Developed Countries

Special Report

Highlights Emerging Market (EM) hard currency debt, both sovereign and corporate, has consistently outperformed the broad global bond index. However, investors should steer clear of always maintaining maximum overweights to EM given its weak volatility reduction benefits and a much higher-than normal tendency of experiencing outsized, negative returns. Our long-term analysis suggests a structural 5% allocation offers the best risk/reward potential. The Fed is still in the early stages of rate normalization. At this point in the Fed policy cycle, where the Fed is hiking rates but monetary conditions are still stimulative, EM hard currency debt has historically performed well both on a relative and absolute basis. Looking ahead, EM returns should begin to suffer in latter half of 2018 as the Fed moves to more restrictive policy stance. While global growth will remain supportive of EM credit next year, renewed U.S. dollar strength and a re-convergence to the downside with commodity prices present considerable headwinds. Maintain an underweight stance on EM hard currency debt. Favor DM spread product due to more supportive relative growth trends and valuations. Feature Emerging market (EM) sovereign and corporate debt returns have surged in 2017, returning 9.4% and 7.5%, respectively (Chart 1). Investor interest has been renewed, with the latest IMF Financial Stability Report indicating that non-resident inflows of portfolio capital to EM countries have recovered since early 2016 and reached $205 billion for 2017 through August. Against a backdrop of above-trend global economic growth, monetary policy settings from the major central banks that are still accommodative, and some diminished risks from the world's geopolitical hotspots, the current uptrend for EM debt performance could continue. Nevertheless, we urge caution. We moved to a moderate underweight stance on EM hard currency debt back in August, while at the same time increasing our current recommended overweight to U.S. investment grade (IG) corporate debt on the other side of the trade.1 Even with synchronized global growth boosting both EM export demand and industrial commodity prices, we prefer U.S. credit exposure over EM at this point in the cycle, for several reasons: The massive flow-driven EM rally has resulted in not only outsized returns but stretched valuations, with EM debt spreads now back to post-2008-crisis low (or even through those levels for EM hard currency corporates) without any major improvement in EM fundamentals; The previously reliable correlation between EM debt and commodity prices, a long-time driver of EM performance, has broken down, bullishly, for EM - potentially another sign of flow-driven overvaluation; Growing uncertainty over the near-term China growth outlook raises risks on further gains in industrial commodity demand and EM exports; The USD will appreciate once again on the back of additional Fed interest rate hikes beyond levels currently discounted by markets, which could trigger some reversal of the sharp inflows into EM seen this year. Over a strategic horizon, however, it remains difficult to argue against owning a core structural allocation of EM hard currency debt within global fixed income portfolios, given the higher yields that are typically on offer and the fairly consistent historical outperformance over Developed Market (DM) debt. Although the benefits of EM in a portfolio context are slightly overstated given its skewed risk profile (i.e. fat negative tails) and high correlation with DM spread product, specifically U.S. high-yield corporates (Chart 2). Chart 1How Much Longer Can This Rally Last? Chart 2EM Debt Offers Little Diversification Benefits In this Special Report, we examine the long-term role of EM hard currency debt within a fixed-income portfolio, and re-iterate our case for being underweight EM debt on a cyclical basis. The Long-Run Case For Owning EM Debt: A Moderate Core Allocation Makes Sense It is not a stretch to say that EM debt has become the most important part of global bond portfolios in the 21st century. Having a significant EM allocation at the right time can make a bond manager's year, while having it at the wrong time can end a bond manager's career. But what is the "right" allocation to optimize the long-run contribution to returns in a global fixed income portfolio? To answer this question, we took a look at the historical performance of a global bond portfolio that consisted of both DM and EM debt (sovereign and corporate), looking for the combination that would maximize the risk-adjusted return of the portfolio. In our analysis, we ran calculations for two different time periods as the available index data for EM sovereign debt goes back to 1994, while EM corporate debt indices begin in 2002. For DM debt, we used a single index - the Bloomberg Barclays Global Aggregate - as this has a long history and is a common benchmark used by global bond managers that includes both DM sovereign and corporate debt. Though the sample size of our combined global portfolio is limited due to the shorter history of the EM corporates asset class, the findings generally align with our intuition. On a standalone basis, modern portfolio theory proposes that an individual asset should be included within a portfolio if its excess return divided by its standard deviation is higher than the excess return of the portfolio divided by the portfolio's standard deviation, multiplied by the correlation between the portfolio and the asset. Though the correlation to the DM portfolio from 2004 was fairly high for both assets at over 0.6, when we applied this formula, both EM sovereign and corporate debt warranted an allocation in a standard global fixed-income portfolio. EM sovereign debt scored higher, by offering a considerably better Sharpe ratio with only a minimally higher correlation to DM fixed income. While EM hard currency debt has fairly consistently outperformed the DM benchmark on a 12-month rolling basis, investors must be careful not to simply maintain large positions at all times. Obviously, the majority of fixed-income investors have volatility constraints that impose limits on credit allocations. Additionally, apart from simple volatility measures, EM debt has a "hidden" risk profile when looking at the higher moments of return distributions. Table 1EM Debt Returns Are##BR##Negatively Skewed Both EM sovereign and corporate credit historical returns have exhibited significant negative skewness and excess kurtosis, indicating a much higher-than-normal tendency of experiencing outsized, negative returns (Table 1). This is confirmed through Historical Value-at-Risk (VaR) analysis, where the 5% worst returns far eclipsed those of DM investment grade and government debt. Nevertheless, it is important to view EM from a holistic perspective. For example, an asset with a high standard deviation may be less desirable as a standalone investment, but can be highly beneficial if it enhances overall the returns of a portfolio while also reducing its volatility. We tested these "portfolio effects" of EM debt by creating 21 hypothetical portfolios. We began with a DM-only portfolio (consisting of the Global Aggregate index) and increased the weighting toward EM debt by one percentage point in each portfolio, with the last portfolio having a 20% weighting toward EM. The breakdown within EM was 62% corporates and 38% sovereigns based on the market capitalizations of the relevant benchmark indices. Our calculations indicate that the highest portfolio Sharpe ratio was achieved with a 5% EM debt allocation, which also happens to be the "neutral" weighting of EM debt in the BCA Global Fixed Income Strategy model portfolio benchmark index (Chart 3).2 Global bond investors should hover around this weighting on EM hard currency debt, absent a high conviction view on EM. Chart 3The Optimal EM Hard Currency Debt Allocation Is 5% So while the data suggests that EM hard currency debt warrants a long-term allocation, its beneficial impact on a fixed-income portfolio is at least slightly exaggerated. Portfolio managers are typically seeking out assets that can both improve return and decrease overall volatility, thereby increasing the efficiency of their portfolios. This was not the case with EM debt. In our study, increasing the EM allocation consistently raised both returns and volatility. Chart 4EM/DM Correlations Should Decline In 2018 This lack of diversification benefit is a result of the high correlation between EM hard currency debt and DM fixed income. Currently, the correlation between EM and DM (the Global Aggregate) is 0.90, near the upper end of its range, indicating that diversification benefits over the last year were essentially non-existent (Chart 4). Nevertheless, this relationship clearly exhibits a mean reversion tendency. That EM/DM correlation in recent years has been itself correlated to global growth and monetary policy changes. As we show in Chart 4, our diffusion index of OECD Leading Economic Indicators (LEI) - the number of countries with a rising LEI relative to those with a declining LEI - does tend to lead the EM/DM correlation and is currently pointing to a lower correlation as global growth becomes a little less synchronized in 2018. The same goes for the growth rate of major central bank balance sheets which is already slowing and will decelerate even more in 2018 on the back of a diminished pace of bond buying by the ECB and the Fed runoff of maturing bonds on its balance sheet. The conclusion is this - the EM/DM correlation should decline in 2018 but, as we discuss below, we think that happens through relative underperformance of EM credit. Bottom Line: EM hard currency debt, both sovereign and corporate, has consistently outperformed the broad global index. However, investors should steer clear of always maintaining maximum overweights given its weak volatility reduction benefits and a much higher-than normal tendency of experiencing outsized, negative returns. Our long-term analysis suggests a structural 5% allocation offers the best risk/reward potential. The Shorter-Run Case For Owning EM Debt: Will Macro Drivers Remain Supportive? So far in 2017, EM sovereign and corporate debt have been beneficiaries of robust global growth, a declining USD and a decoupling from a broader index of commodity prices. While we expect global growth will remain strong over the medium term, our outlook for the USD is still bullish and there is a risk that commodity prices and EM debt performance re-converge to the downside. Global growth will remain strong. Outside of a major global growth slowdown, which we currently view as a low probability event, a mass flight out of EM assets anytime soon is highly unlikely. Indicators such as the global PMI index, industrial production growth and the OECD leading economic indicator are all booming (Chart 5). Inflation will head higher on the back of rising oil prices, but the increase is likely to be gradual. Importantly, this is happening alongside global monetary conditions that remain generally accommodative, even with the Fed in a tightening cycle. Credit, both DM & EM, has historically performed well against this backdrop, as we discuss in the next section of this report. A renewed upleg in the USD bull market is already underway. The correlation between EM currencies and EM debt performance has recovered after breaking down during 2013-15 (Chart 6). Year-to-date, EM currency strength - the flipside of the weaker U.S. dollar - has been a major driver of EM relative performance. Using the IMF's measure real effective exchange rates based on unit labor costs, the U.S. dollar is fairly valued.3 Neutral valuations suggest that directional market indicators are driving currency movements. As the EM business cycle slows and the Fed ramps up its rate hikes in response to rising