no ETFs that would allow for an overweight/underweight position in the same sector. Funds: There are no funds that would allow for an overweight/underweight position in the same sector. Please note this trade recommendation is strategic and based on an overweight/underweight pair trade. We do not see a need for specific market timing for this call (for technical indicators please refer to our website link). For convenience, the performance of both market cap-weighted and equal-weighted equity baskets will be tracked (please see upcoming updates as well as the website link to follow performance). Risks To Our Investment Case Because of the overall market neutral exposure, the portfolio performance will be largely immune to the direction of Greek economic growth and political developments. Some macro risk factors stem from a slower-than-expected property market recovery, which would affect the rental income of Grivalia Properties. Other major macro risks include an oil price drop, which would benefit Hellenic Petroleum's profit margins within its refining operations. Also, a slow recovery of consumer sentiment and retail sales would put downward pressure on Jumbo's domestic top-line performance. Company specific risks worth mentioning include remarkable management efforts in CCBA's financial performance in the coming quarters. This would send the market a bullish signal on Coca-Cola HBC's stock price due to potentially strong synergies, posing upside risk to the underweight basket. Furthermore, Jumbo would be negatively affected by excessive focus on overseas markets, and thus it could miss further business development and market share expansion opportunities in the domestic market. Last but not least, asset quality remains problematic among banks, reflected by elevated NPLs, which would weigh on performance indefinitely if not properly tackled. Billy Zicheng Huang, Research Analyst billyh@bcaresearch.com Sophie McGrath, Research Assistant sophiemc@bcaresearch.co.uk

The GAA DM Equity Country Allocation model is updated as of February 28, 2018. After the large upgrade in January, the model has furthered upgraded the U.S. to a small overweight of 3.3 percentage points from neutral in January. This change is mainly financed by a reduction in the large overweight in the Netherlands. Directionally, the model is becoming more defensive in the sense that the sizes of large bets have shrunk two months in a row, as shown in Table 1. As shown in Table 2 and Chart 1, Chart 2 and Chart 3, the overall model underperformed its benchmark by 55 bps in February, largely driven by the Level 2 model which underperformed by 131 bps. The large underweight in Japan hurt the performance the most because in USD terms Japan was the best performer thanks to the strength of JPY versus USD. Since going live in January 2016, the overall model has outperformed the benchmark by 102 bps, largely from the allocation among the 11 non-U.S. countries, which has outperformed its benchmark by 345 bps. The Level 1 model has performed on par with the MSCI benchmark. Table 1Model Allocation Vs. Benchmark Weights Table 2Performance (Total Returns In USD) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see the January 29, 2016 Special Report, "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model." http://gaa.bcaresearch.com/articles/view_report/18850. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of February 28, 2018. Table 3Allocations Table 4Performance Since Going Live Chart 4Overall Model Performance The model has turned negative on cyclical sectors by sending negative signals from the growth component. Additionally, the recent correction in equity markets has also created unfavorable momentum signals. From being overweight on cyclical sectors by 10%, the model has now turned underweight by 1.3%. However, energy stocks have seen their overweight increase by 3% on the back of favorable valuations. The biggest change was an upgrade to overweight for the utilities sector on the back of the weaker growth outlook and not so negative momentum. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com

Fiscal Stimulus To Prolong The Expansion The market swoon in early February should not induce investors to lower risk. The stock market correction (the first for almost two years) was triggered by a couple of inflation and wage readings that came in slightly above expectations, and was exacerbated by some technical factors such as automated trading by volatility-target funds. But, significantly, it was not accompanied by the usual signals of rising risk aversion: for example, credit spreads barely widened and the gold price was stable (Chart 1). Volatility is likely to remain high but, as our U.S. Investment Strategy service recently found, the VIX has not been a useful indicator of recessions and bear markets: many times over the past 30 years it has spiked higher without risk assets producing negative returns over the subsequent 12 months (Chart 2).1 Recommended Allocation Chart 1Sell-Off Didn't Trigger Risk Signals Chart 2Spike In Vix Is Not A Sell Signal Fiscal policy moves in the U.S. make us believe, rather, that the current economic expansion will last longer than we previously forecast. A combination of tax cuts plus recent spending proposals (including $165 billion on the military and $45 billion on disaster relief) will boost GDP by about 0.8% of GDP this year and 1.3% next, compared to the IMF's earlier forecast of a fiscal contraction this year (Chart 3).2 Add to that the boost from the 8% trade-weighted depreciation of the U.S. dollar over the past 12 months (which should add 0.3% to growth over two years), and it is difficult to imagine U.S. GDP growth turning down any time soon. Accordingly, BCA has shifted its recession call from the second half of 2019 to sometime in 2020. Of course, this is not all good news. The U.S. budget deficit is likely to increase to 5½% of GDP in 2019, which will put upward pressure on interest rates. The fiscal impulse will hit an economy already at full capacity, and so will be inflationary. The scenario we envisage is boom-and-bust, leading to a nastier recession than we had previously expected. Nonetheless, the boost to growth should be positive for risk assets over the next 12 months. Our model of earnings growth now suggests that U.S. EPS should continue to grow at close to a 20% rate for the rest of this year (Chart 4). Chart 3Fiscal Boost To U.S. Growth Chart 4Earnings Growth Gets A Boost Too How quickly will the Fed push back against the potentially inflationary implications of this higher growth? We have found a remarkable turnaround in investors' perceptions of inflation over the past few weeks. Whereas last year most argued that structural forces (online shopping, the gig economy etc.) meant that inflation would stay depressed, now many worry that it will quickly shoot above 2% and force the Fed to tighten policy aggressively. This has caused them to over-react, for example, to the (rather obvious) statement from the last FOMC minutes that "participants noted that a stronger outlook for economic growth raised the likelihood that further gradual policy firming would be appropriate." Our view remains that core PCE inflation - the Fed's favorite measure - is likely to move back gradually to 2% (from 1.5% currently), but not accelerate dramatically. Unit labor costs remain subdued (Chart 5), the continued rise in the participation rate means there is more slack in the labor market than implied by headline unemployment (Chart 6), and inflation expectations remain low. This should allow new Fed chair Jerome Powell to continue to withdraw accommodation at a measured pace. The market has already priced in that the Fed will tighten this year at least in line with its dots (Chart 7). We expect four, rather than the Fed's projected three, hikes this year, but this should not be too hard for the market to absorb. Chart 5Unit Labor Costs Don't Point To Jump In Inflation Chart 6 Still Some Slack In Labor Market Chart 7Market Has Caught Up To The Fed We have for some months now advised long-term, more risk-averse investors to consider dialing back risk, and the volatility in February was a good example of why. We would expect further such bouts of volatility. However, with a recession still probably two years away, and a combination of stronger-than-expected growth and a Fed reluctant to accelerate tightening, the next 12 months should remain positive for equities and other risk assets. Fixed Income: We now expect the 10-year U.S. Treasury bond yield to rise to 3.3-3.5%. This will come from a further 40 BP increase in inflation expectations (taking them back to a level compatible with the Fed achieving its inflation target) plus a rise in the real yield, as markets start to price in the end of secular stagnation (Chart 8). The rise in global yields will be exacerbated by increasing net supply, as fiscal deficits rise and central banks wind down QE (Chart 9). We are, accordingly, underweight duration, and prefer inflation-linked bonds to nominal ones. We will likely reduce our exposure to credit before we turn defensive on equities. But, for now, strong economic growth and higher oil prices mean spread product is likely to outperform government bonds. Chart 8Inflation Expectations And Real Yields To Rise Chart 9Net Government Bond Supply To Increase Currencies: Rising interest rate differentials have failed to cause the dollar to rally (Chart 10). FX markets are trading, rather, on valuations (the euro and yen are, indeed, undervalued), on current account positions (the euro zone and Japan have large surpluses), and on the narrative that U.S. twin deficits historically caused the dollar to weaken. Our FX strategists find this is true only when, as in 2001-3, U.S. real rates were falling; after the Reagan tax cuts in 1981, real rates rose, pushing up the dollar (Chart 11). The key, therefore, is how quickly the Fed reacts this time. The dollar currently has strong downward momentum (especially against the yen) and this could continue. But as global growth slows relative to the U.S., relative interest rates are likely to reassert themselves as a factor, causing the dollar to strengthen again. Chart 10Rising Rate Differentials Fails To Boost Dollar Chart 11Do Twin Deficits Matter For Dollar? Equities: Given the macro environment, we continue to recommend pro-cyclical equity tilts, with overweights in higher beta markets such as the euro zone and Japan, and cyclical sectors such as financials, energy, and industrials. Our underweight on EM equities is based on the risk of a slowdown in China (where tighter financial conditions point to a slowing of the industrial sector, Chart 12), the possibility of a U.S. dollar rebound, and the vulnerability of highly leveraged foreign-currency EM borrowers to a rise in U.S. interest rates. Commodities: Our energy team has further revised up their oil price forecast, on expectations that the OPEC agreement will be extended, which will cause a greater draw-down in oil inventories (Chart 13).3 They see Brent crude averaging $74 a barrel this year, with spikes above $80. However, the response of the U.S. shale industry will begin to kick in, pushing the price down to below $60 by end-2019. We are neutral on industrial commodities, which will benefit from stronger global growth but are at risk in the event of dollar appreciation and slowdown in China. Chart 12Tighter Monetary Conditions In China Chart 13Oil Inventories To Draw Down Further Please note that, due to the Easter holidays in some countries, the GAA Quarterly Portfolio will be published one day later than usual, on April 3. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see U.S. Investment Strategy Weekly Report, "Late Innings," dated 26 February 2018, available at usis.bcaresearch.com 2 For details, please see The Bank Credit Analyst, "March 2018," available at bca.bcaresearch.com 3 Please see Commodity & Energy Strategy Weekly Report, "OPEC 2.0: Getting Comfortable With Higher Prices," dated 22 February 2018, available at ces.bcaresearch.com GAA Asset Allocation

