Energy

Highlights The market will not give OPEC 2.0 until March to sort out a durable modus operandi to manage supply and maintain the discipline required to defend crude oil prices. While the odds of Libya and Nigeria being able to keep production at current levels - much less grow output - are less than 50:50 in our estimation, the fact remains the Kingdom of Saudi Arabia (KSA) and Russia need to start communicating post-haste how OPEC 2.0 will manage higher Libyan and Nigerian production. Critically, these leaders will need to follow through on whatever they guide the market to expect. We think OPEC 2.0 will stand by its "whatever it takes" proclamations. Not acting in the face of more than 300k b/d of unexpected supply from a once-moribund Libya placed in the market since October will send a signal, as well: OPEC 2.0 will not defend its Agreement. Should this occur, it likely would result in a breakdown in production discipline within the coalition, sending crude oil prices lower. Energy: Overweight. Crude oil prices remain under pressure as markets price the likelihood of continued increases in production in Libya and the U.S. Spoiler alert: We think OPEC 2.0 will act to accommodate Libya's and Nigeria's return to export markets. Base Metals: Neutral. Workers at the Zaldivar copper mine owned by Antofagasta and Barrick Gold voted to strike earlier this week. If government mediation fails to resolve the issues separating labor and management this week, workers will walk. Precious Metals: Neutral. Gold is recovering from last week's "flash crash" in silver, but markets continue to process recent hawkish guidance from systematically important central banks that could lift real rates and pressure precious metals. Ags/Softs: The USDA's WASDE was published just before our deadline. We will review it in next week's publication. Feature Markets may have tacitly assumed OPEC 2.0 would have until March to figure out how KSA, Russia, and their respective allies would work together to re-gain some control over oil prices. However, given almost-daily reductions in banks' oil-price forecasts in the wake of steadily increasing Libyan and U.S. production, belief in OPEC 2.0's strategy and commitment appears to be all but exhausted. Stronger-than-expected output from Libya and Nigeria - up some 400k b/d vs. the October production levels OPEC 2.0 benchmarks to (Chart of the Week) - is being offset by strong inventory draws in high-frequency data from the U.S. and Europe, as we expected. In addition, a reduction in 2018 U.S. shale-growth forecasts in the EIA's just-released estimates of global supply and demand boosted sentiment some. Even so, markets remain skeptical. Libya's production now is estimated at 850k b/d, and accounts for 300k b/d of newly arrived OPEC supply since October. Nigeria, at close to 1.6mm b/d, accounts for another 90k b/d of the unexpected supply on the market since October. OPEC's total crude output is running at just over 32.6mm b/d, down 470k b/d from October's levels, based on the EIA's tally.1 This was 300k b/d more than May's output. Taking Libyan and Nigerian output out of the tally leaves OPEC crude production at 30.21mm b/d, or 860k b/d below October's level. Close to 26mm b/d of OPEC's output is being exported, according to Thompson Reuters data, surpassing OPEC's 4Q16 export levels when Cartel members' output was surging ahead of the OPEC 2.0 production cuts that took effect in January.2 Although benchmark crude oil prices had recovered from their bear-market lows of late June, the steady increase in Libyan production, in particular, reversed this recovery, taking $2.70 and $2.80/bbl off the interim highs registered by WTI and Brent prompt contracts between July 3 and July 10 (Chart 2). Chart of the WeekLibya, Nigeria Add Close ##br##To 400k b/d To OPEC 2.0 Production Libya, Nigeria Add Close To 400k b/d To OPEC 2.0 Production Libya, Nigeria Add Close To 400k b/d To OPEC 2.0 Production Chart 2Libya's Resurgence Clobbers ##br##Benchmark Prices Libya's Resurgence Clobbers Benchmark Prices Libya's Resurgence Clobbers Benchmark Prices Prices have since moved higher of the back on larger-than-expected draws in crude and products in the OECD, led by the U.S. On Wednesday, the EIA reported U.S. crude inventories declined by a whopping 10.7 million barrels, although product inventories grew by 3.7 million barrels for the week ended July 7. These sharp draws (over 17 million barrels of crude storage reduction in the past two weeks, including SPR withdrawals) are what we have been expecting, so we are not surprised, although this is the second week in a row in which the inventory draws exceeded market expectations for the EIA's reporting week. WTI was trading just above$45/bbl, while Brent was just over $47.60/bbl as we went to press. OPEC 2.0's Problem The problem for OPEC 2.0 is that Libya's unexpectedly strong return will retard the drawdown in OECD inventories around which the reformed Cartel is organized. This is compounded by higher U.S. production, which the EIA's latest estimates put at 9.2mm b/d. U.S. crude production in June was up 410k b/d vs. 4Q16 levels, and 510k b/d yoy, by the EIA's reckoning. The bulk of this increase comes from shale-oil production, which is running at ~ 5.1mm b/d (Chart 3). Lower prices will slow the growth of U.S. shale-oil output, but it won't reverse the absolute increase unless prices once again push below $40/bbl for an extended period. We do not expect such an evolution of prices, and continue to expect Brent will average $55/bbl and will reach $60/bbl by the end of the year, with WTI trading at ~ $58/bbl by then. OPEC 2.0's production is not as sensitive to price as the U.S. shales. The coalition banded together to remove some 1.8mm b/d of oil production from the market, and, based on media reports, continues to maintain production discipline. We reckon actual cuts have been on the order of 1.4 to 1.5mm b/d from OPEC 2.0, favoring the lower end of that range, given the latest estimates of the EIA. Given demand growth of ~ 1.6mm b/d on average this year and next, we are expecting a net physical deficit this year of ~ 900k b/d (Chart 4). This will draw OECD inventories down by March below five-year average levels (Chart 5). Chart 3Higher Prices Lifted U.S. ##br##Shale-Oil Production, But Lower Prices Will Slow The Growth Higher Prices Lifted U.S. Shale-Oil Production, But Lower Prices Will Slow The Growth Higher Prices Lifted U.S. Shale-Oil Production, But Lower Prices Will Slow The Growth Chart 4Output Declines And Demand ##br##Gains Will Produce A Physical Deficit ... Output Declines And Demand Gains Will Produce A Physical Deficit ... Output Declines And Demand Gains Will Produce A Physical Deficit ... Chart 5OPEC 2.0 Has To Defend Its Strategy, ##br##If OECD Inventories Are To Fall OPEC 2.0 Has To Defend Its Strategy, If OECD Inventories Are To Fall OPEC 2.0 Has To Defend Its Strategy, If OECD Inventories Are To Fall It is worth remembering Libya and Nigeria are not parties to the OPEC 2.0 deal. Nor did the leaders of this coalition anticipate a sustained increase in production by these states when the OPEC 2.0 deal was agreed at the end of last year. This is particularly true for Libya, which is a failed state. The suggestion by Kuwait that Libya and Nigeria be brought into the OPEC 2.0 production-cutting agreement beggars belief: The Arab Spring destroyed Libya as a state, and its oil production. Since March 2011, when the state collapsed, Libya's oil production has averaged 650kb/d, versus 1.65mm b/d in 2010. Even if there were a government in place, it is unlikely it would agree to cap its production. Nigeria's production also has been hampered by civil unrest, particularly in the Niger Delta region, where insurgents periodically sabotage pipelines and loading platforms, which forces oil exports to be suspended until repairs can be made. Nigeria's production averaged over 2mm b/d until 2013, when it fell to 1.83mm b/d. Since then, it has averaged 1.66mm b/d, with 2017 production to June averaging 1.43mm b/d. Any increase in production resulting in export sales is "found money" for these states. And their need for this money is as great, if not greater, than that of the OPEC 2.0 coalition members. Who In OPEC 2.0 Is Likely To Cut Production? KSA, Kuwait and the UAE were producing close to 2.4mm b/d more in June than they were in 2010, the last year Libya was an intact state, even with the cuts agreed under the OPEC 2.0 deal accounted for. Even at its recent high of 850k b/d of production, Libya still is producing 800k b/d less than it did in 2010. We believe an accommodation involving KSA, and possibly Kuwait and the UAE, can and will be reached at the upcoming OPEC 2.0 technical committee meeting in St. Petersburg on July 24. Something on the order of 500k b/d from these Gulf Arab producers will allow Libya and Nigeria to flex into higher production without undermining the OPEC 2.0 production-cutting deal. The stakes are sufficiently high for the OPEC 2.0 members - KSA and Russia in particular - that an accommodation for Libya will be found. Libya's maximum production likely is no more than 1mm b/d, given the damage years of neglect has caused its fields and productive capital. Rebuilding this province will take years, if a way can be found to reconstitute the organs of a functioning state. Absent an accommodation, OPEC 2.0's leaders risk undermining the credibility of the coalition and causing production discipline to collapse as each state in the group rushes to increase output before prices take their inevitable dive. This would severely reduce the proceeds KSA could expect from IPO'ing Aramco, and would again put Russia's revenue under pressure, forcing it to draw down foreign reserves. OPEC 2.0's End Game Hasn't Changed Neither KSA nor Russia wants to re-visit the conditions that prevailed in 1Q16, when markets were pricing a global full-storage event that would require prices to push through $20/bbl to kill off supply so that storage could drain. For this reason, both have shown their commitment to the production-cutting pact they negotiated at the end of last year. Both, we are convinced, are working closely to map a strategy to allow U.S. shale production to co-exist - within limits - with OPEC and Russian production. In earlier research, we laid out a strategy that could work to achieve this result - draw storage down enough to backwardate the WTI forward curve so that deferred prices trade below prompt-delivery prices. This will moderate - but not stop - the rate at which horizontal rigs return to the shale fields.3 OPEC 2.0's leaders will have to find a way to use their production and storage - which is why it is critical to open some space now - to guide markets to expect higher production and crude availability in the future and tighter market conditions in the present. Bottom Line: We expect OPEC 2.0 to accommodate Libya's and Nigeria's increased production with further cuts in their own production, particularly from KSA, Kuwait and the UAE. This will allow Libya and Nigeria to flex into higher output, should they find a way to maintain it going forward. We continue to believe the odds of sustained higher production from these states is less than 50:50, but that does not matter. What matters is that markets see OPEC 2.0 defending their production-cutting strategy so that inventories continue to draw. OPEC 2.0's end-game has not changed. But the leaders of the coalition will have to adapt if they are to succeed in drawing storage to five-year averages or lower. Critically, they must begin to communicate their longer-term strategy to the market, or risk undermining their coalition. 2Q17 Trade Recommendations Re-Cap We closed out 2Q17 with an average loss of 77% on trades recommended and closed during the quarter (Table 1). The primary driver of this underperformance was a return to contango in the WTI and Brent forward curves, as inventories failed to draw as quickly as we expected. Directional trade recommendations anticipating higher prices also performed poorly. Table 1Trade Recommendation Performance In 2Q17 Time For "Whatever It Takes" In Oil Markets! Time For "Whatever It Takes" In Oil Markets! Open trades at the end of 2Q17 were up an average of 26%, led by good performances in option recommendations - i.e., long call spreads in WTI and Brent in Dec/17. Year to date, our trade recommendations are up 72.6%, on the back of strong 1Q17 results. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 This is adjusted for the inclusion of Equatorial Guinea and the recent opting out of Indonesia. We will be updating our global supply-demand balances next week. 2 Please see "Oil slides as OPEC exports rise, prices end 8 days of gains," published by reuters.com July 5, 2017. 3 Please see BCA Research's Commodity & Energy Strategy reports of April 6, 2017, entitled "The Game's Afoot in Oil, But Which One," and March 30, 2017, entitled "KSA's, Russia's End Game: Contain U.S. Shale Oil." Both are available at ces.bcaresearch.com. Investment Views And Themes Recommendations Strategic Recommendations Tactical Trades Trades Open And Closed In 2017 Time For "Whatever It Takes" In Oil Markets! Time For "Whatever It Takes" In Oil Markets! Summary Of Trades Closed In 2016 Trades Closed In 2017 Commodity Prices And Plays Reference Table

Energy equities are down roughly 20% year-to-date versus the broad market, driven by rising U.S. shale oil production, inventory accumulation, and investor doubts about whether all nations will comply with OPEC's mandated production cuts. There are tentative signs that this relative performance bear phase is drawing to a close. Three main drivers support our modestly sanguine view of energy stocks. First, the long term inverse correlation between the U.S. dollar and the commodity complex has been re-established; global growth suggests that a tightening interest rate cycle is brewing which should be supportive to energy stocks (top panel). Second, the steepest drilling upcycle in recent memory is showing signs of fatigue with Baker Hughes reporting flattening growth in domestic oil rig count; At least a modest deceleration in shale oil production is likely (middle panel). Finally, our S&P energy sector Valuation Indicator has gravitated back to the neutral zone (bottom panel). Overall, we are upgrading to an above benchmark allocation in the S&P energy index. Buy Energy Stocks Buy Energy Stocks

Highlights Portfolio Strategy The energy bear market is drawing to a close. Lift exposure to above benchmark. Firming refining operating conditions, at the margin, suggest that it no longer pays to underweight this energy sub-group. Book gains and lift to neutral. Softening profit fundamentals are weighing on the real estate outlook. Trim REITs to neutral. Recent Changes S&P Energy - Lift to overweight. S&P Oil & Gas Refining & Marketing - Upgrade to neutral, lock in profits of 14.3%. S&P Real Estate - Trim to neutral and remove from high-conviction overweight list. Table 1 SPX 3,000? SPX 3,000? Feature Equities wrestled to hold on to gains last week, fighting a spike in geopolitical tensions, synchronized global central bank hawkish rhetoric and sector rotation. Investors continued to shed tech stocks in favor of financials, pushing our recently initiated long financials/short tech pair trade return near double digits. Our view remains that a rotational correction is the dominant market theme. Nevertheless, on the eve of earnings season, profits will soon take center stage and serve as a catalyst for the overshoot equity phase to resume. Our sense is that before the end of the business cycle, there are high odds that the S&P 500 will hit the 3,000 mark. That does not mean it will be a straight line advance from here. Garden variety 5-10% corrections are all but inevitable. Rather, our point is that before the next recession hits late in the decade, the SPX can attain 3,000. How did we come up with this figure? We derived the S&P 500's peak cycle value using three different methods: Dividend Discount Model (DDM) Forward P/E and EPS growth sensitivity analysis Equity Risk Premium (ERP) Table 2SPX Dividend Discount Model SPX 3,000? SPX 3,000? Table 2 shows our DDM on the S&P 500. It assumes healthy dividend growth in 2017 and 2018. Our expectation of a 2019 recession drives a steep decline in dividends that year, followed by a slow climb in 2020 and 2021, in line with the 2009-2011 experience (Chart 1). 2022 is our terminal year when dividend growth settles at 6.6%, close to the long-term average. Our discount rate assumes a 3.2% 10-year Treasury yield and a 5% equity risk premium (the past decade's average, Chart 2). This discount rate mirrors the historical average corporate junk bond yield. This valuation model delivers an S&P 500 value of 2904. Chart 1Joined At##br## The Hip Joined At The Hip Joined At The Hip Chart 2FX10 ERP And The Economy##br## Are Inversely Correlated ERP And The Economy Are Inversely Correlated ERP And The Economy Are Inversely Correlated Alternatively, we examine the S&P 500's sensitivity to EPS growth rates and forward valuation multiples. If we use the street's 160.8 (or 10.6% implied CAGR) S&P 500 2019 EPS estimate and assign the current 12-month forward multiple as a starting point, Table 3 shows an S&P 500 value of just under 3,000. Downside risks look limited. Using this EPS forecast, even a 2-turn multiple contraction results in the S&P 500 appreciating 10% from here. Table 3SPX EPS & Multiple Sensitivity SPX 3,000? SPX 3,000? Lastly, a conservative ERP analysis reveals that SPX 3,000 is a realistic peak cycle estimate. Our assumptions include: a 200 bps ERP, a 3.2% 10-year Treasury yield and 160.8 SPX EPS. These assumptions result in an S&P 500 value of slightly over 3,000. How do we justify a decline in the ERP from its current level of 338 bps to our assumed 200 bps? G10 central banks are no longer putting out GFC-related fires; in fact, a slew of them are briskly turning from dovish to hawkish following the Fed's lead (Chart 3). As a result, a sustained decline in the ERP should follow as interest rates rise. Chart 3G10 Central Banks Map SPX 3,000? SPX 3,000? Chart 4Negative Correlation Is Re-Established Negative Correlation Is Re-Established Negative Correlation Is Re-Established The bottom panel of Chart 2 drives this point home. Since the history of SPX forward EPS data, the year-over-year change in the ERP has been almost perfectly inversely correlated with the ISM manufacturing index, i.e. an improving economy is synonymous with a receding ERP and vice versa. Lastly, keep in mind that a 200 bps ERP is still significantly higher than the 80 bps mean ERP that prevailed in the 1998-2007 decade (middle panel, Chart 2). The depreciating greenback is another source of support for our SPX 3,000 view. The yearlong positive correlation between the U.S. dollar and commodities has likely come to an end and the three plus decade inverse correlation has been re-established (Chart 4). As the cycle matures and enters its late stages, commodities and resource-related equities tend to pick up steam as profits rebound. Even energy stocks may catch a bid. Buy Energy Stocks... Energy equities are down roughly 20% year-to-date versus the broad market. In fact, the energy sector has broken down to a level last seen in 2004, when oil traded near $30/bbl (Chart 5). The three main culprits have been rising U.S. shale oil production, inventory accumulation, and investor doubts about whether all nations will comply with OPEC's mandated production cuts. While going overweight the energy space has been a "widow maker" trade recently, we are now tempted to take a punt on the S&P energy sector from the long side. There are tentative signs that this relative performance bear phase is drawing to a close. Three main drivers support our modestly sanguine view of energy stocks. First, as we mentioned above, the inverse correlation between the U.S. dollar and the commodity