inflation, the USD cyclical bull market should resume. Chart 5Robust Global Growth##BR##Is Supportive For EM Chart 6Can EM Ignore Another##BR##Round Of USD Strength? The de-coupling between EM debt and commodity price movements is unsustainable. EM debt has experienced a strong rally since 2016 with only a moderate rise in commodity prices compared to past periods of EM strength. We view this decoupling to be temporary (Chart 7). Many sovereign EM issuers are commodity producers, suggesting that this divergence is unsustainable. EM sovereign and corporate debt will not be able to continue their massive rallies if commodity prices relapse. We maintain a bullish view on oil prices, but there are signals that base metal prices are at risk over the next 6-12 months. Chinese monetary authorities have tightened policy and the resulting sharp slowdown in money supply growth is a worrisome sign for Chinese demand for commodities (Chart 8).4 Chart 7EM-Commodity Divergence##BR##Is Unsustainable Chart 8China Downside Risks For##BR##Industrial Commodity Prices Bottom Line: While global growth will remain supportive of EM credit, currency weakness and a re-convergence with commodity prices present considerable headwinds. EM Debt Performance & The Fed Policy Cycle Chart 9The Fed Policy Cycle As more central banks are shifting to a tightening bias, investors are becoming increasingly concerned over policy normalization and its potential impact on credit market performance. Given the strong historical linkages between EM debt performance and Fed policy changes, the current U.S. tightening cycle looms as a major potential problem for EM assets. We have found it most useful to think about changes in Fed monetary policy and asset market performance in terms of breaking up the Fed policy into four distinct phases (Chart 9).5 These are characterized by both the level of interest rates (whether they are above or below "equilibrium") and the direction of policy changes (whether the Fed is raising or cutting rates):6 Phase 1 - the Fed is hiking while the fed funds rate is below equilibrium (i.e. monetary conditions are stimulative). Phase 2 - the Fed is hiking or keeping policy on hold while the fed funds rate is above equilibrium (i.e. monetary conditions are restrictive). Phase 3 - the Fed is cutting while the fed funds rate is above equilibrium (i.e. monetary conditions are restrictive). Phase 4 - the Fed is cutting rates while the fed funds rate is below equilibrium (i.e. monetary conditions are stimulative). For EM sovereign debt where we have index data going back to 1994, there have been four episodes of Phase 1 and three episodes of the other phases. For EM corporate debt, where the index data begins in 2002, there have been two episodes of Phases 1 and 4 and only one occurrence of Phases 2 and 3. We present the excess returns of EM debt relative to other major fixed income classes by phase in Table 2. In the limited sample, EM sovereign debt and corporate debt consistently outperformed the Global Aggregate index and most individual bond classes. However, relative to DM high-yield debt, which has the most comparable risk profile, EM sovereign bonds underperformed in Phase 1 and EM corporate debt underperformed in all phases. Table 2Relative EM Debt Performance Worsens As Fed Policy Tightens Excess returns for both EM debt classes were highest in Phase 4, where the central bank is easing while conditions are stimulative. Similar to other risk assets, EM debt also outperformed in Phase 1, where the central bank is tightening while rates are below equilibrium. This makes sense, as the early stages of monetary tightening typically occur in conjunction with stable, above-trend growth. Liquidity conditions are still stimulative in Phase 1, which provides a substantial tailwind for spread product performance. On the other end of the spectrum, EM debt excess returns were relatively low during Phase 2 and Phase 3, and even negative in the case of EM corporate debt for Phase 3. Surprisingly, EM debt has been less affected by the direction of U.S. interest rates than what we would have expected. Monetary easing in Phase 3 was not enough to substantially boost EM relative returns and tightening in Phase 1 did not derail growth or lift the USD enough for EM debt to underperform. In fact, because EM debt still offers robust excess returns during Phase 1 when the central bank is tightening, while also suffering during Phase 3 during central bank easing, we can conclude that the level of policy rates relative to equilibrium has a greater impact on returns than the direction of rates. The severity of the Global Financial Crisis and the relatively subdued pace of recovery for both growth and inflation led to one of the longest Phase 4s in history. Given the low level of starting yields, indicating a large gap to equilibrium, and the 'gradual' pace of normalization, the current Phase 1 should also last longer than it typically has. This bodes well for all credit sectors, including EM sovereign and corporate debt, if history is any guide. However, there are still reasons to be concerned about the impact of U.S. monetary policy on EM assets next year. If the Fed follows through with the interest rate hikes it is currently projecting - another 100bps in total by the end of 2018 - the funds rate will be much closer to equilibrium. If the U.S. dollar rallies alongside that Fed tightening, as we expect, overall U.S. monetary conditions could end up being much closer to a restrictive level than implied by strictly looking at our Fed Policy Cycle (which only looks at the funds rate to determine monetary conditions). Also, the equilibrium funds rate may now be lower than the levels we are assuming in the Fed Policy Cycle framework, suggesting that policy could turn restrictive more quickly in the current tightening cycle. Bottom Line: The Fed is still in the early stages of rate normalization. At this point in the Fed policy cycle, where the Fed is hiking rates but monetary conditions are still stimulative, EM hard currency debt has historically performed well both on a relative and absolute basis. Looking ahead, EM returns should begin to suffer in latter half of 2018 as the Fed moves to more restrictive policy stance. Another Reason For Caution: Our EM Corporate Health Monitor The BCA EM Corporate Health Monitor (CHM) is a directional indicator aimed at modeling the path of EM corporate spread movements. Financial data from 220 emerging market companies in over 30 countries is aggregated. Only firms that issue USD-denominated bonds are included, with banks and other financials also omitted in a similar fashion to the CHMs we have constructed for DM corporates. The indicator is made up of four financial ratios: profit margins, free cash flow to total debt, liquidity and leverage. Unlike the DM CHMs, the ratios are not equally weighted in the construction of the EM CHM. Profit margins and free cash flow to debt combined represent 75% of the EM CHM. The latest available reading is from Q2 2017, showing a large decrease, with the indicator now only barely in 'Improving Health' territory (Chart 10). This has occurred in tandem with EM corporate spreads narrowing to post-crisis lows, leaving EM debt at potentially overvalued levels on a fundamental basis. While this slowdown in the EM CHM is not yet a cause for concern, if this became an extended trend of financial health deterioration, the divergence with EM corporate debt performance would be unsustainable and leave EM corporates highly vulnerable to a correction. Chart 10The BCA EM Corporate Health Monitor Has Rolled Over EM Corporate Health Monitor Is Sending A 'Sell' Signal Bottom Line: Our EM Corporate Health Monitor has declined drastically and is barely in 'Improving Health' territory. This alone is not cause for concern yet, but further deterioration in our Monitor combined with additional credit spread narrowing would be a worrisome divergence. Investment Implications Emerging market debt is facing conflicting forces. While continued robust global growth and accommodative monetary policy provide a substantial tailwind for credit performance, extended valuations, the turn in the USD and a potentially worsening commodities outlook present difficult hurdles for EM to overcome. Given the mixed messages, we prefer owning cyclical credit exposure through DM corporate debt, particularly U.S. investment grade. EM debt yields have collapsed and are expensive relative to DM investment grade debt (Chart 11). Combined with a higher risk profile in EM, elevated valuations indicate that EM sovereign and corporate debt are vulnerable to larger corrections. From a return perspective, the difference in the corporate option-adjusted spreads (OAS) has been an excellent leading indicator for relative total returns (Chart 12). This differential indicates that there is considerable relative upside potential for U.S. investment grade over EM hard currency debt. Additionally, while global growth should support credit-related plays, relative growth dynamics are more supportive of U.S. investment grade because the next phase of the global growth upturn will be driven by DM countries and not EM. The difference between the manufacturing PMIs in the U.S. and EM has historically been a good directional indicator for the spread between U.S. corporate bond spreads and EM debt spreads (Chart 13). The gap between the relative manufacturing PMI readings is at a post-crisis high, and could widen further if EM economies suffer on the back of any pullback in Chinese growth in 2018. Chart 11EM Yields & Spreads Look Full Valued Chart 12Favor U.S. IG Over EM Corporates... Chart 13...Because Of Stronger U.S. Growth What are the risks to our view? Our recommended position would suffer in the event that inflation in the U.S. slows, keeping the Fed on hold and maintaining this year's USD downtrend. Also, if China were to ease up on its policy tightening, industrial commodity prices could strengthen once again. Under these scenarios, EM hard currency debt would likely outperform DM spread product. Bottom Line: Maintain moderate underweight positions in EM hard currency debt. Favor DM spread product (especially U.S. investment grade corporates) due to more supportive relative valuations and growth trends. Patrick Trinh, Associate Editor Global Fixed Income Strategy patrick@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 This “EM versus IG” trade was implemented in both our Emerging Markets Strategy and Global Fixed Income Strategy services. Please see BCA Emerging Markets Strategy Weekly Report, “EM: The Focus Is On Profits”, dated August 16th 2017, available at ems.bcaresearch.com, as well as the BCA Global Fixed Income Strategy Weekly Report, “A Lack Of Leadership”, dated August 22nd 2017, available at gfis.bcaresearch.com. 2 The weighting to EM debt in the Global Fixed Income Strategy model bond portfolio benchmark is based on market capitalizations of all the fixed income sectors we wanted to have in the benchmark, which includes non-investment grade debt like global high-yield corporates. It is reassuring to see that our benchmark weighting is also the desired weighting from a long-run portfolio optimization perspective. 3 Please see BCA Emerging Markets Strategy Weekly Report, "Is The Dollar Expensive, And Are EM Currencies Cheap?", dated October 11th, 2017, available at ems.bcaresearch.com. 4 Please see the joint BCA Global Asset Allocation/Emerging Markets Strategy Special Report, "Global Equity Allocation: The Underwhelming Case For EM", dated August 9th 2017, available at ems.bcaresearch.com & gaa.bcaresearch.com. 5 Please see BCA U.S. Bond Strategy Special Report, "Bonds And The Fed Funds Rate Cycle", dated May 27th 2014, available at usbs.bcaresearch.com. 6 The equilibrium policy rate is a BCA calculation based on long-run real potential GDP growth and long run inflation expectations.