Highlights The political path of least resistance leads to fiscal profligacy - in the U.S. and beyond. The response to populism is underway. The U.S. midterm election is market-relevant. Gridlock between the White House and Congress does, in fact, weigh on equity returns, after controlling for macro variables. The Democratic Party's chances of taking over Congress have fallen, but remain 50% in the House of Representatives. A divided House and Senate is the worst combination for equities, but macro factors matter most. China is clearly rebooting its "reform" agenda as Xi Jinping becomes an irresistible force. We remain long H-shares relative to EM, for now. Emerging markets - including an improved South Africa - will suffer as politics become a tailwind for U.S. growth and a headwind for Chinese growth. Feature The bond market has been shocked into action this month by the twin realizations that the Republican-held Congress is not as incompetent as believed and that the Republican Party is not as fiscally conservative as professed. When combined with steady U.S. wage growth and rising inflation expectations (Chart 1), our core 2018 theme - that U.S. politics would act as an accelerant to growth - has been priced in by the bond market with impressive urgency.1 The tax cuts alone were not enough to wake the bond market. First, the realization that a tax cut would pass Congress struck markets in late October, when it became increasingly clear that the $1.5 trillion Tax Cuts And Jobs Act would indeed pass the Senate. Second, the bill's passage along strict party lines - including the slimmest of margins in the Senate thanks to reconciliation rules - convinced investors that there would be no further compromises down the pipeline. The real game changer was the realization that the political path of least resistance leads towards profligacy. This happened with the signing into law of the February 9 two-year budget compromise (the Bipartisan Budget Act of 2018) that will see fiscal spending raised by around $380 billion.2 The deal failed to gain the support of a majority of Republicans in the House, despite House Speaker Paul Ryan's support, but 73 Democrats crossed the aisle to ensure its passage. They did so despite a lack of formal assurances that the House would consider an immigration bill. The three-day shutdown in late January has forced Democrats, who largely took the blame, to assess whether they care more about preserving their liberal credentials on fiscal policy or immigration policy. The two-year budget agreement is a testament to their concern for the former. The deal will see the budget deficit most likely rise to about 5.5% of GDP in FY2019, up from 3.3% in last year's CBO baseline forecast (Chart 2). Chart 1Rising U.S. Inflation Expectations Chart 2Fiscal Policy Gets Expansive Adding to the newly authorized fiscal spending could be a congressional rule-change that reintroduces earmarks - leading to a potential $20 billion additional spending per year. There is also a 10-year infrastructure plan that could see spending increase by another ~$200 billion over the next decade. The new budget compromise, combined with last year's tax cuts, will massively increase U.S. fiscal thrust beyond the IMF's baseline (Chart 3). The IMF's forecast, done before the tax cuts were passed, suggested that fiscal thrust would contract by about 0.5% of GDP this year, and would only slightly expand in 2019. Now we estimate that fiscal thrust will be a positive 0.8% of GDP in 2018 and 1.3% in 2019. These figures are tentative because it is not clear exactly how much of the spending will take place this year versus 2019 and 2020. Our colleague Mark McClellan, author of BCA's flagship The Bank Credit Analyst, has stressed that the impact on GDP growth will be less than these figures suggest because the economic multipliers related to tax cuts are less than those for spending.3 Our theme that the political path of least resistance will lead to profligacy is not exclusive to the U.S. After all, populism is not exclusive to the U.S, with non-centrist parties consistently capturing around 16% of the electoral vote in Europe (Chart 4). Chart 3The Budget Deal And Tax Cuts##br## Will Expand U.S. Fiscal Thrust Chart 4Populism Will Fuel Fiscal##br##Spending Beyond The U.S. Policymakers are not price-setters in the political marketplace, but price-takers. The price-setter is the median voter, who we believe has swung to the left when it comes to economic policy in developed markets after a multi-year, low-growth, economic recovery.4 Broadly speaking, investors should prepare for higher fiscal spending globally on the back of this dynamic. Aside from the U.S., the populist dynamic is evident in the world's third (Japan), fourth (Germany), and sixth (the U.K.) largest economies. Japan may have started it all, as a political paradigm shift in 2011-12 spurred a historic reflationary effort.5 Geopolitical pressure from China and domestic political pressures on the back of an extraordinary rise in income inequality, and natural and national disasters, combined to create the political context that made Abenomics possible. While the fiscal arrow has somewhat disappointed - particularly when PM Shinzo Abe authorized the 2014 increase in the consumption tax - Japan has still surprised to the upside on fiscal thrust (Chart 5). On average, the IMF has underestimated Japan's fiscal impulse by 0.84% since the beginning of 2012. Investors often understate the ability of centrist, establishment policymakers to rebrand anti-establishment policies - whether on fiscal spending or immigration - as their own. In January 2015, we asked whether "Abenomics Is The Future?"6 We concluded that rising populism in Europe would require a policy response not unlike the policy mix favored by Tokyo. Today, the details of the latest German coalition deal between the formally fiscally conservative Christian Democratic Union (CDU) and the center-left Social Democratic Party (SDP) means that even Germany has now succumbed to the political pressure to reflate. The CDU has agreed to fork over the influential ministry of finance to the profligate SPD and apparently spend an additional 46 billion euros, over the duration of the Grand Coalition, on public investment and tax cuts. Finally, in the U.K., the end of austerity came quickly on the heels of the Brexit referendum, the ultimate populist shot-across-the-bow. The new Chancellor of the Exchequer, Philip Hammond, announced a shift away from austerity almost immediately, scrapping targets for balancing the budget by the end of the decade. The change in rhetoric has carried over to the new government, especially after the Labour Party pummeled the Tories on austerity in the lead up to the June 2017 election. The bond market action over the past several weeks suggests that investors have not fully appreciated the political shifts underway over the past several years. Bond yields had to "catch up" to the political reality essentially over the course of February. However, the structural upward trajectory is now in place. The end of stimulative monetary policy will accelerate the rise in bond yields. Quantitative easing programs have soaked up more than the net government issuance of the major economies. Chart 6 shows that the flow of the major economies' government bonds available for the private sector to purchase was negative from 2015-2017. This flow will now swing to the positive side as fiscal spending necessitates greater issuance and as central banks withdraw demand. Real interest rates may therefore be higher to the extent that government bonds will have to compete with private-sector issuance for available savings. Chart 5Japan's Abenomics Leads The Way To More Spending Chart 6Lots Of Bonds Hitting The Private Market Bottom Line: The U.S. electorate chose the populist, anti-establishment Donald Trump as president with unemployment at a multi-decade low of 4.6%. The message from the U.S. election, and the rise of anti-establishment parties in Europe, is that the electorate is restless, even with the post-Great Financial Crisis recovery now in its ninth year. Policymakers have heard the message, loud and clear, and are adjusting fiscal policy accordingly. Over the course of the next quarter, BCA's Global Investment Strategy expects the rapid rise in bond yields to peter out, but investors should use any bond rallies as an opportunity to reduce duration risk. BCA's House View calls for the 10-year Treasury yield to finish the year at about 3.25%.7 Our U.S. bond strategists expect the end-of-cycle level of the nominal 10-year Treasury yield to be between 3.3% and 3.5%.8 Does The U.S. Midterm Election Matter? The three-day government shutdown that ended on January 22 has hurt the chances of the Democratic Party in the upcoming midterm election. The Democrats' lead in the generic congressional ballot has gone from a high of 13% at the end of 2017 to just 9% today (Chart 7). As Chart 8 illustrates, this generic ballot has some predictive quality. However, it also suggests that for Democrats, the lead needs to be considerably larger than for Republicans to generate the type of seat-swing needed to win a majority in the House of Representatives in 2018. Chart 7Democrats Have Lost Some Steam Chart 8Democrats Need Big Polling Lead To Win Majority There are three reasons for this built-in advantage for the Republican Party in recent midterm elections. First, the Republicans dominate the rural vote, which tends to be overrepresented in any electoral system that draws electoral districts geographically. Second, redistricting - or gerrymandering - has tended to favor