complex has been re-established after a one-year hiatus. Synchronized global growth suggests that a corresponding tightening interest rate cycle is brewing (Chart 3). Thus, there are high odds that a number of G10 central banks will hike rates later this summer or early this fall, now that the Fed has paved the path.1 As long as the greenback drifts lower, even energy stocks should catch a bid (Chart 6). Chart 5Crude Oil... Crude Oil... Crude Oil... Chart 6...And The Dollar Say Buy Energy Stocks ...And The Dollar Say Buy Energy Stocks ...And The Dollar Say Buy Energy Stocks Second, on the domestic operating front, the steepest drilling upcycle in recent memory is showing signs of fatigue. Baker Hughes reported the first weekly decline in 24 weeks in the oil rig count for the week ending June 30th. At least a modest deceleration in shale oil production is likely. Encouragingly, Cushing crude oil inventories are contracting on a year-over-year basis and OECD oil stocks appear poised to contract in late autumn/early winter (Chart 7). Predicting OPEC's compliance is tricky. However, BCA's Commodity & Energy Strategy service believes that little to no cheating will occur and in a worst case scenario Saudi Arabia will step in and curtail production were Libya and/or Iraq to pump oil above quota. Finally, our S&P energy sector Valuation Indicator has gravitated back to the neutral zone. Technicals are also washed out with our Technical Indicator breaching one standard deviation below its historical mean, a level that typically heralds a reversal (Chart 8). Recent anecdotes that the sell-side is throwing in the towel on their bullish oil forecasts for the remainder of the year are also contrarily positive. Chart 7Improving Supply Dynamics Improving Supply Dynamics Improving Supply Dynamics Chart 8S&P Energy Unloved And Fairly Valued Unloved And Fairly Valued Unloved And Fairly Valued Our newly introduced S&P energy sector relative EPS model encapsulates this cautiously optimistic industry backdrop (Chart 9). Simultaneously, the budding recovery in our S&P energy Cyclical Macro Indicator also signals that profits should best those of the overall market (second panel, Chart 8), giving us comfort to lift the S&P energy sector to a modest overweight position. ... As Refiners Are No Longer Cracking Under Pressure We are executing the upgrade to overweight in the broad energy sector via booking gains of 14.3% since inception in the S&P oil & gas refining & marketing sub-group and lifting exposure to neutral from underweight. It no longer pays to remain bearish on the pure play downstream energy business. Back in late September 2015, when we turned negative on refiners, we were anticipating a cyclical earnings downturn on the back of a refined product glut in this low margin / high volume industry. Fast forward to 2017 and that bearish profit view has materialized as relative EPS have fallen by roughly 60 percentage points from the most recent peak, and have only lately managed to stabilize (Chart 10). Chart 9EPS Model Waves Green Flag EPS Model Waves Green Flag EPS Model Waves Green Flag Chart 10Refining Profit Contraction Is Over Refining Profit Contraction Is Over Refining Profit Contraction Is Over If relative EPS have indeed troughed, then relative performance should soon find a bottom. Relative profit fortunes move with the ebb and flow of gasoline consumption. The latter is on the cusp of expanding for the first time since last November, heralding the same for relative profitability (bottom panel, Chart 10). Industry shipments tell a similar story. After recently bottoming at levels similar to those reached during the GFC, refinery shipments have staged a mini V-shaped recovery (top panel, Chart 11). Crack spreads have not collapsed to razor thin levels as the nearly eliminated Brent/WTI spread would suggest, but have remained resilient in the high-teens per barrel (third panel, Chart 11). Three forces are likely in play. First, not only is domestic gasoline demand underpinning refining margins, but petroleum products are also finding their way into foreign markets with net exports running at over 3 million bbl/day (bottom panel, Chart 11). Second, the U.S. dollar selloff since mid-December is making U.S. refined products more competitive in global markets. Finally, crude oil inventories are nearly 40% higher than gasoline inventories. Lower industry feedstocks represent a boost to refining margins (third, Chart 11). Nevertheless, we refrain from turning outright bullish on refiners. Refinery production hit all-time highs recently, refinery runs are climbing steadily and utilization rates are running hot north of 90%. Tack on, historically high refined products inventories and rising industry capacity growth and the profit backdrop darkens (Chart 12). Chart 11Three Positives... Three Positives... Three Positives... Chart 12...But Do Not Get Carried Away ...But Do Not Get Carried Away ...But Do Not Get Carried Away Netting it out, we expect a balanced refining profit outlook in the coming quarters. Bottom Line: Upgrade the S&P oil & gas refining & marketing index (PSX, VLO, TSO, MPC) to neutral and lock in profits of 14.3%. This also pushes the S&P energy index to an above benchmark allocation. Downgrade REITs We are making space for the energy sector upgrade to overweight via trimming the niche S&P real estate sector to neutral and concurrently removing it from the high-conviction overweight list. REITs have marked time year-to-date, but recently operating conditions have downshifted a notch. Three key drivers argue for lightening up exposure on this newly formed S&P GICS1 sector. First, REITs have been unable to materially benefit from the 50bps fall in the 10-year Treasury yield from the mid-December peak to the mid-June trough. As the economy recovers from the first quarter lull, Treasury yields will resume their advance. This is a net negative for the fixed income proxy real estate sector (top panel, Chart 13). Second, real estate occupancy rates have crested and generationally high supply additions in the apartment space are all but certain to push vacancies higher still. The implication is that rental inflation will remain under intense downward pressure (Chart 13). Worrisomely, credit quality in select commercial real estate (CRE) segments is deteriorating at the margin. The bottom panel of Chart 13 shows that retail and office delinquency rates have taken a turn for the worse, and represent a yellow flag. Finally, according to the Fed's latest Senior Loan Officer Survey, bankers are less willing to extend CRE credit. In fact, if one excludes the GFC spike, the tightening in CRE lending standards is near the two previous recessionary highs. If banks continue to close the credit taps, CRE prices will suffer a setback (Chart 14). Chart 13Time To Move To the Sidelines Time To Move To the Sidelines Time To Move To the Sidelines Chart 14Conflicting Signals Conflicting Signals Conflicting Signals Chart 15 puts the CRE price appreciation in historical perspective. Currently, CRE prices are on track to climb to two standard deviations above the long-term trend. Such exuberance is a cause for concern as it has historically marked the beginning of a corrective phase in CRE prices. Nevertheless, there are some positive offsets that prevent us from throwing in the towel in the S&P real estate sector. The tight labor market and accelerating industrial production explain the reacceleration in our REITs Demand Indicator, while the recent selloff in the bond market is a modest offset. If CRE appetite remains upbeat, this in turn suggests that CRE prices have a bit more room to run before reaching a cyclical peak (bottom panel, Chart 14). In addition, compelling relative valuations and washed out technicals argue against becoming overly bearish on REITs (Chart 16), as some of the bad news is already reflected in relative share prices. Chart 15An Historical Perspective An Historical Perspective An Historical Perspective Chart 16Positive Offsets Positive Offsets Positive Offsets Bottom Line: Trim the S&P real estate sector to neutral and remove it from the high-conviction overweight list. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see the June 30th, 2017 Foreign Exchange Strategy Service Special Report titled "Who Hikes Next?", available at www.bcaresearch.com Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights With crude-oil inventory transfers from OPEC to western refining centers slowing, OPEC 2.0's production cuts will begin to show up in high-frequency OECD inventory data in the form of lower stock levels. The coalition has been bedeviled by higher production from Libya and Nigeria, and a push from Iraq asserting its right - in line with its huge reserves - to increase production. U.S. imports from Iraq are growing this year, even as other OPEC members slow shipments. In addition, Iraqi crude oil inventories also were increasing while other OPEC states were running their stocks down, which suggests Iraq may be preparing to lift production and exports in the near future. Energy: Overweight. Crude oil rallied sharply over the past week, despite reports of higher Libyan production. We remain long via Dec/17 $50/bbl vs. $55/bbl call spreads in Brent and WTI. Base Metals: Neutral. The U.S. reportedly is using a national security review of the U.S. steel industry, to determine whether it will impose tariffs on steel imports at this week's G20 meeting in Germany. Precious Metals: Neutral. Gold recovered after selling off last week on the back of more aggressive guidance from central bankers. We remain long gold as a portfolio hedge. Ags/Softs: Underweight. The USDA's acreage reports for grains were less bearish than expected, rallying markets into this week. We remain bearish, but also recommend investors continue to avoid shorting these markets. Feature Chart of the WeekCrude Oil Prices Rally,##BR##Despite Reports Of Higher Production Crude Oil Prices Rally, Despite Reports Of Higher Production Crude Oil Prices Rally, Despite Reports Of Higher Production Oil rallied 9.6% over the past week from recent lows, despite news reports of Libya pushing crude oil production toward 1mm b/d by the end of this month, and further indications Iraq is gearing up to increase production and exports (Chart of the Week). We expect prices to continue to be well supported in 2H17, as the production cuts engineered by OPEC 2.0 - the OPEC and non-OPEC producers' coalition led by the Kingdom of Saudi Arabia (KSA) and Russia, respectively - finally begin showing up in the high-frequency storage data for the U.S. and the OECD. This is because, we believe, the massive crude-oil inventory transfers between OPEC and OECD refining centers is winding down. OPEC Inventory Transfer Winding Down Crude oil inventories in major oil importers with significant refining capabilities - in particular, the U.S. and the Amsterdam-Rotterdam-Antwerp (ARA) refining center in the Netherlands and Belgium - grew by a bit more than 35mm barrels (bbl) year-on-year (yoy) on average over the January - April period, based on data from the Joint Organisations Data Initiative (JODI), a transnational group made up of producing and consuming interests headquartered in Riyadh, Saudi Arabia. The January - April period marked the first four months of the OPEC 2.0 production-cutting Agreement, in which OPEC pledged to reduce output by 1.2mm b/d, and non-OPEC obliged itself to cut an additional 600k b/d of production. The yoy builds in the U.S. and ARA inventories were a mirror-image of the average yoy inventory withdrawals occurring in OPEC states that reported their stock levels to JODI in the first four months of this year (Chart 2). The JODI inventory data indicates that even as OPEC 2.0 was cutting production in the first four months of the year - by some estimates by more than 100% of the pledged 1.8mm b/d of reductions - these states were draining stocks from inventories during this period to maintain sales to key clients. The declining trend in high-frequency U.S. inventory data from the EIA for the U.S. East coast (PADD 1), the Midwest (PADD 2), and the U.S. Gulf (PADD 3), and declining weekly import estimates support our contention that OPEC inventories will continue to decline, and that the production surge by OPEC in 4Q16 will finally be worked off (Chart 3). Given the downtrend in the weekly high-frequency crude oil import data for the U.S., we expect crude-oil shipments from OPEC to continue to slow as production cuts no longer are masked by inventory draws (Chart 4). Among the top 10 crude oil exporters to the U.S., KSA shipments are down an average 55k b/d in yoy 2Q17 vs. an increase of slightly more than 150k b/d in 1Q17. KSA shipped 1.09mm b/d to the U.S. in 2Q17 vs. 1.23mm b/d in 1Q17. The rates at which Iraq and Nigeria were shipping oil to the U.S. also slowed, but are still above year-ago levels, as is to be expected given the civil strife from which both are recovering - Iraq's 2Q17 exports to the U.S. were up 279k b/d vs. 316k in 1Q17 yoy at 663k and 592k b/d, while Nigeria's exports to the U.S. were up 67k b/d yoy in 2Q17 and 69k b/d in 1Q17, at 286k b/d and 270k b/d, respectively. Chart 2OPEC Inventory Transfer##BR##Winds Down In 2017 OPEC Inventory Transfer Winds Down In 2017 OPEC Inventory Transfer Winds Down In 2017 Chart 3Surge In 2H16 OPEC Production##BR##Is Being Worked Off Surge In 2H16 OPEC Production Is Being Worked Off Surge In 2H16 OPEC Production Is Being Worked Off Continued high levels of U.S. refining runs and exports of crude and products also will accelerate draws in the U.S., even though refining runs are not growing at rates seen last year when the overall level of refining was lower (Chart 5). Chart 4OPEC Exports To##BR##The U.S. Are Slowing OPEC Exports To The U.S. Are Slowing OPEC Exports To The U.S. Are Slowing Chart 5U.S. Refinery Runs And Exports##BR##Remain High U.S. Refinery Runs And Exports Remain High U.S. Refinery Runs And Exports Remain High Watch Iraq Chart 6Libya, Nigeria Increase Production,##BR##But The Big Story Will Be Iraq Libya, Nigeria Increase Production, But The Big Story Will Be Iraq Libya, Nigeria Increase Production, But The Big Story Will Be Iraq The OPEC 2.0 agreement has been bedeviled by higher-than-expected production from Libya, where officials claim they will be producing at 1.0mm b/d by the end of July, and Nigeria.1 In our balances, we have Libyan production up some 100k b/d from last month at ~ 800k b/d. Nigeria currently is producing ~ 1.5mm b/d, after falling to as low as 1.2mm b/d due to sabotage of its export facilities. But, without doubt, the OPEC state with the greatest potential for production growth is Iraq, which currently is producing ~ 4.5mm b/d (Chart 6). Iraqi local inventories were up 43% yoy in April at just over 11mm bbl. Iraqi exports to the U.S. were up more than 50% yoy to just over 640k b/d in June. Ordinarily, this would not warrant much attention, given the harmony that so far has characterized OPEC 2.0's performance since year-end 2016. However, Iraqi officials have begun advocating for higher production levels, which, in their protestations, would be consistent with their high reserve levels. Just this week, the country's oil minister, Jabar al-Luaibi, asked rhetorically, "Why should Iraq be deprived from increasing its production? Not to disturb or disrupt OPEC at all, or the prices, but it is our right to have our production that corresponds to our reserves."2 He observed, "We have gas, we have oil. We have the right to do well. As simple as that." Iraq certainly has the reserves necessary to increase production significantly, but would require significant time and capital to grow production materially above the record levels reached in Q4 2016, which were about 200,000-300,000 b/d above current levels. "Whatever It Takes" May Require KSA To Cut Again If Libya can hold to its higher production level, and even reach 1mm b/d, and Iraq decides to exercise its "right" to produce more, OPEC 2.0 will have to cut additional barrels from the coalition's production to accommodate the higher output. Given Russia's apparent reluctance to do so, this could mark the first significant test of the durability of the agreement that created OPEC 2.0. The stakes are high if these production cuts are not addressed. As Russians go to the polls in March 2018, and, later in the year, KSA seeks to IPO Aramco, multiple problems will present themselves: Another production free-for-all that collapses prices would trigger another round of high consumer-level inflation in Russia, as the rouble falls once again, and KSA's IPO would value Aramco far below the $2 trillion Saudi officials are hoping for. Our bullish price view - we're expecting Brent to trade to $60/bbl by year-end - will be deep-sixed if production cannot be controlled. As it stands, we have total OPEC crude production just over 32mm b/d in 2017, and slightly over 32.5mm b/d in 2018. Given the stout demand growth we expect this year and next, we expect close to 900k b/d more demand growth over supply growth, based on our modelling. Next year, we expect supply growth of 2.25mm b/d, and demand growth of 1.62mm b/d, so supply growth exceeds demand growth in 2018 by 630k b/d, moving oil markets from undersupplied to balanced/slightly over-supplied. Obviously, higher production would change these balances. The big questions for the market going forward: Will OPEC states that have drained inventories supporting sales to key clients maintain production discipline, allowing inventories in the U.S. and ARA to drain? Will OPEC 2.0 unravel under pressure from Russia and KSA assessments of the need for additional cuts? Can Libya and Nigeria maintain higher output? Libya is a failed state, and warring tribes almost surely will seek to take control over as much of the revenue-generating capacity of the oil-export facilities in the East and West of the country as possible. Nigeria, although not a failed state, faces similar difficulties containing the sabotage that has disabled export capacity on and off for the past few years. Whither Iraq? A price collapse would definitely reduce U.S. shale output, as the 2015 - 1H2016 experience demonstrated. If domestic U.S. prices stayed lower for longer, we would expect rig counts to decline, reducing the rate of growth in U.S., supply. Right now, we expect U.S. shale output to grow 340k b/d this year and by ~ 1mm b/d next year based on earlier, higher price levels. Our research has shown the very high correlation between U.S. shale output and WTI prices along the forward curve out to 3 years forward, and a low price definitely will lead to lower rig counts. Bottom Line: OPEC 2.0 still is holding together. Going into its ministerial meeting at the end of this month, it must provide clear guidance to the market over how it will handle a sustained increase in Libyan production. In addition, Iraq's intentions must be clear - otherwise, the market will assume the worst. We remain bullish, and continue to recommend low-risk long positions - we are long Dec/17 $50 vs. $55/bbl call spreads in Brent and WTI. Once markets are given greater clarity, we will look for higher-risk alternatives for putting new length on. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see "Libya's Oil Production Nears 4 Year High," in oilprice.com's June 29, 2017, online edition. 2 The minister's remarks were reported in the July 5, 2017, issue of, Iraq Daily Journal's online edition. Please see "Iraq Has Right To Achieve Oil Output In Line With Reserves - Minister." Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 OPEC's Oil Inventory Shift Winding Down OPEC's Oil Inventory Shift Winding Down Summary of Trades Closed in 2016