Dear Clients, Please note there was an error in the Recommend Asset Allocation table published on November 1, 2017. This has now been amended. We apologize for the confusion and any inconvenience it may have caused. Best Regards, Garry Evans Senior Vice President Global Asset Allocation Reflation Trade Returns Recommended Allocation The market mood has shifted remarkably quickly over the past couple of months. The probability of a December Fed rate hike has moved up from 20% in early September to close to 100%, pushing the 10-year Treasury bond yield from 2.0% to 2.4% and causing the trade-weighted U.S. dollar to appreciate by 2%, and Emerging Market equities to underperform. We expect this trend to continue. Global growth continues to surprise to the upside (Chart 1). The softness in U.S. inflation this year is likely to reverse over coming quarters - an argument supported by the New York Fed's new Underlying Inflation Gauge, which indicates that sustained movements in inflation continue to trend higher (Chart 2). This makes it likely that the Fed will move ahead with its forecast three rate hikes in 2018, which the market has not yet priced in (Chart 3) - the implied probability of this is only 10%. Consequently, rates have further to rise: our fair value for the U.S. 10-year Treasury yield currently is 2.7%. And the increasing gap between U.S. and euro zone interest rates suggests that the dollar can appreciate further (Chart 4). All this supports our view that risk assets (equities and corporate credit) should outperform over the next 12 months, with developed government bonds producing a negative return, and emerging markets lagging because of rising rates and the stronger dollar (and a possible slowdown in China, as it focuses on reforming its economy and cleaning up the debt situation). Chart 1Growth Surprising To The Upside Chart 2Underlying Inflation Still Trending Up Chart 3Market Expects Fed To Move Only Slowly Chart 4Rate Gap Suggests Dollar Appreciation The key question, though, is how long this positive scenario can continue. With stock market valuations expensive (Chart 5) and investors fully invested, though not yet euphoric (Chart 6), we are clearly in late cycle. Rising rates could put a dampener on growth. Chart 5 Equities Close To Extremely Overvalued Chart 6Investors Are Fully Invested, But Cautious We find the Fed policy cycle a useful tool for thinking about probable investment returns from different assets (Chart 7). The best quadrant for risk assets is when the Fed is easing and policy is easy (with the Fed Funds Rate below the neutral rate). Currently we are in the bottom-right quadrant (Fed tightening, but not yet in the tight zone), which also has produced attractive returns for equities and credit. But once the Fed Funds Rate (FFR) moves above the neutral rate, returns from risk assets are on average poor and, historically, recession often followed quite quickly. How much longer do we have before Fed policy moves into the top-right quadrant? The Fed's own estimate of the neutral rate, in real terms, is 0.3%. The current real FFR (using core PCE inflation, 1.3%, as the deflator) is -0.17 (Chart 8). This implies that it will take only two further Fed hikes to move into the tight zone, which could happen as soon as March. This is why the outlook for inflation is critical. If, as the Fed forecasts and we also expect, core PCE inflation rises to 2%, it will be another five hikes before policy turns tight - we are unlikely to get there until early 2019. Chart 7The Fed Policy Cycle Chart 8How Far From The Tight Zone? For now, therefore, we continue to recommend an overweight on risk assets and pro-cyclical portfolio tilts. Global monetary policy remains easy and we see no indicators that suggest growth is slowing or that the risk of recession over the next 12 months is rising. The risks to this optimistic scenario (a hawkish Fed, over-eager structural reform in China, provocation from North Korea) seem limited. But we also continue to warn of the possibility of a recession in 2019 or 2020 caused, as so often, by excessive Fed tightening. We see, therefore, the possibility of our turning more defensive somewhere in mid-2018. Equities: We prefer developed over emerging market equities. Rising interest rates and an appreciating dollar will be headwinds for EM. Moreover, Xi Jinping's speech at the Communist Party Congress hinted at supply side structural reforms, overcapacity reduction, and deleveraging efforts. A renewed reform effort could dampen Chinese growth somewhat which, as in 2013-15, would negatively impact EM equities (Chart 9). Within DM, we are overweight euro zone and Japanese equities, which are higher beta, have stronger earnings momentum, and benefit from looser monetary policy. Fixed Income: We expect bonds to underperform over coming quarters, as U.S. inflation picks up and the Fed moves raises rates in line with its "dots". Corporate credit still has some attractions, provided the economic expansion continues. U.S. sub-investment grade bonds, in particular, have an attractive default-adjusted yield, as long as a strong economy keeps the default rate over the next 12 months to the historically low 2% our model suggests (Chart 10). The pick-up in inflation we expect would mean inflation-linked bonds outperform nominal bonds. Chart 9Slowing China Would Hurt EM Equities Chart 10Junk Attractive If Defaults Stay This Low Currencies: The ECB delivered a dovish tapering last month, extending its asset purchases until at least September 2018 and emphasizing that its current low interest rates will continue "well past the horizon of our net asset purchases". Given this, and the gap between U.S. and euro zone interest rates (Chart 4), we expect moderate further euro weakness over coming months. The dollar is likely to appreciate even more against the yen. There are the first tentative signs of inflation emerging in Japan (Chart 11) which, combined with the Bank of Japan sticking to its 0% 10-year JGB target and rising global interest rates, could push the yen to 120 against the dollar over coming months. Commodities: BCA's energy strategists recently revised up their crude oil forecasts on the back of strong demand, a likely extension of the OPEC agreement until at least end-2018, and possible supply disruptions in Iraq, Venezuela and other troubled regions.1 They see inventories continuing to draw down until at least 2H 2018 (Chart 12). Accordingly, they forecast $65 a barrel for Brent and $63 for WTI and flag upside risk to those projections. The outlook for industrial and precious metals, however, is less positive. A stronger dollar and a shift in the growth drivers in China will depress prices for base metals. Rising real interest rates will hurt gold, although we still like precious metals as a long-term hedge. Chart 11First Signs Of Inflation In Japan? Chart 12Oil Inventory Drawdowns Support Higher Price Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report "Oil Forecast Lifted As Market Tightens," dated 19 October 2017, available at ces.bcaresearch.com GAA Asset Allocation

Highlights Duration: Treasury yields likely have another 50-60 basis points of upside during this cycle, and at least for now their uptrend should not be constrained by unreasonably elevated economic expectations. Stay at below-benchmark duration. Economy & Inflation: GDP growth remains firmly entrenched above levels necessary to ensure that the unemployment rate continues to fall and inflation is pressured higher. Weakness in residential investment presents a risk to the view that above-trend growth will persist, but leading housing indicators suggest it will bounce back in the coming quarters. Municipal Bonds: State & Local government net borrowing declined in the third quarter, but the improvement is already reflected in historically tight Muni / Treasury yield ratios. Remain underweight municipal bonds. Feature Chart 1Discounting An Inflation Rebound In last week's report we pointed out that a flat yield curve is incompatible with core inflation so far below the Fed's target and that the bond market is fast approaching a day of reckoning where either inflation will rise quickly enough to justify the Fed's rate hike expectations, or those expectations will be revised lower.1 Meantime, the Treasury curve has been bear-steepening since early September, and the 37 basis point increase in the 10-year yield has been driven both by higher real yields and a higher cost of inflation compensation (Chart 1). This suggests that the market is pricing-in a rebound in inflation rather than a capitulation from the Fed. Yesterday's PCE inflation report didn't do much to justify those expectations, coming in at only 1.33% year-over-year, not far above the 1.30% reading from August. However, we have previously noted mounting evidence that we are past the worst of the inflation downtrend.2 This raises the question of how much higher Treasury yields can rise, and this is the question we tackle in this week's report. Data Surprises & Playing The Odds Longer run, the 10-year cost of inflation compensation (currently 1.88%) will likely settle into a range between 2.4% and 2.5% by the time that core inflation returns to the Fed's 2% target. Assuming that inflationary pressures are sufficiently strong for that outcome to be achieved with the Fed lifting rates at a pace of about 50 bps per year, then long-dated real yields should stay roughly flat. This means that the nominal 10-year Treasury yield can move another 50-60 bps higher before the end of the cycle. But in the meantime, depending on swings in the macroeconomic data, bonds could experience several playable rallies and sell-offs. Is there a way for us to get a handle on when those might occur? One way might