the Republican Party in the past several elections. While the Supreme Court has recently struck down some of the most egregiously drawn electoral districts, the overall impact of gerrymandering since 2010 overwhelmingly favors the GOP. Third, midterm elections tend to have a lot lower voter turnout than general elections, which hurts the Democrats who rely on the youth and minority vote. Both constituencies tend to shy away from participation in the midterm election. Does the market care who wins the House and Senate? On the margin, yes. If the current GOP control of the White House, House of Representatives, and Senate were to be broken, markets might react negatively. It is often stated that gridlock has a positive effect on stock prices, as it reduces the probability of harmful government involvement in the economy and financial markets. However, research by our colleague Jonathan LaBerge, which we have recently updated, suggests otherwise. After controlling for the macro environment, gridlock between the White House and Congress is actually associated with modestly lower equity market returns.9 This conclusion is based on the past century of data. For most of that period, polarization has steadily risen to today's record-setting levels (Chart 9). As such, the negative impact of gridlock could be higher today. Table 1 illustrates the impact of four factors on monthly S&P 500 price returns. The first two columns demonstrate the effect on returns of recessions and tightening monetary policy, respectively, whereas the last two columns measure the effects of executive/legislative disunity and reduced uncertainty in the 12-months following presidential and midterm elections.10 The table presents the beta of a simple regression based on dummy variables for each of the four components (t-statistics are shown in parentheses). Chart 9U.S. Polarization Has Risen For 60 Years Table 1Divided Government Is, In Fact, Bad For Stocks As expected, the macro context has a much larger impact on stock returns than politically driven effects. The impact of political gridlock is shown to be negative regardless of timeframe. The takeaway for equity investors is that, contrary to popular belief, political gridlock is not positive for stock prices after controlling for important macro factors. Absolute results are similarly negative, with the average monthly S&P 500 returns considerably larger during periods of unified executive and legislative branches (Chart 10). Intriguingly, the less negative constellation of forces is when the president faces a unified Congress ruled by the opposing party. We would reason that such periods force the president to compromise with the legislature, which constitutionally has a lot of authority over domestic policy. The worst outcome for equity markets, by far, is when the president faces a split legislature. In these cases, we suspect that uncertainty rises as neither party has to take responsibility for negative policy outcomes, making them more likely. Chart 10A Unified Congress Is A Boon For Stocks In the current context, gridlock could lead to greater political volatility. For example, a Democratic House of Representatives would begin several investigations into the Trump White House and could potentially initiate impeachment proceedings against the president. But as we pointed out last year, impeachment alone is no reason to sell stocks.11 The Democrats would not have the ability to alter President Trump's deregulatory trajectory - which remains under the purview of the executive - nor would they be likely to gain enough seats to repeal the tax cut legislation. Yet given President Trump's populist bias, center-left Democrats could find much in common with the president on spending. This would only reinforce our adage that the political path of least resistance will tend towards profligacy. The only thing that President Trump and the Democrats in Congress will find in common, in other words, will be to blow out the U.S. budget deficit. Bottom Line: The chances of a Democratic takeover following the midterm elections have fallen, but remain at 50% for the House of Representatives. A gridlocked Congress is mildly negative for equity markets, taking into consideration that macro variables still dominate. Nonetheless, investors should ignore the likely higher political volatility and focus on the fact that President Trump and the Democrats are not that far apart when it comes to spending. China: The Reform Reboot Is Here And It Is Still Winter He told us not to believe the people who say it's spring in China again. It's still winter. - Anonymous Chinese government official referring to Liu He, the top economic adviser.12 The one risk to the BCA House View of a structural bond bear market - at least in the near term - is a peaking of global growth and a slowdown in emerging markets. The EM economies, which normally magnify booms in advanced economies, particularly in latter stages of the economic cycle, are currently experiencing a relative contraction in their PMIs (Chart 11). BCA Foreign Exchange Strategy's "carry canary" indicator - which shows that EM/JPY carry trades tend to lead global industrial activity - is similarly flashing warning signs (Chart 12).13 Chart 11EM Economies Underperforming Chart 12Yen Carry Trades Signal Distress At the heart of the divergence in growth between EM and DM is China. Beijing has been tightening monetary conditions as part of overall structural reform efforts, causing a sharp deceleration in the Li Keqiang index (Chart 13). In addition, the orders-to-inventories ratio has begun to contract, import volumes are weak, and export price growth is slowing sharply (Chart 14). Chart 13Li Keqiang Index Surprises Downward Chart 14China's Economy Weakens... The Chinese slowdown is fundamentally driven by politics. Last April we introduced a checklist for determining whether Chinese President Xi Jinping would "reboot" his reform agenda during his second term in office. We define "reform" as policies that accelerate the transition of China's growth model away from investment-driven, resource-intensive growth. Since then, political and economic events have supported our thesis. Most recently, interbank lending rates have spiked due to China's new macro-prudential regulations and monetary policy (Chart 15), and January's total credit growth clocked in at an uninspiring 11.2% (Chart 16). Tight credit control in the first calendar month typically implies that credit expansion will be limited for the rest of the year (Chart 17). A strong grip on money and credit growth is entirely in keeping with the three-year "battle" that Xi Jinping has declared against systemic financial risk.14 Chart 15...While Policy Drives Up Interbank Rates Chart 16January Credit Growth Disappoints... Chart 17... And January Credit Is The Biggest In short, we have just crossed the 50% threshold on our checklist, confirming that China is indeed rebooting its reform agenda (Table 2). Going forward, what matters is the intensity and duration of the reform push. Three events at the start of the Chinese New Year suggest that the market will be surprised by both. Table 2How Do We Know China Is Reforming? First, the National People's Congress (NPC), which convenes March 5, is reportedly planning to remove term limits for the president and vice-president, thus enabling Xi Jinping to remain as president well beyond March 2023. Xi was already set up to be the most powerful man in China's politics through the 2020s,15 so we do not consider this a material change in circumstances: the material change occurred last October when "Xi Thought" received the status of "Mao Zedong Thought" in the Communist Party's constitution and reshaped the Politburo to his liking. The point is that Xi's position is irresistible which means that his policies will have greater, not lesser, effectiveness as party and state bureaucrats scramble to enact them faithfully.16 Chart 18Crackdown On Shadow Lending Has Teeth Second, the Communist Party is reportedly convening its "Third Plenum" half a year early this year - that is, in late February and early March, just before the annual legislative meeting that begins March 5. This is a symbolic move. The third plenum is known as the "reform plenum," and this year is the fortieth anniversary of the 1978 third plenum that launched China's market reform and opening up to the global economy under Deng Xiaoping. However, the last time China convened a third plenum - in 2013 when Xi first announced his agenda - the excitement fizzled as implementation proved to be slow.17 As we have repeatedly warned clients, China's political environment has changed dramatically since 2013: the constraints to painful structural reforms have fallen.18 If the third plenum is indeed held early, some key decisions on reform initiatives will be made as we go to press, and any that require legislative approval will receive it instantly when the National People's Congress convenes on March 5.19 This will be a "double punch" that will supercharge the reform agenda this year. It is precisely the kind of ambition that we have been expecting. Third, one of the most important administrative vehicles of this new reform push, the Financial Stability and Development Commission (FSDC), has just made its first serious move.20 On February 23, China's top insurance regulator announced that it is taking control of Anbang Insurance Group for one year, possibly two, in order to restructure it amid insolvency and systemic risks. Anbang's troubles are idiosyncratic and have received ample media attention since June 2017.21 Nevertheless, China's government has just seized a company with assets over $300bn. Clearly the crackdown on the shadow financial sector has teeth (Chart 18). Anbang's case will reverberate beyond the handful of private companies involved in shadow banking and highly leveraged foreign acquisitions abroad. Beijing's focus is systemic risk, not merely innovative insurance products. The central government is scrutinizing state-owned enterprises (SOEs) and local governments as well as a range of financial companies and products. We provide a list of reform initiatives in Table 3. Table 3China Is Rebooting Economic Reforms What is the cumulative effect of these three developments? Basically, they raise the stakes for Xi's policies dramatically this year. If Xi makes himself president for life, and yet this year's third plenum is as over-hyped and under-delivered as in 2013, then we would expect China's economic future to darken rapidly. China will lose any pretext of reform just as the United States goes on the offensive against Beijing's mercantilism. It would be time to short China on a long-term time line. However, it would also spell doom for our positive U.S. dollar outlook and bearish EM view. If, on the other hand, Xi Jinping couples his power grab with renewed efforts to restructure China's economy and improve market access for foreigners, then he has a chance of deleveraging, improving China's productivity, and managing tensions with the U.S. This is the best outcome for investors, although it would still be negative for Chinese growth and imports, and hence EM assets, this year. The next political indicator to watch is the March 5 NPC session. This legislative meeting will be critical in determining what precise reforms the Xi administration will prioritize this year. The NPC occurs annually but is more important this year than usual because it installs a new government for the 2018-23 period and will kick off the new agenda. In terms of personnel, there is much speculation (Table 4).22 Investors should stay focused on the big picture: four months ago, the news media focused on Xi Jinping's Maoist thirst for power and declared that all reform efforts were dead in the water. Now the press is filled with speculation about which key reformer will get which key economic/financial position. The big picture is that Xi is using his Mao-like authority in the Communist Party to rein in the country's economic and financial imbalances. His new economic team will have to establish their credibility this year by remaining firm when the market and vested interests push back, which means more policy-induced volatility should be expected. Table 4China's New Government Takes Shape At National People's Congress The risk is that Beijing overcorrects, not that reforms languish like they did in 2015-16. Our subjective probability of a policy mistake remains at 30%, but we expect that the market will start to price in this higher probability of risk as the March political events unfold. As Liu He declared at Davos, China's reforms this year will "exceed the international community's expectations."23 The anti-corruption campaign is another important factor to monitor. In addition to any major economic legislation, the most important law that the NPC may pass is one that would create a new nationwide National Supervisory Commission, which will expand the Communist Party's anti-corruption campaign into every level of the state bureaucracy. In other words, an anti-corruption component is sharpening the policy effectiveness of the economic and financial agenda. In the aforementioned Anbang case, for instance, corporate chief Wu Xiaohui was stung by a corruption probe in June 2017 and is being tried for "economic crimes" - now his company and its counterparty risks are being restructured. The combination of anti-corruption campaign and regulatory crackdown has the potential to cause significant risk aversion among financial institutions, SOEs, and local governments. Add in the ongoing pollution curbs, and any significant SOE restructuring, and Chinese policy becomes a clear source of volatility and economic policy uncertainty this year that the market is not, as yet, pricing (Chart 19). On cue, perhaps in anticipation of rising domestic volatility, China has stopped updating its home-grown version of the VIX (Chart 20). Chart 19Market Expects No Political Volatility Yet Chart 20Has China Halted Its Version Of The VIX? We would not expect anything more than a whiff, at best, of policy easing at the NPC this March. For instance, poverty alleviation efforts will require some fiscal spending. But even then, the point of fiscal spending will be to offset credit tightness, not to stimulate the economy in any remarkable way. Monetary policy may not get much tighter from here, as inflation is rolling over amid the slowdown (Chart 21),24 but anything suggesting a substantial shift back to easy policy would be contrary to our view. More accommodative policy at this point in time would suggest that Xi has no real intention of fighting systemic risk and - further - that global growth faces no significant impediment from China this year. In such a scenario, the dollar could fall further and EM would outperform. We expect the contrary. We are long DXY and short EUR/JPY. We remain overweight Chinese H-shares within emerging markets, but we will close this trade if we suspect either that reform is a fig leaf or that authorities have moved into overcorrection territory. Otherwise, reform is a good thing for Chinese firms relative to EM counterparts that have come to rely on China's longstanding commodity- and capital-intensive growth model (Chart 22). Chart 21Monetary Policy May Not Tighten From Here Chart 22Tighter-Fisted China Will Hit EM Bottom Line: Xi Jinping has rebooted China's economic reforms. The new government being assembled is likely to intensify the crackdown on systemic financial risk. Reforms will surprise to the upside, which means that Chinese growth is likely to surprise to the downside amidst the current slowdown, thus weighing on global growth at a time when populism provides a tailwind to U.S. growth. What It All Means For South Africa And Emerging Markets We spent a full week in South Africa last June and came back with these thoughts about the country's economy and the markets:25 The main driving force behind EM risk assets, year-to-date, has been U.S. TIPS yields and the greenback (Chart 23). Weak inflation data and policy disappointments as the pro-growth, populist, economic policy of the Trump Administration stalled have supported the ongoing EM carry trade. The actual emerging market growth fundamentals and politics are therefore unimportant. Chart 23Weak Inflation And Dollar Drove EM Assets Chart 24Market Likes Ramaphosa, Unlike Zuma In the near term, South African politics obviously do matter. Markets have cheered the election of Cyril Ramaphosa to the presidency of the African National Congress (ANC), a stark contrast to the market reaction following his predecessor's ascendancy to the same position (Chart 24). However, the now President Ramaphosa's defeat of ex-President Jacob Zuma's former cabinet minister and ex-wife, Nkosazana Dlamini-Zuma was narrow and has split the ANC down the middle. On one side is Ramaphosa's pragmatic wing, on the other is Dlamini-Zuma's side, focused on racial inequality and social justice. Chart 25Chronic Youth Unemployment Chart 26Few Gains In Middle Class Population For now, the ANC bureaucracy has served as an important circuit-breaker that will limit electoral choices in the 2019 election to the pro-market Ramaphosa, centrist Democratic Alliance, and radical Economic Freedom Fighters. From investors' perspective, this is a good thing. After all, it is clear that if the South African median voter had her way, she would probably not vote for Ramaphosa, given that the country is facing chronic unemployment (Chart 25), endemic corruption, poor healthcare infrastructure, and a desire for aggressive, and targeted, redistributive economic policies. South Africa stands alone amongst its EM peers when it comes to its tepid rise in the middle class as a percent of the population (Chart 26) and persistently high income inequality (Chart 27). We see no evidence that the electorate will welcome pro-market structural reforms. Chart 27Inequality Remains Very High Nonetheless, Ramaphosa's presidency is a positive given the recent deterioration of South Africa's governance, which should improve as the new regime focuses on fighting corruption and restructuring SOEs. Whether Ramaphosa will similarly have the maneuvering room to correct the country's endemically low productivity (Chart 28) and still large twin deficits (Chart 29) is another question altogether. Chart 28A Distant Laggard In Productivity Chart 29Twin Deficits A Structural Weakness Will investors have time to find out the answer to those latter questions? Not if our core thesis for this year - that politics is a tailwind to U.S. growth and a headwind to Chinese growth - is right. In an environment where the U.S. 10-year Treasury yield is rising, DXY stabilizes, and Chinese economy slows down, commodities and thus South African assets will come under pressure. As our colleague Arthur Budaghyan, BCA's chief EM strategist, recently put it: positive political developments are magnified amid a benign external backdrop. Conversely, in a negative external environment, positive political transformations can have limited impact on the direction of financial markets. Bottom Line: Markets are cheering Ramaphosa's ascendancy to the South African presidency. We agree that the development is, all other things being equal, bullish for South Africa's economy and assets. However, the structural challenges are vast and we do not see enough political unity in the ANC to resolve them. Furthermore, we are not sure that the global macro environment will remain sanguine for long enough to give policymakers the time for preemptive structural reforms. To reflect the potential for a positive political change and forthcoming orthodox macro policies, we are closing our recommendation to bet on yield curve steepening in South Africa, which has been flat since initiation on June 28, 2017. However, we will maintain our recommendation to buy South African 5-year CDS protection and sell Russian, even though it has returned a loss of 17.08 bps thus far. We expect that Russia will prove to be a low-beta EM play in the next downturn, whereas South Africa will not be so lucky. On a different note, we are booking gains of 2525bps on our short Venezeulan vs. EM 10-yr sovereign bonds, as our commodity team upgrades its oil-price forecast for this year. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 2 Please see the Congressional Budget Office, "Bipartisan Budget Act of 2018," February 8, 2018, available at www.cbo.gov. 3 Please see BCA The Bank Credit Analyst Monthly Report, "March 2018," dated February 22, 2018, available at bca.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Japan's Political Paradigm Shift: Investment Implications," dated December 21, 2012, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Monthly Report, "Is Abenomics The Future?" dated February 11, 2015, available at gps.bcaresearch.com. 7 Please see BCA Global Investment Strategy Weekly Report, "A Structural Bear Market In Bonds," dated February 16, 2018, available at gis.bcaresearch.com. 8 Please see BCA U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds," dated February 20, 2018, available at usbs.bcaresearch.com. 9 Please see BCA U.S. Investment Strategy Weekly Report, "A Party On The QE2," dated November 8, 2010, available at usis.bcaresearch.com. 10 We include the last factor in the regression because it could be that the market responds positively in the post-election period, irrespective of the election outcome, simply because political uncertainty is diminished. 11 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 12 Please see Tom Mitchell, "Xi's China: The Rise Of Party Politics," Financial Times, July 25, 2016, available at ft.com. See also BCA Geopolitical Strategy and China Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, available at www.bcaresearch.com. 13 "Carry Canary" indicator tracks the performance of EM/JPY carry trades. These trades short the Japanese Yen and long an emerging market currency with a high interest rate (Brazilian real, Russian ruble, or South African rand), and as such they are highly geared to a positive global growth back-drop. Please see BCA Foreign Exchange Strategy Weekly Report, "The Yen's Mighty Rise Continues ... For Now," dated February 16, 2018, available at fes.bcaresearch.com. 14 The other two battles are against pollution and poverty. 15 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Weekly Report, "Xi Jinping: Chairman Of Everything," dated October 25, 2017, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Monthly Report, "Reflections On China's Reforms," in "The Great Risk Rotation - December 2013," dated December 11, 2013, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 19 Consider that the standard political calendar would have called for Xi to make personnel adjustments at the second plenum (which was held in January), then to formalize those personnel changes at the legislature in March, and then to announce reform initiatives at the third plenum in the fall, leaving implementation until late in the year or even March 2019. Instead, all of this will be done by March of this year, leaving the rest of the year for implementation. 20 The Financial Stability and Development Commission was created last July at an important financial gathering that occurs once every five years. We dubbed it a "Preemptive Dodd Frank" at the time because of China's avowed intention to use it to tackle systemic financial risk. Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. The FSDC's purpose is to coordinate the People's Bank of China with the chief financial regulators - the banking, insurance, and securities regulatory commissions (CBRC, CIRC, and CSRC) and the State Administration of Foreign Exchange (SAFE). There is even a possibility under discussion (we think very low probability of happening) that the FSDC will preside above the central bank - though the precise organizational structure will remain unclear until it is formalized, probably during the March legislative session. 21 Anbang is part of a group of companies, including Foresea, Fosun, HNA, Ping An, and Dalian Wanda, that have been targeted over the past year for shady financial doings, corruption, excessive debt, and capital flight. In particular, Anbang was integral to the development of universal life products, which have been highly restricted since last year. These were not standard insurance products but risky short-term, high-yield shadow investment products. Investors could redeem them easily so there was a risk that purchasers could swamp insurance companies with demands for paybacks if investment returns fell short. This would leave insurance companies squeezed for cash, which in turn could shake other financial institutions. The systemic risk not only threatened legitimate insurance customers but also threatened to leave insurance companies unable to make debt payments on huge leveraged buyouts that they had done abroad. Anbang and others had used these and other shadow products to lever up and then go on a global acquisition spree, buying assets like insurance subsidiaries, hotels, and media/entertainment companies. The targeted firms are also in trouble with the central government for trying to divest themselves of China's currency at the height of the RMB depreciation and capital flight of 2015. They were using China's shadow leverage to springboard into Western assets that would be safe from RMB devaluation and Chinese political risk. The government wants outward investment to go into China's strategic goals (such as the Belt and Road Initiative) instead of into high-profile, marquee Western assets and brands. 22 Particularly over whether Xi Jinping's right-hand man, Liu He, will be appointed as the new central bank governor, to replace long-serving Governor Zhou Xiaochuan, and/or whether he will replace Vice Premier Ma Kai as chairman of the FSDC. It is important whether Liu He takes the place of central banker or chief reformer because those roles are so different. Making him PBoC chief would keep a reformer at the helm of a key institution at an important point in its evolution, but will raise questions about who, if anyone, will take charge of structural reform. Giving him the broader and more ad hoc role of Reformer-in-Chief would be reminiscent of Zhu Rongji at the historic NPC session in March 1998, i.e. very optimistic for reforms. Of course, Liu He is not the only person to watch. It is also important to see what role former anti-corruption czar Wang Qishan gets (for instance, leading U.S. negotiations) and whether rising stars like bank regulator Guo Shuqing are given more authority (he is a hawkish reformer). 23 Please see Xie Yu and Frank Tang, "Xi picks team of problem solvers to head China's economic portfolios," South China Morning Post, dated February 21, 2018, available at www.scmp.com. 24 Please see BCA China Investment Strategy Weekly Report, "Seven Questions About Chinese Monetary Policy," dated February 22, 2018, available at cis.bcaresearch.com. 25 Please see BCA Geopolitical Strategy Special Report, "South Africa: Crisis Of Expectations," dated June 28, 2017, available at gps.bcaresearch.com.

For much of the past twelve years, pharmaceutical pricing power has been a reliable predictor of the S&P pharma relative share price ratio, both to the up and down sides (top panel). In 2018, this relationship appears to be breaking down somewhat as pricing power growth has stabilized at a relatively low level but the index has continued to fall. We think a more pressing concern than falling pricing power has taken over investor's attention, namely the soaring industry leverage ratios (shown inverted on second panel). With a declining share of both domestic (third panel) and foreign (bottom panel) wallets, the sustainability of even this low level of pricing power is questionable. As such, it seems likely that leverage will get worse before it gets better; in the context of a rising interest rate environment, weak operating metrics and high financing costs all bode poorly for industry EPS growth. Stay underweight. The ticker symbols for the stocks in the S&P pharmaceuticals index are: BLBG: S5PHAR - JNJ, PFE, MRK, BMY, AGN, LLY, ZTS, MYL, PRGO.

Highlights Federal Reserve: Is the U.S. neutral rate now higher? ECB: How much has the euro rally damaged European growth? Bank of Japan: Will a stronger yen tip Japan back into deflation? Bank of England: Will higher real wages offset Brexit uncertainties? Bank of Canada & Reserve Bank Of Australia: How much spare capacity truly exists? Feature We have not published a regular Weekly Report in Global Fixed Income Strategy since February 6th. We instead published necessary Special Reports on two countries of immediate relevance: Japan, because of the recent surprising strength in the yen, and Italy, because of the upcoming election. The pause in our regular commentary on the state of the markets, however, was useful. It has given us more time to reflect on the potential for a continuation of the global bond bear market after the volatility spike earlier in the month. What we find interesting is that, despite the common narrative that the back-up in global bond yields seen in 2018 has been about rising inflation fears, market pricing suggests the big shift has instead been in real bond yields and central bank policy expectations. In Table 1, we present the year-to-date change in the 10-year government bond yield for the major developed markets. We also show the changes in various other interest rate measures, including: Table 12018 Year-To-Date Changes In Government Bond Yield Components Our 12-month Policy Rate Discounters, which show the change in short-term interest rates priced into money market curves Our proxy measure of the market pricing of the real neutral ("terminal") interest rate - the 5-year Overnight Index Swap (OIS) rate, 5-years forward minus the 5-year CPI swap rate, 5-years forward Our estimate of the term premium on the 10-year government bond yield. What stands out in the table is that markets have moved to price in both a higher amount of expected rate hikes over the next year (Chart 1) and a higher neutral real interest rate, even with very little change in expected inflation. This can also been seen by looking at recent declines in the correlations between inflation expectations and nominal bond yields in the major economies, which are off from the peaks seen late in 2017 (Chart 2). Chart 1Rising Rate Expectations Have##BR##Been Pushing Yields Higher Of Late... Chart 2...Rather Than Higher##BR##Inflation Expectations The obvious conclusion is that the bulk of the rise in global bond yields seen year-to-date has been driven by increases in the real yield component, which itself has been heavily influenced by expected changes to central bank policy rates. Keeping that in mind, in this Weekly Report, we take a look at the most important question faced by each major central bank, and what that means for future decisions on policy interest rates - and by extension, for government bond yields. The Federal Reserve: "Is The U.S. Neutral Rate Now Higher?" With the 10-year U.S. Treasury yield having taken several runs at the critical 3% level in recent weeks, the debate has raged among investors as to whether that should be considered a breakout point or a buying opportunity. Comparing the U.S. economy now to what it looked like the last time the 10-year yield was at 3% at the end of 2013 suggests that yields could have more upside: Real GDP growth: 1.7% then, 2.3% now1 The unemployment rate: 6.7% then, 4.1% now Headline CPI inflation: 1.4% then, 2.1% now Core CPI inflation: 1.7% then, 1.8% now Average Hourly Earnings growth: 1.9% then, 2.9% now Growth is faster, there is less spare capacity, and inflation is higher now than it was just over four years ago. Yet when looking at the decomposition of the 10-year U.S. Treasury yield into its real and inflation expectations component (Chart 3, 2nd panel), we find that the mix is only slightly more skewed to real yields today: Chart 3Treasury Yields Still Have More Upside,##BR##Based On 2013 Comparisons Nominal 10-year Treasury yield: 3.03% then (December 31st, 2013), 2.87% now (February 26th, 2018) Inflation expectations (10-year CPI swap): 2.54% then, 2.30% now Real yields (nominal 10-year yield minus 10-year CPI swap): 0.49% then, 0.57% now In other words, the real yield today is 20% of the total nominal 10-year yield compared to 16% back at the end of 2013. Not a major difference. Yet there are much bigger discrepancies between the elements that go into our real neutral rate proxy for the U.S. (bottom two panels): 5-year OIS rate, 5-years forward: 4.1% then, 2.6% now 5-year CPI swap rate, 5-years forward: 2.9% then, 2.3% now Real neutral rate proxy: 1.2% then, 0.3% now The market is now pricing in a real neutral funds rate that is nearly one full percentage point below the level that prevailed the last time the 10-year Treasury yield reached 3% prior to 2018. Even though the U.S. economy is now growing faster, with far less spare capacity and higher inflation, than it did at the end of 2013. This does suggest that the level of the neutral real fed funds rate has likely gone up, which the 43bps increase in our market-implied real neutral rate proxy so far in 2018 is likely reflecting. But does the Fed actually believe that the neutral funds rate should be higher? The minutes from the January FOMC meeting, released last week, noted that there was discussion on the neutral funds rate, but one that was different than during previous FOMC meetings in 2017 - the actual appropriate level of the neutral funds rate was a topic of debate: "Some participants also commented on the likely evolution of the neutral federal funds rate. [...] the outlook for the neutral rate was uncertain and would depend on the interplay of a number of forces. For example, the neutral rate, which appeared to have fallen sharply during the Global Financial Crisis when financial headwinds had restrained demand, might move up more than anticipated as the global economy strengthened. Alternatively, the longer-run level of the neutral rate might remain low in the absence of fundamental shifts in trends in productivity, demographics, or the demand for safe assets."2 Any change in the Fed's estimation of the long-run neutral funds rate is critical for the future path of Treasury yields, given where market pricing is at the moment. The U.S. OIS curve has now fully converged to the FOMC interest rate projections (the "dots") for this year and next year. More importantly, the market-implied terminal rate (the nominal 5-year OIS rate, 5-years forward) has now caught up to the FOMC terminal rate dot (Chart 4). The implication is that any further meaningful increase in Treasury yields can only come from higher inflation expectations - unless the Fed signals that a higher neutral rate is required. Our colleagues at our sister publication, U.S. Bond Strategy, recently noted that the Fed has historically been much more reluctant to raise its terminal rate projection in response to rising inflation than it was in cutting the projection when inflation falls.3 The conclusion is that inflation expectations will likely need to return to levels consistent with the Fed's inflation target - 2.3-2.5% on both the 10-year TIPS breakeven rate and the 5-year breakeven rate, 5-years forward - before the Fed would make any significant upward revisions to its terminal rate projection. In the meantime, Treasury yields are more likely to see a near-term consolidation, as U.S. data surprises have rolled over, market positioning has become very short, momentum is oversold and market pricing has fully converged with Fed expectations (Chart 5). In terms of data, the release of the next U.S. Employment report on March 9th is critical for the Treasury market in the near term, given that the January uptick in wage growth was the trigger for the spike in bond yields, and subsequent equity market correction, at the beginning of February (bottom panel). Chart 4Could The Fed Move##BR##The Interest Rate 'Goalposts'? Chart 5Treasury Selloff May Be##BR##Due For A Pause The ECB: "How Much Has The Euro Rally Damaged European Growth?" The European Central Bank (ECB) has been slowly preparing markets for an eventual withdrawal of its extraordinary monetary policy stimulus since last summer. Specifically, the ECB has begun a discussion of what it would take to end its bond buying program. Already, the central bank cut the monthly pace of its asset purchases in half at the beginning of 2018, and the topic of "tapering" has come up in many speeches from ECB officials. The ECB has been trying to not present an overly hawkish message when discussing an eventual end to its hyper-easy monetary stance. The overall level of government bond yields - both in the core and Periphery of the Euro Area - has been drifting higher, but by less than the increases seen in the U.S. Inflation expectations have been rising since the middle of 2017, although most of the 23bps increase in the benchmark 10-year German Bund yield seen so far in 2018 can be attributed to rising real yields (Chart 6). The market-implied real neutral rate has also been increasing, but still remains below zero (-0.2%). Yet despite only the modest increase in European interest rate expectations, there has been a substantially larger move in the euro. The trade-weighted euro has bond up by 8% over the past year, bringing the currency back to levels last seen in 2014 (Chart 7, top panel). The appreciating euro has become a subject of focus by the ECB, although it is not yet a cause for worry according to the minutes of the January ECB meeting released last week: Chart 6Only A Modest Rise In European Yields, So Far Chart 7A Potential ECB Dilemma "[...] although the past appreciation of the euro had so far had no significant impact on euro area external demand, volatility in foreign exchange markets represented a further increase that need monitoring."4 Chart 8No Damage Yet To European##BR##Exports From The Euro Rally The ECB is correct that the rising euro has not yet impacted Euro Area exports, the growth rate of which remains solid at 8% (bottom panel). This contrasts sharply with the performance the last time the trade-weighted euro was at current levels in 2014, when exports were barely growing at all. The difference is a much stronger global economy that is demanding far more European goods and services now compared to four years ago. For now, the ECB can look to the stability of export demand as a sign that the euro has not become a drag on the economy, but some warning signals may be flashing. Euro Area economic data surprises have plunged sharply, and the manufacturing PMI data has been softer in the past couple of months (Chart 8). While the absolute levels of the PMIs suggest an economy that is still growing at an above-trend pace, a continuation of the recent drops could pose a problem for the ECB as it tries to communicate its next policy move to the markets. The surging euro has done very little to drag down overall Euro Area headline inflation, given the strength in global oil prices over the past year (3rd panel). Core inflation has struggled to stay much above 1% over the past year or so, but our core inflation diffusion index - which measures the number of core Euro Area HICP sectors with rising inflation rates versus those with falling inflation rates - has surged in the past couple of months, which typically leads to a faster rate of core inflation (bottom panel). As long as the Euro Area export growth data holds up, the ECB is likely to focus more on rising core inflation than a stronger euro and should begin signaling an end to the asset purchase program by year-end. The Bank Of England: "Will Faster Wage Growth Offset Brexit Uncertainty?" The Bank of England (BoE) has surprised markets with its more hawkish commentary of late, particularly given the reason for the change - faster wage growth. The BoE had previously been cautious on its outlook for the U.K. economy, which was suffering from two powerful drags. First, the uncertainty over the Brexit negotiations was dampening business confidence and restraining capital spending. Second, the surge in realized inflation following the post-Brexit collapse of the British Pound triggered a period of contracting real wages that would be a drag on consumer spending. Until these were resolved, the BoE would be cautious with its future policy moves. Next month's European Union (EU) summit can provide some news on Brexit, as the U.K. government will be seeking a transition agreement that would give U.K. businesses a firm timeline for the separation of the U.K. from the EU. The U.K. government is reported to be seeking a two-year period for the agreement, but it may take longer than that to hammer out all the deals involved with the contentious issues of trade, immigration, etc. The longer the Brexit transition period, the more likely that U.K. firms will hold back on long-term investment spending because of uncertainty. As for the wage side of the story, the annual growth rate of Average Weekly Earnings has increased from 1.7% to 2.6% since the April 2017 low, but this is still below the headline CPI inflation rate of 3% (Chart 9, bottom panel). With the U.K. unemployment rate at a cyclical low of 4.4% - far below the OECD's estimate of the full employment NAIRU rate of 5.1% - additional increases in wage growth are possible if hiring demand does not begin to slow. Yet with U.K. data surprises rolling over (top panel), and with the OECD's U.K. leading economic indicator decelerating (middle panel), there is a growing risk that economic growth will slow in the coming quarters, to the detriment of hiring activity and wages. The current market pricing shows that there remains a wide gap between U.K. inflation expectations and nominal Gilt yields (Chart 10). The real 10-year Gilt yield is -1.84% (deflated by CPI swaps), while the market-implied neutral real interest rate is -1.94%. While such a deeply negative interest rate is unlikely to be a permanent state of affairs in the U.K., such an accommodative policy setting is required to prevent the economy from falling into a deep slump. Chart 9Is The BoE More Worried About##BR##Wage Pressures Than Growth? Chart 10Real Gilt Yields Rising,##BR##But Still Very Low As we noted back in January, we do not see the BoE being able to raise rates much at all this year given the likelihood of prolonged sluggishness of the U.K. economy and some reversal of the currency-fueled surge in inflation seen in 2017.5 The BoE choosing to tackle rising wage inflation while growth was decelerating would be a huge policy error that would eventually benefit the performance of U.K. Gilts. The Bank Of Japan: "Will A Stronger Yen Tip Japan Back Into Deflation?" The extraordinary monetary policy accommodation provided by the Bank of Japan (BoJ) makes an analysis of Japanese Government Bond (JGB) yields far less interesting. After all, when the central bank is actively intervening in large quantities to hold the level of the 10-year JGB around 0%, do the signals sent from money market and bond yield curves have any meaning vis-à-vis the actual Japanese economy? Right now, the pricing of the real 10-year JGB yield (deflated by CPI swaps) is just below 0%, as is the real terminal rate proxy from the Japanese OIS curve (Chart 11). Keeping JGB yields at such low levels is part of the BoJ's attempt to raise Japanese inflation back towards the central bank's 2% yield target. The mechanism by which that should happen is through a weaker Japanese yen. Yet the yen has been showing surprising strength in recent weeks, most notably the USD/JPY exchange rate that has been falling in the face of rising U.S.