Highlights A whiff of global deflation shook-up financial markets in June, driven by melting oil prices and a startling May U.S. CPI report. Nonetheless, we have not changed our recommended asset allocation. Bond markets have over-discounted the impact of the commodity price weakness, especially with regard to Fed policy and long-term inflation expectations in the major countries. We do not see the selling pressure in the commodity pits as a harbinger of slower global growth. Above-trend growth in the U.S. is likely in the second half of the year, along with continuing robust activity at the global level. Oil prices should rebound, based on our view that consumption will outstrip production in the second half of the year; the surprise will be how strong oil prices are in the coming months. The FOMC appears more determined than in the past to stick with the current policy normalization timetable. Unemployment will edge further below the full-employment level if the FOMC does not slow the pace of job creation. We believe that the labor market is tight enough to gradually push up inflation. Together with a rebound in the commodity pits, this means that the recent bond rally will reverse. Soft U.S. CPI readings are a challenge to our view. The Fed will delay the next rate hike into next year if core inflation does not move up in the next few months. The equity market is vulnerable to unforeseen shocks given stretched valuation. Nonetheless, none of the main indicators that have provided leading information in the past are warning of an equity bear market. The profit backdrop remains constructive. Our base case is that stocks beat bonds and cash for the remainder of 2017. We expect to trim exposure to equities next year, but the evolution of a number of indicators will influence the timing. The same is true for corporate bonds. The dollar's bull phase has one more upleg left. Japanese, European and U.K. equities will outperform the U.S. in local currency terms. Feature A whiff of global deflation shook-up financial markets in June, driven by melting oil prices and a startling May U.S. CPI report. Investors quickly concluded that the Fed will have to proceed even more slowly in terms of its policy normalization plan which, in turn, sent the dollar and global bond yields sharply lower. Equity indexes held up because of the dollar and bond yield "relief valves". Stocks are also benefiting from the continuing rebound in corporate earnings growth in the major economies. Nonetheless, the commodity pullback and soft U.S. inflation data are a challenge to our reflation theme, which includes a final upleg in the U.S. dollar and a negative view on bond prices. We believe that markets have over-discounted the impact of the commodity price weakness, especially with regard to Fed policy and long-term inflation expectations in the major countries. Above-trend growth in the U.S. is likely in the second half of the year, along with continuing robust activity at the global level. We also think that the FOMC is more determined than in the past to stick with the current policy normalization timetable. The bottom line is that we are not changing our recommended asset allocation based on June's market action. We remain overweight stocks and corporate bonds relative to government bonds and cash. We are also short duration and long the dollar. A key risk to our asset allocation relates to our contrarily bullish view on oil prices. Oil Drove The Bond Rally... The decline in long-term bond yields since March reflected in large part a drop in inflation expectations (Chart I-1). BCA's fixed-income strategists point out that the slump in long-term inflation expectations has been widespread across the major countries, irrespective of whether actual inflation is trending up or down.1 Core inflation has moved lower in the U.S., Japan, Canada and (slightly) in the Eurozone, but has increased in Australia and the U.K. In terms of diffusion indexes, which often lead core inflation, they are falling in the U.S., Japan and Canada, but are rising in the U.K., the Eurozone and Australia (Chart I-2). Chart I-1 Inflation Expectations Drive Bond Rally Inflation Expectations Drive Bond Rally Inflation Expectations Drive Bond Rally Chart I-2Diverging Inflation Trends Diverging Inflation Trends Diverging Inflation Trends Given all these diverging signals within the national inflation data, it is odd that there has been such a uniform decline in inflation expectations across the major bond markets. That leads us to look to the commodity price decline as the main driver of the downshift in expectations. Short-term moves in oil prices should not affect long-term inflation expectations, but in practice the correlation has been strong since the plunge in oil prices beginning in 2014. Weaker oil and other commodity prices have also fed investor concerns that global growth is waning. We see little evidence of any slowdown in global growth, although some leading indicators have softened. Key monthly data such as industrial production, retail sales and capital goods orders reveal an acceleration in growth for the advanced economies as a group (Chart I-3). There has also been a general upgrading of the consensus growth forecast for the major countries and for the world in both 2017 and 2018 (Chart I-4). This is unlike previous years, when growth forecasts started the year high, only to be slashed as the year progressed. Chart I-3No Slowdown In Advanced Economies No Slowdown In Advanced Economies No Slowdown In Advanced Economies Chart I-4Growth Expectations Revised Up Growth Expectations Revised Up Growth Expectations Revised Up ...But Watch Out For A Reversal The implication is that we do not see the selling pressure in the commodity pits as a harbinger of slower global growth. Nonetheless, the mini oil meltdown in June went against our medium-term bullish view. In a recent report,2 our Energy Sector Strategy team noted that investors are confused about conflicting supply signals in oil markets. Traders do not yet see the physical shortage that the IEA/EIA/OPEC and BCA's top-down supply & demand analyses argue will prevail in the coming months. Chart I-5Falling Inventories To Drive Oil Rebound Falling Inventories To Drive Oil Rebound Falling Inventories To Drive Oil Rebound The investment community is being overly pessimistic in our view. The coalition led by the Saudi Arabia and Russia will have removed 1.4 MMB/d of production on average from the market between January 2017 and end-March 2018, versus peak production in November of last year. This will be diluted somewhat by the Libyan and U.S. production gains, but the increased production will not be sufficient to counter the OPEC/Russia cuts entirely. We expect global production to increase by only 0.7 MMB/d in 2017, an estimate that includes rapid increases in U.S. shale output. Meanwhile, we expect consumption to grow by 1.5 MMB/d, implying that oil inventories will fall over the remainder of this year. If history is any guide, this will lead to a rebound in oil prices (Chart I-5). It will be quite a shock to markets if crude reaches $60/bbl by December as we expect. As for base metals, it appears that the correction is largely related to reduced speculative demand rather than weak global and/or Chinese demand. It is true that the Chinese economy has slipped a notch according to some measures, such as housing starts and M2 growth. Nonetheless, the government remains cognizant of the risks of tightening policy too aggressively, especially with the National Party Congress slated for this autumn. The PBoC injected 250 billion yuan into the financial system in June and fiscal policy has been eased. Real-time measures of industrial activity such as railway freight traffic, excavator sales, and electricity production remain upbeat. Retail sales continue to expand at a healthy clip. Export growth is accelerating thanks to a weaker currency and stronger global activity. Given that many investors remain concerned about a hard landing in China, the bar for positive surprises is comfortably low. If China can clear this bar, as we expect it will, it will be good news for the commodity currencies and other commodity plays. A rebound in base metal and, especially, oil prices would boost global inflation expectations and bond yields, especially since inflation expectations have fallen too far relative to underlying non-energy inflation pressures. This forecast also applies to the U.S. bond market, although there was more to the soft May CPI report than oil prices. Is The Fed's Inflation Target Credible? Investors are questioning whether the Fed has the ability to reach its inflation goals. Is it possible that the U.S. is following Japan's roadmap where even an over-heated labor market is insufficient to generate any meaningful inflation? We argued above that the moderation in inflation expectations in the major markets was mostly related to the decline in commodity prices. However, in the U.S., it also reflected a fairly widespread pullback in CPI inflation this year. This is contrary to Fed Chair Yellen's assertion that most of it reflects special factors such as wireless telecommunications prices. The deceleration in inflation began around the start of the year. The three-month rate of change of the headline index fell by more than five percentage points between January and May, of which energy accounts for 3.3 percentage points. The deceleration in the core rate was a less severe, but still substantial at 2.8 percentage points. Table I-1 presents the components of the CPI that made the largest contribution to the deceleration in core inflation. Motor vehicles, owners' equivalent rent, apparel, recreation, wireless telecom and medical care services accounted for 1.2 percentage points as a group. However, many other sectors contributed in a small way to the overall deceleration of core inflation in the first five months of the year. Table I-1Key Drivers Of U.S. Core Inflation Deceleration In 2017 July 2017 July 2017 Some special factors were at play. The moderation in rent inflation likely reflects the bottoming of the vacancy rate. Discounting in the auto sector is not a surprise given weak sales. Wireless prices can be viewed as a special case as well. Nonetheless, the breadth and suddenness of the deceleration in core inflation across such diverse sectors, some unrelated to labor markets, commodity prices, the dollar or on-line shopping, is worrying. The disinflation this year in the Fed's preferred measure, the PCE price index, is not as extended but the data are published almost a month behind the CPI data. A diffusion index made up of the components of the PCE index is still in positive territory, unlike the CPI's diffusion index (Chart I-6). Nonetheless, the CPI data suggest that core PCE inflation will edge lower when the May data are released at the end of June. There has also been a moderation in some of the wage inflation data, such as average hourly earnings (Chart I-7). The slowdown has been fairly widespread across manufacturing and services. However, the soft patch already appears to be over; 3-month rates of change have firmed almost across the board (retail is a major exception). There is no slowdown evident at all in the better-constructed Employment Cost Index (ECI) as of the first quarter (Chart I-8). The ECI is adjusted to avoid compositional effects that can distort the aggregate index. The related diffusion indexes also remain constructive. Chart I-6PCE Inflation Rate To Follow CPI Lower PCE Inflation Rate To Follow CPI Lower PCE Inflation Rate To Follow CPI Lower Chart I-7AHE SoftPatch Appears Over... AHE SoftPatch Appears Over... AHE SoftPatch Appears Over... Chart I-8...And The ECI Marches Higher ...And The ECI Marches Higher ...And The ECI Marches Higher We conclude from these and other wage measures that the Phillips curve is still operating in the U.S. Admittedly, the curve appears to be quite flat, which means it is difficult to generate inflation even with a tight labor market. Nonetheless, the relationship between the ECI and various measures of labor market tightness shown in Chart I-8 does not appear to have broken down. The percentage of U.S. states with unemployment below the Fed's estimate of full employment jumped to 70% in May. Anything over 60% in the past has been associated with wage pressure (Chart I-9). The bottom line is that, while we are concerned about the breadth of the soft patch in the consumer price data, we are in agreement with the Fed hawks that the labor market is tight enough to gradually push up inflation. We are willing at this point to chalk up the recent drop in core inflation partly to randomness in the data, and partly to lagged effects of the slowdown in real GDP growth in the first half of 2016 (Chart I-10). Admittedly, however, the U.S. inflation reports in the coming months are a key risk to our reflation-related asset allocation. Chart I-9More Than 70% Of U.S. States Have Excess Labor Demand More Than 70% Of U.S. States Have Excess Labor Demand More Than 70% Of U.S. States Have Excess Labor Demand Chart I-10Financial Conditions Point To Faster Growth And Inflation Financial Conditions Point To Faster Growth And Inflation Financial Conditions Point To Faster Growth And Inflation What Will The Fed Do? The CPI data have certainly rattled some members of the FOMC. Federal Reserve Bank Presidents Kaplan and Kashkari, for example, believe that the Fed needs to be patient to ensure that the inflation pullback is temporary. However, the June FOMC Statement and Yellen's press conference suggested that the consensus is determined to stick with the current tightening timetable in terms of rate hikes and balance sheet adjustment. She stressed that the FOMC makes policy for the "medium term," and should not over-react to short-term wiggles in the data. Vice President Dudley echoed this view in recent comments he made to the press. The Fed has been quick to back away from planned rate hikes at the first hint of trouble in recent years. However, it appears that the reaction function has changed, now that the labor market is at full employment. This is especially the case because financial conditions have eased further, despite the June rate hike. Unemployment will edge further below the full-employment level if the FOMC does not slow the pace of job creation. Policymakers know that the Fed has had little success in the past when it tried to nudge unemployment higher in order to relieve budding inflation pressure; these attempts almost always ended in recession. Dudley added that "...pausing policy now could raise the risk of inflation surging and hurting the economy." Other FOMC members are worried that financial stability risk will build if the low-rate environment extends much further. The bottom line is that we expect the Fed to stick with the game-plan for now. The FOMC will begin shrinking the balance sheet in September, but will wait until December for the next rate hike. That said, a stubbornly low inflation rate in the coming months would likely see the FOMC postpone the next rate increase into next year. Where Next For Bonds? We see three possible scenarios for the bond market: Reflation Returns: Weak recent inflation readings are nothing more than a lagged response to last year's deceleration in economic growth. U.S. growth accelerates in the second half, unemployment falls further and both wage growth and inflation pick up. Oil inventories begin to contract and prices head higher. The FOMC is vindicated in its inflation view and proceeds with the current rate hike and balance sheet adjustment agenda. Investors receive a "wake up call" from the Fed, bond prices get hit and recent curve-flattening trend reverses. Fed Capitulates: The U.S. labor market continues to tighten, but core PCE inflation is still close to 1½% by the September FOMC meeting. We would expect the Fed to lower its forecasted rate hike path, signaling that no further rate hikes are likely in 2017. Long-maturity real yields would fall in this scenario, although long-term inflation expectations could rise to the extent that the Fed's more dovish tilt will weaken the dollar and generate more inflation in the medium term. Nominal yields may not end up moving much in this scenario. A Policy Mistake: If core inflation remains low between now and the September FOMC meeting and the Fed continues to write-off low inflation as transitory, signaling its intention to stick to its current projected rate hike path, then the market would begin to discount a "policy mistake" scenario. The yield curve would flatten and long-maturity nominal yields would fall, led by tighter TIPS breakevens. In terms of probabilities, we would characterize Scenario 1 as our base case, Scenario 2 as unlikely and Scenario 3 as a tail risk. We remain short-duration in anticipation of a rebound in long-term inflation expectations and higher yields. A bond selloff, however, should not present a major headwind for stocks as long as the earnings backdrop remains constructive. Will The Real Profit Margin Please Stand Up For some time we have been highlighting the importance of the mini-cycle in U.S. earnings growth; the corporate sector is in a catch-up phase following last year's profit recession, a trend that extends beyond the energy patch. EPS growth has surged this year on the back of somewhat stronger sales and rising S&P 500 margins. The National Accounts (NIPA) data, however, paint a different picture. Earnings growth for the entire corporate sector fell sharply in the first quarter and margins continued to slide. If the NIPA data are telling the true story, then the equity market is in big trouble because it suggests that the earnings outlook is much weaker than what is discounted in stock prices. There are many definitional differences that make it difficult to reconcile the NIPA and S&P data.3 Nonetheless, we can make some general observations. Chart I-11 presents the 4-quarter growth rate of NIPA profits4 and a proxy for aggregate S&P earnings. For the latter, we multiplied earnings-per-share by the divisor to obtain an estimate of the level of aggregate earnings in dollar terms (i.e. not on a per-share basis). The bottom panel of Chart I-11 compares the level of profits, each indexed to be 100 in 2011 Q1. The charts highlight that, while there have been marked differences in annual growth rates between the two measures in some years, the levels ended up being close to the same point in the first quarter of 2017. The dip in NIPA profit growth in the first quarter was not reflected in the S&P measure. It appears that this is partly due to different profiles for profit growth in the energy and financials sectors. That said, broadly speaking, it does not appear that the difference in margins is due to a significant divergence in aggregate profits. It turns out that most of the margin divergence is related to the denominator of the calculation (Chart I-12). The NIPA denominator is corporate sector Gross Domestic Product (GDP). This is a value-added concept that is quite different from sales. It is not clear why, but GDP has grown much faster than sales since the end of 2014. It appears to us that the S&P data are telling the correct story at the moment. After all, sales are straight forward to measure, while value added is complicated to construct. The fact that sales are growing slowly is not a bullish point for stocks. Nonetheless, it does not appear that financial engineering has distorted bottom-up company data to such an extent that the S&P data are signaling strong profit growth when the reality is the opposite. We expect the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning early in 2018. Nonetheless, the profit backdrop remains positive for stocks for now. The same is true in the Eurozone and Japan, where margins are also rising. It is worrying that a large part of this year's U.S. equity market advance has been concentrated in a small number of stocks, but that belies the breadth of the profit recovery (Chart I-13). The proportion of S&P industry groups with rising earnings estimates is above 75%. Such widespread participation is consistent with ongoing upward revisions to 12-month forward earnings estimates. Chart I-11S&P And NIPA Profit Comparison S&P And NIPA Profit Comparison S&P And NIPA Profit Comparison Chart I-12Denominator Explains S&P/NIPA Margin Divergence Denominator Explains S&P/NIPA Margin Divergence Denominator Explains S&P/NIPA Margin Divergence Chart I-13Positive Earnings Revisions Are Broadly Based Positive Earnings Revisions Are Broadly Based Positive Earnings Revisions Are Broadly Based The solid earnings backdrop is the main reason we remain overweight stocks versus bonds and cash. Of course, given poor valuation, we must be extra vigilant in watching for warning signs of a bear market. Valuation has never been good leading indicator for bear markets, but it does provide information on the risks. Monitoring The Bear Market Barometer BCA's Chief Economist, Martin Barnes, highlighted the best "equity bear market" indicators to watch in a 2014 Special Report.5 He noted that no two bear markets are the same, and that there are no indicators that have reliably heralded bear phases. Nonetheless, there are some common elements. The safest time to invest in the market is when monetary conditions are favorable, there are no signs of a looming economic downturn, there is not extreme overvaluation, and technical indicators are not flashing red. Some indicators related to each of these fundamental factors are shown in Chart I-14: Chart I-14Equity Bear Market Indicators Equity Bear Market Indicators Equity Bear Market Indicators Monetary Conditions: The yield curve is quite flat by historical standards, but it is far from inverting. Moreover, real short-term interest rates are normally substantially higher than today, and above 2%, when bear markets commence. Excess liquidity, which we define as M2 growth less nominal GDP growth, is also still well above the zero line, a threshold that has warned of a downturn in stock prices in the past. Valuation: Our composite valuation indicator is still shy of the +1 standard deviation level that defines over-valued. However, this is because of the components that compare equity prices to bond yields. The other three components of the equity indicator, which are unrelated to bond yields, suggest that stock valuation is quite stretched. Economic Outlook: Economic data such as the leading economic indicator and ISM have been unreliable bear market signals. That said, we do not see anything that suggests that a recession is on the horizon. Indeed, U.S. growth is likely to remain above-trend in the second half of the year based on its relationship with financial conditions. Technical conditions: Sentiment is elevated, which is bearish from a contrary perspective. However, breadth, the deviation from the 40-week moving average, and our composite technical indicator are not flashing red. Earnings: Trends in earnings and margins did not provide any additional reliable signals for timing equity market downturns in the past. Still, it has been a bad sign when EPS growth topped out. And this has often been preceded by a peak in industrial production growth. We expect U.S. EPS growth to continue to accelerate for at least a few more months, but are watching industrial production closely. EPS growth in Japan and the Eurozone will likely peak after the U.S., since these markets are not as advanced in the profit rebound. The bottom line is that the equity market is vulnerable to unforeseen shocks given stretched valuation. Nonetheless, none of the main indicators that have provided some leading information in the past are warning of an equity bear market. Investment Conclusions The major world bourses remain in a sweet spot because of the mini cyclical rebound in profits. One can imagine many scenarios in which equities suffer a major correction or bear phase. However, stocks would likely perform well under the two most likely scenarios for the remainder of the year. If U.S. and global growth disappoint, the combination of low bond yields and still-robust earnings growth will continue to support prices. Conversely, if world growth remains solid and the U.S. picks up, as we expect, then bond yields will rise but investors will pencil-in an even stronger profit advance over the next year. Of course, this win-win situation for stocks will not last forever. Perhaps paradoxically, the economic cycle could be shortened if the U.S. Congress gets around to passing a bill that imparts fiscal stimulus in 2018. The Fed would have to respond with a more aggressive tightening timetable, setting the stage for the next recession. In contrast, the economic cycle would be further stretched out in the absence of fiscal stimulus, keeping alive for a while longer the lackluster growth/low inflation/low bond yield backdrop that has been favorable for the equity market. We are watching the indicators discussed above to time the exit from our pro-risk asset allocation that favors stocks and corporate bonds to government bonds and cash. As for the duration call, the whiff of deflation that has depressed bond yields over the past month is overdone. Investors have also become too complacent on the Fed. We expect that the recent drop in commodity prices, especially oil, will reverse. If this view is correct, it means that the cyclical bull phase in the dollar is not over because market expectations for the pace of Fed rate hikes will rise relative to expectations in the other major economies (with the exception of Canada). We are still looking for a 10% dollar appreciation. It also means that Treasurys will underperform JGBs and Bunds within currency-hedged fixed-income portfolios. We expect the Eurostoxx 600 and the Nikkei indexes to outperform the S&P 500 this year in local currencies, despite our constructive view on U.S. growth. Stocks are cheaper in the former two markets. Moreover, both Japan and the Eurozone are earlier in the profit mini-cycle, which means that there is room for catch-up versus the U.S. over the next 6-12 months when growth in the latter tops-out. The prospect of structural reform in France is also constructive for European stocks, following the election of a reformist legislature in June. However, the upcoming Italian election warrants close scrutiny. The key risk to this base case is our view that oil prices will rebound. This is clearly a non-consensus call. If OPEC production cuts are unable to overwhelm the rise in U.S. shale output, then inventories will remain elevated and oil prices could move even lower in the near term. Our bullish equity view would be fine in this case, but the bond bear market and dollar appreciation we expect would at least be delayed. Finally, a few words on the U.K. Our geopolitical experts highlight two key points related to June's election outcome: fiscal austerity is dead and the U.K. will pursue a "softer" variety of Brexit. This combination should provide a relatively benign backdrop for U.K. stocks and the economy over the next year. Nonetheless, the cloud of uncertainty hanging over the U.K. is large enough to keep the Bank of England (BoE) on hold. Some BoE hawks are agitating for tighter policy due to the worsening inflation overshoot, but it will probably be some time before the consensus on the Monetary Policy Committee shifts in favor of rate hikes. This means that it is too early to position for gilt underperformance within fixed-income portfolios. Sterling weakness looks overdone, although we do not see much upside either. As long as Brexit talks do not become acrimonious (which is our view), the U.K. stock market should be one of the outperformers in local currency terms among the major developed markets. Mark McClellan Senior Vice President The Bank Credit Analyst June 29, 2017 Next Report: July 27, 2017 1 For more discussion, see Alternative Facts in the Bond Market at BCA Global Fixed Income Strategy Weekly Report, dated June 13, 2017 available at gfis.bcaresearch.com 2 Please see Energy Sector Strategy Weekly Report, "Views from the Road," dated June 21, 2017, available at nrg.bcaresearch.com 3 The first problem is that the S&P data are expressed on a per-share basis. Moreover, the NIPA data adjusts for inventory and depreciation allowance. S&P margins are calculated using sales in the denominator, while we generally use GDP as the denominator for calculating NIPA profits. 4 The NIPA data shown include financials and profits earned overseas, as is the case for the S&P. 5 Please see BCA Special Report "Timing The Next Equity Bear Market," dated January 24, 2014, available at bcaresearch.com II. Preferences As Trading Constraints: A New Asset Allocation Indicator Our new Revealed Preference Indicator (RPI) is the latest installment in our ongoing research into trading rules that can augment our top-down macro approach to asset allocation. The RPI borrows from Paul Samuelson's "revealed preference" theory of consumer behavior to market behavior. It combines the idea of market momentum with valuation and the monetary policy backdrop. A trading rule for the stock/bond allocation based on the RPI outperforms traditional technical, monetary, and valuation indicators. It provides a powerful bullish signal if positive equity market momentum lines up with positive signals from policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. This model adds value on its own, but we feel that it is best used in conjunction with other indicators designed to improve performance around major market turning points. Future research will experiment with combining the RPI with other indicators to further enhance performance. In the meantime, we will present the RPI's signals each month in Section III of the monthly publication. As with all indicators and models, however, the RPI is only one input to our decision process. We base our asset allocation decision on a combination of indicators, macro themes, detailed data analysis and judgment. In 1938, economist Paul Samuelson published a paper entitled, "A Note on the Pure Theory of Consumer's Behavior," in which he outlined an alternative to the well-known economic principle, utility theory. He dubbed his work "revealed preference theory."1 His goal was to redefine utility - a measure of consumer satisfaction with a good or service - by observing behavior. He posited that when consumers reveal their preferences by buying one item rather than another, they reveal the way in which they maximize happiness or satisfaction. For instance, one can measure preferences via experiments in which a subject is given $200 and the choice between two brands of shoes at different prices. Repeating the exercise at different levels of income and relative prices generates "preference axioms." Samuelson's theory has many more layers of complexity, but this Special Report focuses on modelling investors' preferences through observed behavior. Borrowing from Samuelson's reasoning, we developed a methodology to identify investors' axioms of preference for equities and bonds at different levels of incomes and prices. Then we compared investors' real actions with those anticipated by our methodology. This allowed us to generalize our findings and analyze the effects on a portfolio of equities and bonds. The main finding of our statistical exercise is that asset allocators can profit from understanding how short-term moves are linked to the market's revealed preferences at different times during the economic cycle. We then use the results to construct an indicator and a trading rule that not only outperforms a buy-and-hold strategy by a wide margin, it outperforms other traditional trading rules as well. Building A Revealed Preference Model Our primary objective in constructing a revealed preference indicator (RPI) is to understand: (1) how market preferences shape the behavior of investors; and (2) how they ultimately affect future returns. To do so, we broke down our analysis into three key areas: Part I identifies market preferences for different levels of income and price in the economy. Part II defines a general investment strategy that utilizes historic preferences and short-term market movements as a market timing tool. Part III optimizes the RPI and compares its historical track record with a buy-and-hold asset allocation and trading rules based on other indicators. Part I - Developing The Framework The first step in building the RPI is to establish the proper control variables. We limited our basket of investable "goods" to U.S. equities and 10-year Treasurys. We also need a variable that is analogous to the income measure that Samuelson used in his study. For the choice facing investors who are deciding between buying two financial assets, we believe that a measure of market "liquidity" is more appropriate than income. By this we do not mean the ease by which financial assets can be bought and sold. Rather, it is "funding liquidity", or how easily it is to borrow to invest. BCA often uses the four phases of the Fed cycle, as interest rates fluctuate around the equilibrium level, as a measure of funding liquidity (Chart II-1):2 Chart II-1Fed Funds Rate As A Proxy For Income Fed Funds Rate As A Proxy For Income Fed Funds Rate As A Proxy For Income Phase I = Policy is accommodative but the fed funds rate is rising. Phase II = Policy is tight and the Fed is still tightening. Phase III = Policy is tight but the Fed is cutting rates. Phase IV = Policy is easy and the Fed is cutting rates. The rationale for using the fed funds-rate cycle as a proxy for income is that, when interest rates are below equilibrium, monetary conditions are accommodative. Leverage is easy to obtain because there is plenty of liquidity (income) to fund investments. When conditions are tight, funding liquidity is relatively scarce. To measure relative prices, we first divided the S&P 500 price index by its 12-month moving average and second, we took the inverse of the 10-year Treasury yield divided by 12-month moving average.3 We then used the ratio of these two deviations-from-trend to construct a relative price measure (Chart II-2). This ratio provides a single measure of how expensive stocks and bonds are, not only to each other, but to their own history as well. We then grouped the relative price data into four sets of percentiles, or buckets, shown in Table II-1. Stocks are expensive and bonds cheap at the top of the table, while the reverse is true at the bottom. Chart II-2Constructing A Single Price Measure For Equities And Bonds Constructing A Single Price Measure For Equities And Bonds Constructing A Single Price Measure For Equities And Bonds Table II-1Distribution Of Relative Price July 2017 July 2017 Table II-2A presents the average historical monthly percent change in stock prices for each combination of the four relative price and liquidity buckets over the entire dataset. In the fourth phase of the Fed cycle (when monetary conditions are easy and the Fed is still cutting interest rates), and when relative prices are in the first bucket (i.e. stocks are expensive), the average stock price increase during the month was slightly above 1% percent. Table II-2B provides the same breakdown for the average change in bond yields (shown in basis points, not returns). Tables II-2A and II-2B are recalculated at each point in time - meaning that we used an expanding sample to calculate the price buckets, and updated the results for the ensuing price or yield movements as new data are added. That way, we completely avoid the advantage of hindsight. To simplify our methodology, we coded the results to end up with the stock and bond returns for the 16 different combinations of Fed and relative price buckets. Table II-3 uses the results from Tables II-2A and II-2B in the last period of history as an example. The "Liquidity" and "Price" columns indicate the bucket (e.g. price in bucket 1 and liquidity in bucket 1). The "Stocks" and "Bonds" columns are coded as "1" if the asset appreciated during the month given the indicated liquidity/price bucket, and a "0" if it depreciated that month. Table II-2AEquity Market Reactions At Given Levels Of Price And Liquidity July 2017 July 2017 Table II-2BTreasury Market Reactions At Given Levels Of Price And Liquidity July 2017 July 2017 Chart II-3Revealing What Investors Prefer July 2017 July 2017 Part II - Habits Create Expectations It is important to keep in mind that the objective of our revealed preference model is not to use the revealed market preferences as forecasts but rather to examine what happens when investors decide to follow or ignore them. Our hypothesis in building this model is that, when investors go against their historical preferences, the result should be interpreted as short-term noise. It is only when preferences and (subsequent) short-term market moves are aligned that we should heed the signal and invest accordingly. Table II-3 can be thought of as the market's revealed preference. Again, keep in mind that we allowed revealed preferences to change over time by recalculating it under our stretching-sample approach. The following steps detail how we used investor preferences to create a trading rule that verifies our hypothesis empirically: Step 1 - Expected vs. Actual: The first step is to examine how actual equity prices and bond yields behaved relative to their expected trajectory. We created two variables - one for equities and one for bonds. If revealed preference last month (t-1) suggested that the asset's return should be positive in the subsequent month (t), and it indeed turned out to be positive in period t, then we coded month t as "1." If both the revealed preference and the actual outcome were negative, we coded it as "-1." If they did not match, the code is "0" (in other words, the market did not follow the typical historical revealed preference). Thus we have two time series, one for bonds and one for stocks, which are made up of 1s, -1s and zeros. Step 2 - Bullish, Bearish, and Neutral: We combined the coded series for stocks and bonds to encompass the nine possible outcomes in our model (i.e. both bonds and stocks can have a value in any month of 1, 0 or -1, providing 9 different combinations). Table II-4 presents the nine outcomes along with the asset allocation that would have maximized investor returns based on our historical analysis. For example, investors were paid to be overweight equities when equities and bonds have a code of "1" and "-1," respectively (top row in Table II-4). In other words, stocks tended to outperform bonds when revealed preferences from the month before predicted rising stock prices and rising bond yields, and these predictions were confirmed. Table II-4Understanding The Signals From Preferences July 2017 July 2017 If revealed preference is not confirmed for both bonds and stocks, then it is best for investors to stand aside with a benchmark allocation. Step 3 - "If It Don't Make Dollars, It Don't Make Sense": To test whether our theory would add strategic value, we computed a trading rule to see how well it performed against a benchmark portfolio of 50% equities and 50% Treasurys. The trading rule was computed as follows: when the revealed preference for equities is positive (at time t-1) and this signal is confirmed in t, then in t+1 we allocate 100% to the S&P 500 and 0% to Treasurys. When the revealed equity preference signal is correctly bearish, we removed all exposure to equities and allocated 100% to Treasurys. When the signal was neutral, we kept a benchmark allocation of 50% equities and 50% Treasurys. Chart II-3 shows that this trading rule outperforms the benchmark, confirming our initial hypothesis - one should fade the short-term movements when investors go against their preferences, and only follow the signals when those movements align with historical preferences. History shows that investors tend to underperform in terms of the stock/bond allocation when they deviate from their revealed preference. Chart II-3Correctly Gauging How Investors Behave Pays Off Correctly Gauging How Investors Behave Pays Off Correctly Gauging How Investors Behave Pays Off Part III - Validating The Results One drawback is that this trading rule would require frequent portfolio allocation changes every month, as shown in Chart II-4. As such, we constructed a smoothed version by imposing the rule that asset allocation is unchanged unless the model provides a new signal for two months in a row (Chart II-5).4 These restrictions not only dramatically reduced the frequency of the asset allocation adjustments, but it also augmented historical cumulative excess returns (Chart II-6). Chart II-4Revealed Preference Indicator Is Inherently Volatile Revealed Preference Indicator Is Inherently Volatile Revealed Preference Indicator Is Inherently Volatile Chart II-5Removing Some Of The Noise Removing Some Of The Noise Removing Some Of The Noise Any new indicator of course must be able to outperform a buy-and-hold strategy to be useful but it is also interesting to see how its performance ranks compared to a set of random portfolios. This way, we can identify if the indicator truly provides additional information. Random portfolios are generated using a monthly allocations of 100% or 0% to equities, with the remainder in Treasurys. Chart II-7 shows the performance of the smoothed indicator versus a set of 1,000 randomly generated portfolios. Chart II-6Once Smoothed, The RPI Truly Shines Once Smoothed, The RPI Truly Shines Once Smoothed, The RPI Truly Shines Chart II-7The RPI Adds A Significant Amount Of Information The RPI Adds A Significant Amount Of Information The RPI Adds A Significant Amount Of Information We compared the indicator's trading rule to simple moving averages or BCA's other indicators. We also wanted to ensure that the RPI adds value beyond investing based strictly on the four phases of the liquidity cycle or based on relative value alone. We therefore compared the track record of the RPI trading rule to rules that are based on: (1) the deviation of the S&P 500 from its 12-month moving trend; (2) BCA's monetary conditions indicator; (3) BCA's valuation indicator; (4) BCA's technical indicator; (5) the four phases of the Fed cycle; and (6) the relative price index. Charts II-8A and II-8B highlights that RPI indeed impressively dominates the other trading rules. The one exception is that, during the Great Recession, the model's performance fell to roughly match the performance of a S&P 500 technical trading rule. Chart II-8AThe RPI Outperforms The Sum Of Its Parts... July 2017 July 2017 Chart II-8B...As Well As Other Indicators July 2017 July 2017 Part IV - Conclusions The RPI is the latest installment in our ongoing research into trading rules that can augment our top-down macro approach to asset allocation. Quite simply, it combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. This model adds value on its own, but we feel that it will best be used in conjunction with other indicators designed to improve performance around major market turning points. Future research will experiment with combining the RPI with other indicators to further enhance performance. In the meantime, we will present the RPI's signals each month in Section III of the monthly publication. As with all indicators and models, however, the RPI is only one input to our decision process. We base our asset allocation decision on a combination of indicators, macro themes, detailed data analysis and judgment. The indicator's current reading for stocks versus bonds, at benchmark, is more conservative than our official recommendation. The benchmark reading reflects the fact that equities are overvalued and that investors have deviated from their preferences in their past two quarters. David Boucher Associate Vice President Quantitative Strategist 1 For more information, please see P. A. Samuelson, "A Note on the Pure Theory of Consumer's Behavior," Economica 5:17 (1938), pp. 61-71. 2 Please see U.S. Investment Strategy Special Report "Stocks And The Fed Funds Rate Cycle," dated December 23, 2013, available at usis.bcaresearch.com 3 We tested a few other measures, most notably the stock-to-bond total return ratio (measured by comparing each asset's total returns), but the chosen measures provided the best and most robust results. 4 We conducted a statistical exercise to validate and optimize the allocations in Table 4 to provide a smoother performance. III. Indicators And Reference Charts Thanks to the recent dollar and bond yield “relief valves”, the S&P 500 is stubbornly holding above the 2,400 level. The breakout above this level further stretched valuation metrics. Measures such as the Shiller P/E and price/book are at post tech-bubble highs. Stocks remain expensive based on our composite Valuation Index, although it is still shy of the +1 standard deviation level that demarcates over-valuation. This is because our composite indicator includes valuation measures that take into account the low level of interest rates. Of course, once interest rate normalization is well underway, these indicator will not look as favorable. It is good news for the equity market that our Monetary Indicator did not move further into negative territory over the past month. Indeed, the indicator has hooked up slightly and is sitting close to a neutral level. Our equity Technical Indicator remains constructive. Other measures, such as our Speculation Index, composite sentiment and the VIX suggest that equity investors are overly bullish from a contrary perspective. On the other hand, the U.S. earnings surprises diffusion index highlights that upside earnings surprises are broadly based. Our elevated U.S. Willingness-to-Pay (WTP) indicator ticked down from a high level this month, suggesting that ‘dry powder’ available to buy this market is depleted. This indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors often say they are bullish but remain conservative in their asset allocation. In contrast to the U.S., the WTP indicators for both the Eurozone and Japan are rising from a low level. This suggests that a rotation into these equity markets is underway and has some ways to go. We remain overweight both the Eurozone and Japanese markets relative to the U.S. on a currency-hedged basis. The pull back in long-term bond yields since March was enough to “move the dial” in terms of the bond valuation or technical indicators. U.S. bond valuation has inched lower to fair value. However, we believe that fair value itself is moving higher as some of the economic headwinds fade. We also think that the FOMC is determined to stick with the current tightening timetable in terms of rate hikes and balance sheet adjustment, which support our negative view on bond prices. Now that oversold technical conditions have been unwound, it suggests that the consolidation phase for bond yields is largely complete. The trade-weighted dollar remains quite overvalued on a PPP basis, although less so by other measures. Technically, it is a bearish sign that the dollar moved lower and crossed its 200-day moving average. However, our Composite Technical Indicator highlights that overbought conditions have been worked off. We still believe the U.S. dollar’s bull phase has one more upleg left. Technical conditions are also benign in the commodity complex. Most commodities have shifted down over the last month to meet support at their 200-day moving averages. Base metals are due for a bounce, but we are most bullish on oil. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-5U.S. Earnings U.S. Earnings U.S. Earnings Chart III-6Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-8U.S. Treasurys and Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-9U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-10Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1110-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-12U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-13Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-14Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-15U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-16U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-17U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-18Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-19Euro Technicals Euro Technicals Euro Technicals Chart III-20Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-21Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-22Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-23Commodity Prices Commodity Prices Commodity Prices Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-26Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-27U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-28U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-29U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-30U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-31U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-32U.S. Consumption U.S. Consumption U.S. Consumption Chart III-33U.S. Housing U.S. Housing U.S. Housing Chart III-34U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-35U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-36Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-37Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China

Highlights The rollover in the economic surprise index is not sending a near-term recession signal and should trough in the next month or so, as decent economic data begins to surpass now lowered expectations. Investors should be prepared for a mild recession in 2019, but odds of a recession are low in the next 12-18 months. Oil prices will move higher from the mid $40s per barrel as investors start to see the inventory drawdowns we expect in the coming months. We expect that the Fed will stick to its plan to begin shrinking its balance sheet in September and hike rates again in December. Still, a stubbornly low inflation rate in the next few months would likely see the Fed postpone any further tightening until early 2018. Small cap stocks have underperformed large caps this year, but investors should not interpret this as a sign of that start of sell-off in risk assets. Feature The Citi Economic Surprise Index (CESI) is not sending a near-term recession signal and should trough in the next month as decent economic data begin to surpass lowered economic expectations. The index is nearly two standard deviations below its mean after peaking in early March in the wake of the election and has been falling for 71 days. It typically takes 90 days for the surprise index to find a footing after readings above 40. Moreover, the mean reverting nature of the index suggests a rebound at two standard deviations, absent a recession that we do not foresee (Chart 1). Chart 1Economic Surprise Index Approaching A Turning Point Economic Surprise Index Approaching A Turning Point Economic Surprise Index Approaching A Turning Point CESI is composed of two components, whose composition and recent behavior are crucial to interpreting the weakness in the overall surprise metric. A positive reading on the "consensus change" index, which tracks economists' forecasts, means that expectations have improved relative to their one-year average. A positive reading on the "data change" component suggests that economic releases have been stronger than their one-year average. The overall surprise index combines these two elements/factors (Chart 2). Chart 2Post Election, Economic Expectations For Soft Data Hit An Eight Year High Post Election, Economic Expectations For Soft Data Hit An Eight Year High Post Election, Economic Expectations For Soft Data Hit An Eight Year High Lofty expectations, rather than poor data, account for much of CESI's weakness in the past three months. This is most pronounced in the soft economic surprise index, where outlooks moved sharply in the wake of the U.S. election when forecasters were swept up in Trump euphoria. By early March 2017, the economic consensus index for soft data was at its highest in seven years, topping out just shy of the all-time record set in late 2009. Prognosticators also ratcheted up their forecasts for the hard data, but not by nearly as much. The inevitable result of elevated expectations, combined with economic reports that signaled that overall growth remained close to 2%, was a prolonged spell of economic disappointment. This type of divergence between heightened expectations and weakness in the overall surprise index has occurred several times in the past 13 years (2004, 2010, 2011, 2012 and 2017). Each episode took place before a bottom in the economic surprise index and our view is that this time is no different (Chart 2). Despite the dismal surprise index, forecasts for U.S. and global GDP in 2017 and 2018 have held up, which is a positive sign for profits (Chart 3). The stability of these forecasts is in sharp contrast to 2012, 2013, 2015 and 2016 when global growth estimates sunk at the same time as the economic surprise index. As we stated in our recent report,1 GDP growth in 1H 2017 in the U.S. is on track to match the Fed's modest 2.1% target for the year. Moreover, in years when Q1 GDP is weak, 2H growth is faster than 1H growth 70% of the time. Chart 3U.S. & Global GDP Estimates For 2017 & 2018 Have Held Up Well U.S. & Global GDP Estimates For 2017 & 2018 Have Held Up Well U.S. & Global GDP Estimates For 2017 & 2018 Have Held Up Well Falling oil prices are another worry for investors concerned that global growth is on the wane. We take a different view and expect oil prices to increase in the coming months. In a recent report,2 our Energy Sector Strategy team noted that investors are confused about conflicting supply signals in oil markets. Traders do not see the physical shortage that the IEA/EIA/OPEC and BCA's top-down supply & demand analyses argue should prevail (Chart 4). Investors are cautious amid the uncertainty. We view the investment environment as overly pessimistic and anticipate that oil prices (and oil-focused upstream equities) will improve as inventory withdrawals escalate in the coming months. The latest 3.5% year-over-year reading on LEI for May points to low odds of a near-term recession (Chart 2, panel 3). However, BCA's Global Investment Strategy service has raised the possibility of a U.S. recession commencing in 2019. Financial markets would move ahead of a recession, thus investors should begin to adjust their portfolios3 for a recession scenario in the latter half of 2018, as economic and profit growth begins to weaken. Until then, we favor stocks over bonds, but we remain vigilant for any signs of imbalances that typically precipitate a recession. Our Global Investment Strategy service points out that in the post-war era the unemployment rate's three-month moving average has never risen by more than one-third of a percentage point without a recession. A good leading indicator of the unemployment rate is the weekly unemployment claims data, and they suggest continued tightening in the labor market (Chart 5). Chart 4We Expect The Oil Balance To Tighten Later This Year We Expect The Oil Balance To Tighten Later This Year We Expect The Oil Balance To Tighten Later This Year Chart 5Claims Not Even Close To Sending A Recession Signal Claims Not Even Close To Sending A Recession Signal Claims Not Even Close To Sending A Recession Signal A tighter labor market will lead to the familiar vicious cycle of a more aggressive Fed, a margin squeeze, slower and eventually falling profits, rising corporate defaults and layoffs. The resulting economic downturn would be mild compared with the 2007-2009 recession because the current imbalances are not as severe as those in 2007. Even so, with valuations stretched, the pain of the recession may be most felt in the financial markets, with a likelihood of a 20-30% equity bear market. Bottom Line: Despite signs to the contrary, the sweet spot that has buoyed risk assets remains in place: a beneficial combination of moderate economic growth, healthy corporate profit growth, stable margins, low inflation and a Fed prepared to only gradually hike rates. We remain overweight stocks versus bonds in the next 6-12 months. Threats to this risk-asset friendly environment include a further drop in core inflation, an over-aggressive central bank, and signs that negative economic shocks are leading to a significant markdown of global growth prospects. Is The Fed's Inflation Target Credible? The recent drop in oil prices has undermined our short-duration recommendation. But more than that, investors are questioning whether the Fed even has the ability to reach its inflation goals, following the surprising May CPI report and the softening in some of the wage data. Is it possible that the U.S. is following Japan's roadmap where even an over-heated labor market is insufficient to generate any meaningful inflation? The sharp flattening of the Treasury curve indicates that the bond market has already rendered its judgement. As we noted last week, the energy component pulled down the headline CPI rate again in May, but the softening of inflation this year is widespread in the index. This is contrary to Fed Chair Yellen's assertion that recent weak readings are due largely to special factors, such as wireless telecommunications prices. The deceleration in inflation began around the start of the year. The 3-month rate of change of the headline index fell by more than five percentage points between January and May, of which energy accounts for 3.3 percentage points. The deceleration in the core rate was a less severe, but still substantial, 2.8 percentage points. Table 1 presents the components of the CPI that made the largest contribution to the deceleration in core inflation. Motor vehicles, owners' equivalent rent, apparel, recreation, wireless telecom and medical care services accounted for 1.2 percentage points as a group. However, many other sectors contributed in a small way to the overall deceleration of core inflation in the first five months of the year. Table 1Key Drivers Of Core Inflation Deceleration In 2017 Waiting For The Turn Waiting For The Turn Some special factors were at play. The moderation in rent inflation likely reflects the bottoming of the vacancy rate. Discounting in the auto sector is not a surprise given weak sales. Wireless prices can be viewed as a special case as well. Nonetheless, the breadth and suddenness of the deceleration in core inflation across such diverse sectors, some unrelated to labor markets, commodity prices, the weak dollar or on-line shopping, is startling. The disinflation this year in the Fed's preferred measure, the PCE price index, is not as extended but the data lag the CPI by roughly a month. A diffusion index made up of the components of the PCE index is still in positive territory, unlike the CPI's diffusion index (Chart 6). Nonetheless, the CPI data suggest that core PCE inflation will edge lower when the May data are released at the end of June. There has also been a moderation in some of the wage inflation data, such as average hourly earnings (Chart 7). The slowdown has been fairly widespread across manufacturing and services. The good news is that the soft patch appears to be over; 3-month rates of change have firmed almost across the board (retail is a major exception). Chart 6CPI, PCE Diffusion##BR##Indices Are Mixed CPI, PCE Diffusion Indices Are Mixed CPI, PCE Diffusion Indices Are Mixed Chart 7Wages Have Accelerated##BR##Over Past Three Months Wages Have Accelerated Over Past Three Months Wages Have Accelerated Over Past Three Months There is no slowdown evident at all in the better-constructed Employment Cost Index (ECI) as of the first quarter (Chart 8). The related diffusion indexes also remain constructive. The ECI is adjusted to avoid compositional effects that can distort the aggregate index. We conclude from these and other wage measures that the Phillips curve is still operating. Admittedly, the curve appears to be quite flat, which means it is difficult to generate inflation even when the labor market overheats. Nonetheless, the relationship between the ECI and measures of labor market tightness, such as the quit rate, the "jobs plentiful" index and NFIB compensation plans, does not appear to have broken down (Chart 9). The percentage of U.S. states with unemployment below the Fed's estimate of full employment is above 70%. Anything over 60% in the past has been associated with wage pressure (Chart 10). The percentage jumped from 58% in March to 71% in April, blasting through the 60% threshold. Chart 8No Slowdown##BR##In ECI Data No Slowdown In ECI Data No Slowdown In ECI Data Chart 9Labor Market Tight Enough##BR##To Push Up Inflation Labor Market Tight Enough To Push Up Inflation Labor Market Tight Enough To Push Up Inflation The bottom line is that, while we are concerned about the breadth of the soft patch in the consumer price data, we are in agreement with the Fed that the labor market is tight enough to gradually push up inflation. We are willing at this point to chalk up the recent drop in core inflation partly to randomness in the data, and partly to lagged effects of the slowdown in real GDP growth in the first half of 2016 (Chart 11). The PPI for services and for core goods are not suggesting there is deflationary pressure in the pipeline (Chart 8). Chart 10Rise In State Level Diffusion Indices Consistent With Higher Compensation Costs Rise In State Level Diffusion Indices Consistent With Higher Compensation Costs Rise In State Level Diffusion Indices Consistent With Higher Compensation Costs Chart 11Inflation Lags Economic Growth By 18 Months Inflation Lags Economic Growth By 18 Months Inflation Lags Economic Growth By 18 Months What Will The Fed Do? The CPI data have rattled some on the FOMC. Federal Reserve Bank of Dallas President Kaplan, for example, believes that the Fed needs to be patient to ensure that the inflation pullback is temporary. However, the June FOMC Statement and Yellen's press conference suggested that the consensus is determined to stick with the current tightening timetable in terms of rate hikes and balance sheet adjustment. FOMC Vice Chairman Dudley echoed this view in comments he made last week to the press. The Fed has been quick to ease or back away from planned rate hikes at the first hint of trouble since the Lehman shock. However, it appears that the reaction function has changed, now that the labor market is at full employment. This is especially the case because financial conditions have eased further since the June rate hike. Unemployment will edge further below the full-employment level if the FOMC does not slow the economy. Policymakers know that the Fed has had little success in the past when it tried to nudge unemployment higher in order to relieve inflation pressure and achieve a soft landing; these attempts almost always ended in recession. Dudley added that "...pausing policy now could raise the risk of inflation surging and hurting the economy." Other FOMC members are worried that financial stability risk will rise if the low-rate environment extends much further. The bottom line is that we expect the Fed will stick with the game-plan for now. The FOMC will begin shrinking the balance sheet in September, but will wait until December for the next rate hike. That said, a stubbornly low inflation rate in the coming months would likely see the FOMC postpone the next rate increase into next year. Where Next For Bonds? Our fixed-income strategists see three possible scenarios for the bond market:4 Base Case: Weak recent inflation readings are nothing more than a lagged response to last year's deceleration in economic growth. U.S. growth accelerates in the second half, unemployment falls further and both wage growth and inflation pick up. Oil inventories begin to contract and prices head higher. The FOMC is vindicated in its inflation view and proceeds with the current rate hike and balance sheet adjustment agenda. Investors receive a "wake up call" from the Fed, bond prices get hit and recent curve-flattening trend reverses. Fed Capitulates: The U.S. labor market continues to tighten, but core PCE inflation is still close to 1½% by the September FOMC meeting. We would expect the Fed to lower its forecasted rate hike path, signaling that no further rate hikes are likely in 2017. Long-maturity real yields would fall in this scenario, although long-term inflation expectations could rise to the extent that the Fed's more dovish tilt will weaken the dollar and generate more inflation in the medium term. Nominal yields may not end up moving much in this scenario. A Policy Mistake: If core inflation remains low between now and the September FOMC meeting and the Fed continues to write-off low inflation as transitory, signaling its intention to stick to its current projected rate hike path, then the market would price-in a policy mistake scenario. The yield curve would flatten and long-maturity nominal yields would fall, led by tighter TIPS breakevens. In terms of likelihoods, we would characterize Scenario 1 as our base case scenario, Scenario 2 as unlikely and Scenario 3 as a tail risk. The bottom line is that short-duration positions have been a "pain trade" in recent weeks, but it appears to us that the rally is overdone. We remain short-duration. No Signal From Small Caps Chart 12Small Caps Are No Longer Expensive Small Caps Are No Longer Expensive Small Caps Are No Longer Expensive The underperformance of small cap stocks since December is not sending a signal about the broader equity market. In fact, small cap relative performance has a mixed track record calling the peak in large cap equities. We maintain our view from a 2014 report:5 There is no basis for concluding that small cap underperformance heralds a fragile economy, stock market weakness or heightened risk aversion. Investors should note the sector/compositional, domestic/international, cyclical/defensive, and valuation discrepancies between small and large cap stocks before drawing any conclusions about the signals from small caps. The S&P 500 small cap index has more exposure to financials, industrials and materials than its large cap cousins, and has lower weights in energy, staples and healthcare. This mix makes small caps more cyclically oriented. Moreover, small caps have less exposure to overseas economies and, therefore, less sensitivity to fluctuations in the U.S. dollar. Plus, our small cap valuation indicator has moved even further into undervalued territory since our discussion of small cap equities in this publication on April 246 (Chart 12). Chart 13Small Caps Are Not Great##BR##Market Prognosticators Small Caps Are Not Great Market Prognosticators Small Caps Are Not Great Market Prognosticators Small-cap stocks outperformed large cap by 12% from November 8 through December 8, 2016, but have lagged since, as investors unwound the Trump trade. The implication is that the recent sell-off in small caps is not a signal that the broader market is poised for a downturn. Instead, it reflects the market's view that Trump's pro-small business agenda has stalled. Moreover, history shows that the relative performance of small caps versus large caps is not a good predictor of the future performance of risk assets versus bonds. The small-to-large ratio sent plenty of mixed signals in the '80s and '90s when the economy was in a long expansion, fostered by low inflation and a gradualist Fed (Chart 13, panels 1 and 2). On the other hand, local peaks and troughs in small cap performance provided solid signals for turns in stock versus bond performance from the early '70s through the mid-80s, a period characterized by soaring inflation that is not present today (Chart 13, panel 1). Small-cap outperformance starting in late 2008 did presage an upturn in the stock-to-bond total return ratio in 2009, and captured a few of the risk on/risk off periods from 2010 through 2012, while the Fed engineered QE2, Operation Twist and QE3. More recently, the relative performance of small versus large has been range-bound and has not provided a consistent signal for turns in the overall market (Chart 13, panel 3). Bottom Line: The underperformance of small caps to large is a reaction to the market's perception that Trump's pro-small business agenda will disappoint, not a sign that U.S. growth is waning. While several planned policies of the Trump administration have been delayed, a legislative agenda that appears to be pro-business is in place. As such, our view is that it is too early to abandon a bullish bias towards small cap stocks, especially given the major improvement in relative valuation noted above. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see U.S. Investment Strategy Weekly Report "Can The Service Sector Save The Day?", June 5, 2017, available at usis.bcaresearch.com. 2 Please see Energy Sector Strategy Weekly Report, "Views From The Road", June 21, 2017, available at nrg.bcaresearch.com. 3 Please see Global Investment Strategy Weekly Report "The Timing Of The Next Recession", June 16, 2017, available at gis.bcaresearch.com. 4 Please see U.S. Bond Strategy Weekly Report "Three Scenarios For Treasury Yields In 2017", June 20, 2017, available at usbs.bcaresearch.com. 5 Please see U.S. Investment Strategy Weekly Report "On The Road Again", June 2, 2014, available at usis.bcaresearch.com. 6 Please see U.S. Investment Strategy Weekly Report "Spring Snapback", April 24, 2017, available at usis.bcaresearch.com.

Highlights Portfolio Strategy Swap consumer staples into financials in our pair trade versus the tech sector. Relative profit fundamentals signal that this relative share price ratio will soon come alive. Global growth tailwinds argue for lifting the air freight & logistics index to high-conviction overweight status. Recent Changes S&P Financials/S&P Tech - Switch the long side of the S&P Consumer Staples/S&P Tech pair trade from S&P Consumer Staples to S&P Financials. S&P Consumer Staples - Remove from the high-conviction overweight list. S&P Air Freight & Logistics - Add to the high-conviction overweight list. Table 1Sector Performance Returns (%) Disentangling Pricing Power Disentangling Pricing Power Feature Equities broke out to new highs early last week, and there are good odds that a playable rally will unfold. Investors' jitters have recently focused on the bear market in oil prices and weak core CPI, which have joined forces to push down inflation expectations (Chart 1). However, we have a more bullish interpretation. Unlike in late-2015/early-2016, oil and stock prices have decoupled. True, energy stocks are plumbing multi-decade lows relative to the broad market, but the energy sector comprises less than 6% of the S&P 500's market cap. In fact, the two largest S&P 500 constituents have a greater weight than the 34 stocks in the S&P energy index combined. In other words, the energy sector's broad market influence has been severely diluted. We think it is unlikely that the positive correlation between oil and stock prices reasserts itself. Rather, our sense is that this is likely an energy/commodity-centered deflation that will not have a serious contagion on the rest of the corporate sector. High yield energy spreads continue to widen, but the overall junk spread is flirting with cyclical lows. This stands in marked contrast with the summer of 2014 and late-2015, the last time oil prices melted (second panel, Chart 1). Chart 2 shows that the nonfarm business sector and the GDP implicit price deflators, both of which are reliable corporate sector pricing power proxies, are positively deviating from core CPI. These deflators have historically been excellent leading indicators of inflation and signal that the recent poor inflation prints will likely prove transitory. Importantly, the U.S. is a large closed economy that benefits greatly from lower oil prices, via a boost to discretionary income. Lower energy costs are adding to an already stimulative backdrop owing to the decline in the U.S. dollar and Treasury yields. At the margin, the broad corporate sector also benefits from oil price deflation: energy is a non-trivial input cost. Our more optimistic overall economic and market outlook is also borne out by survey data: economists revised higher their U.S and global GDP growth expectations both for 2017 and 2018, according to Bloomberg estimates (bottom panel, Chart 1). Finally, real yields, the bond market's gauge for economic growth expectations, have climbed close to a 2-year high, and suggest that GDP growth will soon pick up steam (Chart 1). Our view remains that this is a goldilocks scenario for equities, as it may keep the Fed at bay for a while longer and sustain easy financial conditions. This thesis also assumes that the corporate sector will maintain its pricing power gains, and likely pull consumer prices out of their lull. On that front, we have updated our corporate pricing power proxy and while it has lost some steam of late, it continues to expand at a healthy clip (Chart 3). Chart 1Decoupled Decoupled Decoupled Chart 2Implicit Price Deflators Lead Core CPI Implicit Price Deflators Lead Core CPI Implicit Price Deflators Lead Core CPI Chart 3Corporate Pricing Power Is Fine Corporate Pricing Power Is Fine Corporate Pricing Power Is Fine Table 2 shows our updated industry group pricing power gauges, which are calculated from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. The table also highlights shorter term pricing power trends and each industry's spread to overall inflation in order to identify potential profit winners and losers. Table 2Industry Group Pricing Power Disentangling Pricing Power Disentangling Pricing Power Our analysis concludes that still ¾ of the industries we cover are enjoying rising selling prices and 43% are also beating overall inflation rates. Admittedly, the inflation rates have come down since our April update, and there was a tick up in the number of deflating industries from 14 to 16, but that figure is still down from the 19 registered in January. Importantly, 27 out of 60 industries have clocked a rising pricing power trend down from 31 in April, but still up from 20 in January, 14 have a flat trend and 19 are falling. Encouragingly, corporate sector selling prices are still comfortably outpacing wage inflation, which suggests that the positive momentum in profit margins has staying power (Chart 3). One theme that stands out from our analysis is that commodity related industries have either falling or flat inflation trends, with the exception of aluminum and chemicals. We take this as confirmation that resources are at the epicenter of deflation/disinflation pressures. Similarly, the majority of tech sub-sectors are still fighting deflation and suffer from a flat or down trend in selling prices. Adding it all up, the recent mild slowdown in corporate sector selling prices is transitory, mostly commodity related and unlikely to infect the broad business sector. There are high odds that an earnings-led playable break out phase in the equity market will develop from here. This week we promote an industrials sub-sector to our high-conviction overweight list and swap a safe haven sector out, and also tweak our long/short pair trade. Pair Trade Tweak: Long Financials/Short Tech Over the past month, we have reduced the extent of our consumer staples overweight, downgrading soft drinks to underweight and hypermarkets to neutral. In contrast, in May we boosted the S&P financials index to overweight on the back of improving earnings fundamentals. As a result, swapping out consumer staples for financials in our existing pair trade versus the tech sector makes sense. This relative share price ratio is at a critical juncture and has dropped to its long term support level (top panel, Chart 4). Importantly, the relative market capitalization differential is at its widest gap since the tech bubble (Chart 5) and a renormalization is in order. Chart 4Long Term Support Should Hold Long Term Support Should Hold Long Term Support Should Hold Chart 5Unsustainable Gap Unsustainable Gap Unsustainable Gap The valuation case is equally compelling: financials are deeply undervalued and unloved compared with the tech sector (Chart 4), such that even a modest shift in sentiment would drive a large relative price swing. The macro outlook is rife with catalysts to trigger a renormalization. Our respective Cyclical Macro Indicators (CMI) signal that financials profits will best tech sector earnings in the coming quarters (top panel, Chart 6). Historically, relative performance has moved in lockstep with relative profitability. The message from our CMIs is that relative earnings will move decisively in favor of the financials sector, thereby producing positive price momentum (bottom panel, Chart 6). A simple relative demand indicator concurs with our CMIs message: bank loan growth should outpace tech capital expenditures in the back half of the year. The middle panel of Chart 6 shows our recently published bank loans and leases regression model compared with our U.S. Capex Indicator (a good proxy for tech spending) and the message is to expect a catchup phase in relative share prices. If our thesis proves accurate, then relative demand will soon show up in relative top line figures. On that front, our forward looking relative sales per share models argue that the budding recovery in relative revenue is sustainable (Chart 7). Relative pricing power dynamics provide another source of support, both in terms of sales and operating profit margins. Firming financials pricing power is the mirror image of chronically deflating tech selling prices (Chart 7). Keep in mind that overall mild price inflation is a boon for financials because it will keep monetary conditions from becoming overly tight, which would undermine credit quality and availability. Using the nonfarm business sector's implicit price deflator as a proxy for overall inflation, the (third panel, Chart 7) shows that relative share prices move in lockstep with overall corporate sector prices. In terms of economic undercurrents, if geopolitical risks remain muted and financial conditions reasonably accommodative, then a further boost in economic and investor sentiment is likely. History shows that the financials/tech share price ratio has benefited when risk premia recede. The same relationship is also evident in the positive correlation with our U.S. sentiment indicator and real 10-year bond yield (Chart 8), and inverse correlation with corporate bond spreads (not shown). Chart 6Heed The Relative##br## CMI Signal Heed The Relative CMI Signal Heed The Relative CMI Signal Chart 7Financials Have##br## The Upper Hand Financials Have The Upper Hand Financials Have The Upper Hand Chart 8Improving Economy = ##br##Go Long Financials/Short Tech Improving Economy = Go Long Financials/Short Tech Improving Economy = Go Long Financials/Short Tech Finally, recent positive bank sector news suggests that financials have the upper hand in this share price ratio. Banks passed the Fed's stringent stress test with flying colors and should become more shareholder friendly, i.e. boost dividend payouts and reinstate/augment share retirement. In addition, even a modest watering down of Dodd-Frank will also lift the appeal of banks and financials at the expense of tech stocks in the coming quarters. Adding it up, we recommend swapping consumer staples with financials in our pair trade versus the tech sector. Relative profit fundamentals suggest that this relative share price ratio will soon spring into action. Bottom Line: Switch consumer staples out and sub financials in the pair trade versus tech stocks. We are also removing the S&P consumer staples index from our high-conviction overweight list for a modest gain of 0.1% since the early-January inclusion. The latter move makes room for an upgrade to high-conviction of a transportation sub-group that has caught fire since our recent upgrade to overweight. Air Freight Stocks Achieve Liftoff! We raised the S&P air freight & logistics group to overweight two months ago, reflecting a lack of recognition in either valuations or earnings estimates that a global trade revival was unfolding and washed out technical conditions. Since then, this transportation sub-group has regained its footing, and firming profit fundamentals now embolden us to add air freight stocks to our high-conviction overweight list. The relative share price ratio has smartly bounced off its GFC lows. Similarly, our Technical Indicator found support at one standard deviation below the historical mean, a typical launch point for playable rallies. Importantly, deeply discounted valuations remain in place, both in terms of P/S and P/E ratios (Chart 9). We expect the rebound in global growth to help unlock excellent value in air freight equities. Global trade is reviving. The synchronized DM and EM economic recovery has buoyed the global manufacturing PMI, which continues to trend well above the boom/bust line. Both global export volumes and prices are expanding. Yet buoyant global trade expectations are still not reflected in tumbling relative sales expectations (Chart 10). Chart 9Unwarranted ##br##Grounding Unwarranted Grounding Unwarranted Grounding Chart 10Buoyant Trade Growth Is Neither Reflected##br## In Collapsing Sales Expectations... Buoyant Trade Growth Is Neither Reflected In Collapsing Sales Expectations... Buoyant Trade Growth Is Neither Reflected In Collapsing Sales Expectations... Chart 11 highlights two additional Indicators to gauge the stage of the global trade recovery. Korea and Taiwan are two small open economies: exports in both countries are accelerating. Meanwhile, our Global Trade Activity Indicator, comprising the economically-sensitive Baltic Dry Index and lumber prices, is also waving a green flag. The upshot is that a number of Indicators confirm that a durable pickup in trade is underway, which should ultimately translate into a recovery in relative earnings expectations (Chart 11). Domestically, business shipments-to-inventories ratios are expanding comfortably in all three major segments: manufacturing, wholesale and retail (bottom panel, Chart 10). Anecdotally, recent news that FedEx beat both top and bottom line estimates also reinforces a firm global activity backdrop. All of this serves as reliable evidence that the budding recovery in global (and domestic) growth has morphed into a sustainable advance. The implication is that air freight pricing power has ample room to grow. Wholesale price momentum has reached a 5-year high. If our thesis plays out, more pricing power gains are in store, which will boost profit margins given the industry's impressive labor cost restraint and high operating leverage (Chart 12). Chart 11...Nor In Depressed##br## Forward EPS ...Nor In Depressed Forward EPS ...Nor In Depressed Forward EPS Chart 12Margin Expansion##br##Phase Looms Margin Expansion Phase Looms Margin Expansion Phase Looms Finally while investors are digesting the Walmart in-store pick up option and Amazon's push for its own delivery service plans, the persistent ascent in online shopping suggests that the structural increase in rapid delivery services will remain intact. Investors should expect pricing power to gravitate toward the long-term trend (bottom panel, Chart 12). Tack on the recent corrective action in the commodity pits and this group also benefits from the fall in fuel costs. Taken together, profit margins should resume expanding. In sum, appealing relative valuations along with a durable synchronized global growth rebound argue for increasing conviction in our overweight position in this transportation sub-group. Bottom Line: Stay overweight the S&P air freight & logistics group (UPS, FDX, CHRW, EXPD), and bump it to the high-conviction overweight list. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights For the time being, our cyclical stance is to underweight the globally-sensitive Energy, Materials and Banks sectors versus Healthcare - in both the equity and credit asset-class. Combined with our expectation of a weakening pound/euro, this necessarily means the following European equity market allocation: Overweight: France, Ireland, U.K., Switzerland and Denmark. Neutral: Germany, Netherlands and Sweden. Underweight: Italy, Spain, and Norway. We anticipate shifting to a more cyclical sector (and country) allocation by the late summer, especially on dips. Feature It is worth reminding readers that picking mainstream equity markets1 is overwhelmingly about the industry sectors and dominant stocks that you are buying, wittingly or unwittingly. Picking equity markets is seldom about the prospects of the underlying domestic economies or head-to-head valuations.2 Chart of the WeekGlobal Energy Has Just Tracked The Global 6-Month Credit Impulse (Down) Global Energy Has Just Tracked The Global 6-Month Credit Impulse (Down) Global Energy Has Just Tracked The Global 6-Month Credit Impulse (Down) The usual top-down approach to picking stock markets ignores two dominant features of these markets. First, they have huge variations in their sector exposures. Second, large industry sector groups like Energy, Banks, Healthcare and Technology tend to move en masse under the influence of global or regional rather than domestic drivers. The combination of these two features means that for most stock markets, the sector (and dominant company) impact swamps the effect that comes from the domestic economy. Right now, by far the most important consideration for country pickers is the relative outlook for the globally-sensitive Energy and Banks sectors versus the more defensive Healthcare. As an example, consider the choice between Spain and Switzerland. Spain's IBEX is at the mercy of its huge weighting to Banks, dominated by Santander and BBVA; while Switzerland's SMI is at the mercy of its similarly dominant weighting in the Healthcare sector, via Novartis and Roche. Box I-1 - Sector Skews That Drive Country Relative Performance For major equity indexes in the euro area, the dominant sector skews that drive relative performance are as follows: Germany (DAX) is overweight Chemicals, underweight Banks (Chart 2). France (CAC) is underweight Banks and Basic Materials (Chart 3). Italy (MIB) is overweight Banks (Chart 4). Spain (IBEX) is overweight Banks (Chart 5). Netherlands (AEX) is overweight Technology, underweight Banks (Chart 6). Ireland (ISEQ) is overweight Airlines (Ryanair) which is, in effect, underweight Energy (Chart 7). And for major equity indexes outside the euro area: The U.K. (FTSE100) is effectively underweight the pound (Chart 8). Switzerland (SMI) is overweight Healthcare, underweight Energy (Chart 9). Sweden (OMX) is overweight Industrials (Chart 10). Denmark (OMX20) is overweight Healthcare and Industrials (Chart 11). Norway (OBX) is overweight Energy (Chart 12). The U.S. (S&P500) is overweight Technology, underweight Banks (Chart 13). It follows that if Banks underperform Healthcare, it is highly likely that Spain's IBEX will underperform Switzerland's SMI, irrespective of the performances of the Spanish and Swiss domestic economies. For long-term investors, the large skews in sector exposure also mean that a head-to-head comparison of country valuations can be very misleading. At first glance, Spain, trading on a forward price to earnings (PE) multiple of 15.5, appears 15% cheaper than Switzerland, trading on a multiple of over 18. But this head-to-head difference just reflects the impact of forward PEs of Banks at 11 and Healthcare at 18. The Bank sector's lower multiple does not necessarily make it better value than Healthcare. Unlike two developed economies - whose long-term growth prospects tend to be broadly similar - two industry sectors could end up experiencing very different structural growth outcomes. Which would justify very different multiples. Despite its low multiple, a structural underweight to Banks might nonetheless be a good strategy if the sector's structural growth outlook is poor. In such a case, the low multiple is potentially a value trap. Picking Stock Markets The Right Way To reiterate, the decision to overweight or underweight a mainstream equity index should not be based on your view of the country's underlying economy - unless, of course, the country is the potential source of a major tail-risk event. Instead, the decision should be based on your over-arching sector view, combined with the country's skews to specific dominant stocks and sectors (Box I-1). Chart I-2, Chart I-3, Chart I-4, Chart I-5, Chart I-6, Chart I-7, Chart I-8, Chart I-9, Chart I-10, Chart I-11, Chart I-12 and Chart I-13 should leave readers in absolutely no doubt. A market's dominant sector skew is by far the most important determinant of its relative performance. Chart I-2Germany (DAX) Is Overweight Chemicals,##br## Underweight Banks Germany (DAX) Is Overweight Chemicals, Underweight Banks Germany (DAX) Is Overweight Chemicals, Underweight Banks Chart I-3France (CAC) Is Underweight Banks##br## And Basic Materials France (CAC) Is Underweight Banks And Basic Materials France (CAC) Is Underweight Banks And Basic Materials Chart I-4Italy (MIB) Is Overweight Banks Italy (MIB) Is Overweight Banks Italy (MIB) Is Overweight Banks Chart I-5Spain (IBEX) Is Overweight Banks Spain (IBEX) Is Overweight Banks Spain (IBEX) Is Overweight Banks Chart I-6Netherlands (AEX) Is Overweight Technology,##br## Underweight Banks Netherlands (AEX) Is Overweight Technology, Underweight Banks Netherlands (AEX) Is Overweight Technology, Underweight Banks Chart I-7Ireland (ISEQ) Is Overweight Airlines (Ryanair) ##br##Which Is, In Effect, Underweight Energy Ireland (ISEQ) Is Overweight Airlines (Ryanair) Which Is, In Effect, Underweight Energy Ireland (ISEQ) Is Overweight Airlines (Ryanair) Which Is, In Effect, Underweight Energy Chart I-8The U.K. (FTSE100) Is Effectively ##br##Underweight The Pound The U.K. (FTSE100) Is Effectively Underweight The Pound The U.K. (FTSE100) Is Effectively Underweight The Pound Chart I-9Switzerland (SMI) Is Overweight Healthcare, ##br##Underweight Energy Switzerland (SMI) Is Overweight Healthcare, Underweight Energy Switzerland (SMI) Is Overweight Healthcare, Underweight Energy Chart I-10Sweden (OMX) Is ##br##Overweight Industrials Sweden (OMX) Is Overweight Industrials Sweden (OMX) Is Overweight Industrials Chart I-11Denmark (OMX20) Is Overweight ##br##Healthcare And Industrials Denmark (OMX20) Is Overweight Healthcare And Industrials Denmark (OMX20) Is Overweight Healthcare And Industrials Chart I-12Norway (OBX) Is ##br##Overweight Energy Norway (OBX) Is Overweight Energy Norway (OBX) Is Overweight Energy Chart I-13The U.S. (S&P500) Is Overweight Technology, ##br##Underweight Banks The U.S. (S&P500) Is Overweight Technology, Underweight Banks The U.S. (S&P500) Is Overweight Technology, Underweight Banks Which brings us to the key consideration for country allocation right now: how to allocate to the sectors that feature most often in the skews: Energy and Banks versus Healthcare. For Energy relative performance, note the very strong recent connection with the global 6-month credit impulse. The downswing in the impulse - heralding a very clear growth pause - lines up with the setback in energy and resource prices and the underperformance of these globally-sensitive equity sectors (Chart of the Week and Chart I-14). Meanwhile, in the most recent mini-cycle, Banks' relative performance is tracking the bond yield almost tick for tick (Chart I-15). There are two reasons. For banks, lower bond yields presage both slimmer net interest margins and weaker economic growth. Chart I-14Commodity Price Inflation Is Just Tracking ##br##The Global 6-Month Credit Impulse Commodity Price Inflation Is Just Tracking The Global 6-Month Credit Impulse Commodity Price Inflation Is Just Tracking The Global 6-Month Credit Impulse Chart I-15Financials Are Just Tracking ##br##The Bond Yield Financials Are Just Tracking The Bond Yield Financials Are Just Tracking The Bond Yield So for both Energy and Banks relative performance the overriding question is: when will this mini-downswing end? To answer this question, we note that we are 4-5 months into the global mini-downswing, whose average duration tends to be around 8-9 months. On this basis, now is a little too early to switch to an aggressively pro-cyclical sector allocation. But we would look for potential opportunities by the late summer, especially on sharp dips. Hence, for the time being our cyclical stance is to underweight the globally-sensitive Energy (and Materials) and Banks versus Healthcare. Combined with our expectation of a weakening pound/euro, this necessarily means the following European country allocation: Overweight: France,3 Ireland, U.K., Switzerland and Denmark. Neutral: Germany, Netherlands, and Sweden. Underweight: Italy, Spain, Netherlands and Norway. Clearly, if you have a different cyclical and over-arching sector view, you will arrive at a different country allocation. That's fine. The important point is that the stock and sector skew approach is the right way to pick between mainstream equity indexes. Financials Drive The European Credit Market Finally, an over-arching sector view is also highly relevant for the European corporate credit market. In the euro area, the credit market is heavily skewed towards bank and other financial sector bonds, which account for almost half of euro area corporate bonds by value. By comparison, the U.S. credit market is not so skewed to one dominant sector. Hence, the outlook for the European credit asset-class hinges on the prospects for one sector: Financials (Chart 16). With the European high yield credit spread already close to a 20-year low, we would again wait for a better opportunity before adding aggressively to the European credit asset-class. Chart I-16Mirror Image: European High Yield Credit Spread And Bank Equity Prices Mirror Image: European High Yield Credit Spread And Bank Equity Prices Mirror Image: European High Yield Credit Spread And Bank Equity Prices Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 In the developed world. 2 Please also see the three European Investment Strategy Special Reports 'Picking 5 European Countries The Right Way' November 13, 2014, 'Picking Countries The Right Way: Part 2' March 26, 2015 and 'Picking Countries The Right Way: Part 3' November 12, 2015. 3 But expect a small near-term countertrend underperformance in the CAC40. See page 11. Fractal Trading Model* There are no new trades this week. Last week's trade, long nickel / short palladium has made an encouraging countertrend move at the classic limit of a trend. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-17 Long Nickel / Short Palladium Long Nickel / Short Palladium The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Odds the leaders of the OPEC 2.0 petro-states will be forced to back up last month's "whatever it takes" declaration - perhaps deepening and extending the 1.8mm b/d production cuts agreed at the end of last year - are not yet overwhelming. All the same, they will continue to increase, if markets do not see sustained draws in visible storage. Our updated supply-demand balances indicate global crude inventories will continue to draw, and that these draws will accelerate. This will keep global storage levels on track to normalize later this year or in 1Q18. We continue to expect Brent to trade to $60/bbl by December, with WTI ~ $2/bbl under that. Energy: Overweight. Our low-risk call spread initiated last week - long Dec/17 $50/bbl WTI calls vs. short $55/bbl WTI calls - is down 18.9%, following continued selling. We are adding to the position with the same Dec/17 strikes in Brent at tonight's close. These are strategic positions. Base Metals: Neutral. SHFE copper inventories fell on the back of increased demand for collateral to support financing deals in China. Tightening credit conditions are beginning to bite as the government pushes deleveraging policies, according to Metal Bulletin. Precious Metals: Neutral. We remain long gold, despite the hawkish rhetoric being thrown around by Fed officials, particularly William Dudley, head of the NY Fed. Our long gold portfolio hedge is up 1.1% since it was put on May 4, 2017. Ags/Softs: Underweight. Chicago and KC winter wheat remain bid, as concerns over drought-induced damage to the crop continue to weigh on markets. Feature Chart of the WeekUpdated Balances Leave Us Bullish Crude Updated Balances Leave Us Bullish Crude Updated Balances Leave Us Bullish Crude Insomuch as such things can ever be "official," crude oil officially entered a bear market - down 20% or more from recent highs - with the unexpected arrival of WTI futures below the lower end of our long-time $45-to-$65/bbl trading range this week.1 The proximate causes of this turn of events are persistently sticky inventory levels - most visible in the high-frequency data from the U.S. - and growing fears increasing Libyan and U.S. shale-oil production will undermine OPEC 2.0's 1.8mm b/d production cuts. We are hard-pressed to see the case for such fears, even though the market is consistently trading in a manner that is more aligned with supply cuts being far less than advertised by OPEC 2.0, or demand slowing considerably more than any agency or data service has yet picked up on. We will never be able to confirm sovereign hedging - e.g., Mexico or Iraq hedging oil-production revenues - until after the fact. However, this cannot be dismissed out of hand. Based on our latest supply-demand analysis, OPEC 2.0 - the coalition lead by the Kingdom of Saudi Arabia (KSA) and Russia - will have removed some 1.4mm b/d of production on average from the market between January 2017 and end-March 2018 vs. peak production in November of last year (Chart of the Week). This will be diluted somewhat by the Libyan and U.S. production gains, but this increased production will not be sufficient to counter the OPEC 2.0 cuts entirely. Global Oil Supply Contracting Sharply Chart 2OECD Storage Draws On Track OECD Storage Draws On Track OECD Storage Draws On Track Against peak production in November 2016, we see just over 1.2mm b/d of crude oil production being cut by OPEC between January and end-March-2018.2 Throw in another 200 - 300k b/d or so from the non-OPEC members of the OPEC 2.0 coalition - mostly Russia - and we get to 1.4 to 1.5mm b/d of production taken off the market in the Jan/17 - Mar/18, interval in our modeling. This will leave the highly visible OECD storage levels being targeted by OPEC 2.0 at ~ 2.70 billion barrels by the end of the year, or some time close to the start of next year (Chart 2). In our modeling, we do not agree with the implied 1.9mm b/d of production cuts that follow from the reported OPEC 2.0 compliance statistics in the press. These reports indicate OPEC 2.0 coalition members are at 106% compliance. This is remarkably high, even if reports of this compliance rely on anonymous sources speaking to reporters following the coalition's technical committee meeting in Vienna earlier this week.3 If the production discipline attested to is true, we will raise our estimate of how quickly inventories will draw this year, and lower our expected global inventory levels for the end of March 2018. As for U.S. crude production, while we do have Dec/17 production 1.1mm b/d over Dec/16, we expect America's contribution to yoy global production growth to be only ~ 340k b/d on average over the course of 2017. The U.S. gains will be driven by shale-oil production, which we expect to grow ~ 410k b/d to 5.2mm b/d this year (Chart 3). Libya's production recently surged to 900k b/d, according to press reports, but, so far this year, it is averaging just under 700k b/d (Chart 4). This is slightly higher than the level we've been modeling in our balances for this year. The 300k b/d yoy increase in Libya's production is impressive, but it does not overwhelm OPEC 2.0's cuts. Even if Libyan production were to average 1mm b/d in 2H17, its net contribution to global production this year would be ~ 840k b/d, an increase of ~ 400k b/d over 2016's levels. We also note that as production and revenue increase the likelihood of renewed violence in Libya also increases.4 Chart 3U.S. Shale-Oil##BR##Growth Could Slow U.S. Shale-Oil Growth Could Slow U.S. Shale-Oil Growth Could Slow Chart 4Libya's Recover Is Impressive,##BR##But It Won't Reverse OPEC 2.0's Cuts Libya's Recover Is Impressive, But It Won't Reverse OPEC 2.0's Cuts Libya's Recover Is Impressive, But It Won't Reverse OPEC 2.0's Cuts Between them, combined growth in U.S. and Libyan production looks like it will be a touch under 650k b/d yoy (on average). Meanwhile, OPEC 2.0's production cuts - assessed against peak output for 2016 - are on track to exceed targets set at the outset of the agreement last December. Net, on a yoy basis, we expect to register inventory draws of close to 900k b/d this year. This should lead to cumulative draws in global storage levels of at least 400mm bbls by end-March. Demand Remains Strong The EIA revised its liquids demand estimates in its most recent Short-term Energy Outlook (STEO), and now has 2015 global consumption up 300k b/d from previous estimates at 95.4mm b/d, and 2016 consumption up 180k b/d at 96.9mm b/d. Our expected growth in global demand for this year and next is in line with the EIA's average estimate of ~ 1.6mm b/d, which will put 2017 demand at 98.5mm b/d and 2018 at 100.1mm b/d, respectively. Growth this year and next is expected to be slightly higher than last year's level (Chart 5). Once again, we expect EM demand - proxied by non-OECD liquids consumption - to lead global growth this year and next. Concern over apparent slowing in U.S. refined-product demand - particularly gasoline - is, we believe, overdone. Growth this year is being compared to stellar rates last year (Chart 6), which still leaves the level of demand above 20mm b/d. Growth in gasoline demand specifically also has slowed, but, again, this is occurring in a market where the level of demand remains high, pushing toward 10mm b/d, which is a mere 2.5% below record demand set in August of last year (Chart 7). Chart 5Expect Global Demand##BR##To Remain Stout Expect Global Demand to Remain Stout Expect Global Demand to Remain Stout Chart 6The Level Of U.S. Product##BR##Demand Remains High The Level Of U.S. Product Demand Remains High The Level Of U.S. Product Demand Remains High Chart 7U.S. Gasoline Demand##BR##Also Remains Stout U.S. Gasoline Demand Also Remains Stout U.S. Gasoline Demand Also Remains Stout 2018 Getting Foggy Uncertainty surrounding the evolution of the oil market next year is growing. The EIA believes markets will tighten in 3Q17, but then get progressively looser going into 2018, apparently disregarding OPEC 2.0's efforts to date, and the high likelihood - in our view - that the coalition will maintain production discipline for the most part (Chart 8). Combined with the robust demand growth BCA and the EIA expect, we get a fairly balanced market next year (Chart of the Week). U.S. shale-oil production, once again, will dictate just how tight markets become next year. Presently, we have average 2018 U.S. shale production in the Big 4 basins - Bakken, Eagle Ford, Niobrara, and the Permian - coming in more than 1mm b/d over 2017 levels. However, the recent sell-off that took WTI into bear-market territory this week could have a profound effect on shale-drilling activity next year, if it persists. Recent econometric work we've done confirms rig counts in the Big 4 plays are highly sensitive to WTI price. A prolonged stretch below $45/bbl could reduce rig counts by as much as 40% next year, especially if private-equity-backed companies cut spending. With hedging levels down, this is not a trivial concern (Chart 9).5 If prices stay depressed for any length of time for whatever reason - an outcome we do not expect - U.S. shale drilling activity could once again plummet. Chart 8EIA Fades OPEC 2.0's Resolve,##BR##BCA Does Not EIA Fades OPEC 2.0's Resolve, BCA Does Not EIA Fades OPEC 2.0's Resolve, BCA Does Not Chart 9Weak Prices Could##BR##Reduce Shale Rig Counts Weak Prices Could Reduce Shale Rig Counts Weak Prices Could Reduce Shale Rig Counts In addition, low prices also increase fiscal stress levels in petro-state revenues. This is of particular concern for KSA and Russia. The former is almost wholly dependent on oil revenues to fund its budgets, and will be looking to IPO its state-owned oil company, Aramco, next year. The latter is heavily dependent on oil and gas revenues, and will be holding an election in mid-March, just ahead of the expiry of the OPEC 2.0 production-cut extensions. The benchmark Russian crude, Urals, trades ~ $1.00 to $1.25/bbl under Brent, and any prolonged excursion into the low-$40s by Brent would stress the state's revenues. This is not our base case, but it is worthwhile considering. This mutual dependence on oil prices to support their respective economies is what compels strong compliance with the OPEC 2.0 production deal. Bottom Line: Our updated balances modeling continues to support our view global oil storage will draw, with OECD inventories likely falling below five-year average levels by year-end or early next year. Self-reported compliance with OPEC 2.0's production-cutting agreement exceeds 100%, implying the coalition is tracking to a 1.9mm b/d reduction in crude-oil output at present. On the demand side, even after upward revisions to 2015 and 2016 demand figures by the U.S. EIA, liquids consumption still is expected to grow on average ~ 1.6mm b/d this year and next. Cuts in production by OPEC 2.0 this year are more than sufficient to offset increases in Libyan and U.S. production, leaving overall production below consumption globally by close to 900k b/d, which will ensure inventories draw. For next year, after storage draws have abated, we expect supply and demand to be roughly balanced. We continue to expect Brent prices to trade to $60/bbl by year-end, and, on that basis, are recommending a long Dec/17 $50/bbl Brent call vs. short a Dec/17 $55/bbl Brent call. Longer term, our central tendency for price remains $55/bbl, with a range of $45 to $65/bbl prevailing most of the time. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 We are using the front-line WTI futures contract, which hit its recent high on Feb. 23 at $54.45/bbl (last price) and traded down to $43.23/bbl on June 20, registering a drop of 20.6%. First-line Brent has yet to fall more than 20% from its recent high of $57.10/bbl on Jan. 6 to $46.02/bbl on June 20 (a 19.4% drop). 2 Measuring against peak production - rather than the October levels referenced by OPEC 2.0 coalition members - is an inherently more conservative way of assessing the effect of the production cuts. 3 Please see "OPEC, non-OPEC compliance with oil cuts hits highest in May: source," published by reuters.com on June 21, 2017. 4 An uptick in Nigerian production also is cited by some observers as a cause for concern vis-à-vis slowing the normalization of global storage levels. However, as Chart 4 illustrates, that country's production remains on either side of 1.5mm b/d, more than 500k b/d below recent steady-state levels. 5 Looking at rig-count sensitivity to prices and rig productivity, we find a 1% increase (decrease) in nearby prices translates into a roughly 70bp increase (decrease) in rig counts, while a 1% increase (decrease) in lagged, deferred WTI futures prices (out to 3 years forward) translates into a 2% change in the same direction. The R2 coefficients of determination for the models we estimated average ~ 0.95. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016 Time For "Whatever It Takes" In Oil? Time For "Whatever It Takes" In Oil?

Highlights The sharp downturn in oil prices triggered last week by an unexpected jump in weekly U.S. oil inventories, along with word Mexico's finance ministry had begun soliciting offers for its 2018 oil-revenue hedge, will be reversed by strong fundamentals in the next few weeks. On the data side, we believe markets simply over-reacted to high-frequency U.S. statistics. Taking a slightly broader view of the data suggests the trend in U.S. oil markets is continued tightening, as the northern hemisphere enters the summer driving season. Globally, we expect the OPEC 2.0 production-cut extension and continued strong EM demand to lead to a normalization of global storage levels by end-2017. We continue to expect Brent to trade to $60/bbl in 4Q17, with WTI trailing by ~ $2/bbl. Energy: Overweight. We were stopped out of our long Dec/17 vs. short Dec/18 WTI and Brent spreads by last week's sell-off. We continue to favor long front-to-back exposure, but will wait to re-establish these positions. We will, however, take a lower-risk position consistent with our view and get long Dec/17 $50/bbl WTI calls vs. short $55/bbl WTI calls at tonight's close. Base Metals: Neutral. Copper's brief rally stalled, taking front-month COMEX prices below $2.60/lb this week. The IMF's upgrade of China's growth prospects likely will support copper prices. Precious Metals: Neutral. Spot gold's chart has formed a bullish inverted head-and-shoulders pattern, which could take prices into a gap that opened in the continuation chart at $1,292/oz in the aftermath of November 2016's price plunge. We remain long spot gold. Ags/Softs: Underweight. The USDA's WASDE report did little to temper expectations for another record harvest - or something close enough to it. Even so, given recent U.S. Midwest weather, we would close any shorts. Feature This past week in the oil markets amply demonstrates that the old adage "One week does not a trend make" is more honored in the breach than in the observance. Events we view as transitory - the unexpected 3.3mm bbl jump in weekly U.S. crude-oil inventories, along with news Mexico's finance ministry began lining up offers on crude-oil put options for its 2018 revenue hedge - conspired to shave close to 6% from Brent prices in less than a week. From just over $51/bbl at the beginning of the month, when the Mexican finance ministry reportedly began soliciting offers on crude-oil put options, to the end of last week, Brent prices had fallen ~ $3/bbl. Front-month Brent continued to languish around that level as we went to press.1 Stronger fundamental data, particularly from the U.S., where last week's inventory shock hammered prices, will reverse these transitory effects going into 2H17. Chart of the WeekU.S. Refinery Runs At Record Levels U.S. Refinery Runs At Record Levels U.S. Refinery Runs At Record Levels U.S. Fundamental Strength Will Reverse Weak Crude Prices Third-quarter refining - typically a high-activity period in the U.S. - is opening on a very strong note: U.S. refining runs are at record highs, with net crude inputs posting a four-week average 17.3mm b/d run rate at June 2, 2017 (Chart of the Week). U.S. demand is reviving and now is back over 20mm b/d (Chart 2). We expect low product prices, particularly for gasoline, to boost demand going into the summer driving season. In addition, surging refined-product exports, particularly into Latin American markets, will keep U.S. refiners' appetite for crude high, allowing storage levels to drain (Chart 3). Note the end-2016/early-2017 surge and the ongoing strength in product exports year to date - exports are seasonally strong, even if they dipped a bit. The resumption in export growth after a short-lived downturn will continue to pull total crude and product net imports down in the U.S. (Chart 4). Chart 2U.S. Product Demand Back##BR##Over 20mm b/d U.S. Product Demand Back Over 20mm b/d U.S. Product Demand Back Over 20mm b/d Chart 3U.S. Product Exports##BR##Are Surging U.S. Product Exports Are Surging U.S. Product Exports Are Surging Chart 4U.S. Crude And Product Export Growth##BR##Continues To Lower Net Import Levels U.S. Crude And Product Export Growth Continues To Lower Net Import Levels U.S. Crude And Product Export Growth Continues To Lower Net Import Levels On the supply side, U.S. crude-oil production is up sharply after bottoming yoy with a decline of ~ 850k b/d last September, and stood at ~9.20mm b/d at the beginning of June, based on monthly production data from the EIA (Chart 5). This is up 330k b/d yoy. Much of this is being consumed domestically, but export volumes continue to increase, after hitting a recent high of close to 1mm b/d on a four-week-moving-average basis in March (Chart 6). Given the reception U.S. light crude is receiving in Asian markets, we expect continued growth, which will support the build-out of export-related facilities along the Gulf. Chart 5U.S. Crude Production Is Recovering Smartly ... U.S. Crude Production Is Recovering Smartly ... U.S. Crude Production Is Recovering Smartly ... Chart 6... And U.S. Crude Exports Are Surging ... And U.S. Crude Exports Are Surging ... And U.S. Crude Exports Are Surging Strong product demand and exports will allow crude inventories to continue to draw in the U.S. (Chart 7), particularly in the critically important Cushing storage market, where the NYMEX WTI futures contract delivers (Chart 8). Note that using 4-week-moving-average data shows yoy crude and product storage levels down an average 2.4mm bbl/week over the past eight weeks even with the unexpected surge in stocks reported last week. Cushing storage has become increasingly integrated with U.S. Gulf storage, which supports the strong refining activity there. Chart 7Strong Demand And Exports Allow##BR##U.S. Crude And Product Stocks To Draw Strong Demand And Exports Allow U.S. Crude And Product Stocks To Draw Strong Demand And Exports Allow U.S. Crude And Product Stocks To Draw Chart 8Cushing Crude Storage##BR##Continues To Draw Cushing Crude Storage Continues To Draw Cushing Crude Storage Continues To Draw Mexico's Revenue Hedge Is A Transitory Event Earlier this month, Mexico's Ministry of Finance reportedly began soliciting market-makers for offers on put options, signalling its annual revenue hedge will be forthcoming in the not-too-distant future. Reportedly, the finance ministry began lining up offer indications at the beginning of June, and by the end of last week the news was on the wire services.2 By purchasing puts, the finance ministry secures the right - but not the obligation - to sell oil at the strike price of the options. This puts a floor on the revenue realized by the ministry, since, if oil prices move higher next year, they will be able to sell into the market at the higher market-clearing price. However, if prices go below the strike price of the options, the market-makers - typically banks and, last year, for the first time, the trading arm of a major oil company - have to pay the difference between the puts' strike price and the market price. These hedges paid out $6.4 billion in 2015 and $2.7 billion last year, according to Bloomberg. The Mexican finance ministry's program, which can hedge up to 300mm bbl worth of production revenue, will keep markets leery for a couple of weeks. This is because the market-makers writing the puts for Mexico's ministry of finance will soak up available liquidity by hitting bids across the WTI, Brent, and refined products futures and swaps forward curves. The market-makers typically try to trade out of the exposure they've taken on by providing the hedge to the ministry, because, at the end of the day, they do not want to be made long oil if the options go into the money. This is what would happen if oil prices were to fall below the strike price of the puts purchased by the ministry, when the options approach their monthly expiry dates and their value is determined. To hedge themselves against this potential risk, the market-makers will sell volumes into the futures and swaps markets that are determined by the output of an option-pricing model. The lower prices go, the more they sell forward, and vice versa. More than likely, market-makers will be selling into rallies, so, at least while this hedge is moving through the market, any rally likely to be short-lived, as market-makers hedge themselves. However, once this activity is out of the way and refinery demand for crude kicks into high gear, we expect the physical reality of crude and product draws to take prices higher and backwardate WTI and Brent curves later this year. As an aside, we would expect lower prices will accelerate the draws at the margin, as we approach the peak of the northern hemisphere's summer driving season, as noted above. Strong Demand, Lower Supply Will Draw Stocks And Lift Prices Chart 9OPEC Really Is Cutting ~1.0mm b/d##BR##For More Than 400 Days OPEC Really Is Cutting ~1.0mm b/d For More Than 400 Days OPEC Really Is Cutting ~1.0mm b/d For More Than 400 Days The extension of OPEC 2.0's production cuts to the end of 1Q18 means that - for more than 400 days from January 2017 to March 2018 - OPEC producers with the ability to hold production at relatively high levels, and to even increase it, will have removed more than 1mm b/d from global flows (Chart 9). This will be supplemented by some 300k b/d of cuts from Russia and sundry non-OPEC producers.3 On the demand side, we continue to expect robust growth, given the behavior of EM global trade volumes and non-OECD oil demand strength, led by continued growth in China and India (Chart 10).4 We will be updating our balances next week, but we see no reason to lower our expectation that global demand will grow by more than 1.5mm b/d this year, especially following the IMF's upgrade of China's expected GDP growth this year to 6.7% from 6.6% on the back of "policy support, especially expansionary credit and public investment."5 This is the third upward revision to China's GDP growth made by the Fund this year. We continue to expect lower supply and robust demand this year and into early 2018 to draw visible inventories down to more normal levels (Chart 11), lift prices and backwardate the Brent and WTI forward curves. Given our analysis, we expect Brent to trade to $60/bbl later this year, with WTI trailing it by ~ $2/bbl. Chart 10 Chart 11... And Inventories Will Normalize ... And Inventories Will Normalize ... And Inventories Will Normalize Bottom Line: Markets appear to have extrapolated the weekly data into a trend that would reverse - or at least materially slow - the normalization of inventories, despite the extension of OPEC 2.0's 1.8mm b/d production cuts to the end of 1Q18, and continued strength in EM oil demand, which is driven by continued strength in China's and India's economies. Net, we believe Mexico's revenue hedge and the one-week surge in U.S. inventories are transitory events, which will be reversed in the weeks ahead. Despite being stopped out of our long Dec/17 vs. short Dec/18 Brent and WTI recommendations following last week's sell-off we still are inclined to keep this exposure. However, we will wait for the market to process Mexico's revenue hedge and to work through the IEA's subdued 2017 demand forecast before re-establishing these positions. In the meantime, we will take a lower-risk position consistent with our view and get long Dec/17 $50/bbl WTI calls vs. short $55/bbl WTI calls at tonight's close. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see "Mexico Said to Take First Steps in Annual Oil Hedging Program," published by bloomberg.com on June 9, 2017. 2 Please see footnote 1. 3 Please see the BCA Research's Commodity & Energy Strategy Weekly Report "Extending OPEC 2.0's Production Cuts Will Normalize Global Oil Inventories", published June 1, 2017, for an in-depth analysis of OPEC 2.0's production cuts. It is available at ces.bcaresearch.com. 4 Please see the BCA Research's Commodity & Energy Strategy Weekly Report "Strong EM Trade Volumes Will Support Oil," published June 8, 2017. It is available at ces.bcaresearch.com. 5 Please see "IMF Staff Completes 2017 Article IV Mission to China," published June 14, 2017, on the IMF's website imf.org. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016 U.S. Oil Inventories Will Resume Drawing U.S. Oil Inventories Will Resume Drawing U.S. Oil Inventories Will Resume Drawing U.S. Oil Inventories Will Resume Drawing