be to examine the economic surprise index (ESI). This index tracks whether economic data are over- or under-shooting consensus expectations. In this way it is very much like a financial market price. It moves higher when the incoming data suggest a rosier outlook than is currently anticipated, but then falls once expectations become so bullish they can no longer be surpassed. This is exactly what happened at the beginning of the year when the 10-year Treasury yield peaked at 2.62% following an extended period of elevated data surprises (Chart 2). Chart 2Economic Surprises Are Mean Reverting More specifically, we observe that when the ESI ends a month above (below) the zero line, it is very likely that the 10-year Treasury yield increased (decreased) during that month (Chart 3). The same is also true for 3-month and 6-month investment horizons, although the correlation is less robust, particularly for values close to zero (Charts 4 & 5). It follows that if we know whether the economic data will surprise on the upside or on the downside in a given month, then we can predict whether Treasury yields will rise or fall. Chart 3Economic Surprise Index & ##br##1-Month Change In Yields Chart 4Economic Surprise Index & ##br##3-Month Change In Yields Chart 5Economic Surprise Index & ##br##6-Month Change In Yields Unfortunately that is not a very profound statement. It is similarly easy to decide how much to bet on a hand of blackjack if you already know what cards will be dealt. But while it is obviously impossible to predict whether data surprises will be positive or negative in a given month, much like a card counter in blackjack, a study of events that have just occurred can help us make inferences that tilt the odds in our favor. In other words, we know that the ESI is mean reverting. A long sequence of elevated readings means it is more likely to fall, and a long sequence of depressed readings means it is more likely to rise. We can even use an AR(3) model to quantify the extent of mean reversion in the index. Using monthly data we run a regression of the ESI on its three most recent lags and get the following result which explains 55% of the variation since 2003: Notice that the index is positively correlated to its reading from the prior month, but negatively correlated with its readings from two and three months ago. Let's now consider that the most recent reading from the ESI is 38.2. One month ago it was -7.9 and two months ago it was -23.1. Using our formula, our best prediction for where the surprise index will be next month is 39. This is still deep in positive territory, meaning that if the model is correct, Treasury yields will remain under upward pressure. More decisively, we conclude from our model that it is unlikely that investor expectations have become so elevated that markets are set up for disappointment. The Appendix to this report provides a reference table for different ranges of the surprise index based on the above formula. It can be used as a quick reference guide for predicting where the ESI is likely to fall next month based on its readings from the prior three months. Bottom Line: Treasury yields likely have another 50-60 basis points of upside during this cycle, and at least for now their uptrend should not be constrained by unreasonably elevated economic expectations. Stay at below-benchmark duration. Economy & Inflation No Signs Of A Slowdown Last week we learned that GDP grew at an annualized rate of 3.0% in the third quarter, well above the Fed's 1.8% estimate of trend. The number was boosted by strong contributions from inventory accumulation (+0.73%) and net exports (+0.41%), but even stripping out those more volatile components to focus on real final sales to domestic purchasers reveals that growth is firmly above trend (Chart 6). Above-trend GDP growth will ensure that the unemployment rate continues to decline, which in turn will ensure that inflation moves higher. The unemployment rate had come close to flattening off late last year as growth decelerated toward 1.8%, but has since started to fall more rapidly alongside the re-acceleration in GDP (Chart 6, bottom panel). In fact, we attribute this year's decline in inflation to last year's growth deceleration and expect inflation will soon follow GDP growth higher (Chart 7). Chart 6Growth Is Steady, And Well Above Trend Chart 7Inflation Lags Growth Considering the contributions from the more stable sources of growth, we observe the following (Chart 8): Consumer spending remains firm, still above its post-2010 average. Nonresidential investment is accelerating back toward its post-2010 average, following a period of weakness that was driven by the mid-2014 commodity price collapse. Leading capex indicators, such as new orders surveys, suggest the acceleration will continue. Residential investment is a source of concern. It had already decelerated to well below its post-2010 average even prior to the hurricanes that depressed its contribution to growth in Q3. We are not yet concerned that the weakness in residential investment will morph into a broader slowdown. In fact, it appears quite likely that residential investment will bounce back in the coming quarters. Growth in residential investment is correlated with changes in the inventory of outstanding homes (Chart 9). Typically, large slowdowns in residential investment are preceded by a big run-up in supply. But at the moment, supply continues to contract, whether or not we include the shadow inventory from properties that were foreclosed upon during the housing bust. This shadow inventory has mostly evaporated in any case (Chart 9, panel 3). Chart 8Housing Not Keeping Pace Chart 9Inventories Still Falling Further support for residential investment comes from homebuilder sentiment which remains very strong (Chart 9, bottom panel). Bottom Line: GDP growth remains firmly entrenched above levels necessary to ensure that the unemployment rate continues to fall and inflation is pressured higher. Weakness in residential investment presents a risk to the view that above-trend growth will persist, but leading housing indicators suggest it will bounce back in the coming quarters. An Improvement In State & Local Government Balance Sheets Assuming that corporate tax revenues were the same in Q3 as in Q2, we can estimate that state & local government net borrowing declined to $163 billion in the third quarter. This represents a substantial improvement from prior quarters, but one that has already been discounted in Municipal / Treasury (M/T) yield ratios (Chart 10). M/T yield ratios are extremely tight, even compared to average pre-crisis levels (Chart 11), and the unattractive valuation underscores our negative stance on the sector. However, at least for now, there are no signs of an imminent surge in state & local government net borrowing that could cause a credit premium to get priced into muni yields. Chart 10Less Borrowing Is In The Price Chart 11Muni / Treasury Yield Ratios Until last quarter, growth in state & local current expenditures had been running consistently above growth in current revenues (Chart 12). However, the weakness in current revenues was mostly attributable to a slowdown in transfers from the federal government. When we look at growth in state & local government tax revenues only, we find that it is substantially outpacing expenditure growth (Chart 12, panel 2). Chart 12Tax Revenue Growth Greater Than Expenditure Growth The acceleration in transfers from the federal government that started in mid-2014 reflected the expansion of Medicaid under the Affordable Care Act. Now that most eligible individuals have signed up, we would expect growth in federal transfer payments to level-off. Unless legislation is passed to further curb transfers from the federal government, state & local borrowing should continue its decline in the coming quarters. Bottom Line: State & Local government net borrowing declined in the third quarter, but the improvement is already reflected in historically tight Muni / Treasury yield ratios. Remain underweight municipal bonds. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "The Fed Must Fall Behind The Curve", dated October 24, 2017, available at usbs.bcaresearch.com. 2 Please see U.S. Bond Strategy Weekly Report, "Living With The Carry Trade", dated October 17, 2017, available at usbs.bcaresearch.com. Appendix Table 1 Table 2 Table 3 Fixed Income Sector Performance Recommended Portfolio Specification

The key theme that has been driving our investment thesis in U.S. Equity Strategy in the past quarter has been accelerating global industrial production and trade, with a corresponding rotation out of defensive and into cyclical stocks. We have been adjusting our portfolio accordingly and it now has a deep cyclical bent with leverage to a burgeoning capex cycle. Industrial conglomerates capitalize on most of these themes: they are globally-oriented and capex-driven, and leading indicators of final demand suggest that earnings should accelerate in the near-term (second panel). However, the index has underperformed the broad market, dragged down by heavyweight GE (third panel) and its specific headwinds, most notably fears of a looming dividend cut. Further, the index's highest exposure sectors (namely aerospace, health care equipment, energy equipment & services and utilities) are mostly weighted negatively in our overall sector view. Adding it up, the negatives offset the positives and, in the context of fair valuations (bottom panel), we expect the S&P industrial conglomerates index to perform in line with the overall market. We are initiating coverage with a neutral rating; please see yesterday's Special Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5INDCX - GE, MMM, HON, ROP.

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

Special Report

A capex revival is underway, powered by exceptionally strong business and consumer sentiment, the breadth of which covers virtually all developed economies. This global capex upcycle should underpin top-line growth and margin expansion for the industrial conglomerates index, whose product and geographic diversification ensures exposure to the global upswing. However, the index has underperformed the broad market, dragged down by heavyweight GE and its specific headwinds. Further, the index's highest exposure sectors (namely aerospace, health care equipment, energy equipment & services and utilities) are mostly weighted negatively in our overall sector view. Adding it up, the negatives offset the positives and, in the context of fair valuations, we expect the S&P industrial conglomerates index to perform in line with the overall market. We are initiating coverage with a neutral rating. The key theme that has been driving our investment thesis in U.S. Equity Strategy in the past quarter has been accelerating global industrial production and trade, with a corresponding rotation out of defensive and into cyclical stocks. We have been adjusting our portfolio accordingly and it now has a deep cyclical bent with leverage to a burgeoning capex cycle. Enticing Macro Outlook Industrial conglomerates capitalize on most of these themes: they are globally-oriented and capex-driven, and leading indicators of final demand suggest that earnings should accelerate in the near-term. Capex Upcycle On the domestic front, regional Fed surveys of domestic capex intentions and the ISM manufacturing survey are hitting modern highs; both have been excellent indicators of a capex upcycle and the signal is unambiguously positive (Chart 1). Our Capex Indicator also corroborates this message. Durable goods orders have already surged and inventories have reverted to a more normal level, coming out of the late-2015/early-2016 manufacturing recession (Chart 2). This implies increasingly resilient pricing power from a demand-driven capital goods upcycle. Further, the capital goods cycle has significant room to run as new orders remain well below the 2013-2014 levels. Chart 1Exceptionally Strong Sentiment... Chart 2...Is Already Reflected In A Capex Upcycle Chart 3Capital Goods Demand Is Globally Synchronous The global picture echoes the domestic, with the global manufacturing PMI surging to a six-year high. The global strength is remarkably broad: all 46 of the economies tracked by the OECD are expected to see gains in 2017, a first since the GFC, and the BCA global leading economic indicator is signaling all-clear (Chart 3). U.S. Dollar Reflation The greenback's slide in 2017 should further boost global demand for domestic exports. In fact, given the diversity of industries served by the industrial conglomerates and the relatively high proportion of foreign sales (Table 1), the U.S. dollar is the single largest driver of both sales and earnings (Chart 4). Due to the lagged impact on results from the currency, industrial conglomerates margins should benefit from translation gains in the next two quarters, regardless of where the U.S. dollar moves. Table 1Conglomerates More Global Than Industrial Peers Chart 4U.S. Dollar Drives Conglomerate Profits But GE Weighs On The Index With the enormously supportive demand environment in mind, one could safely assume that the globally integrated niche industrial conglomerates index has been a strong performer in 2017. That would be true were it not for index heavyweight (and laggard) General Electric. Excluding GE from this index, industrial conglomerates have outperformed the S&P 500 by 20% since the start of the year (Chart 5). However, GE represents 40% of the index (Chart 5) and its current transformation continues to weigh heavily on its share price and, hence, the index at large. The new CEO, who took over earlier this month, has stated that "everything is on the table" as part of a $20 billion target for divestitures over the coming two years. The current fear among investors is that GE will need to reduce its dividend to preserve enough liquidity to continue growing despite the fairly synchronous storm in its end-markets. In March, 2009, GE's share price reached its modern nadir, a level not seen since the recession of the early 1990's, a week following its dividend cut announcement. While hardly analogous to GE today (recall that a cash crisis at GE Capital threatened to bankrupt the entire firm), the risk of a dividend cut will keep GE's share price suppressed, and likely hold the overall index hostage. Payout ratios in the industrial conglomerates index reflect GE's cash flow woes and have now surpassed the pre-dividend cut level during the GFC (Chart 6). This largely reflects cash contraction, combined with an unwillingness to even halt dividend growth. Regardless, GE investors clearly anticipate the new CEO will reduce the dividend, having pushed the yield to its highest level since the last dividend cut (Chart 6). Chart 5GE Still Dominates The Index Chart 6A Dividend Cut Looks To Be In The Cards Soft End-Markets Backdrop From the mid-1990's until 2007, the narrative of the S&P industrial conglomerates index was the rise and fall of GE Capital, as evidenced by the index' price. In 2015, the now largely complete sale of the majority of GE Capital was announced, realigning the company as an industrial manufacturer. Accordingly, analyzing the key end-market industries that the S&P industrial conglomerates cater to is in order: aerospace, healthcare, oil & gas and utilities. Chart 7Aerospace Profits Look Set To Fall Chart 8Health Care Equipment Pricing Collapsing Aerospace (Underweight recommendation) - We downgraded the BCA aerospace index to underweight at the end of 2015, corresponding fairly closely to the peak of the aerospace orders cycle (Chart 7). Since then, orders have fallen by half reflecting a downturn in the commercial aerospace cycle. While shipments have been falling, the decline has been much less precipitous as manufacturers have been running down backlogs. Historically, maintenance has buffered aerospace profits, repair and consumables activity, though weak current pricing power suggests that this may prove less sustainable than in previous cycles. Both GE & HON share extensive exposure to aerospace demand as it represented 23% and 38% of 2016 revenues, respectively. Health Care Equipment (Neutral recommendation) - We reduced our recommendation to neutral earlier this year as weaker demand no longer supported the thesis of an earnings-led outperformance. Since then the industry's outlook has not improved as demand has downshifted and pricing has cooled substantially; orders and production both crested last year and pricing power has contracted relative to overall since December 2016 (Chart 8). This bodes ill for medical equipment margins. Health care equipment represented 16% and 18% of GE & MMM 2016 revenues, respectively. Energy Equipment & Services (Overweight recommendation) - Energy Equipment & Services is our only overweight recommended sector relevant to the industrial conglomerates analysis. We upgraded in late 2016 (and doubled down on June 2) based on three key factors: troughing rig counts, cresting global oil inventories and falling production growth. Two of these factors have come to fruition: the global rig count bottomed in 2015, and has staged its best recovery since 2009 (Chart 9) and the growth in total OECD oil stocks is moderating rapidly with recent large storage draws. The key missing ingredient has been pricing power, which should eventually turn up if rig counts prove resilient. Energy equipment & services represented 11% of GE's 2016 revenues. Utilities (Underweight recommendation) - As previously noted, a key macro theme in U.S. Equity Strategy is accelerating global industrial production and trade. Utilities tend to move in the opposite direction of that theme given their safe haven status (top panel, Chart 10). Combined with falling domestic electricity production and capacity utilization, and rising turbine & generator inventories, the industry's outlook is bleak (middle & bottom panels, Chart 10). GE's Power segment is one of the world's largest gas and steam turbine manufacturers and delivered 24% of 2016 revenues. Investment Recommendation A roaring, globally synchronous capital goods upcycle should mostly keep sales and profits buoyant in this industrials subsector. However, high concentration in one stock, which is experiencing a greater than normal amount of flux, adds significant specific risk. Further, we are less optimistic about the key industries served by the industrial conglomerates than we are for the economy at large, implying more opportunity for outperformance from other, more focused, S&P industrials peers. If valuations were particularly compelling they could provide a cushion to any profit mishap, but this is not the case. Our Valuation Indicator is in the neutral zone and, while our Technical Indicator is in oversold territory, it has shown an ability to remain at these levels for prolonged periods (Chart 11). Chart 9Energy Services Is A Bright Spot Chart 10Utilities Are In A Deep Cyclical Decline Chart 11Valuations Are Not Compelling Bottom Line: Netting it out, we think the S&P industrial conglomerates index should perform broadly in line with the overall market. Accordingly, we are initiating coverage with a neutral rating. The ticker symbols for the stocks in this index are: BLBG: S5INDCX - GE, MMM, HON, ROP. Chris Bowes, Associate Editor U.S. Equity Strategy chrisb@bcaresearch.com

Underweight This summer, we downgraded the S&P soft drinks index to underweight based on a collapse in beverage shipments and its high correlation with relative performance. That decline has since accelerated but even lower volumes have not been enough to reverse the industry's price deflation (second panel). Index heavyweights KO & PEP recently reported declining Q3 revenues and profits, confirming the message that demand is shrinking and earnings will continue to suffer. Valuations too have come down, reflecting the industry's woes (third panel). However, they sport a 21% premium to the S&P 500 despite much worse growth prospects (bottom panel). Given these industry dynamics, we think the valuation slide has further to go; stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5SOFD - PEP, KO, DPS, MNST.

Feature This week we are sending you a shorter-than-usual market update, as we are also publishing a Special Report exploring the outlook for USD cross-currency basis swap spreads. This report argues that USD basis swap spreads should widen over the next 12 months. Being a phenomenon associated with higher FX vols, this should hurt carry trades, including EM and dollar bloc currencies. It will also potentially create additional support for the USD. Also, next week, we will provide a deeper analysis of the fallout from the New Zealand government's dynamics. ECB Tapers? European Central Bank President Mario Draghi refused to call it "tapering," but he nonetheless announced that the ECB will be cutting back its asset purchases to EUR30 billion per month until at least September 2018. However, because the ECB will continue to proceed with re-investment of the stock of assets it holds, the monthly total presence of the ECB in European bond markets will stay above EUR 30 billion. Moreover, the ECB is keeping the door open to leaving its purchases in place beyond September 2019, if inflation does not keep track with the central bank's forecasts, and thus referred to the adjustment as being open-ended. Ultimately, the ECB does think that the recent rebound in inflation has been and remains a function of maintaining a very accommodative monetary setting. We think this option to keep the asset purchases in place beyond September 2018 is just this: an option. However, we do believe that yesterday's change in policy means the ECB will not increase interest rates until well into 2019. We also anticipate U.S. core inflation to begin outperforming euro area core inflation as U.S. financial conditions have eased significantly relative to the euro area - a key factor to redistribute inflationary pressures among these two economies (Chart I-1). As a result, because we anticipate that the Federal Reserve will increase the fed funds rate by more than the 67 basis points currently expected over the next two years, there could be some downside risk in EUR/USD. This downside risk is already highlighted by the large gap that has recently emerged between the 1-year/1-year forward risk-free rate spread between Europe and the U.S. versus the euro itself (Chart I-2). Chart I-1U.S. Inflation Set To Outperform Euro Area Prices Chart I-2Forward Interest Rates Point To A Lower Euro Moreover, the elevated long positioning right now further highlights the downside risk present in the euro (Chart I-3), probably explaining the European currency's rather violent reaction to what was a well-anticipated policy move. This means that EUR/USD could end 2017 in the 1.15 neighborhood, and fall further in 2018. Chart I-3Positioning Risk In EUR/USD Bottom Line: The ECB delivered exactly what was anticipated, yet the euro sold off. The ECB is unlikely to increase interest rates until well into 2019, suggesting the first anticipated rate hike in Europe is fairly priced. Thus, in order to justify any downside in the euro, one needs to be more positive on the Fed than what is currently priced into the U.S. interest rate curve. We fall into this camp. Moreover, positioning remains too long the euro. We expect EUR/USD to fall toward 1.15 by year end, and display more downside in 2018. Bank Of Canada The Bank of Canada (BoC) surprised the market this week by expressing a reversing of its recent pronounced hawkish bias, instead expressing a much more cautious tone. Where a closed output gap was once driving the need for tighter policy, residual labor market slack now warrants a more restrained approach to tightening. What has changed? NAFTA. The most recent and tenuous NAFTA negotiation round raised the specter of an end to the North American FTA. While NAFTA is still not dead, the rising probability that Canada-U.S. trade falls backs under the umbrella of the previous CUSFTA or even maybe something worse is causing a headache for Canadian policymakers. Some 20% of Canadian GDP is made up of products destined to be exported to the U.S., and this large chunk of GDP could be under some risk. Additionally, as the BoC highlighted, future investment decisions by firms in Canada may become investments in the U.S. to bypass regulatory uncertainty. Ultimately, if the Canada / U.S. trade relationship falls back under the CUSFTA umbrella, the impact on Canadian growth will be limited. Nonetheless, we think the BoC is correct to play its hand carefully, especially as the Canadian housing market is cooling. Moreover, a recent IPSOS survey revealed that around 40% of Canadian households would face financial difficulties if rates moved up significantly, which may justify a slower pace of hiking. With all this uncertainty looming, it is logical for the BoC to take its time before tightening policy anew. But in the end, we do anticipate the Canadian central bank to increase rates around two times next year, which is in line with the market's assessment: Canada's output gap is closing, and inflation is moving in the right direction. Thus, the outlook for the CAD is likely to be dominated by the outlook for oil. Robert Ryan, who runs BCA's Commodity And Energy Strategy service, expects WTI to move toward US$63/bbl next year, with upside risk to his forecast.1 This could help the CAD. However, the CAD does not seem particularly cheap against the USD when Canada's poor productivity performance is taken into account (Chart I-4), and speculators are now quite long the CAD (Chart I-5). As a result, our preferred medium to express positive views on the CAD is to be short AUD/CAD, where a valuation advantage is still present for the loonie (Chart I-6). Moreover, the AUD is more likely to suffer from China moving away from its investment-led growth model, while the CAD is less exposed to this risk. Chart I-4The CAD Is Not That Cheap Chart I-5Speculators Are Very Long The CAD Chart I-6Short AUD/CAD Bottom Line: The BoC is rightfully concerned that a breakdown of NAFTA would negatively affect the Canadian economy. While a return to CUSFTA would minimize any impact, the current high degree of uncertainty warrants that the BoC takes a more cautious stance. Ultimately, the BoC will increase rates next year, potentially two times. We continue to prefer to short AUD/CAD. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report, titled "Upside Risks Dominate BCA's Oil Price Forecast", dated October 26, 2017, available at ces.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data has been strong: Manufacturing PMI came out at 54.5, stronger than expected; Services PMI came out at 55.9, also stronger than expected; Durable goods orders increased by 2.2%; New home sales increased by 18.9% monthly, the highest growth rate in 25 years; Initial jobless claims declined and beat expectations. Crucially, the DXY is above its 100-day moving average and has broken the reverse head-and-shoulders neckline, with momentum in the greenback's favor. The ECB's tapering weakened the euro by 1.4%. Further weakness in commodity currencies also allowed the dollar to gain momentum. We expect this momentum to continue as inflation in the U.S. re-emerges over the next six to twelve months. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The ECB's decision was largely in line with market consensus, but the euro nonetheless fell significantly. The ECB will halve its rate of purchases to EUR 30 bn a month starting next year until at least September 2018. However, President Mario Draghi stated that this could be extended beyond September, or even increased, if conditions warrant it. Draghi noted that "domestic price pressures are still muted overall and the economic outlook and the path of inflation remain conditional on continued support from monetary policy", also stating that rates would remain low for an extended period of time, and possibly even "past the horizon of the net asset purchases". Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: The Leading Economic Index increased from 105.2 to 107.2 in the month of August. Nikkei Manufacturing PMI surprised to the downside, coming in at 52.5, declining from 52.9 the month before. However, corporate service prices year-on-year growth came in at 0.9%, against expectations of 0.8%. Following the overwhelming victory of Prime Minister Shinzo Abe, the USD/JPY traded above 114, before stabilizing just below later in the week. Now that Abe has won the election, he is freer to implement loose fiscal policy in order to increase his chances to amend the pacifist Japanese constitution. This, accompanied by 10-year JGB rates anchored around zero, and a Federal Reserve that is likely to hike more than expected, should push USD/JPY higher. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in Britain has been mixed: Gross Domestic product yearly and quarterly growth surprised to the upside, coming in at 1.5% and 0.4% respectively. Moreover, public sector net borrowing was also lower than expected coming in at 5.236 billion pounds for the month of September. However, BBA mortgage approvals came below expectations, coming in at 41.584 thousand, which is lower than the month before. The pound has gone up following the positive GDP reading. As of now the market considers there is a 91% probability that the Bank of England hikes rates in November. However any hikes beyond that would require a significant improvement in economic activity. Thus, we would tend to fade any strength in GBP/USD, as the Fed is more likely to hike rates than the BoE on a sustainable basis. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The AUD declined on weak consumer price numbers. The trimmed mean CPI remained steady at 1.8% annually, below the expected 2% rate, and weakened to 0.4% quarterly, down from 0.5%. The largest yearly decline was in communication (services or equipment) of 1.4%, although declines in food prices and clothing were also substantial at 0.9%. This is largely in line with our view that the consumer sector is handicapped with poor wage growth. We believe inflation is unlikely to move much higher; this will keep the RBA at bay. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been negative: Imports surprised to the upside, coming in at 4.92 billion dollars. This figure also increased form last month's reading. However exports underperformed expectations, coming in at 3.78 billion dollars for the month of September. Finally the trade balance, also underperformed expectations, coming in at -1.143 billion dollars. After the election of new Prime Minister Jacinda Ardern the kiwi has plunged, and now has a negative return year-to-date. The government is trying to implement three measures which significantly affect the value of the kiwi: a dual central bank mandate, restrictions on immigration, and a stop to foreign real estate purchases. All these measures lower the terminal rate for the RBNZ. With this being said, we are still shorting AUD/NZD given that commodity dynamics will dominate the movements of this cross. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 CAD had an eventful week as the Bank of Canada came out with a monetary policy decision. The decision was in line with the consensus, but the statement was not. The Bank was particularly concerned "about political developments and fiscal and trade policies, notably the renegotiation of the North American Free Trade Agreement". Additionally, it was also noted that "because of high debt levels, household spending is likely more sensitive to interest rates than in the past". The Bank also made a U-turn in its view of the labor market, stating that "wage and other data indicate that there is still slack in the labor market". These unexpected remarks dropped the CAD's value by 1% against USD. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 The Franc continues to depreciate against the Euro, even as EUR/USD has gone down more than 2.5% since peaking early in December. Meanwhile, as the franc has depreciated, economic variables have improved. The KOF Industry Survey Business Climate indicator is now positive for the first time since 2011. Meanwhile, core inflation has reached 2011 highs as well. Additionally multiple components of PMI are at their highest level in the past 6 years. All of these factors bode well for the Swiss economy, and prove that the SNB's ultra-loose monetary policy and currency intervention is working. That being said, we would like to see more strength from key economic variables to consider shorting EUR/CHF, given that the recovery is still too fragile for the SNB to change policy. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The Norges Bank left their key policy rate unchanged at 0.5% yesterday. The central bank highlighted that capacity utilization was below normal levels and that inflation was expected to be below 2.5% in the coming years. Furthermore, the comittee highlighted that although the labor market appears to be improving, inflation has been lower than expected, while the krone is also weaker than projected. The bank has reassured our view that even in the face of strong oil prices, slack is still too big in the Norwegian economy for the Norges Bank to start raising rates. Furthermore, a hawkish fed will further put upward pressure on USD/NOK. Than being said, EUR/NOK should depreciate, given that this cross is much more sensitive to oil than it is to rate differentials. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The SEK has depreciated considerably in recent weeks owing to somewhat weaker inflation figures. It has weakened particularly against the EUR, as markets are expecting the Riksbank to follow the ECB in its rate path. This was confirmed by a particularly dovish tone from the recent monetary policy statement which exacerbated this decline, with the board expecting to maintain the current monetary policy until mid-2018, and even discussed a possible extension of asset purchase programs beyond December. The Board has "also taken a decision to extend the mandate that facilitates a quick intervention in the foreign exchange market". Finally, they lowered their inflation forecasts for both 2017 and 2018. Stefan Ingves is firmly in control. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Special Report

Highlights Three factors point to stable or narrower USD cross-currency basis swap spreads: the improving health of global banks, the end of the adjustment to the regulatory change affecting prime-money market funds, and the relaxation to the Supplementary Leverage Ratio rules by the U.S. Treasury. Four factors point to wider basis swap spreads: BCA's forecast that U.S. loan growth will pick up, our view on U.S. inflation, the coming decline in the Federal Reserve's balance sheet, and the potential for U.S. repatriation. We expect USD basis swap spreads to widen again, which suggests increasing FX vol. This would hurt carry trades, EM currencies and dollar bloc currencies. Feature Three factors point to stable or narrower USD cross-currency basis swap spreads: the improving health of global banks, the end of the adjustment to the regulatory change affecting prime-money market funds, and the relaxation to the Supplementary Leverage Ratio rules by the U.S. Treasury. Four factors point to wider basis swap spreads: BCA's forecast that U.S. loan growth will pick up, our view on U.S. inflation, the coming decline in the Federal Reserve's balance sheet, and the potential for U.S. repatriation. We expect USD basis swap spreads to widen again, which suggests increasing FX vol. This would hurt carry trades, EM currencies and dollar bloc currencies. The rather arcane topic of cross-currency basis swap spreads has periodically surfaced in the news in the past few years. The widening in cross-currency basis swap spreads has been highlighted as one of the key factors explaining why covered interest rate parity relationships (the link between the price of FX forward, spot prices and interest rate differentials) have not held as closely after the Great Financial Crisis (GFC) as before. The widening of cross-currency basis swap spreads has also been highlighted as a factor behind the strength in the U.S. dollar in 2014 and 2015. Similarly, the recent narrowing in the cross-currency basis swap spread has been highlighted as a factor behind the weakness in the USD this year. This week we delve a little deeper into what cross-currency basis swap spread measures, and what some of its major determinants are. We ultimately expect the USD cross-currency basis swap spread to widen again, which should contribute to a stronger dollar and increased global FX volatility. What Is A Cross-Currency Basis Swap? To examine what drives cross-currency basis swap spreads, one first needs to understand what these instruments are. Let's begin with a regular FX swap. An FX swap in EUR/USD is a contract through which two counterparties agree to exchange EURs for USDs today, with a reversal of that exchange at the maturity of the contract - a reversal set at a predetermined exchange rate simply equal to the forward value of the EUR/USD. So, if counterparty A lends X million EURs to counterparty B, the former receives in U.S. dollars the equivalent of X million EURs times the prevalent EUR/USD spot rate from counterparty B today. The transaction does not end there. Simultaneously, the FX swap forces B to give back the X million EURs to counterparty A at maturity, while counterparty A gives back X million EUR times the EUR/USD forward rate in U.S. dollars to counterparty B. This forward rate is the rate prevalent when the contract was agreed upon. The transactions are illustrated in the top panel of Chart 1. Chart 1FX Swaps Vs. Cross Currency Basis Swaps The problem with regular FX swaps is that they offer little liquidity at extended maturities. If market players want to hedge long-term liabilities and assets, they tend to do so using a cross-currency basis swap, where much more liquidity is available at long maturities. Chart 2A Bigger Funding Gap = ##br##A Wider Basis Swap Spread A EUR/USD cross currency basis swap begins in the same way as a regular FX swap: counterparty A lends X million EURs to counterparty B, and the former receives in U.S. dollars the equivalent of X million EURs times the prevalent EUR/USD spot rate from counterparty B today. However, this is where the similarities end. A cross-currency basis swap has exchanges of cash flows through its term. Counterparty B, which provided USDs to counterparty A, receives 3-month USD Libor, while counterparty A, which provided EURs to counterparty B, received 3-month EUR Libor + a (alpha being the cross-currency basis swap spread). At the maturity of the contract, counterparty A and B both receive their regular intermediary cash flows, and also re-exchange their respective principal - but this time at the same spot rate as the one that existed at the entry of the contract (Chart 1, bottom panel). In both regular FX and cross-currency basis swaps, counterparties have removed their FX risks, except that in the latter, the interest differentials have been paid during the life of the contract instead of being factored through the forward premium/discount. This is fine and dandy, but it leaves a unexplained. The cross currency basis swap spread (a), is a direct function of the relative supply and demand for each currency. If investors demand a lot of EUR in the swap market relative to its supply, a will be positive. If they demand more USDs, a will be negative. A good example of this dynamic is the funding gap of banks. Let's take the Japanese example. Japanese banks have a surplus of domestic deposits (thanks to the massive savings of the Japanese corporate sector) relative to their yen lending. As a result, they have large dollar lending operations. To hedge their dollar assets, Japanese banks borrow USD in large quantities in the cross-currency swap market. This tends to result in a negative swap spread in the yen (Chart 2). This is particularly true if both the banking sector and the other actors in the economy (institutional investors and non-financial firms) also borrow dollars in the swap market to hedge dollar assets, which is the case in Japan (Chart 3). Chart 3Japanese Investors Are Accumulating Assets Abroad Additionally, if there are perceived solvency risks in the European banking sector, this should further weigh on the cross-currency basis swap spread, pushing it deeper into negative territory, as the viability of the main EUR counterparties becomes at risk. The same dance is true for any currency pair. Chart 4The Structural Gap In The Basis Swap Spread##br## Reflects Regulation The other factor that affects USD cross-currency basis swap spreads is the supply of U.S. dollars, especially the room on large banks' balance sheets to service these markets. The cross-currency basis swap spread could be close to zero if large arbitrageurs take offsetting positions to arbitrage the spread away, doing so until the spread disappears. However, with the imposition of Basel III and Dodd-Franks, banks have been constrained in their capacity to do this. Indeed, increased leverage ratio requirements (now banks need to post more capital behind repo transactions as well as collateralized lending and other derivatives) mean that arbitraging cross-currency basis swap spreads and deviations from covered interest rate parity has become much more expensive. Furthermore, the increase in Tier 1 capital ratios associated with these regulations has forced banks to de-lever; however, engaging in arbitrage activities still requires plenty of leverage (Chart 4). Economic Factors Driving The Spread The factors that we look at essentially relate to the supply of USD available for lending in offshore markets, as well as determinants of relative counterparty risks between the U.S. and the rest of the world. Factors Arguing For Narrower Cross-Currency Basis Swap Spreads Global Banks Health The price-to-book ratio of global banks outside the U.S. has been largely correlated with USD cross-currency swap spreads. When global banks get de-rated, spreads widen, and it becomes more expensive to hedge USD positions in the swap market (Chart 5). This is because as investors perceive the solvency of global banks deteriorating, they impose a penalty as the Herstatt risk increases. Additionally, solvency problems can force banks to scramble to access USD funding, prompting deeper spreads. Chart 5Banks Perceived Health Determines ##br##Basis Swap Spreads BCA is positive on global financials and sees continued improvement in European NPLs. This means that solvency risk concerns are likely to remain on the backburner for now, pointing to narrower basis swap spreads. Supplementary Leverage Ratio Changes In June, the U.S. Treasury announced a relaxation of some of its rules on supplementary leverage ratios, lowering the amount of capital required to support activity in the repo market behind initial margins for centrally cleared derivatives, and behind holdings of Treasurys. This means that commercial banks in the U.S. can have bigger balance sheets and more room to engage in arbitrage activity, implying a greater supply of dollars in the USD cross-currency basis swap market. In response to last June's proposal, basis swap spreads narrowed by 11 basis points. BCA believes these changes will continue to support dollar liquidity, and will further help in narrowing cross-currency basis swap spreads. Prime Money-Market Funds Debacle Is Over Chart 6More Expensive Bank Funding Equals ##br##Wider Basis Swap Spreads In October 2016, regulatory changes were implemented that allowed prime money market funds to have fluctuating net asset values. Obviously, this meant that prime money-market funds would be not-so-prime anymore. As a result, to remain the ultra-safe vehicles that they once were, prime money-market funds de-risked. As a result, they cut their exposure to risky activities in anticipation of these changes. In practice, a key source of short-term funding for banks evaporated from the market, putting upward pressure on bank financing costs. As the LIBOR-OIS spread increased, so did basis-swap spreads (Chart 6): as it became more expensive for banks to finance themselves, they had to curtail the supply of USDs provided to the swap market, an activity normally requiring intense demand on banks' balance sheets. This adjustment is now over, suggesting limited potential widening in USD basis swap spreads. Factors Arguing For Wider Cross-Currency Basis Swap Spreads 1. U.S. Loan Growth When U.S. banks increase their loan formation activity, USD cross-currency basis swap spreads widen (Chart 7). As banks increase their extension of credit through loans, they decrease the amount of securities they hold on their balance sheets (Chart 8). This means there is less supply of liquidity available for balance sheet activities, particularly providing dollar funding in the offshore market. In the Basel III / Dodd-Frank world, less-liquid bank balance sheets are synonymous with wider USD basis-swap spreads. As we argued last week, increasing U.S. capex, easing lending standards for firms and rising household income levels should result in increasing loan growth in the U.S. which will result in lower abundance of liquid assets and a widening basis swap spreads.1 Chart 7More Bank Loans Lead To Wider Swap Spreads Chart 8More Debt Equals Less Securities In Bank Credit 2. U.S. Inflation There is a fairly close relationship between U.S. inflation and the USD basis swap spread, where a higher core CPI tends to lead to a wider spread (Chart 9). The fall in U.S. inflation this year likely contributed to the narrowing in basis swap spreads. Our take on this is that as inflation falls, it gives an incentive for banks to hold low-yielding liquidity on their balance sheets as real returns on cash improve. This fuels a gigantic carry trade through the basis-swap market. We expect inflation to pick up meaningfully by mid-2018, which should widen cross-currency basis swap spreads.2 3. Central Bank Balance Sheets When the Federal Reserve increases the size of its balance sheet relative to other balance sheets, this tends to lead to a narrowing of the USD basis swap spread as the global supply of dollars relative to other currencies increases. The opposite is also true. This relationship did not work after late 2016 (Chart 10). However, during that episode, as the change in prime money-market funds caused a dislocation in banks' funding, commercial banks exhibited cautious behavior and increased their reserves with the Fed. As Chart 11 illustrates, there is a tight relationship between the change in commercial banks' reserves held at the Fed and cross-currency basis swap spreads. Going forward, as the Fed lets it balance sheet run off, we expect to see a decrease in commercial banks' excess reserves. This could contribute to upward movement in the basis swap spread. Chart 9When U.S. Inflation Increases, ##br##Swap Spreads Widen Chart 10Smaller Fed Balance Sheet Leads To##br## Wider Basis Swap Spreads Chart 11Fed Runoff Could##br## Widen Basis Swap Spreads 4. U.S. Repatriations The most revealing relationship unearthed in our study was that when U.S. entities repatriate funds at home, this tends to put strong widening pressure on the USD cross-currency basis swap spread (Chart 12). U.S. businesses hold large cash piles abroad - by some estimates more than US$2.5 trillion. However, most of these funds are held in highly liquid, high-quality U.S.-dollar assets offshore. These assets are perfect collaterals for various transactions in the interbank market. The funds held abroad by U.S. firms are a source of supply for U.S. dollars in the offshore markets. When U.S. entities bring assets back home, the widening in the basis swap spread essentially reflects a decline in the supply of USD in offshore markets, and vice versa when Americans export capital abroad. Chart 12U.s. Repatriations Support Wider Basis Swap Spreads BCA's base case is that tax cuts are likely to hit the U.S. economy in 2018, even if the growing feud between Trump and the establishment Republican party members is a growing risk. BCA still views a tax repatriation as a higher-likelihood event, as it is the easiest way for the U.S. government to bring funds into its coffers. The 2004 tax repatriation under former President George W. Bush did result in substantial fund repatriation in the U.S. This time will not be different. We expect any such tax repatriation to cause a potentially large deficit of supply in the USD offshore markets, which could create a strong widening basis on the cross-currency basis swap spread in favor of the dollar. Bottom Line: Three factors argue for USD cross-currency basis swap spreads to stay at current levels, or even narrow further. These factors are the health of global banks, the easing in U.S. supplementary leverage ratios and the end of the adjustment of U.S. bank funding to new regulations affecting prime money-market funds. On the other hand four factors points to wider USD cross-currency basis swap spreads: BCA's positive outlook for U.S. credit growth; BCA's positive outlook on U.S. inflation; the run-off of the Fed's balance sheet; and the potential for U.S. entities repatriating funds from abroad. Potential Direction And Investment Implications We anticipate USD cross-currency basis swap spreads to widen over the coming 12 months. We think the easing in the Supplementary Leverage Ratios rules by the U.S. Treasury is the most important factor pointing to narrower USD cross-currency basis swap spreads. However, Basel III rules and most of Dodd-Frank are still in place, which suggest there remains large constraints on the balance-sheet activities of global banks, which will limit the potential for a narrowing of the USD basis swap spread as U.S. banks will remain constrained in their ability to supply U.S. dollars in the offshore market. On the other hand many factors support wider USD cross-currency basis swap spreads, most important of which is the potential for more credit growth. This is in our view a very strong force as it requires banks to ration the use of their balance sheets, limiting their activity in the offshore market. Moreover, we do foresee a high probability of tax repatriation, which would put strong widening pressure on the swap spreads. In terms of implications, wider USD basis swap spreads tend to be associated with rising FX vols (Chart 13). As we highlighted in a Special Report last year, higher FX vols are poison for carry trades.3 As such, we think that widening swap spreads could spur a period of trouble for traditional carry currencies. This means EM and dollar-block currencies are likely to suffer in this environment. Chart 13Wider Basis Swap Spreads Equals Higher Vol Additionally, in China, Xi Jinping is consolidating power and has taken control of the Politburo. This implies he now has more room to implement reforms. Removal of growth targets after 2020, removal of growth as a criterion for grading local officials, a focus on balanced growth, and a focus on combatting pollution all suggest that Chinese growth is unlikely to follow the same debt-fueled, capex-led model.4 This will weigh on Chinese imports of raw materials, and hurt export volumes and prices for many EM countries and commodities producers. This means these policies represent a headwind for many carry currencies. Moreover, historically, wider USD funding costs have been associated with a stronger dollar, as it makes it more expensive to hedge dollar assets. Thus, in an environment where U.S. interest rates are rising relative to the rest of the world - making U.S. assets attractive - wider basis swap spreads are an additional factor that could lift the dollar. Bottom Line: We anticipate the USD cross-currency basis swap spread to widen over the next 12 months. This will be associated with higher FX vols, which hurt carry trades, EM currencies and dollar-block currencies. Chinese reforms will reinforce these risks. Additionally, wider basis swap spreads will create support for the USD. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "All About Credit", dated October 20, 2017, available at fes.bcaresearch.com. 2 Please see Foreign Exchange Strategy Weekly Report, titled "Conflicting Forces For The Dollar", dated September 8, 2017, and "Is The Dollar Expensive?", dated October 13, 2017. 3 Please see Foreign Exchange Strategy Special Report, titled "Carry Trades: More Than Pennies And Steamrollers", dated May 6, 2016. 4 Please see Geopolitical Strategy Weekly Report, titled "Xi Jinping: Chairman Of Everything", dated October 25, 2017 and Special Report, titled "How To Read Xi Jinping's Party Congress Speech", dated October 18, 2017.