-Japan interest rate differentials (Chart 12, top panel). Chart 11Negative Real Rates Still Necessary In Japan Chart 12An Unwelcome Rise In The Yen The risk going forward is that the strengthening yen will create a drag on headline Japanese inflation that has recently accelerated back to 1% (middle panel). Given that both core CPI and nominal wages barely growing at all (bottom panel), the odds are increasing that Japanese inflation could begin to move lower without getting anywhere close to the BoJ's 2% target. As we discussed in our recent Special Report, a much weaker yen (i.e. USD/JPY between 115 and 120) is the first necessary precondition before the BoJ would consider raising its yield target on the 10-year JGB.6 We had placed odds of no more than 20% that the BoJ would raise its yield target in 2018, but if the yen continues to hold firm or even strengthen further from current levels, those odds fall to zero. Bank Of Canada & Reserve Bank Of Australia: "How Much Spare Capacity Truly Exists?" We are lumping the Bank of Canada (BoC) and Reserve Bank of Australia (RBA) together in this report, as both are facing the same critical question. The BoC has already raised its policy rate three times since last summer, in response to accelerating growth and diminished spare capacity in Canada. Canadian bond yields have risen in response through higher inflation expectations, rising real yields and greater expected rate increases from the BoC (Chart 13). The real 10-year Canadian yield has risen back to the highs last seen in late 2013, while inflation expectations are not quite back to those levels - a similar story to that seen in the U.S. The BoC's own estimate of the Canadian output gap flipped into positive territory at the end of 2017, signifying that there was no longer any spare capacity in the Canadian economy (Chart 14, top panel). The signal from the Canadian labor market is similar, with the unemployment rate now at 5.9% - well below the OECD NAIRU estimate of 6.5% (middle panel). Yet Canadian inflation rates, both for headline and core CPI, are only at 1.7% and 1.5%, respectively - both not even at the midpoint of the BoC's 1-3% target band (bottom panel). At the same time, wages have been accelerating, with the annual growth rate of Average Hourly Earnings now up to a two-year high of 3.3%. Chart 13All Bond Yield Components Rising In Canada Chart 14Where's The Inflation? Such a wide gap between price inflation and wage growth does throw into the question if the BoC's own output gap estimate is correct. We expect Canadian price inflation to eventually begin to close the gap with wage inflation, which will keep the BoC on its current expected rate hiking path in 2018 as long as the economy does not begin to slow meaningfully. The CPI inflation reports will be the most important data to watch in Canada over the next few months to determine if our view will pan out. In Australia, the market pricing is nowhere near as hawkish as in Canada, with inflation expectations (10-year CPI swaps) having been stuck in a range between 2.2-2.4% for the past two years (Chart 15, 2nd panel). The market-implied neutral real interest rate is stuck at 0% and has not been sustainably above that level since 2014 (bottom panel). Yet, like Canada, there are questions about the true degree of slack in the economy. The Australian unemployment rate is currently at 5.5%, well below NAIRU (Chart 16, top panel). The last time that the Australian economy ran for so long beyond full employment was in 2010-11, when headline inflation breached the upper limit of the RBA's 1-3% target band (bottom panel). Yet the so-called "underemployment rate" - essentially, those working part-time that would like to work full-time - has been much higher in recent years and now sits at 8.3%. This also fits with the IMF's estimate of the Australian output gap, which is still a very large -1.8%. Chart 15Australian Yields Are Stuck In A Range Chart 16Very Different Than 2011-12 Given these signs of excess capacity in both the labor market and the overall economy, it is no surprise that Australian inflation has struggled to surpass even the 2% midpoint of the RBA target band. The implication is that the Australian NAIRU is much lower than the official OECD estimate, and that the RBA is under no pressure to contemplate any interest rate increases for at least the rest of 2018. Net-net, while both the BoC and RBA are facing questions over the true amount of spare capacity in their economies, the situation is much more bullish for Australian government bonds than Canadian equivalents given the greater slack Down Under. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 These are average quarterly growth rates of U.S. real GDP for the full calendar year of 2013 and 2017, respectively. 2 https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20180131.pdf 3 Please see BCA U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20th, 2018, available at usbs.bcaresearch.com. 4 https://www.ecb.europa.eu/press/accounts/2018/html/ecb.mg180222.en.html 5 Please see BCA Global Fixed Income Strategy Weekly Report, "A Melt Up In Equities AND Bond Yields?", dated January 23rd, 2018, available at gfis.bcaresearch.com. 6 Please see BCA Global Fixed Income Strategy Special Report, "What Would It Take For The Bank Of Japan To Raise Its Yield Target?", dated February 13th 2018, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Neutral While internet retail moved to the mainstream more than a decade ago, it continues to capture the lion's share of retail growth and investors' imaginations along with it. Further, the philosophy of "profits don't matter" in pursuit of explosive growth has been replaced with more sustainable models. The consumer is gradually becoming more aware that the intangible benefits of convenience and comparison information and tangible benefits including transportation and time expenses should mean that internet retail should be able to command greater pricing power than physical peers. As such, an eventual convergence between bricks and mortar and online retail margins looks to be in the offing. Still, despite a market full of eye-watering valuations, the S&P internet retail index stands out as expensive; expectations appear to have overreached. Further, one of BCA's themes for 2018 is higher interest rates; with the Fed poised to increase rates at least three times this year, our style preference favoring value stocks over growth seems well supported. Bottom Line: We initiate coverage of the S&P internet retail index with a neutral weight. Please see yesterday's Special Report for more details. The ticker symbols for the stocks this index are: BLBG: S5INRE - AMZN, NFLX, PCLN (changing to BKNG, effective February 27, 2018), EXPE, TRIP.

Highlights Fed: The Fed is getting more optimistic on growth and continues to forecast a rebound in inflation. Nevertheless, the March FOMC meeting is probably too soon to expect an upward revision to the Fed's rate hike expectations. Inflation: The headwinds working against inflation are set to fade this year. The core goods and medical care sectors will lead the way, but there are even tentative signs that the deceleration in shelter inflation might start to ease. Spread Product: A survey of investment grade bond sectors shows that municipal bonds, Foreign Agency bonds and Local Authority bonds are all attractively valued relative to corporates. In contrast, USD-denominated Sovereign bonds are expensive. At the upper-end of the credit spectrum, Consumer ABS offer good value but deteriorating credit fundamentals. Feature One byproduct of this year's increase in Treasury yields is that market expectations for the near-term path of Fed rate hikes have converged with the Fed's most recent median projection (Chart 1). At present, the overnight index swap curve is priced for a fed funds rate of 2.19% by the end of this year and 2.54% by the end of 2019. The Fed's most recent median projection calls for a fed funds rate between 2% and 2.25% by the end of 2018, and of 2.75% by the end of 2019.1 Chart 1Market Expectations Have Converged With The Fed Dots This convergence makes the next few Fed meetings particularly interesting. Will the Fed revise up its rate projections, giving the market permission to push short-dated yields even higher? Or will the Fed continue to signal three hikes this year and 2-3 more in 2019, restraining the bear market in short-dated bonds? Fortunately, last week we received a lot of information to help us answer these questions. Several FOMC members made noteworthy public remarks and the Fed released the minutes from the January FOMC meeting. What To Expect From The March FOMC Meeting The Fed's Rosy Growth Outlook The minutes from the January FOMC meeting showed a great deal of optimism about the U.S. recovery, from both the Fed staff and FOMC participants. Chart 2Substantial Stimulus In The Pipeline The minutes noted that the Fed staff submitted stronger economic projections at the January meeting than at previous meeting, noting that: [T]he forecast for real GDP growth was revised up, reflecting a reassessment of the recently enacted tax cuts, along with higher projected paths for equity prices and foreign economic growth and a lower assumed path for the foreign exchange value of the dollar. It's important to note that while these projections include the impact of recent changes to the tax code, they do not include the potential impact from the newly proposed two-year appropriations bill that is poised to pass through Congress in the next few weeks. This bill is significant with large outlays for disaster relief ($45 billion), the military ($165 billion) and non-defense discretionary items ($131 billion), spread over the next two years. Chart 2 demonstrates how much this spending bill and the recent tax cuts have altered the growth outlook. It shows two estimates of fiscal thrust, the initial economic impulse of changes in government tax and spending policies.2 One estimate is the IMF's baseline forecast that was made before the tax legislation was passed. That estimate showed that fiscal policy would have been contractionary this year, trimming about 0.5% from GDP, and only slightly expansionary in 2019. The second estimate, which incorporates both the tax legislation and the proposed spending bill, shows that the fiscal impulse will be +0.8% this year and +1.3% next year. A major turnaround, and the most stimulative fiscal policy since the immediate aftermath of the financial crisis. Staying The Course On Inflation At the January FOMC meeting the Fed saw a presentation on the performance of different inflation models, an exercise that is particularly important given that the Fed's traditional expectations-augmented Phillips curve model was not able to explain why prices decelerated last year. The staff concluded that while the prediction errors from Phillips curve-style models have been larger in recent years than during the 2001-07 period, they were not completely out of line with history. This synchs up with our own analysis. We re-created the Fed's expectations-augmented Phillips curve model using details from a speech given by Janet Yellen in 2015 (Chart 3).3 That model certainly shows a large prediction error in 2017, but one that is not inconsistent with past errors. The message is that 2017 was not an outlier in terms of the Fed's ability to forecast inflation, but rather that inflation is quite often difficult to forecast. The Fed staff did provide a couple reasons for why inflation lagged the model's predictions last year: [S]tructural changes in the price setting for some items, such as medical care, and the effects of idiosyncratic price shocks, such as the unusual drop in prices of wireless telephone services. And also forecast that inflation would reverse course in 2018: [C]ore PCE prices were forecast to rise notably faster in 2018, importantly reflecting both the expected waning of transitory factors that held down 12-month inflation measures in 2017 as well as the projected further tightening in resource utilization. We agree with this assessment. In fact, both CPI and PCE inflation measures have formed tentative troughs in the past few months and should see further near-term upside from both the core goods and medical care components (Chart 4). Core goods inflation has still not caught up with accelerating import prices (Chart 4, panel 2) and the PPI data show a recent large jump in health-care prices (Chart 4, panel 3). Chart 3The Fed's Inflation Model Chart 4Inflation Headwinds Will Fade On medical care, research from the San Francisco Fed has shown that a major reason for lower inflation in recent years has been the slower growth of Medicare payments to physicians and hospitals as mandated by the Affordable Care Act. But these payments are also forecast to grow 2% this year, much higher than the 0.6% growth seen last year and the 0.9% growth seen in 2016.4 It is even possible that the deceleration in shelter inflation could moderate in the months ahead, given the renewed decline in the rental vacancy rate (Chart 4, panel 4). Meanwhile, we continue to expect that stronger wage growth will eventually pressure core services inflation (excluding shelter and medical care) higher (Chart 4, bottom panel). But What Are They Saying? Even though the minutes conveyed a decidedly optimistic tone with regards to both growth and inflation, Fed speakers were much more cautious last week. Philadelphia Fed President Patrick Harker said that "based on the relatively strong economy, but the continued stubbornness of inflation, I've penciled in two hikes for 2018." Atlanta Fed President Raphael Bostic said he is "comfortable continuing with a slow removal of policy accommodation" but also that "that doesn't necessarily mean as many as three or four moves per year." St. Louis Fed President James Bullard also said that 100 basis points of rate hikes in 2018 "seems like a lot." At the very least it appears that upward revisions to GDP growth forecasts are not sufficient for these three members to revise their rate projections higher. But these three members also already projected shallower paths for rate hikes than the median FOMC member (Table 1). Table 1Composition Of The FOMC More important is whether FOMC members whose projections are consistent with the median - those with a "neutral" policy bias in Table 1 - are inclined to get more hawkish. One of those members is San Francisco Fed President John Williams who said last week that "it makes sense to think about three or four rate increases in 2018." Chart 5Still Not Back To Target At the moment, the median Fed projection calls for three rate hikes in 2018, and that median will only move higher in March if four out of the six members who currently forecast three hikes this year decide to increase their dots. Given the cautious tone struck by most Fed speakers last week, we think the odds of an upward revision to the Fed's 2018 rate hike forecasts at the March meeting are low. Bottom Line: The Fed is getting more optimistic on growth and continues to forecast a rebound in inflation. Nevertheless, the March FOMC meeting is probably too soon to expect an upward revision to the Fed's rate hike expectations. Our own assessment is that the headwinds working against inflation are set to fade this year and that 3-4 Fed rate hikes are likely. In either case, bond yields are still biased higher given that they are still not priced for an eventual return of inflation to the Fed's target (Chart 5). Maintain a below-benchmark duration stance. Searching For Late-Cycle Value In Spread Product As we have noted repeatedly in recent reports, we anticipate that we will start to de-risk the spread product side of our U.S. bond portfolio sometime in 2018, possibly quite soon depending on the future path of inflation.5 So this week we perform a survey of investment grade spread product sectors, with an eye towards identifying sectors that look attractively valued and also present a low risk of spread widening. Our primary tool for identifying value is the 12-month breakeven spread. The 12-month breakeven spread is the basis point spread widening required on a 12-month horizon for a sector to earn zero excess returns versus a duration-equivalent position in Treasury yields.6 Table 2 shows the 12-month breakeven spread for each sector split by credit rating. Table 212-Month Breakeven Spreads By Credit Rating The first thing we notice is the attractive spreads offered by municipal bonds after adjusting for the tax advantage. In fact, for investors exposed to the top marginal tax rate, the 12-month breakeven spread on a Aaa-rated municipal bond exceeds the spread offered by a Baa-rated corporate bond. We have previously noted that when the tax-adjusted spread on a 10-year Aaa-rated municipal bond exceeds the spread offered by the duration-matched investment grade corporate bond index, it has historically been a signal that the credit cycle is very late. We are not seeing this signal yet, but it is getting very close (Chart 6). The second observation that jumps out is that USD-denominated Sovereign debt is not attractive compared to U.S. corporate debt. This is true across the entire investment grade credit spectrum. Further, Chart 7 shows that Sovereign bonds typically exhibit greater excess return volatility than U.S. corporate bonds. Chart 6Positive Muni/Corporate Spreads##br## Are A Late-Cycle Indicator Chart 712-Month Breakeven Spread Versus ##br##Excess Return Volatility We anticipate getting an opportunity to shift out of corporate bonds and into Sovereign debt at some point during the next 12 months, but expect some poor performance from Sovereign bonds first. A quicker expected pace of Fed rate hikes has historically coincided with Sovereign bond underperformance (Chart 8), and if that plays out while growth outside the U.S. starts to moderate - a risk that has been flagged by both our leading indicators for the Chinese economy and the performance of EM/JPY currency carry trades - then this would further exacerbate the underperformance of Sovereign bonds by putting upward pressure on the U.S. dollar.7 A third observation from Table 2 is that Foreign Agency bonds look very attractive, and Chart 7 also shows that the sector has historically exhibited quite low volatility. Foreign state-owned energy companies make up a large portion of the Foreign Agency index, and this sector's performance closely tracks the price of oil (Chart 9). With our commodity strategists now calling for average 2018 crude oil prices of $74/bbl and $70/bbl for Brent and WTI respectively, the Foreign Agency sector should stay well supported.8 Local Authority bonds are also attractively valued, though to a lesser extent than Foreign Agencies, and also tend to exhibit relatively low excess return volatility. We continue to recommend an overweight position in this sector that is comprised principally of taxable municipal debt and USD-denominated Canadian provincial bonds. Chart 8Underweight Sovereigns Chart 9Overweight Foreign Agencies Finally, we notice that credit card and auto loan backed Consumer ABS offer very attractive spreads and relatively low volatility. While we retain a neutral allocation to Consumer ABS, we note that credit trends are starting to shift against the sector. Bank are now tightening lending standards on both credit cards and auto loans, and the delinquency rate has made a cyclical bottom (Chart 10). Aaa-rated non-Agency CMBS also offer an attractive breakeven spread, though this sector has historically been much more volatile. Here too we see that banks are tightening lending standards, but the tightening has moderated in recent quarters. If this continues then delinquencies could start to roll over and property prices could start to accelerate (Chart 11). We remain underweight non-agency CMBS for now, but note the tentative improvement in credit quality. Chart 10Neutral Consumer ABS Chart 11A Nascent Improvement In Credit Quality Bottom Line: A survey of investment grade bond sectors shows that municipal bonds, Foreign Agency bonds and Local Authority bonds are all attractively valued relative to corporates. In contrast, USD-denominated Sovereign bonds are expensive. At the upper-end of the credit spectrum, Consumer ABS offer good value but deteriorating credit fundamentals. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 We exclude the forecast provided by the St. Louis Fed President as an outlier and calculate the median from the remaining forecasts. 2 The fiscal thrust is defined as the change in the cyclically-adjusted budget balance, expressed as a percentage of GDP. 3 https://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 4 https://www.frbsf.org/economic-research/publications/economic-letter/2017/november/contribution-to-low-pce-inflation-from-healthcare/ 5 Please see U.S. Bond Strategy Weekly Report, "On The MOVE", dated February 13, 2018, available at usbs.bcaresearch.com 6 We calculate the 12-month breakeven spread as the average index option-adjusted spread divided by the average index duration. We ignore the impact of convexity. 7 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 2018, available at usbs.bcaresearch.com 8 Please see Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Getting Comfortable With Higher Prices", dated February 22, 2018, available at ces.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification