Equities

Highlights ECB policy is set to become less dovish relative to other central banks. Stay long the euro; stay underweight German bunds within a global bond portfolio; and overweight euro area Financials within a global Financials portfolio. Female labour participation is surging. The state of the euro area labour market is not nearly as bad as many pessimists would have you believe. Play the mega-trend of rising female labour participation with a structural overweight in the Personal Products sector. Allowing for euro break-up risk, European equities are fairly valued - rather than cheap - versus U.S. equities. Prefer to gain exposure via a 50:50 combination of Germany (DAX) and Sweden (OMX). Feature "Domestic sources of risk to euro area growth have diminished while global, geo-global sources of risk have increased." - Mario Draghi The Cleanest Dirty Shirt Since the end of 2014, an unspectacular 1.9% growth rate1 has been enough to make the euro area the world's top-performing major economy - bettering the U.S., U.K. and Japan (Chart I-2). Chart of the WeekThe Percentage Of The French Population In Employment Is At An All-Time High Chart I-2The Euro Area Is The Top-Performing Economy The euro area economy has achieved this outperformance with exceptionally low volatility. For eight consecutive quarters, growth2 has remained within a very tight 1.2-2.2% band, less than half of the equivalent volatility in the U.S., U.K. and Japan. And growth is now "solid and broad", meaning that it includes all countries. The ECB's dispersion index of value-added growth in different countries stands at a historical minimum. We expect the euro area to remain the cleanest dirty shirt. As Draghi points out, the ECB is less worried about domestic risks and more worried about global risks. Specifically: "Markets are in the course of reassessment of U.S. fiscal policy" - Trumponomics will not be nearly as stimulative as first thought. "How the U.K. economy does post-Brexit has a channel of economic consequences for the euro area." "Possible negative surprises in some emerging market economies" - notably China. If any of the global risks do flare up, the ECB will sit pat, but other central banks will have to become more dovish relative to current expectations. If the risks do not flare up, the ECB will start to reduce its own extreme dovishness - at least with words, if not actions. Either way, ECB policy is set to become less dovish relative to other central banks. And the investment implications are: stay long the euro; stay underweight German bunds within a global bond portfolio; and overweight euro area Financials within a global Financials portfolio. Female Labour Participation Is Surging Chart I-3Rising Participation Boosts Employment As Emanuel Macron prepares to become the twenty fifth President of the French Republic, he can take heart from a statistic which may surprise you: The percentage of the French population in employment has never been this high. (Chart of the Week). How can this be when the French unemployment rate is still hovering around 10%? The answer is: as millions of formerly inactive French citizens have entered the labour market, it has lifted the percentage of the population with jobs to an all-time high (Chart I-3). But the flip side of rising participation is that it has kept the unemployment rate elevated - because some citizens who were formerly 'uncounted inactive' are now 'counted unemployed'. Remember that to count as unemployed, a person has to be in the labour market available for work. Some argue that French citizens have simply flooded into the labour market to claim generous and long-lasting unemployment benefits. This argument might hold during downturns, but it cannot explain the 25-year uptrend which also includes economic booms. Unpalatable as it might be to the pessimists, we are left with a more optimistic explanation. France has raised activity levels in the working age population with policies that encourage much greater female participation in the labour market. The important lesson is that when labour participation is rising or falling, we must interpret the headline unemployment rate with extreme care.3 If a country's unemployment rate is high because labour participation has increased - as in France - the labour market is not quite as bad as the high unemployment rate might suggest.4 Conversely, if a country's unemployment rate is low because labour participation has decreased - as in the U.S. (Chart I-4) - the labour market is not quite as good as the low unemployment rate might suggest. Counted unemployment has just been replaced with uncounted inactivity. We propose that the percentage of the working age population in employment is the truer measure of labour utilisation. With surging female participation boosting employment in France and most other European countries (Chart I-5), the state of the euro area labour market is not nearly as bad as many pessimists would have you believe. Chart I-4Participation Down In The U.S.,##br## But Up In Europe... Chart I-5...Led By ##br##Women Play the mega-trend of rising female labour participation with a structural overweight in the Personal Products sector. Political Risk Is Correctly Priced Many people saw the Brexit and Trump victories as the leading edge of a wave of economic nationalism. However, subsequent election results in the Netherlands, Austria, Finland, Bulgaria and now France have seen economic nationalists consistently underperforming their expectations. In hindsight, the Brexit and Trump victories were idiosyncratic. Both the Remain and Clinton campaigns were lacking in personality or a strong emotional message, and this proved to be their undoing. Nowadays, many voters care about personalities more than policies; emotional appeal matters more than rational appeal. Behavioural psychologist and Nobel Laureate Daniel Kahneman calls the emotional way of thinking "System 1", and the colder rational way of thinking "System 2". Crucially, in a tight contest, both the Brexit and Trump campaigns resonated with the emotional System 1 with passionate pleas such as "Take Back Control" and "Make America Great Again". By contrast, the Remain and Clinton campaigns tried to appeal mainly to the rational System 2. But as Kahneman explains, when rational System 2 competes with emotional System 1, emotional System 1 almost always wins. Chart I-6Euro Break-Up Probability = 5% A Year In more recent elections, candidates and parties opposing the nationalists - including Emanuel Macron - have used a good balance of System 1 and System 2 arguments, thereby helping to prevent shock outcomes. This is also likely to be case in the two round French legislative elections on June 11 and 18 which we do not expect to impact financial markets significantly. Does this mean that political risk is over in Europe? No. Until the euro area turns into a permanent and irreversible political union, there has to be a probability of euro break-up. To value euro area assets, investors must ask: what is this break-up probability? The sovereign bond market says it is 5% a year (Chart I-6). This shows up in a discount on German bund yields, because after a euro break-up a new deutschmark would rise; and a symmetrical premium on Italian BTP yields, because a new lira would fall. For the aggregate euro area bond, the risk largely cancels out because intra-euro currency redenomination would be zero sum. But European equities must trade at a discount for this tail-event. At the peak of the euro debt crisis in 2011, the Eurostoxx600 underperformed the S&P500 by 25% in one year. In an outright break-up, the underperformance would almost certainly be worse, let's conservatively say 30-40%. So assuming the tail-event probability is 5% a year, European equities must compensate with a valuation discount which allows a 1.5-2.0%5 excess annual return over U.S. equities. Today, the valuation discount on European equities relative to U.S. equities implies an excess annual return of 1.8%.6 This makes European equities cheap versus U.S. equities only if the annual probability of euro break-up is less than 5%. Our assessment is that a 5% annual risk is about right. Therefore, European equities are fairly valued - rather than cheap - versus U.S. equities. But to avoid the undesirable sector skews in the Eurostoxx600, a much better way to gain long-term exposure to European equities is via a 50:50 combination of Germany (DAX) and Sweden (OMX) (Chart I-7). Chart I-7Prefer A DAX/OMX Combo To The Eurostoxx50 Or Eurstoxx600 Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 At an annualized rate. 2 At an annualized rate. 3 Geek's note: the unemployment rate can be expressed as: 100*(participation rate - employment to population rate) / (participation rate). Hence, all else being equal, a rising participation rate will raise the unemployment rate and a falling participation rate will depress the unemployment rate. 4 This lesson applies equally to any studies of labour market slack such as this one: https://www.ecb.europa.eu/pub/pdf/other/ebbox201703_03.en.pdf that do not take into account the dynamics of participation rates. 5 5% multiplied by 30-40% equals 1.5-2.0% 6 Through the next ten years. Please see the European Investment Strategy Weekly Report titled "Markets Suspended In Disbelief" dated April 13, 2017 available at eis.bcaresearch.com Fractal Trading Model The rally in the CAC40 after the French election is technically extended. The recommended technical trade is to short the CAC40 versus the Eurostoxx600. 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-8 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 Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

The financial sector is poised to make a run to new relative performance highs in the coming months. The combination of slumping credit creation, falling inflation expectations, a narrowing yield curve and sluggish economic growth have undermined the sector in 2017, but these drags should steadily recede as the year progresses. Financial conditions have continued to ease, aided by tightening credit spreads, decline in oil prices, U.S. dollar softness and rise in equity prices. Easier monetary conditions should ensure that the recovery in overall corporate sector profits stays on track. In turn, that will sustain both consumer and corporate credit quality at high levels, and pave the way for a more expansionary mindset. Credit demand already appears to be turning the corner, as evidenced by the budding upturn in total bank credit growth. Thus, financial sector profits will benefit from this year's easing in financial conditions, sustaining the positive correlation between relative performance and the Bloomberg Financial Conditions Index. We reiterate our recent upgrade to overweight.

While homebuilders are discounting selling prices in order to move new product, underscoring that high lumber prices represent a drag on profit margins. The opposite is true for home improvement retailers. Industry sales are running at a healthy single-digit clip, well above the rate of overall retail sales growth. Pricing power for furniture and appliances has soared in recent months, reinforcing that demand remains upbeat. Importantly, high lumber prices will boost profit margins, given that retailers typically earn a fixed spread such that a high dollar value sold will boost profitability. Our home improvement relative performance model has surged in recent months, reflecting both increased productivity and rising leading profit indicators. We reiterate our high-conviction overweight position, especially within the context of subdued relative profit and earnings growth expectations. The ticker symbols for the stocks in this index are: BLBG: S5HOMI - HD, LOW.

Homebuilding relative performance is pulling back from the top end of its trading range, and there are low odds that it can exit this lateral pattern for the foreseeable future. The introduction of U.S. tariffs on Canadian lumber imports will keep lumber prices elevated, adding to the cost of building a new home. While homebuilders could attempt to pass through these cost increases, they are already having to offer price concessions to move new product. New home prices are deflating, warning that total sales growth is likely to slip further. Thus, while total home sales activity remains robust and there is still plenty of runway for residential construction to increase as a share of GDP, we are doubtful that this will translate into homebuilding stock outperformance. We recommend taking profits and downgrading to neutral, focusing housing-related investments in the home improvement retail index, as discussed in the next Insight. The ticker symbols for the stocks in this index are: BLBG: S5HOME-PHM, DHI, LEN.

Highlights The Economic Surprise Index has declined and may continue to roll over until expectations wash out. But that shouldn't derail risk assets or the Fed. The GDP data is a mix of art and science. For investors focused on what the quarterly GDP release reveals about the state of the economy, it is important to remember that the advance release involves more of the former. The FOMC called the weakness in Q1 "transitory". The U.S. economy can grow fast enough over the final three quarters of the year to meet the Fed's 2.0% growth target. The recent readings on inflation and the labor market remain consistent with 2 more rate hikes this year, starting in June. We expect the stock-to-bond ratio to hit new highs by the end of the year even without a big move in equity prices. Feature U.S. equities have now returned to their early March highs despite the ongoing weakness in economic surprises. The latest high profile negative surprises were in the Q1 GDP report, and the March reading on core PCE inflation. Have equity prices disconnected from the underlying economic fundamentals or is something else at play? More importantly, how does the Fed view the recent weakness in economic data? The outlook for inflation, the Fed, and growth supports the relative performance of stocks vs bonds, even assuming modest returns to the former. What To Expect After A Weak Q1 The Q1 GDP report was weak. It was the latest in a string of U.S. economic reports stretching back to mid-March that have disappointed relative to (raised) expectations. In February,1 we highlighted the risk that the "current period of economic surprise could last for another month or two..." before inevitably giving way to elevated expectations and finally disappointment. On average since 2010, elevated levels of economic surprise have lasted roughly two months, with the latest period lasted about 11 weeks (Chart 1). So now what? Chart 1Economic Surprise Index Has Rolled Over Since Early to Mid March Each day that passes, economic expectations move lower, adjusting the bar down for the next batch of economic reports. The starting point was set relatively high just after last fall's election and early this year, as investors anticipated quick action from the Trump Administration and Congress on tax cuts, tax reform and infrastructure. More recently however, some of the key data have not only failed to match raised expectations, but have begun to roll over. Since 2010, periods of disappointing economic reports have persisted, on average, for 4 months (Chart 1). We are nearly 2 months in, implying that expectations will be washed out soon. With a solid backdrop for corporate earnings, and ebbing geopolitical risk, any equity pullback based on near-term weakness in the economic data should be short-lived. Q1 real GDP growth came in at just 0.7%, well below expectations of a 1.1% increase. At the start of 2017, consensus estimates were in the 2 to 2.5% range, but we were not surprised by the weak report and markets should not have been either. In our two most recent reports,2 we highlighted the well-known seasonality issues with Q1 GDP. Markets seemed to have - correctly in our view - taken the Q1 GDP report in stride and are looking ahead to Q2 and beyond. We expect a snapback in growth in Q2 and over the rest of 2017. The Atlanta Fed's Q2 estimate (+4.2%) supports our view but the NY Fed's latest nowcast for Q2 (+1.8) suggests a more modest rebound. In addition to the potential for higher growth later in the year, there is also the chance that Q1 growth was misstated. Investors can track revisions to Q1 GDP via the Atlanta and NY Fed's Nowcasts, and should bear in mind that the GDP data is a mix of art and science. For investors focused on what the quarterly GDP release reveals about the state of the economy, it is important to remember that the advance release involves more of the former. The Bureau of Economic Analysis' (BEA) GDP data are subject to near constant revision. For example, the Q1 2007 GDP data (released in April 2007) has already been revised 10 times (Table 1). Availability to the BEA of input data that is both timely and comprehensive is at the root of this constant revision. Investors need to take this into account as they try to assess the health of the U.S. economy in "real time". In the past 8 years, Q1 GDP has been revised lower half the time between the advance estimate (1/3 of the hard data) and the second estimate (50% of the data). But as currently reported, Q1 GDP in 5 of the last 8 years is now higher than it was when first reported and in some cases these revisions have been significant in magnitude (Table 1). Which reading should investors trust? A look at the composition of those estimates may help. Table 1GDP Is A Mix Of Art And Science When the BEA released Q1 GDP in late April it had collected just over a third of the "hard" data that feeds into GDP (Chart 2). The rest of the data used to calculate Q1 GDP was filled in by the BEA using assumptions, or "judgmental trend," or by using data from a similar data series. By the time the second estimate is released in late May, the BEA will have just 50% of the "hard" data. Thus, a healthy dose of skepticism is warranted when evaluating the U.S. economy on the initial reports of GDP. Chart 2Advance Estimate Of GDP##br## Is More Art Than Science For now, U.S. equities have not been affected by the weak Q1 GDP data or the recent collapse in positive economic surprises. Our work shows that the disappointing economic data may persist for another few months. Stocks are within a few points of their all-time high set in March; which suggests that markets are less focused on the noise in the economic data, but remain intently focused on the Trump Administration passing some profit friendly legislation at some point this year. If economic disappointments persist for longer than a few more months and Congress doesn't follow through, we can't rule out a meaningful correction in U.S. equities. Nonetheless, the lack of excesses in the economy, general agreement between the Fed and the market on the path of rates for this year and rising, but still modest, inflation are likely to make any pullback in U.S. stocks a buying opportunity for investors. Bottom Line: Investors should fade the recent disappearance in positive economic surprises by staying overweight stocks vs bonds over the coming 6-12 months. FOMC: Growth Weakness Is Transitory Chart 3GDP, Inflation And Labor Market All Tracking##br## To Fed's Forecast = Gradual Rate Hikes The pace of economic growth, and more importantly how that growth impacts the labor market and inflation, remain a crucial factor in how investors assess the number of additional Fed rate hikes that can be expected this year. We continue to expect two more 25 basis point hikes in 2017, whereas the market, as of May 4, was pricing in just 38 bps. At the start of the weakness in the economic data in early March, the market had penciled in 68 bps (almost 3 rate hikes). The soft performance of the economy in Q1 was certainly a focus at last week's FOMC meeting. The FOMC's assessment was that the slowdown in growth in the economy in Q1 was "transitory." The FOMC made no material changes to its assessment of inflation or the labor market in the statement. The minutes of last week's meeting due on May 24 will provide more color. While not officially part of the Fed's dual mandate (of inflation and unemployment), economic growth obviously matters to the Fed. Growth that runs above the Fed's view of potential GDP will push the unemployment rate lower and push inflation higher. Top panel of Chart 3 shows that real GDP growth rose 1.9% from a year ago in Q1, just a tenth of a percent below the Fed's central tendency range for 2017 of 2.0 to 2.2% (Chart 3, panel 2). Despite the poor start to 2017, real GDP growth would have to average only a modest 2.5% per quarter over the rest of the year to hit the Fed's 2.0% target. Is 2.5% growth over the final three quarters achievable absent positive revisions to Q1? We think it is. Since 2010, GDP growth in the final 3 quarters of the year has averaged 2.5%. The headwinds facing the economy today are weaker than they were in the early years of the recovery. The April readings on manufacturing (54.8) and non-manufacturing (57.5) ISM imply GDP growth in the 3 to 3.5% range in Q2. The FOMC is correct to look through the temporary weakness in Q1 and continue on its gradual path of rate hikes this year to match the "modest" pace of economic growth. Investors got a few other key inputs to the FOMC's decision making process last week: The March reading on PCE inflation and the April employment report. Both readings keep the Fed on track for gradual hikes in 2017. A soft reading on core PCE inflation - the Fed's preferred measure - was also a contributor to the weakness in the economic surprise index. For now, we see few signs that suggest core inflation is headed sustainably lower. Chart 4 shows that, since 2000, core PCE inflation has closely correlated with a one year lag of real consumer spending. Even with the recent deceleration in spending, the chart suggests that the recent decline in inflation is temporary. In addition, our sense is that the Fed is more likely to tolerate a rate of inflation that is modestly below its estimate as long as growth remains strong and there is evidence that the weakness in inflation is transitory. Chart 4Core PCE Inflation Likely To Move Higher To Meet Spending The April labor market data was released last week as well and confirmed the FOMC's assessment of a solid labor market, but it also had a one negative surprise for markets. The 211,000 increase in jobs in April exceeded expectations (+185,000) and accelerated from the 79,000 gain in March. Over the past three months, the average monthly gain in payrolls was 174,000,well above the 100,000 to 125,000 per month pace the Fed says is needed to tighten the labor market. The drop in the unemployment rate in April to 4.4% puts the unemployment rate at pre-recession lows and more importantly, below the lower end of the Fed's 4.5% to 4.6% central tendency for this year. (Chart 3, panel 3). The negative surprise in the April jobs report came from wages. Average hourly earnings decelerated to 2.5% year-over-year in April from +2.6% in March. The consensus was looking for a 2.7% increase. Despite the lack of traction on wages, the April jobs supports the view that the economy is growing fast enough to tighten the labor market, push up wages and ultimately inflation. June remains a close call for the next Fed rate hike, but an analysis of the economy and the Fed's reaction function suggests that two rate hikes remain the most likely event this year. Our view is that the market will adjust up expectations toward the Fed's view for 2018. Bottom Line: The recent disappointment in the data is not enough to knock the Fed off course. Investors should continue to expect two additional rate hikes in 2017, with the next move coming at the June meeting. A Pro-Cyclical Asset Stance: It's Not Just About Stocks Chart 5Investors' Preference For Bonds##br## Is Understandable... One of the most basic ways that BCA evaluates the trend in financial markets is to look at what we call the "stock-to-bond ratio". In this publication the ratio is shown as the S&P 500 total return index divided by that of U.S. 10-year government bond. Chart 5 shows the amazing evolution of the stock-to-bond ratio over the past decade, rebased to 100 at the end of 2007 (the official beginning of the 2008-2009 recession). Panel 2 of the chart shows the component total return indexes, also rebased to 100 at the end of 2007. The chart illustrates two incredible points. First, while it is true that stocks have massively outpaced bonds since the low in March 2009, it took equity investors who bought and held at the onset of recession until late-2013 to outpace bond investors who did the same. Second, until the U.S. election in November, the stock-to-bond ratio was only 10% higher than it was in December 2007, which is a powerful testament to the ability of bonds to preserve capital over the long haul. Given these observations and the still-fresh memory of the global financial crisis, it is easy to see how some investors continue to prefer the relative safety of bonds, especially since equity multiples have risen significantly over the past year. However, Chart 6 highlights how our long stock-to-bond call is motivated by an expectation of higher stock prices and negative returns from bonds. The chart shows the likely trajectory of the 10-year Treasury yield over the coming year, under the base case scenario envisioned by our U.S. Bond Strategy service: core PCE inflation rises to 2%, and the spread between the 10-year breakeven inflation rate and core rises to 50 bps. Chart 7 illustrates the implications of this forecast for bond total returns, alongside the resulting stock-to-bond ratio. For stocks, we assume a very conservative 3% annualized nominal total return, which is the sum of a 2% dividend yield and a 1% assumed nominal price return. Chart 6...But The Bond Bull Market Is Over Chart 7A New High By Year-End The key point from Chart 7 is that the stock-to-bond ratio is likely to rise to a new high by the end of the year, even without aggressive assumptions for equity returns. We agree that bond yields will fall in the event of another risk-off event, and that 10-year Treasurys remain an important component of a diversified portfolio. But it is also important for investors to recognize that, absent these types of events, the relative performance of stocks vs. bonds is set to move higher in part because 10-year Treasurys are likely to generate a negative absolute return over the coming 6-12 months. Bottom Line: Investors should retain a pro-cyclical asset allocation stance. The outlook for the inflation, the Fed, and growth supports the relative performance of stocks vs bonds, even assuming modest returns to the former. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see U.S. Investment Strategy Special Report "Goldilocks: For How Long?," dated February 20, 2017, available at usis.bcaresearch.com. 2 Please see U.S. Investment Strategy Special Reports "Spring Snapback" dated April 24, 2017 and "The Good And The Bad". May 1, 2017, available at usis.bcaresearch.com.

Highlights Portfolio Strategy Any advance in Treasury yields should be gradual and more reflective of an improving global economy than it would be restrictive for equities. Book profits in homebuilders and downgrade to neutral. Rising lumber prices will do more harm than good. In contrast, home improvement retailers are in a sweet spot. We reiterate our high-conviction overweight stance. Recent Changes S&P Homebuilding - Downgrade to neutral. Table 1 Feature Equities marked time at the top end of their range last week. A catalyst may be required to sustain a breakout to new highs, as robust corporate profitability and forward guidance, coupled with tame monetary conditions, are battling against a spate of economic disappointments and soft commodity prices. Financial conditions remain sufficiently easy that economic growth should rebound in the back half of the year. The Fed is in no hurry to aggressively tighten monetary policy, owing to the lack of a serious inflation threat. If hard data begin to firm, then investors will gain confidence in the durability of the profit recovery, powering a further share price advance. While there may be some concern that stronger growth will simply embolden the Fed and push up Treasury yields, we doubt that the latter will become a roadblock just yet. Last week we highlighted that it typically takes a rise to at least one standard deviation above the mean in BCA's Treasury Bond Valuation Indicator to warn that the economy and stocks are at risk of a major downturn. That level would equate to 3.3% on the 10-year Treasury yield (Chart 1). Such large moves in Treasury yields do occur occasionally, (Nov/2010-Feb 2011, summer of 2013 and winter of 2016) and have sometimes preceded/caused economic slowdowns and/or financial accidents. The speed of the adjustment clearly plays a role, as short-term spikes are much harder to digest than gradual yield advances. Nominal GDP growth is comfortably above the 10-year Treasury yield, signaling that financial conditions will stay sufficiently easy for some time, barring a major bond selloff (second panel, Chart 2). Chart 1Yields Have Room To Rise##br## Before Becoming Restrictive Chart 2Sales Will Support##br## The Overshoot In other words, any advance in yields should be gradual and more reflective of a better global economy than restrictive, especially given the ongoing gentle softening in the U.S. dollar. The upshot is that the string of economic disappointments should begin to fade. In recent research, we have stressed the importance of a meaningful revival in corporate sector revenue growth in order to sustain sky-high valuations (top panel, Chart 2). Encouragingly, inflation expectations are recovering globally. A whiff of inflation is a positive omen for top line growth prospects. Inflation and economic growth expectations have firmed around the world. Chart 2 shows that euro area sales per share are on track to exit deflation after a multiyear slump, based on the message from the bond market. The same is true for emerging markets. If companies outside the U.S. finally enjoy renewed top-line growth, that would bode well for a continued recovery in U.S. business sales, especially if the U.S. dollar weakens. Chart 3 shows that both EM currencies and regional confidence surveys are heralding ongoing gains in U.S. profits sourced from overseas. Nevertheless, it is critical to keep the backdrop in a longer-term context. BCA's Equity Speculation Index (ESI) signals that the advance is at a very high risk stage (Chart 4). The ESI can stay in elevated territory for a prolonged period, as occurred in 2014/2015, before a correction unfolds. But, investors should maintain some non-cyclical exposure even if the market continues its advance in the short run. Chart 3Foreign-Sourced Profit Support Chart 4The Rally Is Very High Risk This week we are updating our overall view of the consumer discretionary sector and tweaking our housing-related equity positioning. Consumer Discretionary: On The Way To All-Time Highs Consumer discretionary stocks have been portfolio stalwarts in 2017 (outside of autos and select media), advancing by over 10% and besting the S&P 500 by about 400bps. The heavyweight media sub-group (ex-cable and satellite) has come under scrutiny recently, as fears that ad spending will endure a deep slump have resurfaced. However, most of our indicators suggest that ad spending, at least outside of autos, will not suffer a major downturn, given our upbeat outlook for consumption and profits. Cord-cutting is not a new phenomenon, and is already reflected in very washed out profit expectations, both on a cyclical and structural horizon (we will be covering media in more detail in an upcoming Report). Consequently, there are good odds that this impressive consumer discretionary showing will remain intact especially as last Friday's payrolls bounced smartly. Two key drivers have added fuel to this fiery performance: border adjustment tax fears have subsided and soft economic data have given the Fed enough breathing room to continue erring on the dovish side. Importantly, leading indicators of discretionary spending are heralding a solid recovery in consumer outlays. Interest rates remain near generationally low levels and oil price inflation has peaked. The economy is near full employment, signaling that wage inflation will quicken. According to BCA's Income Indicator1, consumer income growth is expected to reaccelerate imminently (bottom panel, Chart 5). While consumers have demonstrated a preference for saving vs. spending, several factors suggest that purse strings should soon loosen. Consumer confidence has soared, buoyed by income gains (third panel, Chart 5). Moreover, new highs in household net worth as a percent of disposable income signal that the upward pressure on the personal savings rate should diminish (second panel, Chart 5). The implication is that recent disappointing consumer spending data should prove transitory. While these factors could ultimately put upward pressure on interest rates, there may be a window where limited inflation pressures and weak credit growth permit only a gradual upshift in the Treasury curve. Regardless, there are other indicators pointing to additional outperformance. For instance, there is still a wide gap between forward earnings breadth and washed-out technical conditions. Roughly 75% of consumer discretionary sub-groups have rising 12-month forward profit estimates. This is sustainable as long as consumers have an incentive to spend. In contrast, the proportion of consumer discretionary sub-indexes with a positive 52-week rate of change and/or are trading above their 40-week moving average remains well below 50%. This divergence between fundamentals and technicals is an exploitable gap, which should narrow via a sustained rise in relative share prices (Chart 6). Chart 5Upbeat Consumption Outlook Chart 6Exploitable Gap Finally, consumer discretionary stocks are no longer expensive. On a relative forward P/E basis they trade below the historical mean and at a discount to the S&P 500. Consumer discretionary EV/EBITDA is also trailing the broad market, as well as its long-term average. If a recovery in consumer outlays pans out in the back half of the year, as we expect, then a re-rating phase is likely. However, not all sub-groups are created equal. This week we are tweaking our housing-related consumer discretionary exposure. Homebuilders' Pain... Homebuilding stocks have been moving sideways for the better part of the past four years in a narrow trading range. They are currently sitting near the top of this range. Is it time to book profits? The short answer is yes. The recent confirmation of U.S. tariffs on Canadian lumber imports represents a source of cost inflation that may embed a risk premium in share prices until a new trade deal can be worked out. Lumber prices have nearly doubled during the past sixteen months and remain the best performing commodity in 2017 (bottom panel, Chart 7). Lumber comprises anywhere between 10%-20% of the cost of a new home, underscoring that a 20% lumber tariff will add to the cost of building a new home, squeezing margins unless homebuilders can pass this cost on via increased house prices. However, we are skeptical that there is a lot of room for new house price increases given that it would make it more difficult to compete with existing house sales. While new homes have taken market share from existing homes since the residential housing market trough earlier in the decade (Chart 8), market share gains have come at the expense of profit margins. Homebuilders have been aggressively discounting properties in order to lure new buyers. Given the buildup in new home inventories, further market share gains are at risk, unless additional selling price concessions materialize. Chart 7Elevated Lumber Prices... Chart 8...Spell Trouble For Homebuilding Margins The implication is that builders would likely have to absorb any input cost inflation, to the detriment of margins. Indeed, homebuilder sales are already decelerating as a consequence of pricing pressure (second panel, Chart 7). A simple homebuilder profit margin proxy (comprising new house price inflation minus the residential construction wage bill) warns that operating margins will compress, irrespective of the path of lumber prices (bottom panel, Chart 8). Nevertheless, there are some positive offsets that prevent us from turning outright bearish on the niche S&P homebuilding index. These counterbalances are related to the stage of the housing recovery. Homebuilders' sales expectations have surged, nearing the previous cycle's peak, according to the NAHB survey (Chart 9). Similarly, overall housing market conditions are probing multi-year highs and buyer traffic has vaulted to the highest level since mid-2005. Homebuilders remain optimistic about new housing demand. Household formation is still running higher than housing starts, representing a bullish backdrop for future new home construction. Rising incomes and a firming job market also bode well for the prospects of residential real estate. In aggregate, house prices are still expanding according to the Case-Shiller indexes and there are pockets of frothiness in select markets. The thirty year fixed mortgage rate recently broke back below 4% (Chart 10) and banks are willing extenders of mortgage credit, allaying fears that the price of credit will undermine housing affordability. According to our updated estimates (not shown), even if mortgage rates spiked 200bps from current levels, neither affordability nor mortgage payments as a percent of median incomes would return to their respective long-term average. Chart 9Housing Market Remains Firm... Chart 10...Warranting A Neutral Stance Still, these positives are already reflected in expectations, as the sell side has aggressively upgraded homebuilding profit estimates. The net earnings revisions ratio has catapulted to a 12-year high (Chart 10). Given our more balanced outlook for homebuilding earnings, we are leaning against this exuberance. Bottom Line: Book profits of 3.4% in the S&P homebuilding index and downgrade to neutral. The ticker symbols for the stocks in this index are: DHI, LEN, PHM. ...Is Home Improvement Retailers' Gain While our confidence in further homebuilding outperformance has ebbed, the opposite is true for the S&P home improvement retail (HIR) index. We put the S&P HIR index on our high-conviction overweight list at the beginning of the year, and so far, so good. HIR stocks have outperformed the broad market and the S&P consumer discretionary sector year-to-date. There are good odds that more gains lie ahead. Industry retail sales are running at a mid-single digit rate, surpassing lackluster overall retail sales (second panel, Chart 11). Importantly, household appliance and furniture selling prices have surged, reinforcing that demand is robust and signaling that HIR same-store sales growth will likely accelerate in the busy spring selling season, and beyond (middle panel, Chart 11). Unlike homebuilders, home improvement retailers benefit from rising lumber prices. HIR companies typically earn a set margin on lumber-related sales. Thus, any absolute increase in lumber prices boosts top line growth, and profit margins (bottom panel, Chart 11). The industry's disciplined approach to store additions in the aftermath of the GFC has set the stage for ongoing selling price gains. Chart 12 shows that while house prices have overtaken the 2006 highs, increasing the incentive for homeowners to remodel and invest in this key asset, building and supply store construction activity has remained depressed. Easier mortgage lending standards should ensure that total home sales activity remains elevated, to the benefit of home prices, and provide the necessary financing needed for large projects (Chart 12). Tight labor markets, rising wages and surging consumer confidence are signaling that consumers have an appetite to re-lever and space to take on more debt (Chart 12). With store capex budgets under tight control, same-store sales and cash flow growth are bound to sustain their solid advance as renovation activity accelerates. All of this is best encapsulated by our HIR model. The model has recently soared, driven by the drop in fixed mortgage rates and surge in lumber prices, signaling that the path of least resistance is higher for relative share prices (top panel, Chart 11). Indeed, relative profits have already soared to fresh highs, also signaling the same for relative share prices (top panel, Chart 13). Oddly, analysts are overly pessimistic about the industry's sales and earnings growth prospects. In fact, top line growth estimates are trailing those of the broad market, and the 12-month forward relative profit growth hurdle is set very low at 2% (middle panel, Chart 13). Chart 11All Signals Flashing Green Chart 12Capacity Restraint Is Paying Dividends Chart 13Earnings Led Advance Given the positive message from leading indicators of remodeling activity we are far more optimistic, and expect both relative top and bottom line growth numbers to overwhelm. Bottom Line: The re-rating phase in the S&P home improvement retail index has room to run. We reiterate our high-conviction overweight stance. The ticker symbols for the stocks in this index are: HD, LOW. 1 Please see Foreign Exchange Strategy Weekly Report, "U.S. Households Remain In The Driver's Seat," dated March 31, 2017, available at fes.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights Chart 1Global Equities At Record Highs Our Stock Market Timing Model points to a heightened risk of a correction for global equities over the next few months. However, the 12-month cyclical outlook still looks reasonably good thanks to accelerating earnings growth. Monetary policy has also yet to reach restrictive levels in most economies. Beyond the next 12 months, lofty valuations (especially in the U.S.), as well as the prospect of a meaningful economic slowdown late next year, will weigh on returns. Tactically, go short the S&P 500 with a target of 7.5% and stop-loss of 2.5%. This trade will automatically expire in six weeks. Cyclically, go long the December 2017 Brent Oil futures contract. Feature Aging Bull? Global equities have been on a tear lately. The MSCI All-Country Index reached a fresh record high this week (Chart 1). The index is up 14.1% in local-currency terms and 13.3% in U.S. dollar terms since early November. Our philosophy at BCA Research is that the best market calls come from combining informed qualitative analysis with time-tested quantitative indicators. With that in mind, this week's report distills the results of our proprietary Stock Market Timing Model. Our main conclusions are only partly reassuring. While the cyclical 12-month outlook for stocks remains reasonably auspicious, our model suggests that there is an elevated risk of a near-term correction. The model is also forecasting subpar long-term returns for stocks, particularly in the U.S. where valuations have become stretched. What Predicts Stock Returns? As we have documented in past research,1 a number of empirical regularities help predict stock market returns: 1. Stocks Tend To Perform Better When Economic Growth Is Accelerating The state of the business cycle is the most important driver of stock returns over horizons of around 12 months. Our model incorporates a variety of forward-looking cyclical variables that span different parts of the economy. For example, Table 1 shows the S&P 500 has delivered an average annualized real total return of 9.8% since 1948 whenever the gap between the ISM manufacturing new orders and inventories components - based on the prior month's ISM reading - was positive. In contrast, the S&P 500 has fallen by an average of 1.2% whenever the gap was negative. In the same vein, the S&P 500 has produced an average annualized real total return of 9.2% since 2000 whenever initial unemployment claims have declined over the prior three months, while losing 3.6% whenever claims have increased. The gap between new orders and inventories fell to 6.5 in April, down from a March reading of 15.5. The downtrend in initial unemployment claims has also flattened out. The moves in the ISM manufacturing index and unemployment claims, along with other measures such as auto sales, suggest that the economy is going through a soft patch. This softening, in turn, has been reflected in a steep drop in Citi's economic surprise index (Chart 2). Table 1Stocks Tend To Perform Better When Growth Is Accelerating Chart 2Some Signs Of Softening U.S. Economic Data... Still, we would not overstate the extent of the deterioration in the growth picture. Goldman's Current Activity Indicator remains near cyclical highs (Chart 3). The Atlanta Fed's preliminary Q2 growth estimate stands at 4.2%, while the NY Fed's Nowcast stands at 2.3%. If these preliminary estimates prove to be correct, Q1 will end up being just a temporary speedbump along the road to recovery. Consistent with this, a variety of forward-looking indicators suggest that the U.S. economy will grow at an above-trend pace over the remainder of the year (Chart 4). Durable goods orders are rising, business capex intentions have surged, building permits are trending higher, and consumer confidence is strong. Chart 3...But Growth Backdrop Still Solid... Chart 4...And Forward-Looking Indicators Remain Upbeat Globally, the picture remains reasonably upbeat, as highlighted by our Global Leading Indicator (Chart 5). Growth in the euro area is particularly strong. Green shoots are also appearing in beleaguered emerging markets such as Brazil and Russia. The Chinese economy has slowed a notch, but is still in much better shape than it was at this time last year. Above-trend global growth is helping to propel corporate earnings. The Q1 earnings season is off to a strong start. According to Thomson Reuters, EPS for the S&P 500 in the first quarter is expected to increase by 14.8% from year-ago levels. 75% of companies have beat earnings estimates, compared to the long-term average of 64%. 63% of companies have beaten revenue estimates, compared to the historic average of 59%. BCA's global earnings model predicts further upside for profits over the coming months (Chart 6).2 Chart 5Global Economy Is Doing Well Chart 6More Upside For Global Earnings Bottom Line: Cyclical indicators are somewhat mixed, but generally point to further upside for global stocks. 2. Stocks Tend To Perform Better When Financial Conditions Are Easing Easy money and equity bull markets tend to go hand in hand. Since 1970, the S&P 500 has delivered a real total average annualized return of 12.9% whenever our monetary indicator - which looks at money growth, bank lending, as well as short-term and long-term rates - was above its long-term average in the prior month, but only 0.5% when the indicator was below its long-term average. Similarly, the S&P 500 has risen at a 9.6% annualized pace whenever BCA's Financial Conditions Index (FCI) - which includes such components as credit spreads, the trade-weighted dollar, oil prices, home prices, and the relative performance of bank shares - was above its 250-day moving average, while gaining only 1.4% when the FCI was below its 250-day moving average. Chart 7 shows that our U.S. FCI remains slightly above its moving average, thanks to the decline in credit spreads over the past 12 months, along with higher stock market and house prices. However, the monetary indicator has now dipped below its respective moving average due to rising rates and slower broad money growth. Chart 7Financial Conditions Still Bode Well For Equity Returns, But U.S. Rate Hikes Loom Large Looking out, monetary and financial conditions are likely to be buffeted by various crosswinds. On the one hand, business lending should recover thanks in part to a rebound in manufacturing output (Chart 8). On the other hand, consumer lending standards have been tightening for some time and delinquencies and charge-offs for auto and credit card loans have edged higher, albeit from very low levels (Chart 9). Higher interest rates are also likely to weigh on credit demand. On balance, we expect a modest tightening in U.S. financial conditions over the remainder of the year. Chart 8Business Lending Should Recover Chart 9Tightening Consumer Lending Standards Outside the U.S., financial conditions are likely to stay accommodative. Unlike the Fed, most other central banks will keep rates near rock-bottom levels. In fact, real short-term rates in the euro area and Japan could even decline as stronger GDP growth lifts inflation expectations. Bottom Line: Financial conditions are still somewhat supportive for global equities, but are likely to become less so in the U.S. as the Fed continues to hike rates. 3. Stocks Tend To Perform Better When Sentiment Is Poor But Improving Warren Buffet once famously said that the secret to being a successful investor is to be "fearful when others are greedy and greedy when others are fearful." There is no doubt that the level of sentiment can be a powerful contrarian indicator. However, our research indicates that the change in sentiment is also important in predicting equity returns. Trading rules that overweight stocks whenever sentiment over the prior weeks has improved from bearish levels, while underweighting stocks whenever sentiment has deteriorated from bullish levels, can significantly outperform a buy-and-hold strategy (Chart 10). This finding is similar to what one sees for individual stocks. As we discussed in our report on bottom-up stock picking,3 the best stocks tend to be the ones for which the consensus analyst opinion is bearish but improving. In contrast, the worst stocks are typically the ones for which the consensus analyst opinion is bullish but deteriorating. Today, market sentiment is on the bullish side (Chart 11). According to the Marketvane survey, the share of traders that expect stocks to rise over the coming weeks is only slightly below where it was during past stock market peaks. Bullish sentiment is less pronounced in the AAII's survey of individual investors. However, equity allocations among AAII members are about five points above their historic average, which limits the scope for "new money" to come into the market. Meanwhile, complacency is setting in (Chart 12). The VIX hit its lowest level in ten years this week. The Minneapolis Fed's market-based probability of a 20%+ correction in the S&P 500 has also dropped to below 10%, a level last seen during the peak of the previous bull market in 2007. Yale University's One-Year Confidence Index - which measures how likely market participants think that stocks will go up in the succeeding year - is near record levels for individual investors and at an absolute record high for institutional investors. U.S. margin debt, expressed as a share of GDP, has also risen above its 2000 and 2007 peaks. Chart 10Buy Stocks When Sentiment Is Poor But Improving Chart 11Equity Sentiment Is More Bullish Than Usual Chart 12Complacency Reigns Bottom Line: Current levels of bullish sentiment are a warning sign for equities. Should sentiment measures begin to deteriorate without a correspondingly large drop in stock prices, it will be time to head for the exit doors. 4. Stocks Tend To Perform Better In "Young" Bull Markets Following Pullbacks When is the trend your friend? The answer is over horizons of about two years. Returns tend to be positively serially correlated over this range. This means that if stocks have done well over the past two years, they are likely to continue doing well. Over shorter horizons of less than a year and longer horizons exceeding three years, the trend is not your friend - returns tend to be negatively correlated (Chart 13). Thus, if stocks have fallen over the past few weeks, they are likely to do better over the following few weeks than if they had risen. Likewise, if stocks have done well over, say, the past five years, then this is evidence that the bull market is getting long in the tooth. Obviously, these are not hard and fast rules, but they do give some guidance about what the future may have in store. The fact that the S&P 500 has done well over the past two years is a bullish sign, but the fact that the bull market is now in its eighth year and price gains have accelerated over the past few months (raising the risk of a blow-off top) are both bearish signs. The bull market is less mature outside the U.S., which works in favor of non-U.S. stocks. Relative momentum is also turning more favorable for non-U.S. markets, especially those in the euro area (Chart 14). Chart 13When Is The Trend Your Friend? Chart 14Relative Momentum Favors Non-U.S. Stocks Bottom Line: Recent price momentum is sending mixed signals for U.S. stocks, but somewhat more encouraging signals for non-U.S. stocks. 5. Stocks Tend To Perform Better When They Are Cheaply Priced Valuations are not especially useful as a short-term timing tool. However, they are by far the most useful tool for gauging long-term expected returns. This can be seen in the fact that there is a strong negative correlation between the Shiller PE ratio and subsequent real total returns (Chart 15). In the U.S., the Shiller PE ratio currently stands at 29. This is 45% above the post-1960 median and 82% above the median since 1880. If profit margins over the past 10 years had been what they were on average during the 1990s, the Shiller PE ratio would stand at 41 today - within reaching distance of its 2000 peak (Chart 16). U.S. valuations are even more stretched if one looks underneath the indices: The median NYSE stock currently trades at a higher price-to-earnings and price-to-cash flow ratio than at the 2000 peak (Chart 17). Chart 15Valuation Is The Single Best Predictor Of Long-Term Equity Returns Chart 16U.S. Valuations Are Stretched... Chart 17...Especially For The Median Stocks One could argue that a structurally lower neutral interest rate justifies a higher equilibrium PE ratio. There are plenty of reasons to challenge this argument - a lower neutral rate may foreshadow slow earnings growth, for instance - but even if one accepts its basic premise, it does not imply that stocks will do well in absolute terms. If you assume a lower discount rate in calculating the present value of future cash flows, you must also assume a lower long-term rate of return from owning stocks. You can't one have without the other. Valuations are generally more favorable outside the U.S., even if one adjusts for differences in sector weights across countries (Chart 18). Chart 18Valuations More Favorable Outside The U.S. Bottom Line: Valuations are stretched in the U.S. Long-term investors should favor non-U.S. stocks over their U.S. peers. 6. Stocks Tend To Perform Better During Certain Days And Months Of The Year Than Others No discussion of stock market-timing strategies would be complete without a few words on calendar effects (Table 2). Table 2When to Buy Stocks As with all stock market anomalies, there is a risk that any particular calendar pattern will disappear once it has been documented. For example, the "Blue Monday" effect, popularized by Yale Hirsch's 1987 book "Don't Sell Stocks On Monday," vanished soon after the book was published, only to make a comeback of sorts during the past 15 years. The so-called January Effect, which describes the tendency for stocks to do well at the start of the year, largely disappeared from the data at the turn of the century. In its place the "Santa Claus rally" was born, presumably reflecting the desire of traders to front run the January effect. Other calendar effects remain alive and well. The tendency for stocks to underperform during the summer and autumn months (the "Sell In May And Go Away" effect) is still around (Chart 19). The same goes for the so-called "turn-of-the-month effect" - the tendency for stocks to do best in the last few days and first few days of each month. Less well known is the tendency for stocks to do much better on FOMC days.4 Remarkably, the S&P 500 would be more than 50% lower today if one were to exclude all the days since 1990 when scheduled FOMC meetings took place from the return tally (Chart 20). Chart 19Sell In May And Go Away Chart 20The Fed Effect Bottom Line: High frequency, tactical investors may be able to profit from exploiting calendar effects in the data. Putting It All Together Our Stock Market Timing Model incorporates the factors discussed above. As Chart 21 illustrates, it has an admirable track record of predicting market returns. The current message from the model differs across time horizons. Tactically, over a three-month horizon, it suggests that stocks are overbought and vulnerable to a correction. This is mainly due to the sharp run-up in most global bourses over the past six months, as well as elevated levels of bullish sentiment. The fact that we are also entering the historically weak summer months is also a slight negative in our model. Cyclically, however, the picture still looks fairly reassuring: leading economic indicators and corporate earnings are in an uptrend. Financial conditions also remain accommodative. Thus, the model continues to predict modestly above-average returns for global equities over a 12-month horizon. Looking beyond the next 12 months, however, the picture begins to dim. The U.S. now accounts for over 50% of global equity market capitalization. Valuations for U.S. stocks have reached elevated levels. The U.S. economy is also approaching full employment, which means that growth will fall back to what so far has been a very anemic pace of potential GDP growth. Interest rates may also eventually reach punitive levels as the Fed continues to hike rates. All this suggests that the bullish window for global stocks, and U.S. stocks in particular, may close late next year. Two New Trades We are initiating two new trades reflecting our differing tactical and cyclical views: Tactically, go short the S&P 500 with a target of 7.5% and stop-loss of 2.5%. This trade will automatically expire in six weeks. Cyclically, go long the December 2017 Brent Oil futures contract (Chart 22). Our commodity strategists remain convinced that the supply backdrop for oil is tighter than the market is discounting. Add to that a firm demand picture, and we have a recipe for what is likely to be at least a temporary recovery in oil prices. Chart 21Message From Our Stock Market Timing Model Chart 22Go long December 2017 Brent Futures Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "Market Timing: Holy Grail Or Fool's Gold?" dated May 27, 2016, available at gis.bcaresearch.com. 2 Please see Global Alpha Sector Strategy Bi-Weekly Report, "Quarterly Review And Outlook," dated April 7, 2017, available at gss.bcaresearch.com. 3 Please see Global Investment Strategy Special Report, "Introducing ETS: A Top-Down Approach To Bottom-Up Stock Picking," dated December 3, 2015, available at gis.bcaresearch.com. 4 David O. Lucca., and Emanuel Moench, "The Pre-FOMC Announcement Drift," Federal Reserve Bank Of New York Staff Reports, August 2013. Appendix Tactical Global Asset Allocation Monthly Update We announced in late March that we are making major upgrades to our Tactical Asset Allocation Model. In the meantime, we will send you a concise update of our recommendations in the first week of every month based on a combination of BCA's proprietary indicators as well as our own seasoned judgement (Appendix Table 1). Appendix Table 1Global Asset Allocation Recommendations (Percent, Relative To Benchmark) Our tactical recommendations are based on a three-month horizon. Thus, at times, they can differ significantly from both our cyclical (12-month) and structural (12-month plus) recommendations. Compared to last month, we are cutting our tactical allocation to global stocks from +7 percentage points to zero (relative to benchmark), reflecting the heightened risk of a near-term pullback. We continue to maintain an underweight position in U.S. stocks within the equity portion of the portfolio. However, given the low-beta nature of U.S. stocks, most of the downgrade in overall equity exposure has occurred among European, Japanese, and EM bourses. We are also increasing our exposure to bonds from -9 to -6 percentage points, and increasing our tactical allocation to cash from +2 to +6 percentage points. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights We are going long spot gold at tonight's closing price, given our view that inflation and inflation expectations will continue to move higher going into 2018. In the U.S., we expect higher fiscal spending and tax cuts hitting the economy next year to have a significant effect on an economy already at or very close to full employment, boosting real wages and inflationary pressures. As a safe-haven, gold also is well suited to hedging geopolitical risks, which also are rising. Lastly, gold exposure has the added benefit of providing a hedge to equity positions. Energy: Overweight. The ~ 10% correction in benchmark crude oil prices from 1Q17 levels likely has run its course, as representatives of key states that are party to the November 2016 production cut deal signal it will be extended at the upcoming May 25 meeting in Vienna. We remain long Dec/17 Brent $65/bbl calls vs. short the Dec/17 Brent $45/bbl puts, which is down $0.88/bbl, and will be getting long Dec/17 Brent $55/bbl calls vs. Dec/17 $60/bbl calls at tonight's close. We expect Dec/17 Brent to reach $60/bbl by year-end, with WTI trading ~ $2.00/bbl lower. Base Metals: Neutral. Indonesia's state mining company PT Aneka Tambang is expected to resume nickel exports, reversing a three-year ban on outgoing trade. We remain neutral base metals. Precious Metals: Neutral. We are recommending an allocation to gold outright as a strategic hedge against higher inflation, particularly emanating from the U.S., and geopolitical risk in Europe (see below). Underweight. Markets remain well stocked with indications stocks-to-use data will continue to weigh on prices. We remain bearish. Feature Recent indications inflation and inflation expectations are ticking higher will persist into 2018 (Chart of the Week). U.S. fiscal spending and tax cuts expected next year will lift real wages and boost spending power. The American economy already is at or very close to full employment, and U.S. rate hikes are lagging wage growth, which will, all else equal, boost inflation and inflation expectations (Chart 2). Although we expect the Fed to raise rates at least two more times this year - perhaps three - we believe the central bank will continue to keep rate hikes behind wage growth, and will not try to get out in front of inflation (Chart 3). Chart Of The WeekGlobal CPI Inflation Continues To Percolate Chart 2Rate Hikes Lagging Wage Growth Chart 3Fed Likely Won't Get Ahead Of Inflation On the political and geopolitical fronts, looming Italian elections are a risk that is all but being ignored by financial markets. Our colleague Marko Papic, head of BCA's Geopolitical Strategy service, identifies next February's Italian elections as "the highest probability risk to European integration at the moment," given its potential to "reignite Euro Area breakup risk."1 Political risks dog the DM economies: falling support for globalization, which will undermine the benefits of sourcing low-cost inputs (labor and capital) worldwide; tighter immigration policies, which go hand-in-hand with falling support for globalization; a predisposition to monetize debt via higher money supply; and higher minimum-wage demands as income inequality increases all raise inflation and inflation expectations in DM economies.2 This financial and political backdrop again points us toward gold in an attempt to identify safe-haven assets and hedges against the increasing likelihood of renewed inflation. In addition, while our House view does not include a marked equities correction in the near term, it is worthwhile pointing out that gold does hedge equities when they are selling off, and in bear markets generally. A corollary to this property is that in equity bull markets, gold tends to hold value, even if it underperforms stocks in absolute terms. These are powerful properties, which increase the stability of investors' portfolios. Before proceeding, it is useful to distinguish between the specifications mentioned above:3 A safe-haven asset refers to an asset that is negatively correlated (or uncorrelated) with other assets that lose value in times of financial stress. An important feature of a safe-haven asset is that it only exhibit low or negative correlation with financial assets (e.g., equities) in extremely negative market conditions, without specifying any particular behavior when markets are not under stress. In other words, both assets could be positively correlated in bull markets, as long as the correlation turns negative when financial-market conditions deteriorate. We make a distinction between the weak and strong form of safe-havens: The weak form represents an asset that is uncorrelated with the reference asset, while the strong form is negatively correlated.4 A hedge is an asset that is negatively correlated (or uncorrelated) with another asset, on average, over the time interval being examined in a particular analysis. As with safe-haven assets, there is a similar distinction between weak- and strong-form hedges. A diversifier refers to an asset that is positively, but imperfectly, correlated with another asset on average during the period of analysis. Gold Vs. Inflation During inflationary periods, assets that generate returns for investors that offset purchasing-power losses experienced by other assets in their portfolio - i.e., a store of value - traditionally have been preferred. Gold has been used as a store of value during inflationary episodes, and for this reason is viewed as a safe haven. Fundamentally, gold's supply is relatively inelastic, and consists of above-ground physical stocks comprising public and private holdings. The world gold council estimates physical gold stocks were ~ 4570.8t at the end of 2016, up 5.8% since 2010. Demand for gold was estimated at 4249.1t at the end of 2016, versus 3281t at the end of 2000. The inelasticity of gold supply makes it difficult to respond to changes in inflation - or to any shocks to the economy, for that matter - by increasing the supply over the short term, as it would be the case with any fiat currencies and other assets. For this reason, price allocates limited supply. During inflationary periods and during a macroeconomic shock, gold's price is bid up, which is the source of returns for holding gold.5 Gold often is seen as a currency; however, it lacks a central bank that can increase its supply via turning up the printing press. This makes the precious metal a so-called "hard currency," and endows it with the ability to maintain its purchasing power during periods of inflation. In addition, it is an asset that is accepted as collateral to support bank lending and margining by the BIS and numerous banks.6 In Table 1, we look at the correlation between year-on-year gold return and U.S. CPI inflation.7 We used a sample period from 1985 to now.8 On average, during the entire sample, we obtained a correlation of 26%. Within the sub-periods gold provides a hedge against inflation, but how much of a hedge depends on other financial factors - chiefly the broad USD TWI and real U.S. interest rates - affecting its performance (Chart 4). We examine these below. Table 1Gold Vs. U.S.##BR##And EU Inflation Chart 4Gold's Inflation-Hedging Properties##BR##Affected By Monetary Conditions The hedging relationship between gold returns and the CPI inflation rates does not consistently hold up in all bear markets - e.g., the GFC, when global assets became highly correlated and lost significant value. It is possible, though, that in times of financial stress or downturn, gold's ability to act as a hedge asset to U.S. equities might sometime dominates its ability to hedge inflation, leading to an ambiguous relationship with inflation during bear markets. We delve further into this below. Gold, Inflation And U.S. Monetary Conditions We typically model gold as a function of financial variables, which are sensitive to inflation and inflation expectations and to Fed policy shifts. Given our preference for modeling gold's price evolution as a function of U.S. financial variables - the broad trade-weighted (TWI) USD and real rates, in particular - we looked further into this (Chart 5). The impact of inflation on gold prices is stronger when the dollar experiences large negative shocks and depreciates, and weaker when the USD appreciates (i.e., a large positive shock).9 So, when the USD broad TWI is falling, gold is an effective hedge. When the greenback is appreciating, it is less effective. Next, we examined the ability of gold to hedge inflation risk when U.S. real rates are high and low. To do this, we used 10-year real rates and cut a long-term sample from 1990 to now into two different sub-periods: a high-rate period from 1990 to 2003, and a low-rate period from 2003 to now (Chart 6).10 Chart 5USD's Evolution Is Important To Gold,##BR##As Are U.S. Real Rates Chart 6U.S. 10-Year##BR##Real Rates During the high-real-rate period, the correlation between gold and inflation is close to zero (0), meaning gold did not act as a strong hedge against inflation, but still could have been acting as a weak hedge (meaning it's uncorrelated). Gold's hedging ability increased significantly in the low-real-rate period (Table 2). Again, this supports our theory that gold's hedging ability depends on U.S. monetary conditions, and that during periods of low real U.S. interest rates gold is an effective hedge against inflation. Table 2Gold Vs. CPI Inflation In High- And Low-Real Rate Environments Gold Vs. U.S. Equities Cutting right to the chase, gold can be used to hedge equities exposure in portfolios, as the correlation analysis in Table 3 demonstrates. Here, we are examining the hedging ability of gold relative to the U.S. stock market (proxied by the S&P 500 Total Return (TR) index). Table 3Gold's Hedging Properties Vs. Equities In our analysis, we find gold and U.S. equities are negatively correlated, on average, over the entire sample (correlation coefficient -0.19). We also tested for time-varying correlation by looking at the correlation separately in different bull- and bear-market sub-periods. Bull (bear) markets are defined as periods in which the U.S. stock index has a positive (negative) move of more than 15% and that lasts for at least 3 months.11 During both bear markets, gold's annualized compound returns were up when the S&P 500 returns were negative (Table 4). This strongly suggests gold is a safe-haven asset in time of extended weakness for equities, all else equal (i.e., we don't have a 100-year global meltdown that takes all correlations to 1.00). Interestingly, the relationship is unclear for bull markets which reflects the non-linearity in gold's hedging ability. We can conclude that during bull markets, gold tends to underperform equity markets; however, this does not imply that holding gold will lead to negative returns. Hence, gold offers protection against bear markets that offsets the costs in terms of returns during bull markets.12 Table 4Gold Hedges U.S. Equities The correlation between month-on-month gold and S&P 500TR returns corroborate the earlier finding. We find that gold is negatively correlated with U.S. equities during equity bear markets, and that it is ambiguous in equity bull markets. Bottom Line: We find gold is a good hedge during inflationary periods, particularly when the USD TWI is weak and real rates are low. We also show gold has excellent safe-haven and hedging properties versus equities (using the S&P 500TR index as a proxy). Based on this analysis, we are recommending a strategic allocation to gold, and will get long at tonight's close. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Assistant Commodity & Energy Strategy hugob@bcaresearch.com 1 Please see "Political Risks Are Understated in 2018," published on April 12, 2017, by BCA Research's Geopolitical Strategy. It is available at gps.bcaresearch.com. 2 Please see "The End Of the Anglo-Saxon Economy?" published April 13, 2016, by BCA Research's Geopolitical Strategy. It is available at gps.bcresearch.com. 3 Baur, Dirk G.; Brian M. Lucey (2010), "Is Gold a Hedge or a Safe Haven? An Analysis of Stocks, Bonds and Gold". The Financial Review 45, 217-229. 4 Baur, Dirk G.; Thomas K.J. McDermott (2010), "Is Gold a Safe Haven? International Evidence", Journal of Banking & Finance 34, 1886-1898. 5 We would note that the real price of gold increased during the Great Depression, which indicated gold's value during a period of significant deflation appears to increase, perhaps as investors fear the debasement of their currencies and the subsequent loss of purchasing power. 6 Please see Section 4 of "Basel III counterparty credit risk and exposures to central counterparties - Frequently asked questions," published by the BIS December 2012. 7 We use CPI here because it drives the payout of inflation-linked securities in the U.S. 8 We begin our analysis in 1990 for consistency throughout. We also note that several papers take note of an important structural break in U.S. inflation around 1984. Please see Batten, Jonathan A.; Cetin Ciner; Brian M. Lucey (2014), "On The Economic Determinants Of The Gold-Inflation Relation", Resources Policy 41, 101-108; and Stock, James H.; Mark W. Watson (2007), "Why Has U.S. Inflation Become Harder to Forecast?", Journal of Money, Credit and Banking 39 (supplement). For the selection of bear and bull markets, please see "Monthly Economic Report" published on April 2017, by Mackenzie investments. 9 We did this by estimating a regression to see how gold responds when the broad trade-weighted USD is trading in the 5% and 90% quantile of year-on-year U.S. dollar variation over the period 1995 to present. We did this using dummy variables to represent the impact of U.S. inflation in periods of large dollar appreciation and dollar depreciation. The model's adj-R2 is 0.45, and all coefficients are significant below 5%. 10 The mean for the high-rates period is 3.77%; for the low-rates period it is 1.07%. These rates are statistically different between these two sub-periods (using a two-tailed t-test). 11 The selection of bull and bear markets is based on Mackenzie investment analysis. Please see "Monthly Economic Report" published on April 2017, by Mackenzie investments. 12 Our results were supported by further econometric analysis of the variance properties using GARCH modeling. These results are available upon request. 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. vehicle sales have slowed markedly in recent months, disappointing more buoyant forecasts. While auto stocks reflect this weakness, there appears to be lingering optimism that auto parts makers will have a better fate: auto parts stocks have diverged positively from auto stocks. However, a similar divergence occurred in 2015, which ultimately culminated in a relapse in auto parts shares. While consumer surveys show strong vehicle buying intentions, their ability to finance these purchases is becoming more restricted. Deteriorating auto loan credit quality has forced banks to significantly tighten vehicle-related credit standards. Rising borrowing rates represent a major headwind to auto sales growth, warning that the rise in auto parts new orders is destined for a sharp reversal. Auto parts industrial production is already contracting at a steep rate, underscoring that it is only a matter of time before auto parts demand tumbles. We reiterate our underweight position. The ticker symbols for the stocks in this index are: BLBG: S5AUTC -DLPH, BWA, GT.

Highlights The global credit impulse is 4 months into a mini-downswing, and it is too soon to position for the next mini-upswing. The euro area economy will remain one of the better performers in a global growth pause. Underweight German bunds in a global bond portfolio. Stay long the euro, especially euro/yuan. Go long euro area Financials versus U.S. Financials, currency unhedged, as a first foray into a beaten-up sector. Feature First the good news: the ECB's latest bank lending data indicate that the euro area 6-month bank credit impulse is stabilizing after a modest but clear decline in recent months (Chart I-2). Now the bad news: the global bank credit impulse continues to weaken. The upshot is that the euro area economy - even with 1.5% growth - will remain one of the better performers in what is now a very clear global growth pause. Chart of the WeekThe Global Bond Yield Has Shown ##br##A Regular Wave Like Pattern Chart I-2The 6-Month Credit Impulse Has Stabilized In The ##br##Euro Area... But Not In The U.S. Or China How To Play The Euro Area's Economic Outperformance In a global growth pause, the best way to play euro area economic outperformance is through relative positions in the bond markets and through currencies. Specifically, underweight German bunds in a global bond portfolio but stay long the euro, especially euro/yuan. The implication for euro area equities is more ambiguous. The Eurostoxx50 has a very low exposure to Technology, which tends to perform defensively in a growth pause. Conversely, the Eurostoxx50 has a high exposure to Financials, whose relative performance reduces to a play on the bond yield (Chart I-3). Given that the global credit impulse is still weakening, it is premature to expect a sustained absolute rally in Financials anywhere. Therefore, the strong knee-jerk absolute rally in European banks after the French election first round is unlikely to last. That said, with the euro area economy likely to outperform in a global growth pause, and euro area Financials still near a 50-year relative low versus U.S. Financials, euro area bank equities can now outperform banks in other markets (Chart I-4). Chart I-3Global Bond Yield = ##br##Financials Vs. Market Chart I-4T-Bond/German Bond Spread Compression =##br## Euro Area Financials Outperform U.S. Financials As a first foray into a beaten-up sector, go long euro area Financials versus U.S. Financials, currency unhedged. (Caveat: all of this assumes that Emanuel Macron beats Marine Le Pen to the French Presidency on Sunday, as we expect.) Don't Rely On Year On Year Comparisons Nature provides many of our units of time. The earth's orbit around the sun gives us a year; the moon's orbit around the earth gives us a month; the earth's rotation on its axis gives us a day. But there is absolutely no reason why economic and financial cycles should follow nature's cycles. Yet most analysts persist at looking for patterns and cycles in economic and financial data using yearly, monthly, or daily rates of change. Unfortunately, by focusing on years, months and days, they risk completely missing some of the strongest patterns and cycles in the economy and markets. Think about a clock pendulum. If you look at it once a second, it will always seem to be in the same position, motionless. You will miss the cycle. Likewise, if an economy regularly accelerates for 6 months and then symmetrically decelerates for 6 months, the yearly rate of change will be a constant, giving the false appearance that nothing is happening. It will miss the cycle. It turns out that the global economy does indeed regularly accelerate and decelerate - and that each half-cycle averages about 8 months. The strongest evidence of this very clear oscillation comes from the remarkably regular wave like pattern in the global bond yield, illustrated in the Chart of the Week and Chart I-5 and Chart I-6. Chart I-5The Global Bond Yield Has Shown A ##br##Regular Wave Like Pattern... Chart I-6...Which Is Easier To See ##br##When Detrended Furthermore, the acceleration and deceleration of bank credit flows - as measured in the global credit impulse - also exhibits a remarkably regular wave like pattern, with each half-cycle lasting about 8 months. But crucially, a half-cycle length of less than a year means that a year on year analysis would miss this very clear oscillation. Hence, our analysis always uses the 6-month credit impulse (Chart I-7). Chart I-7The Global Credit Impulse Has Also Shown A Regular Wave Like Pattern Mini Half-Cycles Average Eight Months It is not a coincidence that the bond yield and bank credit impulse exhibit near identical half-cycle lengths. The bond yield and credit impulse cycles are inextricably embraced in a perpetual feedback loop. A higher bond yield will initiate a mini down cycle. All else being equal, the higher cost of credit will weigh on credit flows. This will slow economic growth, which will then show up in GDP (and other hard) data. The bond yield will respond by readjusting down. In turn, a lower bond yield will then initiate a mini up cycle. And so on... But each stage in the sequence comes with a delay. For a change in the cost of credit to register with households and firms and fully impact credit flows, it clearly takes time. The credit flows do not generate instantaneous economic activity either. Fully spending the credit flows also takes time. Once you accept these assumptions of internal regulating feedback combined with delays in economic response, the economy has to be a naturally-oscillating system whose half-cycle length depends on the delays in economic response. And the important point is that these delays have little connection with nature's cycles. For those who are mathematically inclined, Box I-1 shows the differential equations which define the economic mini-cycle and its half-cycle length. Box 1The Mathematics Of Mini-Cycles Still, some commentators counter that credit flows don't just depend on the cost of credit. They also depend on so-called "animal spirits" - optimism or pessimism about the future. These commentators point to sentiment and survey data which show that animal spirits have soared. Our response is yes, for credit flows, heightened animal spirits in isolation are indeed a tailwind. But any rise in the cost of credit is a headwind. It follows that the net impact on credit flows depends on the relative strengths of the tailwind from heightened animal spirits and the headwind from the higher cost of credit. It is the net effect on the 6-month credit impulse - rather than heightened animal spirits per se - that determines the cyclical direction of the economy. We would suggest that the tailwind from heightened animal spirits has been countered by an even stronger headwind - the sharpest proportional rise in borrowing costs for at least 70 years (Chart I-8). Chart I-8The Sharpest Proportional Rise In Borrowing Costs For At Least 70 Years! As anticipated in our 16th February report The Contrarian Case For Bonds, incoming GDP data from the world's largest economies - the U.S., U.K. and France - now confirm this. First quarter growth (at annualised rates) sharply decelerated to 0.7%, 1.2% and 1.0% respectively. And this is not just about so-called first quarter "residual seasonality" as 6-month growth rates have also lost momentum. The global credit impulse is 4 months into a mini-downswing; the global bond yield is 2 months into a mini-downswing. Previous half-cycles have averaged 8 months, with the shortest at around 5 months. Hence, we feel it is somewhat premature to position for the next mini-upswing. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com Fractal Trading Model* The rally in Portuguese sovereign bonds appears technically overextended. Go short Portuguese sovereign 10-year bonds versus Spanish sovereign 10-year bonds with a profit target and stop loss of 2.5% . 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-9 * 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 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. 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 Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations