Financials

Highlights Economic Outlook: The global economy is in a reflationary window that will stay open until mid-2018. Growth will then slow, culminating in a recession in 2019. While the recession is likely to be mild, the policy response will be dramatic. This will set the stage for a period of stagflation beginning in the early 2020s. Overall Strategy: Investors should overweight equities and high-yield credit during the next 12 months, while underweighting safe-haven government bonds and cash. However, be prepared to scale back risk next spring. Fixed Income: For now, stay underweight U.S. Treasurys within a global fixed-income portfolio; remain neutral on the euro area and the U.K.; and overweight Japan. Bonds will rally in the second half of 2018 as growth begins to slow, but then begin a protracted bear market. Equities: Favor higher-beta developed markets such as Europe and Japan relative to the U.S. in local-currency terms over the next 12 months. Emerging markets will benefit from the reflationary tailwind, but deep structural problems will drag down returns. Currencies: The broad trade-weighted dollar will appreciate by 10% before peaking in mid-2018. The yen still has considerable downside against the dollar. The euro will grind lower, as will the Chinese yuan. The pound is close to a bottom. Commodities: Favor energy over metals. Gold will move higher once the dollar peaks in the middle of next year. Feature Reflation, Recession, And Then Stagflation The investment outlook over the next five years can be best described as a three-act play: First Act: "Reflation" (The present until mid-2018) Second Act: "Recession" (2019) Third Act: "Stagflation" (2021 onwards) Investors who remain a few steps ahead of the herd will prosper. All others will struggle to stay afloat. Let us lift the curtain and begin the play. Act 1: Reflation Reflation Continues If there is one chart that best encapsulates the reflation theme, Chart 1 is it. It shows the sum of the Citibank global economic and inflation surprise indices. The combined series currently stands at the highest level in the 14-year history of the survey. Consistent with the surprise indices, Goldman's global Current Activity Indicator (CAI) has risen to the strongest level in three years. The 3-month average for developed markets stands at a 6-year high (Chart 2). Chart 1The Reflation Trade In One Chart The Reflation Trade In One Chart The Reflation Trade In One Chart Chart 2Current Activity Indicators Have Perked Up Current Activity Indicators Have Perked Up Current Activity Indicators Have Perked Up What accounts for the acceleration in economic growth that began in earnest in mid-2016? A number of factors stand out: The drag on global growth from the plunge in commodity sector investment finally ran its course. U.S. energy sector capex, for example, tumbled by 70% between Q2 of 2014 and Q3 of 2016, knocking 0.7% off the level of U.S. real GDP. The fallout for commodity-exporting EMs such as Brazil and Russia was considerably more severe. The global economy emerged from a protracted inventory destocking cycle (Chart 3). In the U.S., inventories made a negative contribution to growth for five straight quarters starting in Q2 of 2015, the longest streak since the 1950s. The U.K., Germany, and Japan also saw notable inventory corrections. Fears of a hard landing in China and a disorderly devaluation of the RMB subsided as the Chinese government ramped up fiscal stimulus. The era of fiscal austerity ended. Chart 4 shows that the fiscal thrust in developed economies turned positive in 2016 for the first time since 2010. Financial conditions eased in most economies, delivering an impulse to growth that is still being felt. In the U.S., for example, junk bond yields dropped from a peak of 10.2% in February 2016 to 6.3% at present (Chart 5). A surging stock market and rising home prices also helped buoy consumer and business sentiment. Chart 3Inventory Destocking Was A Drag On Growth Inventory Destocking Was A Drag On Growth Inventory Destocking Was A Drag On Growth Chart 4The End Of Fiscal Austerity? Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Chart 5Corporate Borrowing Costs Have Fallen Corporate Borrowing Costs Have Fallen Corporate Borrowing Costs Have Fallen Fine For Now... Looking out, global growth should stay reasonably firm over the next 12 months. Our global Leading Economic Indicator remains in a solid uptrend. Burgeoning animal spirits are powering a recovery in business spending, as evidenced by the jump in factory orders and capex intentions (Chart 6). The lagged effects from the easing in financial conditions over the past 12 months should help support activity. Chart 7 shows that the 12-month change in our U.S. Financial Conditions Index leads the business cycle by 6-to-9 months. The current message from the index is that U.S. growth will remain sturdy for the remainder of 2017. Chart 6Global Growth Will Stay Strong In The Near Term Global Growth Will Stay Strong In The Near Term Global Growth Will Stay Strong In The Near Term Chart 7Easing Financial Conditions Will Support Activity Easing Financial Conditions Will Support Activity Easing Financial Conditions Will Support Activity ... But Storm Clouds Are Forming Home prices cannot rise faster than rents or incomes indefinitely; nor can equity prices rise faster than earnings. Corporate spreads also cannot keep falling. As the equity and housing markets cool, and borrowing costs start climbing on the back of higher government bond yields, the tailwind from easier financial conditions will dissipate. When that happens - most likely, sometime next year - GDP growth will slow. In and of itself, somewhat weaker growth would not be much of a problem. After all, the economy is currently expanding at an above-trend pace and the Fed wants to tighten financial conditions to some extent - it would not be raising rates if it didn't! The problem is that trend growth is much lower now than in the past - only 1.8% according to the Fed's Summary of Economic Projections. Living in a world of slow trend growth could prove to be challenging. The U.S. corporate sector has been feasting on credit for the past four years (Chart 8). Household balance sheets are still in reasonably good shape, but even here, there are areas of concern. Student debt is going through the roof and auto loans are nearly back to pre-recession levels as a share of disposable income (Chart 9). Together, these two categories account for over two-thirds of non-housing related consumer liabilities. Chart 8U.S. Corporate Sector Has Been Feasting On Credit U.S. Corporate Sector Has Been Feasting On Credit U.S. Corporate Sector Has Been Feasting On Credit Chart 9U.S. Household Balance Sheets Are In Good Shape, But Auto And Student Loans Are A Potential Problem U.S. Household Balance Sheets Are In Good Shape, But Auto And Student Loans Are A Potential Problem U.S. Household Balance Sheets Are In Good Shape, But Auto And Student Loans Are A Potential Problem The risk is that defaults will rise if GDP growth falls below 2%, a pace that has often been described as "stall speed." This could set in motion a vicious cycle where slower growth causes firms to pare back debt, leading to even slower growth and greater pressure on corporate balance sheets - in other words, a recipe for recession. Act 2: Recession Redefining "Tight Money" "Expansions do not die of old age," Rudi Dornbusch once remarked, "They are killed by the Fed." On the face of it, this may not seem like much of a concern. If the Fed raises rates in line with the median "dot" in the Summary of Economic Projections, the funds rate will only be about 2.5% by mid-2019 (Chart 10). That may not sound like much, but keep in mind that the so-called neutral rate - the rate consistent with full employment and stable inflation - may be a lot lower now than in the past. Also keep in mind that it can take up to 18 months before the impact of tighter financial conditions take their full effect on the economy. Thus, by the time the Fed has realized that it has tightened monetary policy by too much, it may be too late. As we have argued in the past, a variety of forces have pushed down the neutral rate over time.1 For example, the amount of investment that firms need to undertake in a slow-growing economy has fallen by nearly 2% of GDP since the late-1990s (Chart 11). And getting firms to take on even this meager amount of investment may require a lower interest rate since modern production techniques rely more on human capital than physical capital. Chart 10Will The Fed's 'Gradual' Rate Hikes End Up Being Too Much? Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Chart 11Less Investment Required Less Investment Required Less Investment Required Rising inequality has also reduced aggregate demand by shifting income towards households with high marginal propensities to save (Chart 12). This has forced central banks to lower interest rates in order to prop up spending. From this perspective, it is not too surprising that income inequality and debt levels have been positively correlated over time (Chart 13). Chart 12Savings Heavily Skewed Towards Top Earners Savings Heavily Skewed Towards Top Earners Savings Heavily Skewed Towards Top Earners Chart 13U.S.: Positive Correlation Between Income Inequality And Debt-To-GDP U.S.: Positive Correlation Between Income Inequality And Debt-To-GDP U.S.: Positive Correlation Between Income Inequality And Debt-To-GDP Then there is the issue of the dollar. The broad real trade-weighted dollar has appreciated by 19% since mid-2014 (Chart 14). According to the New York Fed's trade model, this has reduced the level of real GDP by nearly 2% relative to what it would have otherwise been. Standard "Taylor Rule" equations suggest that interest rates would need to fall by around 1%-to-2% in order to offset a loss of demand of this magnitude. This means that if the economy could withstand interest rates of 4% when the dollar was cheap, it can only withstand interest rates of 2%-to-3% today. And even that may be too high. Consider the message from Chart 15. It shows that real rates have been trending lower since 1980. The real funds rate averaged only 1% during the 2001-2007 business cycle, a period when demand was being buoyed by a massive, debt-fueled housing bubble; fiscal stimulus in the form of the two Bush tax cuts and the wars in Iraq and Afghanistan; a weakening dollar; and by a very benign global backdrop where emerging markets were recovering and Europe was doing well. Chart 14The Dollar Is In The Midst Of Its Third Great Bull Market The Dollar Is In The Midst Of Its Third Great Bull Market The Dollar Is In The Midst Of Its Third Great Bull Market Chart 15The Neutral Rate Has Fallen The Neutral Rate Has Fallen The Neutral Rate Has Fallen Today, the external backdrop is fragile, the dollar has been strengthening rather than weakening, and households have become more frugal (Chart 16). And while President Trump has promised plenty of fiscal largess, the reality may turn out to be a lot more sobering than the rhetoric. Chart 16Return To Thrift Return To Thrift Return To Thrift End Of The Trump Trade? Not Yet The failure to replace the Affordable Care Act has cast doubt in the eyes of many observers about the ability of Congress to pass other parts of Trump's agenda. As a consequence, the "Trump Trade" has gone into reverse over the past few weeks, pushing down the dollar and Treasury yields in the process. We agree that the "Trump Trade" will eventually fizzle out. However, this is likely to be more of a story for 2018 than this year. If anything, last week's fiasco may turn out to be a blessing in disguise for the Republicans. Opinion polls suggest that the GOP would have gone down in flames if the American Health Care Act had been signed into law (Table 1). Table 1Passing The American Health Care Act Could Have Cost The Republicans Dearly Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play The GOP's proposed legislation would have reduced federal government spending on health care by $1.2 trillion over ten years. Sixty-four year-olds with incomes of $26,500 would have seen their annual premiums soar from $1,700 to $14,600. Even if one includes the tax cuts in the proposed bill, the net effect would have been a major tightening in fiscal policy. That would have warranted lower bond yields and a weaker dollar. The failure to pass an Obamacare replacement serves as a reminder that comprehensive tax reform will be more difficult to achieve than many had hoped. However, even if Republicans are unable to overhaul the tax code, this will not prevent them from simply cutting corporate and personal taxes. Worries that tax cuts will lead to larger budget deficits will be brushed aside on the grounds that they will "pay for themselves" through faster growth (dynamic scoring!). Throw some infrastructure spending into the mix, and it will not take much for the "Trump Trade" to return with a vengeance. Trump's Fiscal Fantasy Where the disappointment will appear is not during the legislative process, but afterwards. The highly profitable companies that will benefit the most from corporate tax cuts are the ones who least need them. In many cases, these companies have plenty of cash and easy access to external financing. As a consequence, much of the corporate tax cuts may simply be hoarded or used to finance equity buybacks or dividend payments. A large share of personal tax cuts will also be saved, given that they will mostly accrue to higher income earners. Chart 17From Unrealistic To Even More Unrealistic From Unrealistic To Even More Unrealistic From Unrealistic To Even More Unrealistic The amount of infrastructure spending that actually takes place will likely be a tiny fraction of the headline amount. This is not just because of the dearth of "shovel ready" projects. It is also because the public-private partnership structure the GOP is touting will severely limit the universe of projects that can be considered. Most of America's infrastructure needs consist of basic maintenance, rather than the sort of marquee projects that the private sector would be keen to invest in. Indeed, the bill could turn out to be little more than a boondoggle for privatizing existing public infrastructure projects, rather than investing in new ones. Chart 18Euro Area Credit Impulse Will Fade In The Second Half Of 2018 Euro Area Credit Impulse Will Fade In The Second Half Of 2018 Euro Area Credit Impulse Will Fade In The Second Half Of 2018 Meanwhile, the Trump administration is proposing large cuts to nondefense discretionary expenditures that go above and beyond the draconian ones that are already enshrined into current law (Chart 17). As such, the risk to the economy beyond the next 12 months is that markets push up the dollar and long-term interest rates in anticipation of continued strong growth and lavish fiscal stimulus only to get neither. Euro Area: A 12-Month Window For Growth The outlook for the euro area over the next 12 months is reasonably bright, but just as in the U.S., the picture could darken later next year. Euro area private sector credit growth reached 2.5% earlier this year. This may not sound like a lot, but that is the fastest pace of growth since July 2009. A further acceleration is probable over the coming months, given rising business confidence, firm loan demand, and declining nonperforming loans. Conceptually, it is the change in credit growth that drives GDP growth. Thus, as credit growth levels off next year, the euro area's credit impulse will fall back towards zero, setting the stage for a period of slower GDP growth (Chart 18). In contrast to the U.S., the ECB is likely to resist the urge to raise the repo rate before growth slows. That's the good news. The bad news is that the market could price in some tightening in monetary policy anyway, leading to a "bund tantrum" later this year. As in the past, the ECB will be able to defuse the situation. Unfortunately, what Draghi cannot do much about is the low level of the neutral rate in the euro area. If the neutral rate is low in the U.S., it is probably even lower in the euro area, reflecting the region's worse demographics and higher debt burdens. The anti-growth features of the common currency - namely, the inability to devalue one's currency in response to an adverse economic shock, as well as the austerity bias that comes from not having a central bank that can act as a lender of last resort to solvent but illiquid governments - also imply a lower neutral rate. Chart 19Anti-Euro Sentiment Is High In Italy Anti-Euro Sentiment Is High In Italy Anti-Euro Sentiment Is High In Italy Indeed, it is entirely possible that the neutral rate is negative in the euro area, even in nominal terms. If that's the case, the ECB will find it difficult to keep inflation from falling once the economy begins to slow late next year. The U.K.: And Now The Hard Part The U.K. fared better than most pundits expected in the aftermath of the Brexit vote. Nevertheless, it would be a mistake to assume that the Brexit vote has not cast a pall over the economy. The pound has depreciated by 11% against the euro and 16% against the dollar since that fateful day, while gilt yields have fallen across the board. Had it not been for this easing in financial conditions, the economic outcome would have been far worse. As the tailwind from the pound's devaluation begins to recede next year, the U.K. economy could suffer. Slower growth in continental Europe and the rest of the world could also exacerbate matters. The severity of the slowdown will hinge on the outcome of Brexit negotiations. On the one hand, the EU has an interest in taking a hardline stance to discourage separatist forces elsewhere, particularly in Italy where pro-euro sentiment is tumbling (Chart 19). On the other hand, the EU still needs the U.K. as both a trade partner and a geopolitical ally. Investors may therefore be surprised by the relatively muted negotiations that transpire over the coming months. In fact, news reports indicate that Brussels has already offered the U.K. a three year transitional deal that will give London plenty of time to conclude a free trade agreement with the EU. In addition, the EU has dangled the carrot of revocability, suggesting that the U.K. would be welcomed back with open arms if enough British voters were to change their minds. Whatever the path, our geopolitical service believes that political risk actually bottomed with the January 17 Theresa May speech.2 If that turns out to be the case, the pound is unlikely to weaken much from current levels. China And EM: The Calm Before The Storm? The Chinese economy should continue to perform well over the coming months. The Purchasing Manager Index for manufacturing remains in expansionary territory and BCA's China Leading Economic Indicator is in a clear uptrend (Charts 20 and 21). Chart 20Bright Spots In The Chinese Economy Bright Spots In The Chinese Economy Bright Spots In The Chinese Economy Chart 21Improving LEI Points To Further Growth Acceleration Improving LEI Points To Further Growth Acceleration Improving LEI Points To Further Growth Acceleration Moreover, there has been a dramatic increase in the sales of construction equipment such as heavy trucks and excavators, with growth rates matching levels last seen during the boom years before the global financial crisis. Historically, construction machinery sales have been tightly correlated with real estate development (Chart 22). Reflecting this reflationary trend, the producer price index rose by nearly 8% year-over-year in February, a 14-point swing from the decline of 6% experienced in late-2015. Historically, rising producer prices have resulted in higher corporate profits and increased capital expenditures, especially among private enterprises (Chart 23). Chart 22An Upturn In Housing Construction? An Upturn In Housing Construction? An Upturn In Housing Construction? Chart 23Higher Producer Prices Boosting Profits Higher Producer Prices Boosting Profits Higher Producer Prices Boosting Profits The key question is how long the good news will last. As in the rest of the world, our guess is that the Chinese economy will slow late next year, setting the stage for a major growth disappointment in 2019. Weaker growth abroad will be partly to blame, but domestic factors will also play a role. The Chinese housing market has been on a tear. The authorities are increasingly worried about a property bubble and have begun to tighten the screws on the sector. The full effect of these measures should become apparent sometime next year. Fiscal policy is also likely to be tightened at the margin. The IMF estimates that China benefited from a positive fiscal thrust of 2.2% of GDP between 2014 and 2016. The fiscal thrust is likely to be close to zero in 2017 and turn negative to the tune of nearly 1% of GDP in 2018 and 2019. The growth outlook for other emerging markets is likely to mirror China's. The IMF expects real GDP in emerging and developing economies to rise by 5.1% in Q4 of 2017 relative to the same quarter a year earlier, up from 4.2% in 2016 (Table 2). The biggest acceleration is expected to occur in Brazil, where the economy is projected to grow by 1.4% in 2017 after having contracted by 1.9% in 2016. Russia and India should also see better growth numbers. Table 2World Economic Outlook: Global Growth Projections Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play We do not see any major reason to challenge these numbers for this year, but think the IMF's projections will turn out to be too rosy for 2018, and especially, 2019. As BCA's Emerging Market Strategy service has documented, the lack of structural reforms in EMs over the past few years has depressed productivity growth. High debt levels also cloud the picture. Chart 24 shows that debt levels have continued to grow as a share of GDP in most emerging markets. In EMs such as China, where banks benefit from a fiscal backstop, the likelihood of a financial crisis is low. In others such as Brazil, where government finances are in precarious shape, the chances of another major crisis remains uncomfortable high. Japan: The End Of Deflation? If there is one thing investors are certain about it is that deflationary forces in Japan are here to stay. Despite a modest increase in inflation expectations since July 2016, CPI swaps are still pricing in inflation of only 0.6% over the next two decades, nowhere close to the Bank of Japan's 2% target. But could the market be wrong? We think so. Many of the forces that have exacerbated deflation in Japan, such as corporate deleveraging and falling property prices, have run their course (Chart 25). The population continues to age, but the impact that this is having on inflation may have reached an inflection point. Over the past quarter century, slow population growth depressed aggregate demand by reducing the incentive for companies to build out new capacity. This generated a surfeit of savings relative to investment, helping to fuel deflation. Now, however, as an ever-rising share of the population enters retirement, the overabundance of savings is disappearing. The household saving rate currently stands at only 2.8% - down from 14% in the early 1990s - while the ratio of job openings-to-applicants has soared to a 25-year high (Chart 26). Chart 24What EM Deleveraging? What EM Deleveraging? What EM Deleveraging? Chart 25Japan: Easing Deflationary Forces Japan: Easing Deflationary Forces Japan: Easing Deflationary Forces Chart 26Japan: Low Household Saving Rate And A Tightening Labor Market Japan: Low Household Saving Rate And A Tightening Labor Market Japan: Low Household Saving Rate And A Tightening Labor Market Government policy is finally doing its part to slay the deflationary dragon. The Abe government shot itself in the foot by tightening fiscal policy by 3% of GDP between 2013 and 2015. It won't make the same mistake again. The Bank of Japan's efforts to pin the 10-year yield to zero also seems to be bearing fruit. As bond yields in other economies have trended higher, this has made Japanese bonds less attractive. That, in turn, has pushed down the yen, ushering in a virtuous cycle where a falling yen props up economic activity, leading to higher inflation expectations, lower real yields, and an even weaker yen. Unfortunately, external events could conspire to sabotage Japan's escape from deflation. If the global economy slows in late-2018 - leading to a recession in 2019 - Japan will be hard hit, given the highly cyclical nature of its economy. And this could cause Japanese policymakers to throw the proverbial kitchen sink at the problem, including doing something that they have so far resisted: introducing a "helicopter money" financed fiscal stimulus program. Against the backdrop of weak potential GDP growth and a shrinking reservoir of domestic savings, the government may get a lot more inflation than it bargained for. Act 3: Stagflation Who Remembers The 70s Anymore? By historical standards, the 2019 recession will be a mild one for most countries, especially in the developed world. This is simply because the excesses that preceded the subprime crisis in 2007 and, to a lesser extent the tech bust in 2000, are likely to be less severe going into the next global downturn than they were back then. The policy response may turn out to be anything but mild, however. Memories of the Great Recession are still very much vivid in most peoples' minds. No one wants to live through that again. In contrast, memories of the inflationary 1970s are fading. A recent NBER paper documented that age plays a big role in determining whether central bankers turn out to be dovish or hawkish.3 Those who experienced stagflation in the 1970s as adults are much more likely to express a hawkish bias than those who were still in their diapers back then. The implication is the future generation of central bankers is likely to see the world through more dovish eyes than their predecessors. Even if one takes the generational mix out of the equation, there are good reasons to aim for higher inflation in today's environment. For one thing, debt is high. The simplest way to reduce real debt burdens is by letting inflation accelerate. In addition, the zero bound is less likely to be a problem if inflation were higher. After all, if inflation were running at 1% going into a recession, real rates would not be able to fall much below -1%. But if inflation were running at 3%, real rates could fall to as low as -3%. The Politics Of Inflation Political developments will also facilitate the transition to higher inflation. In the U.S., the presidential election campaign will start coming into focus in 2019. If the economy enters a recession then, Donald Trump will go ballistic. The infrastructure program that Republicans in Congress are downplaying now will be greatly expanded. Gold-plated hotels and casinos will be built across the country. Of course, several years could pass between when an infrastructure bill is passed and when most new projects break ground. By that time, the economy will already be recovering. This will help fuel inflation. As the economy turns down in 2019, the Fed will also be forced to play ball. The market's current obsession over whether President Trump wants a "dove" or a "hawk" as Fed chair misses the point. He wants neither. He wants someone who will do what they are told. This means that the next Fed chair will likely be a "really smart" business executive with little-to-no-experience in central banking and even less interest in maintaining the Federal Reserve's institutional independence. The empirical evidence strongly suggests that inflation tends to be higher in countries that lack independent central banks (Chart 27). This may be the fate of the U.S. Chart 27Inflation Higher In Countries Lacking Independent Central Banks Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Europe's Populists: Down But Not Out Whether something similar happens in Europe will also depend on political developments. For the next 18 months at least, the populists will be held at bay (Chart 28). Le Pen currently trails Macron by 24 percentage points in a head-to-head contest. It is highly unlikely that she will be able to close this gap between now and May 7th, the date of the second round of the Presidential contest. In Germany, support for the europhile Social Democratic Party is soaring, as is support for the common currency itself. For the time being, euro area risk assets will be able to climb the proverbial political "wall of worry." However, if the European economy turns down in 2019, all this may change. Chart 29 shows the strong correlation between unemployment rates in various French départements and support for Marine Le Pen's National Front. Should French unemployment rise, her support will rise as well. The same goes for other European countries. Chart 28France And Germany: Populists Held At Bay For Now France And Germany: Populists Held At Bay For Now France And Germany: Populists Held At Bay For Now Chart 29Higher Unemployment Would Benefit Le Pen Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Meanwhile, there is a high probability that the migrant crisis will intensify at some point over the next few years. Several large states neighboring Europe are barely holding together - Egypt being a prime example - and could erupt at any time. Furthermore, demographic trends in Africa portend that the supply of migrants will only increase. In 2005, the United Nations estimated that sub-Saharan Africa's population will increase to 2 billion by the end of the century, up from one billion at present. In its 2015 revision, the UN doubled its estimate to 4 billion. And even that may be too conservative because it assumes that the average number of births per woman falls from 5.1 to 2.2 over this period (Chart 30). Chart 30Population Pressures In Africa Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play The existing European political order is not well equipped to deal with large-scale migration, as the hapless reaction to the Syrian refugee crisis demonstrates. This implies that an increasing share of the public may seek out a "new order" that is more attuned to their preferences. European history is fraught with regime shifts, and we may see yet another one in the 2020s. The eventual success of anti-establishment politicians on both sides of the Atlantic suggests that open border immigration policies and free trade - the two central features of globalization - will come under attack. Consequently, an inherently deflationary force, globalization, will give way to an inherently inflationary one: populism. The Productivity Curse Just as the "flation" part of stagflation will become more noticeable as the global economy emerges from the 2019 recession, so will the "stag." Chart 31 shows that productivity growth has fallen across almost all countries and regions. There is little compelling evidence that measurement error explains the productivity slowdown.4 Cyclical factors have played some role. Weak investment spending has curtailed the growth in the capital stock. This means that today's workers have not benefited from the same improvement in the quality and quantity of capital as they did in previous generations. However, the timing of the productivity slowdown - it began in 2004-05 in most countries, well before the financial crisis struck - suggests that structural factors have been key. Most prominently, the gains from the IT revolution have leveled off. Recent innovations have focused more on consumers than on businesses. As nice as Facebook and Instagram are, they do little to boost business productivity - in fact, they probably detract from it, given how much time people waste on social media these days. Human capital accumulation has also decelerated, dragging productivity growth down with it. Globally, the fraction of adults with a secondary degree or higher is increasing at half the pace it did in the 1990s (Chart 32). Educational achievement, as measured by standardized test scores in mathematics, is edging lower in the OECD, and is showing very limited gains in most emerging markets (Chart 33).5 Given that test scores are extremely low in most countries with rapidly growing populations, the average level of global mathematical proficiency is now declining for the first time in modern history. Chart 31Productivity Growth Has Slowed In Most Major Economies Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Chart 32The Contribution To Growth From Rising Human Capital Is Falling Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Chart 33Math Skills Around The World Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Productivity And Inflation The slowdown in potential GDP growth tends to be deflationary at the outset, but becomes inflationary later on (Chart 34). Initially, lower productivity growth reduces investment, pushing down aggregate demand. Lower productivity growth also curtails consumption, as households react to the prospect of smaller real wage gains. Chart 34A Decline In Productivity Growth Is Deflationary In The Short Run, But Inflationary In The Long Run Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Eventually, however, economies that suffer from chronically weak productivity growth tend to find themselves rubbing up against supply-side constraints. This leads to higher inflation.6 One only needs to look at the history of low-productivity economies in Africa and Latin America to see this point - or, for that matter, the U.S. in the 1970s, a decade during which productivity growth slowed and inflation accelerated. Financial Markets Overall Strategy Risk assets have enjoyed a strong rally since late last year, and a modest correction is long overdue. Still, as long as the global economy continues to grow at a robust pace, the cyclical outlook for risk assets will remain bullish. As such, investors with a 12-month horizon should stay overweight global equities and high-yield credit at the expense of government bonds and cash. Global growth is likely to slow in the second half of 2018, with the deceleration intensifying into 2019, possibly culminating in a recession in a number of countries. To what extent markets "sniff out" an economic slowdown before it happens is a matter of debate. U.S. equities did not peak until October 2007, only slightly before the Great Recession began. Commodity prices did not top out until the summer of 2008. Thus, the market's track record for predicting recessions is far from an envious one. Nevertheless, investors should err on the side of safety and start scaling back risk exposure next spring. The 2019 recession will last 6-to-12 months, followed by a gradual recovery that sees the restoration of full employment in most countries by 2021. At that point, inflation will take off, rising to over 4% by the middle of the decade. The 2020s will be remembered as a decade of intense pain for bond investors. In relative terms, equities will fare better than bonds, but in absolute terms they will struggle to generate a positive real return. As in the 1970s, gold will be the standout winner. Chart 35 presents a visual representation of how the main asset markets are likely to evolve over the next seven years. Chart 35Market Outlook For Major Asset Classes Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Equities Cyclically Favor The Euro Area And Japan Over The U.S. Stronger global growth is powering an acceleration in corporate earnings. Global EPS is expected to expand by 12% over the next 12 months. Analysts are usually too bullish when it comes to making earnings forecasts. This time around they may be too bearish. Chart 36 shows that the global earnings revision ratio has turned positive for the first time in six years, implying that analysts have been behind the curve in revising up profit projections. We prefer euro area and Japanese stocks relative to U.S. equities over a 12-month horizon. We would only buy Japanese stocks on a currency-hedged basis, as the prospect of a weaker yen is the main reason for being overweight Japan. In contrast, we would still buy euro area equities on a U.S. dollar basis, even though our central forecast is for the euro to weaken against the dollar over the next 12 months. Our cyclically bullish view on euro area equities reflects several considerations. For starters, they are cheap. Euro area stocks currently trade at a Shiller PE ratio of only 17, compared with 29 for the U.S. (Chart 37). Some of this valuation gap can be explained by different sector weights across the two regions. However, even if one controls for this factor, as well as the fact that euro area stocks have historically traded at a discount to the U.S., the euro area still comes out as being roughly one standard deviation cheap compared with the U.S. (Chart 38). Chart 36Global Earnings Picture Looking Brighter Global Earnings Picture Looking Brighter Global Earnings Picture Looking Brighter Chart 37Euro Area Stocks Are A Bargain... Euro Area Stocks Are A Bargain... Euro Area Stocks Are A Bargain... Chart 38...No Matter How You Look At It ...No Matter How You Look At It ...No Matter How You Look At It European Banks Are In A Cyclical Sweet Spot Of course, if euro area banks flounder over the next 12 months as they have for much of the past decade, none of this will matter. However, we think that the region's banks have finally turned the corner. The ECB is slowly unwinding its emergency measures and core European bond yields have risen since last summer. This has led to a steeper yield curve, helping to flatter net interest margins. Chart 39 shows that the relative performance of European banks is almost perfectly correlated with the level of German bund yields. Our European Corporate Health Monitor remains in improving territory, in contrast to the U.S., where it has been deteriorating since 2013 (Chart 40). Profit margins in Europe have room to expand, whereas in the U.S. they have already maxed out. The capital positions of European banks have also improved greatly since the euro crisis. Not all banks are out of the woods, but with nonperforming loans trending lower, the need for costly equity dilution has dissipated (Chart 41). Meanwhile, euro area credit growth is accelerating and loan demand continues to expand. Chart 39Performance Of European Banks And Bond Yields: A Good Fit Performance Of European Banks And Bond Yields: A Good Fit Performance Of European Banks And Bond Yields: A Good Fit Chart 40Corporations Healthier In The Euro Area Corporations Healthier In The Euro Area Corporations Healthier In The Euro Area Chart 41Cyclical Background Positive For Bank Stocks Cyclical Background Positive For Bank Stocks Cyclical Background Positive For Bank Stocks Beyond a 12-month horizon, the outlook for euro area banks and the broader stock market look less enticing. The region will suffer along with the rest of the world in 2019. The eventual triumph of populist governments could even lead to the dissolution of the common currency. This means that euro area stocks should be rented, not owned. The same goes for U.K. equities. EM: Uphill Climb Emerging market equities tend to perform well when global growth is strong. Thus, it would not be surprising if EM equities continue to march higher over the next 12 months. However, the structural problems plaguing emerging markets that we discussed earlier in this report will continue to cast a pall over the sector. Our EM strategists favor China, Taiwan, Korea, India, Thailand, Poland, Hungary, the Czech Republic, and Russia. They are neutral on Singapore, the Philippines, Hong Kong, Chile, Mexico, Colombia, and South Africa; and are underweight Indonesia, Malaysia, Brazil, Peru, and Turkey. Fixed Income Global Bond Yields To Rise Further We put out a note on July 5th entitled "The End Of The 35-Year Bond Bull Market" recommending that clients go structurally underweight safe-haven government bonds.7 As luck would have it, we penned this report on the very same day that the 10-year Treasury yield hit a record closing low of 1.37%. We continue to think that asset allocators should maintain an underweight position in global bonds over the next 12 months. In relative terms, we favor Japan over the U.S. and have a neutral recommendation on the euro area and the U.K. Chart 42The Market Expects 50 Basis Points Of Tightening Over The Next 12 Months The Market Expects 50 Basis Points Of Tightening Over The Next 12 Months The Market Expects 50 Basis Points Of Tightening Over The Next 12 Months Underweight The U.S. For Now We expect the U.S. 10-year Treasury yield to rise to around 3.2% over the next 12 months. The Fed is likely to raise rates by a further 100 basis points over this period, about 50 bps more than the 12-month discounter is currently pricing in (Chart 42). In addition, the Fed will announce later this year or in early 2018 that it will allow the assets on its balance sheet to run off as they mature. This could push up the term premium, giving long Treasury yields a further boost. Thus, for now, investors should underweight Treasurys on a currency-hedged basis within a fixed-income portfolio. The cyclical peak for both Treasury yields and the dollar should occur in mid-2018. Slowing growth in the second half of that year and a recession in 2019 will push the 10-year Treasury yield back towards 2%. After that, bond yields will grind higher again, with the pace accelerating in the early 2020s as the stagflationary forces described above gather steam. Neutral On Europe, Overweight Japan Yields in the euro area will follow the general contours of the U.S., but with several important qualifications. The ECB is likely to roll back some of its emergency measures over the next 12 months, including suspending the Targeted Longer-Term Refinancing Operations, or TLTROs. It could also raise the deposit rate slightly, which is currently stuck in negative territory. However, in contrast to the Fed, the ECB is unlikely to hike its key policy rate, the repo rate. And while the ECB will "taper" asset purchases, it will not take any steps to shrink the size of its balance sheet. As such, fixed-income investors should maintain a benchmark allocation to euro area bonds. Chart 43A Bit More Juice Left A Bit More Juice Left A Bit More Juice Left A benchmark weighting to gilts is also warranted. With the Brexit negotiations hanging in the air, it is doubtful that the Bank of England would want to hike rates anytime soon. On the flipside, rising inflation - though largely a function of a weak currency - will make it difficult for the BoE to increase asset purchases or take other steps to ease monetary policy. We would recommend a currency-hedged overweight position in JGBs. The Bank of Japan is committed to keeping the 10-year yield pinned to zero. Given that neither actual inflation nor inflation expectations are anywhere close to that level, it is highly unlikely that the BoJ will jettison its yield-targeting regime anytime soon. With government bond yields elsewhere likely to grind higher, this makes JGBs the winner by default. High-Yield Credit: Still A Bit Of Juice Left The fact that the world's most attractive government bond market by our rankings - Japan - is offering a yield of zero speaks volumes. As long as global growth stays strong and corporate default risk remains subdued, investors will maintain their love affair with high-yield credit. Thus, while credit spreads have fallen dramatically, they could still fall further (Chart 43). Only when corporate stress begins to boil over in late 2018 will things change. Nevertheless, investors will continue to face headwinds from rising risk-free yields in most economies even in the near term. This implies that the return from junk bonds in absolute terms will fall short of what is delivered by equities over the next 12 months. Currencies And Commodities Chart 44Real Rate Differentials Are Driving Up The Dollar Real Rate Differentials Are Driving Up The Dollar Real Rate Differentials Are Driving Up The Dollar Real Rate Differentials Will Support The Greenback We expect the real trade-weighted dollar to appreciate by about 10% over the next 12 months. Historically, changes in real interest rate differentials have been the dominant driver of currency movements in developed economies. The past few years have been no different. Chart 44 shows that the ascent of the trade-weighted dollar since mid-2014 has been almost perfectly matched by an increase in U.S. real rates relative to those abroad. Interest rate differentials between the U.S. and its trading partners are likely to widen further through to the middle of 2018 as the Fed raises rates more quickly than current market expectations imply, while other central banks continue to stand pat. Accordingly, we would fade the recent dollar weakness. As we discussed in "The Fed's Unhike," the March FOMC statement was not as dovish as it might have appeared at first glance.8 Given that monetary conditions eased in the aftermath of the Fed meeting - exactly the opposite of what the Fed was trying to achieve - it is likely that the FOMC's rhetoric will turn more hawkish in the coming weeks. The Yen Has The Most Downside, The Pound The Least Among the major dollar crosses, we see the most downside for the yen over the next 12 months. The Bank of Japan will continue to keep JGB yields anchored at zero. As yields elsewhere rise, investors will shift their money out of Japan, causing the yen to weaken. Only once the global economy begins to teeter into recession late next year will the yen - traditionally, a "risk off" currency - begin to rebound. The euro will also weaken against the dollar over the next 12 months, although not as much as the yen. The ECB's "months to hike" has plummeted from nearly 60 last summer to 26 today (Chart 45). That seems too extreme. Core inflation in the euro area is well below U.S. levels, even if one adjusts for measurement differences between the two regions (Chart 46). The neutral rate is also lower in the euro area, as discussed previously. This sharply limits the ability of the ECB to raise rates. Chart 45Market's Hawkish View Of The ECB Is Too Extreme Market's Hawkish View Of The ECB Is Too Extreme Market's Hawkish View Of The ECB Is Too Extreme Chart 46Core Inflation In The U.S. Is Still Higher, Even Excluding Housing Core Inflation In The U.S. Is Still Higher, Even Excluding Housing Core Inflation In The U.S. Is Still Higher, Even Excluding Housing Unlike most currencies, sterling should be able to hold its ground against the dollar over the next 12 months. The pound is very cheap by most metrics (Chart 47). The prospect of contentious negotiations over Brexit with the EU is already in the price. What may not be in the price is the possibility that the U.K. will move quickly to reach a deal with the EU. If such a deal fails to live up to the promises made by the Brexit campaign - a near certainty in our view - a new referendum may need to be scheduled. A new vote could yield a much different result than the first one. If the market begins to sniff out such an outcome, the pound could strengthen well before the dust settles. EM And Commodity Currencies The RMB will weaken modestly against the dollar over the coming year. As we have discussed in the past, China's high saving rate will keep the pressure on the government to try to export excess production abroad by running a large current account surplus. This requires a weak currency.9 Nevertheless, a major devaluation of the RMB is not in the cards. Much of the capital flight that China has experienced recently has been driven by an unwinding of the hot money flows that entered the country over the preceding years. Despite all the talk about a credit bubble, Chinese external debt has fallen by around $400 billion since its peak in mid-2014 - a decline of over 50% (Chart 48). At this point, most of the hot money has fled the country. This suggests that the pace of capital outflows will subside. Chart 47Pound: Cheap By All Accounts Pound: Cheap By All Accounts Pound: Cheap By All Accounts Chart 48Hot Money In, Hot Money Out Hot Money In, Hot Money Out Hot Money In, Hot Money Out A somewhat weaker RMB could dampen demand for base and bulk metals. A slowdown in Chinese construction activity next year could also put added pressure on metals prices. Our EM strategists are especially bearish on the South African rand, Brazilian real, Colombian peso, Turkish lira, Malaysian ringgit, and Indonesian rupiah. Crude should outperform metals over the next 12 months. This will benefit the Canadian dollar and other oil-sensitive currencies. However, Canada's housing bubble is getting out of hand and could boil over if domestic borrowing costs climb in line with rising long-term global bond yields. A sagging property sector will limit the ability of the Bank of Canada to raise short-term rates. On balance, we see modest downside for the CAD/USD over the coming year. The Aussie dollar will suffer even more, given the country's own housing excesses and its export sector's high sensitivity to metal prices. Finally, a few words on the most of ancient of all currencies: gold. We do not expect bullion to fare well over the next 12 months. A stronger dollar and rising bond yields are both bad news for the yellow metal. However, once central banks start slashing rates in 2019 and stagflationary forces begin to gather steam in the early 2020s, gold will finally have its day in the sun. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Seven Structural Reasons For A Lower Neutral Rate In The U.S.," dated March 13, 2015, available at gis.bcaresearch.com. 2 Please see Geopolitical Strategy Weekly Report, "The "What Can You Do For Me" World?" dated January 25, 2017, and Special Report, "Will Scotland Scotch Brexit?" dated March 29, 2017, available at gps.bcaresearch.com. 3 Ulrike Malmendier, Stefan Nagel, and Zhen Yan, "The Making Of Hawks And Doves: Inflation Experiences On The FOMC," NBER Working Paper No. 23228 (March 2017). 4 Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com. 5 Please see The Bank Credit Analyst Special Report, "Taking Off The Rose-Colored Glasses: Education And Growth In The 21st Century," dated February 24, 2011, available at bca.bcaresearch.com. 6 Note to economists: We can think of this relationship within the context of the Solow growth model. The model says that the neutral real rate, r, is equal to (a/s) (n + g + d), where a is the capital share of income, s is the saving rate, n is labor force growth, g is total factor productivity growth, and d is the depreciation rate of capital. In the standard setup where the saving rate is fixed, slower population and productivity growth will always result in a lower equilibrium real interest rate. However, consider a more realistic setup where: 1) the saving rate rises initially as the population ages, but then begins to decline as a larger share of the workforce enters retirement; and 2) habit persistence affects consumer spending, so that households react to slower real wage growth by saving less rather than cutting back on consumption. In that sort of environment, the neutral rate could initially fall, but then begin to rise. If the central bank reacts slowly to changes in the neutral rate, or monetary policy is otherwise constrained by the zero bound on interest rates and/or political considerations, the initial effect of slower trend GDP growth will be deflationary while the longer-term outcome will be inflationary. 7 Please see Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gis.bcaresearch.com. 8 Please see Global Investment Strategy Weekly Report, "The Fed's Unhike," dated March 16, 2017, available at gis.bcaresearch.com. 9 Please see Global Investment Strategy Weekly Report, "Does China Have A Debt Problem Or A Savings Problem?" dated February 24, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Financials stocks have taken it on the chin, reflecting the unwinding of the 'Trump Trade' following the Administration's inability to tackle health care reform. As a result, the financials sector is reverting from hopes for deregulation to fundamentals for support. Worrisomely, credit growth has stalled. The middle panel of the chart shows that the credit impulse is sinking quickly. While this may prove a temporary/transitory phenomenon, the breadth of the credit contraction is broad-based, and thus, worthy of close attention. Of the eight loan categories tracked by the Fed, only one loan segment has a positive credit impulse: consumer loans. Historically, both the credit impulse and our diffusion index for the credit impulse have been solid leading indicators for relative financials EPS growth. Consequently, there is no confirmation that earnings momentum has turned the corner on a sustained basis. Bottom Line: Within a neutral overall financials stance we remain underweight the S&P banks index and continue to overweight the S&P consumer finance sub-group, which has high-conviction status. (If you would like to receive the breakdown of the credit impulse per loan category please email us at clientservices@bcaresearch.com and we will email you the chart.) The ticker symbols for the stocks in the S&P consumer finance and S&P banks index are: BLBG: BLBG: S5CFINX-AXP, COF, DFS, SYF, NAVI and BLBG: S5BANKX -WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT, respectively. Financials Selectivity Is Warranted Financials Selectivity Is Warranted

Bank stocks are being jettisoned from portfolios almost as fast as they were added after the election, on the back of the perceived dovish Fed shift and concerns about the efficacy of Trump's policy goals. The latter has raised the specter of a cooling in economic growth, which would remove the major source of support for bank stocks. Indeed, there is little fundamental support to drive earnings outperformance. Total bank credit growth is contracting and credit quality is no longer adding to profitability. Bank productivity growth is sinking quickly, because balance sheet expansion has ended but banks are adding to their cost structures. If the yield curve begins to narrow on fears of economic disappointment, it will remove the primary driver of capital inflows into banks. Regional banks have been particularly hard hit, but the entire banking group is at risk of a letdown. Bottom Line: Continue to shy away from banks, and please see the March 6 Weekly Report for more details on our banking view. The ticker symbols for the stocks in the S&P Banks index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT. The Bank Party Is Over, A Hangover Looms The Bank Party Is Over, A Hangover Looms

Highlights Please note that today we are publishing an abbreviated Weekly Bulletin as tomorrow we will publish Great Debate: Does China Have Too Much Debt Or Too Much Savings? The latter report will elaborate on long-standing view differences on China within BCA. I will be debating my colleagues Peter Berezin and Yan Wang on the issues surrounding China's savings and debt as well as the growth outlook. Arthur Budaghyan Feature Singapore: MAS Will Cap Interest Rates Higher U.S. interest rates will temporarily place upward pressure on Singaporean local interest rates (Chart I-1). However, Singapore is not in position to tolerate higher borrowing costs due to lingering credit excesses and deflationary pressures that currently prevail in its economy. The Monetary Authority of Singapore (MAS) will therefore respond by injecting liquidity to keep interbank rates low. The MAS operates monetary policy by guiding the exchange rate - and by default - often allowing interest rates to fluctuate freely. Yet higher interest rates are not an optimal policy option at the moment. If and as U.S. interest rates and the U.S. dollar rise, the MAS will intervene to cap local rates even if it entails a weaker Singapore dollar. While there is a recovery going on in non-oil export volumes and narrow money (M1) (Chart I-2), many other cyclical indicators are still negative. Chart I-1Rising Libor Rates Will Exert ##br##Upward Pressure On Singaporean Rates Rising Libor Rates Will Exert Upward Pressure On Singaporean Rates Rising Libor Rates Will Exert Upward Pressure On Singaporean Rates Chart I-2Singapore: Non-Oil ##br##Exports Are Picking Up Singapore: Non-Oil Exports Are Picking Up Singapore: Non-Oil Exports Are Picking Up The exchange rate-targeting system was introduced in the early 1980s when exports stood at 150% of GDP. Today, exports relative to GDP have fallen substantially to 115% of GDP (Chart I-3). On the other hand, total private non-financial sector debt levels have risen to 180% of GDP (Chart I-3). Therefore, the Singaporean economy has become much more leveraged to interest rates and somewhat less exposed to global trade. Improving exports will not be sufficient to offset the negative impact of rising borrowing costs. Moreover, our proxy for interest payments on domestic debt has also surged and now stands at close to 10% of GDP (Chart I-4). What is precarious is that the rise in interest payments relative to income has occurred in a period when rates are close to record-low levels. Chart I-3Singapore: Debt Is ##br##Overshadowing Exports Singapore: Debt Is Overshadowing Exports Singapore: Debt Is Overshadowing Exports Chart I-4Singapore: Interest Payments Are ##br##Large Despite Record Low Rates Singapore: Interest Payments Are Large Despite Record Low Rates Singapore: Interest Payments Are Large Despite Record Low Rates If borrowing costs rise, it will likely cause major debt deflation concerns. The MAS will not allow this to happen. Employment is stagnating, while employment in the construction and manufacturing sectors is contracting (Chart I-5). Weak employment has weighed on the consumer sector. Retail and department store sales are still shrinking (Chart I-6). Chart I-5Singapore: Employment Is Weak Singapore: Employment Is Weak Singapore: Employment Is Weak Chart I-6Retail Spending Is Contracting Retail Spending Is Contracting Retail Spending Is Contracting Importantly, the real estate sector, one of the major pillars of the Singapore economy, is depressed. Property prices across the board are deflating, while vacancy rates are rising (Chart I-7). Bank loan growth to property developers has also stalled (Chart I-7, bottom panel). Weak economic growth should be reflected on banks' balance sheets. Surprisingly, non-performing loans (NPLs) among Singapore's three largest banks still stands at a low 1.4%. If and as loan losses begin to rise, commercial banks will rush to increase provisioning for these losses, which will hurt their profits and keep credit growth subdued. Furthermore, Singaporean banks are also very exposed to Malaysia. Singapore's largest banks have extended loans to Malaysia of approximately 67 billion Singapore dollars - or 16% of GDP. Aggregate external loans stand at 137% of GDP (Chart I-8). Economic fundamentals are currently very weak and will continue to deteriorate in Malaysia. This warrants more assets write-offs among Singapore banks and less appetite to expand their balance sheet. Chart I-7Property Sector In Singapore Property Sector In Singapore Property Sector In Singapore Chart I-8Singaporean External Loans Are Enormous Singaporean External Loans Are Enormous Singaporean External Loans Are Enormous On the whole, if Singaporean interest rates begin to rise due to either depreciation of the Singapore dollar or higher U.S. interest rates, the central bank will intervene to bring local rates down. It would not be the first time the MAS has intervened to bring down interest rates. In 2015 when EM risks escalated, local interbank rates spiked. The MAS promptly injected liquidity in the banking system by buying back its outstanding MAS bills, and by also purchasing government securities, supplying liquidity to the banking system. This essentially placed a cap on interbank rates. Chart I-9Go Long Singapore Real ##br##Estate Stocks Vs. Hong Kong Go Long Singapore Real Estate Stocks Vs. Hong Kong Go Long Singapore Real Estate Stocks Vs. Hong Kong What is noteworthy is that the Singapore dollar weakened as a result of the intervention, although the MAS's official monetary policy stance was not stimulative - i.e. the monetary authorities did not target to weaken the trade-weighted SGD. In that instance, the MAS decided to focus on interest rates/funding market stability and ignore the exchange rate's response. This highlights that despite the MAS's official monetary policy framework of guiding the exchange rate, it will not allow interest rates to rise. Unlike Singapore, Hong Kong does not operate an independent monetary policy and as such will be forced to import higher U.S. rates. As a bet on higher interest rates in Hong Kong and the U.S. relative to Singapore, investors should consider going long Singaporean real estate stocks and shorting Hong Kong real estate stocks. Chart I-9 shows that Singaporean real estate stocks outperform Hong Kong's when the latter's interest rates/bond yields rise relative to Singapore and when Singapore's M1 growth accelerate relative to Hong Kong. As discussed above, the MAS has the capacity and will to inject liquidity to lower interest rates. Hong Kong, however, does not have this privilege due to the currency's peg to the greenback. Besides, Singapore's property correction is now much more advanced than Hong Kong's. In fact, Hong Kong property prices are still rising, i.e., the real estate market adjustment in Hong Kong has not yet started. While both city states are vulnerable to a potential slowdown in Chinese inflows, Hong Kong real estate prices will ultimately fall from a higher starting point. Bottom Line: A rising U.S. dollar and U.S. interest rates may exert upward pressure on Singaporean local interest rates. However, the Singaporean central bank will respond by injecting liquidity, which will cap rates relative to the U.S. and Hong Kong. This opens a tactical trade opportunity (for the next 3 months): Long Singapore real estate stocks / short Hong Kong real estate shares. Asian equity portfolio investors should have a neutral allocation to Singapore stocks within the EM/emerging Asian benchmarks. Ayman Kawtharani, Research Analyst ayman@bcaresearch.com Colombia: Not Out Of The Woods Yet Even though global economic growth has been improving and commodities prices have rallied, Colombia's growth is still bound to disappoint. We remain structurally bullish on the nation's longer-term prospects. That said, there will still be more downside this year. Credit growth will continue to decelerate, despite the beginning of a rate cut cycle (Chart II-1). Interest rates are still high, both in nominal and real terms (Chart II-2). This along with poor consumer and business confidence (Chart II-3) will depress credit demand and spending. Chart II-1Colombia: Negative Credit Impulse Colombia: Negative Credit Impulse Colombia: Negative Credit Impulse Chart II-2Borrowing Costs Are Still High Borrowing Costs Are Still High Borrowing Costs Are Still High Chart II-3Consumer & Business Confidence Are Weak Consumer & Business Confidence Are Weak Consumer & Business Confidence Are Weak Furthermore, the central bank's liquidity injections into the banking system have dropped considerably (Chart II-4). In the past few years, abundant liquidity provisioning by the central bank had allowed commercial banks to sustain robust credit growth. Hence, a withdrawal of banking system liquidity will cap loan origination. The current account deficit remains wide at $12.5 billion, or 5.2% of GDP. Financing such a wide deficit will prove challenging. Besides, BCA's Emerging Markets Strategy team believes oil prices are at risk of additional declines. Hence, we are bearish on the Colombian peso. Fiscal policy is set to tighten as the budget deficit has ballooned due to strong spending and shrinking revenues (Chart II-5). Recently introduced tax reforms represent a step forward with respect to the country's structural reforms agenda, as it will simplify the tax code and reduce corporate tax rates. Chart II-4Withdrawal Of Liquidity Will Cap Credit Growth Withdrawal Of Liquidity Will Cap Credit Growth Withdrawal Of Liquidity Will Cap Credit Growth Chart II-5Government Fiscal Balance Is Deteriorating Government Fiscal Balance Is Deteriorating Government Fiscal Balance Is Deteriorating However, redistributing the tax burden onto individuals, mainly by increasing the VAT from 16% to 19%, will reinforce the slump in household spending. In terms of high frequency data, there are little signs of economic revival (Chart II-6). Retail sales volume remain tame. The latest bounce in this series most likely reflects consumers front running the impending VAT hike. Furthermore, oil production is likely to decline further, and non-oil exports are still contracting. In terms of financial markets, we recommend the following: We are closing our bet on yield curve flattening - receive 10-year/pay 1-year swap rates. Initiated on September 16, 2015, this trade has produced a 190 basis-point gain (Chart II-7). At the moment, the risk-reward for this position is no longer attractive. Chart II-6Cyclical Economic Activity Remains Subdued Cyclical Economic Activity Remains Subdued Cyclical Economic Activity Remains Subdued Chart II-7Take Profits On The Yield Curve Trade Take Profits On The Yield Curve Trade Take Profits On The Yield Curve Trade We remain neutral on Colombian equities and sovereign credit relative to their respective EM universes. Even though our long Colombian bank stocks/short Peruvian banks bet has been deep in the negative, we are reluctant to cut it. The basis is that Colombia's central bank may opt to cut rates further, even if the peso depreciates anew. In contrast, the Peruvian central bank is more likely to hike rates if its currency comes under downward pressure. Bank share prices will likely react to marginal shifts in relative interest rates between the two countries. Andrija Vesic, Research Assistant andrijav@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Eurostoxx50 versus S&P500 boils down to a simple choice: Banco Santander, BNP Paribas and ING; or Apple, Microsoft and Google? Right now, we would rather own the three tech stocks than the three banks - which necessarily means underweighting the Eurostoxx50 versus the S&P500. Eurostoxx50 performance relative to the FTSE100 boils down to the inverse direction of euro/pound. Right now, we expect euro/pound to strengthen - which necessarily means underweighting the Eurostoxx50 versus the FTSE100. Stay overweight Spanish Bonos versus French OATs as a structural position. Feature Which would you rather own: Banco Santander, BNP Paribas and ING; or Apple, Microsoft and Google?1 Surprising as it may seem, the all-important allocation decision between the Eurostoxx50 and the S&P500 boils down to this simple choice. The Chart of the Week should leave no doubt that everything else is largely irrelevant. Chart of the WeekEurostoxx50 Vs. S&P500 = Santander, BNP & ING Vs. Apple, Microsoft & Google Eurostoxx50 Vs. S&P500 = Santander, BNP & ING Vs. Apple, Microsoft & Google Eurostoxx50 Vs. S&P500 = Santander, BNP & ING Vs. Apple, Microsoft & Google Right now, we would rather own the top three U.S. tech stocks rather than the top three euro area banks - which necessarily means underweighting the Eurostoxx50 versus the S&P500. The Fallacy Of Division For Equities The fallacy of division is a logical fallacy. It occurs when somebody falsely infers that what is true for the whole is also true for the parts that make up the whole. As a simple example, somebody might infer that because their computer screen appears purple, the pixels that make up the screen are also purple. In fact, the pixels are not purple. They are either red or blue. The fallacy of division is that the property of the whole - purpleness - does not translate to the property of the constituent parts - redness or blueness. As investment strategists, we hear a common fallacy of division. Since global equities are a play on the global economy, it might seem that national equity markets - like Ireland's ISEQ or Denmark's OMX - are plays on their national economies. In fact, nothing could be further from the truth. The property of the equity market as a global aggregate does not translate to the property of equity markets as national parts. The equity markets in Ireland and Denmark are each dominated by one stock which accounts for almost a quarter of national market capitalization - in Ireland, Ryanair, the pan-European budget airline, and in Denmark, Novo Nordisk, the global pharmaceutical company. Therefore, the relative performance of Ireland's ISEQ has almost no connection with Ireland's economy; rather, it is a just a play on airlines. And given budget airlines' sensitivity to fuel costs, Ireland's ISEQ is counterintuitively an inverse play on the oil price (Chart I-2). Likewise, the relative performance of Denmark's OMX has no connection with Denmark's economy; it is just a strong play on global pharma (Chart I-3). Chart I-2Ireland = Short Oil Ireland = Short Oil Ireland = Short Oil Chart I-3Denmark = Long Pharma Denmark = Long Pharma Denmark = Long Pharma In a similar vein, the relative performance of Switzerland's SME is also a play on global pharma - via Novartis and Roche (Chart I-4); Norway's OBX is a play on global energy - via Statoil (Chart I-5); and Italy's MIB and Spain's IBEX are plays on banks (Chart I-6 and Chart I-7). We could continue, but you get our drift... Chart I-4Switzerland = Long Pharma / Short Oil Switzerland = Long Pharma / Short Oil Switzerland = Long Pharma / Short Oil Chart I-5Norway = Long Oil Norway = Long Oil Norway = Long Oil Chart I-6Italy = Long Banks Italy = Long Banks Italy = Long Banks Chart I-7Spain = Long Banks Spain = Long Banks Spain = Long Banks But what about a regional index like the Eurostoxx50 or Eurostoxx600: surely, with the broader exposure, there must be a strong connection with the euro area economy? Unfortunately not - at least, not when it comes to relative performance. Consider that for the past few years, the euro area economy has actually outperformed the U.S. economy2 (Chart I-8). Yet the Eurostoxx50 has substantially underperformed the S&P500 (Chart I-9). What's going on? The answer is that the Eurostoxx50 has a major 15% weighting to banks and a minor 7% weighting to tech. The S&P500 is the mirror image; a minor 7% weighting to banks and a major 22% weighting to tech. Chart I-8The Euro Area Economy ##br##Has Outperformed... The Euro Area Economy Has Outperformed... The Euro Area Economy Has Outperformed... Chart I-9...But The Eurostoxx50##br## Has Underperformed ...But The Eurostoxx50 Has Underperformed ...But The Eurostoxx50 Has Underperformed For the Eurostoxx50 the distinguishing property is 'bank'; for the S&P500 it is 'tech'. And as we saw earlier, these distinguishing properties are captured by just three large euro area banks and three large U.S tech stocks. So index relative performance simply boils down to whether the three euro area banks outperform the three U.S. tech stocks, or vice-versa. Everything else is largely irrelevant. Equities' Connection With Economies Is Often Counterintuitive When it comes to the FTSE100, it turns out that it is not more bank or tech than the Eurostoxx50. Major sector weightings across the two indexes are broadly similar. Hence, relative performance is more connected to relative economic performance. But there is a catch - the connection is not as intuitive as you might first think. You see, both major indexes are made up of dollar-earning multinational companies. Yet the index value and earnings are quoted in pounds and euros respectively. If the home currency appreciates, index earnings - translated from dollars into home currency - go down, depressing index relative performance with it. And the opposite happens if the home currency depreciates. So the counterintuitive thing is that a relatively strengthening home economy does not result in index outperformance. Quite the opposite, it normally means a relatively more hawkish central bank, and an appreciating currency (Chart I-10). Thereby it causes index underperformance. Hence, Eurostoxx50 performance relative to the FTSE100 boils down to the inverse direction of euro/pound. Once again, Chart I-11 should leave readers in no doubt. Chart I-10A Relatively More Hawkish Central Bank =##br## A Stronger Currency A Relatively More Hawkish Central Bank = A Stronger Currency A Relatively More Hawkish Central Bank = A Stronger Currency Chart I-11A Stronger Currency = ##br##Equity Index Underperformance A Stronger Currency = Equity Index Underperformance A Stronger Currency = Equity Index Underperformance Which neatly brings us to today's ECB meeting. The ECB is a tunnel-vision 2% inflation-targeting central bank. Any upgrade to its inflation forecast, as seems likely, would imply less need for its extreme and experimental monetary easing. Once digested by the market, this would support the euro. Meanwhile, on the other side of the Channel, the U.K. Government is preparing to trigger Article 50 of the Lisbon Treaty and start its formal divorce from the EU within a couple of weeks. Expect the EU's immediate response to cast long shadows across Theresa May's vision of a future in sunlit uplands. Once digested by the market, this would further weigh down the pound. A stronger euro/pound necessarily means underweighting the Eurostoxx50 versus the FTSE100. The Fallacy Of Division For Bonds The fallacy of division also applies to euro area sovereign bonds. The aggregate euro area sovereign yield just equals the average ECB policy rate anticipated over the lifetime of the bond (Chart I-12). This is directly analogous to the relationship between the U.K. gilt yield and the anticipated path of the BoE base rate, and the relationship between the U.S. T-bond yield and the anticipated path of the Fed funds rate (Chart I-13). Chart I-12The Aggregate Euro Area Bond Yield = ##br##The Average ECB Policy Rate Expected The Aggregate Euro Area Bond Yield = The Average ECB Policy Rate Expected The Aggregate Euro Area Bond Yield = The Average ECB Policy Rate Expected Chart I-13The U.S. T-Bond Yield = ##br##The Average Fed Funds Rate Expected The U.S. T-Bond Yield = The Average Fed Funds Rate Expected The U.S. T-Bond Yield = The Average Fed Funds Rate Expected But what is true for the whole is not necessarily true for the parts that make up the whole. Individual euro area sovereign bond yields carry a second component which can override everything else. This second component is a redenomination premium as compensation for the expected loss if the bond redenominates out of euros. For example, the redenomination premium on a Spanish Bono versus a French OAT equals: The annual probability of euro breakup Multiplied by The expected undervaluation of a new peseta versus a new franc. However, the ECB's own analysis shows that Spain is now as competitive as France (Chart I-14), meaning that a new peseta ultimately should not lose value versus a new franc. So irrespective of the probability of euro breakup, the second item of the multiplication should be zero. Meaning that the redenomination premium should also be zero, rather than today's 75 bps (on 10-year Bonos over OATs). Bear in mind that Spain's housing bust and subsequent recapitalisation of its banks has followed Ireland's template - just with a two year lag. And observe that the redenomination premium on Irish 10-year bonds over OATs, which once stood at a remarkable 1100 bps, has now completely vanished. We expect Spain to continue following in the footsteps of Ireland (Chart I-15). As a structural position, stay long Spanish Bonos versus French OATs. Chart I-14Spain Has Dramatically Improved##br## Its Competitiveness Spain Has Dramatically Improved Its Competitiveness Spain Has Dramatically Improved Its Competitiveness Chart I-15Spain Is Following In The##br## Footsteps Of Ireland Spain Is Following In The Footsteps Of Ireland Spain Is Following In The Footsteps Of Ireland Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Listed as Alphabet. 2 On a per capita basis. Fractal Trading Model* Long tin / short copper hit its 5% profit target, while short MSCI AC World hit its 2.5% stop-loss. This week's recommendation is to short ruble / dollar. 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-16 Short RUB/USD Short RUB/USD * 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 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 Portfolio Strategy A relapse in the global financials sector threatens to spill into U.S. financials as credit growth sinks. Bank equities are the most vulnerable to such a phase, given their reliance on rising interest rate expectations rather than increased lending. Take profits in the S&P health care facilities index and downgrade to neutral. Recent Changes S&P Health Care Facilities - Take profits of 12% and downgrade to neutral. Table 1Sector Performance Returns (%) As Good As It Gets? As Good As It Gets? Feature Momentum continues to trump all else, with the equity market surging to new all-time highs last week. However, in the background, the Fed is becoming steadily more hawkish, and the odds of a March rate hike have risen substantially. This should be cause for some trepidation. Chart 1Multiples Are Headed##br## Lower As The Fed Hikes Multiples Are Headed Lower As The Fed Hikes Multiples Are Headed Lower As The Fed Hikes The market advance since November has been supported primarily by valuation expansion, along with some improvement in corporate profits. The forward P/E has climbed to 18, its highest level in well over a decade. The scope for further expansion is limited. Importantly, if a transition to an earnings-led rally is in the offing, Fed funds expectations likely need to be ratcheted higher. Chart 1 shows that valuation multiples contract during Fed tightening cycles, using cycle-on-cycle analysis. Thus, the valuation expansion is inconsistent with a significant upgrade in the economic and profit outlook, particularly with return on equity so weak (Chart 1). In other words, the economy has good momentum, but that is not translating one for one to the corporate sector. Keep in mind that even a small two P/E multiple point decline requires 11% earnings growth for the market just to hold its ground. That is a tall order given the squeeze on profit margins from labor cost inflation and a strong U.S. dollar. Ironically, high multiples would be more durable if economic data softened enough for the Fed to hold its fire. Against this background, it is not surprising that a stealthy flight to safety has developed, although it is not uniform across asset classes. For instance, gold has outperformed most major currencies (note we recently upgraded the gold shares group as a portfolio hedge); global government yields have eased back while sovereign bond spreads have widened (Chart 2). In the U.S., the economically-sensitive transport group has rolled over in line with the yield curve narrowing (Chart 2), the equity SKEW index remains historically elevated, and a defensive vs. cyclical portfolio bias has outperformed handily since early December (Chart 2, bottom panel), on broad-based non-cyclical sector participation. These shifts, on the margin, signal that some investors are bracing for a bout of volatility. On the flipside, U.S. junk bond spreads have narrowed back to 2014 lows, and emerging market corporate bond spreads are testing similarly tight levels. The global purchasing manager survey recorded yet another monthly gain (Chart 3). Chart 2Contrarian##br##Alert... Contrarian Alert... Contrarian Alert... Chart 3... Defensives Can Outperform##br## When Growth Is Good ... Defensives Can Outperform When Growth Is Good ... Defensives Can Outperform When Growth Is Good Ergo, a systemic economic threat is not the main obstacle to further asset price appreciation. Rather, it is that expectations in some assets and sectors have become divorced from reality. Indeed, we have noted for the last two months the disturbing downtrend in bank credit growth and the unprecedented gap between strong 'soft' and pedestrian 'hard' economic data. Mixed economic and financial market messages suggest that any equity turbulence may be marked by a mostly rotational correction rather than a savage drawdown in the broad averages. Still, the latter cannot be ruled out given the high degree of complacency and buoyant profit and economic expectations. It is notable that defensive equities embarked on a massive outperformance phase when both U.S. and EM bond spreads were just as low as they are currently, i.e. they hit 'as good as it gets' levels (Chart 3). Any widening in corporate bond spreads would tighten financial conditions, spurring a slowdown in growth down the road. In sum, the odds of an equity market sweet spot extension beyond the very near run have diminished as a consequence of ongoing strong economic data, which reflects the easing in financial conditions a year ago. In terms of positioning portfolios, there is still a mismatch between developed and developing markets, as measured by the relative ISM indexes (Chart 3, fourth panel). The upshot is that defensives will continue to generate much more cash than their cyclical counterparts (Chart 3, bottom panel), supporting the nascent relative share price recovery. The financial sector could also be due for a correction. Financials And Banks: Where To Next? The global financials sector has cheered the firming in leading economic indicators and back up in bond yields since last autumn, but that celebration is likely drawing to a close. Euro area financials have rolled over, in line with renewed weakness in German government bond yields (Chart 4). Continued slippage in global yields could cap U.S. yields, thereby flattening the yield curve (Chart 5). U.S. financials are much more expensive than their euro area counterparts (Chart 5, bottom panel), suggesting heightened vulnerability. Chart 4Are EMU Financials ##br##Sending A Warning Signal? Are EMU Financials Sending A Warning Signal? Are EMU Financials Sending A Warning Signal? Chart 5Watch The##br## Yield Curve Watch The Yield Curve Watch The Yield Curve In our view, the S&P bank index contains the most downside vulnerability, in relative performance terms, of all the financial sector sub-components, especially if regulatory reform disappoints and/or is slow to evolve. True, as outlined in a Special Report published on October 3, 2016, interest rate expectations have a checkered history of predicting bank stock relative performance. When they do drive bank stocks, it is typically because most other profit drivers are lacking, as is currently the case (Chart 5, top panel). This cycle, interest rate spreads have been unduly suppressed by the zero lower bound. Under normal circumstances, when short-term interest rates are well above zero lower bound, banks can target a spread between rates on assets and liabilities. But when the fed funds rate is at zero, the spread is compressed, because banks generally cannot charge customers a penalty implied by negative interest rates on deposits (at least in the U.S.). As the Fed pushes interest rates back upward, banks may be able to return their spreads to their target levels, by raising deposit rates more slowly than loan rates. However, this dynamic has been fully priced in over the last few months and the risk is that higher net interest margins will not offset the lack of credit creation and/or that Fed funds rate expectations will level off if economic data start to disappoint. After all, Chart 6 shows that net interest margins can both widen and narrow when the Fed is hiking interest rates. Moreover, the yield curve is narrowing, after peaking two months ago. If rising fed interest rate expectations are the primary factor driving bank stock performance, then it follows that market expectations must continue to price in a much more hawkish rate environment in order to extend any rally in bank share prices. However, the global credit impulse is still negative, albeit less so, reflecting capital constraints and deleveraging. The Bank of International Settlements global credit impulse indicator has been an excellent leading indicator of relative bank profitability, and it is premature to expect earnings outperformance (Chart 7). U.S. credit data are also inconsistent with a major upshift in Fed funds interest rate expectations. Total loan growth is contracting, led by commercial & industrial loans (Chart 8). Commercial real estate loan growth has also turned lower. Chart 6Net Interest Margins And The Fed Net Interest Margins And The Fed Net Interest Margins And The Fed Chart 7Don't Chase Without Profit Support Don't Chase Without Profit Support Don't Chase Without Profit Support Chart 8Shrinking Balance Sheets Shrinking Balance Sheets Shrinking Balance Sheets The most recent Fed Senior Loan Officer Survey showed that banks are tightening lending standards in most categories, with the exception of mortgages (Chart 9). The number of banks reporting increased loan demand has also softened. Since the credit crisis, banks have shifted their balance sheet exposure toward businesses and away from consumers and residential mortgages, underscoring that a decent housing market is unlikely to provide an offset to lackluster corporate credit demand. Only mortgages have experienced an uptick in loan demand and availability of funds (Chart 9). This credit backdrop is not conducive to a much more aggressive Fed, reinforcing that it would be dangerous to discount a sustained and meaningful uptrend in net interest margins. To further confound the bank stock reward/risk profile, bank employment continues to rise steadily (Chart 10), even though balance sheet expansion is no longer a sure thing. We have shown in past Reports that bank stocks have almost always underperformed when bank employment is rising. Chart 9Credit Standars Are Tightening Credit Standars Are Tightening Credit Standars Are Tightening Chart 10Sagging Productivity Sagging Productivity Sagging Productivity The current combination of fading credit creation and rising employment has done a number on our bank productivity proxy. The latter is now contracting on a rate of change basis, warning that the expansion in bank stock valuations is due for a squeeze (Chart 10). Bottom Line: The run in bank stocks over the past few months is on the cusp of a reversal, based on the leading message from the euro area, sinking productivity and punk credit demand. Our financial sector preference remains skewed toward areas not dependent on credit creation, such as asset managers. Book Profits In Health Care Facilities We bought the S&P health care facilities index last December after a steep post-election sell-off created a valuation and technical undershoot relative to the fundamental outlook. The doomsday concern was that President Trump would tear up the Affordable Care Act (ACA), potentially leaving millions without insurance: treating the uninsured is the bane of any hospital's existence. At the time of purchase, the 52-week rate of change was diverging positively from the share price ratio after hitting deeply oversold levels, often a harbinger of a playable rally (Chart 11). That was particularly true given an historically high short position. The index has outperformed by 12% since then, encouraged by a jump in analyst net profit revisions following upbeat profit results and guidance from industry heavyweights such as HCA Holdings (Chart 11), and a realization that any ACA action is likely to be more of a rework than a total rebuild. Valuations remain appealing, but a technical breakout above key resistance levels requires increased confidence in the durability of profit outperformance. Is such a phase forthcoming? Our conviction level has decreased a notch. Our concern is primarily revenue based, rather than fear that provisions for doubtful accounts will suddenly deteriorate as a consequence of treating uninsured patients. Instead, the main push from the surge in the insured population and increase in procedures on the back of rising consumer confidence/job security is likely to peter out. Consumer spending on hospitals has already rolled over decisively on a growth rate basis (Chart 12, third panel), and is contracting compared with total consumer spending. The same is true of spending on physician visits. Fewer doctor visits mean a reduction in procedures performed at hospitals. Chart 11Hitting Resistance Hitting Resistance Hitting Resistance Chart 12Top-Line Trouble Ahead? Top-Line Trouble Ahead? Top-Line Trouble Ahead? Health care is a labor-intensive industry. Health care facilities staff up when they get busy and prune when capacity utilization slips. As such, slowing growth in hospital employment reinforces that patient volume growth is likely to ebb (Chart 12). In fact, the contraction in hospital hours worked signals the same ahead for hospital sales (Chart 12, bottom panel). The good news is that labor costs remain in check, as measured by the employment cost index for hospitals (Chart 13). Other input costs, such as the cost of medical equipment and supplies, have perked up (Chart 13), which may require increased pricing power in order to sustain profit margins. However, the revenue trends noted above suggest that hospitals may not experience a sufficient rise in patient volumes to the extent that restores pricing power to a more solid footing. Chart 14 shows that the consumer price index for hospitals is losing momentum relative to overall inflation. Durable outperformance phases require accelerating relative pricing power, in addition to a cooling in overall economic growth, as proxied by the ISM manufacturing index (see shading, Chart 14). Those conditions provide a durable competitive profit advantage. Chart 13A Mixed Picture For Costs A Mixed Picture For Costs A Mixed Picture For Costs Chart 14Shaky Long-Term Support Shaky Long-Term Support Shaky Long-Term Support Chart 15Macro Headwinds Macro Headwinds Macro Headwinds In addition, the ideal macro conditions for hospital stocks exist when consumer spending on overall health care services is accelerating relative to total spending. That implies that the providers of health care services have an advantage over those that pay for them, such as insurers. Total medical care spending is steadily decelerating (Chart 15), underscoring that investors are better off targeting investments in other parts of the sector. In sum, the forces required to sustain the oversold rally in the S&P 1500 health care facilities index are losing clout, so we recommend booking profits. Bottom Line: Downgrade the S&P 1500 health care facilities index to neutral, locking in a 12% profit since inception in December 2016. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

Highlights In this week's report, we update the "Three Controversial Calls"1 we made at BCA's New York Investment Conference held on September 26-27th, 2016. Call #1: "Trump Wins, And The Dollar Rallies." We still see 5% more upside for the greenback. Call #2: "Japan Overcomes Deflation." Inflation expectations have moved higher over the past five months, while the yen has weakened. This trend will persist. Call #3: "Global Banks Finally Outperform." Bank shares have beaten their global benchmark by 14% since we made this prediction. European financials have finally turned the corner. Feature Call #1: "Trump Wins, And The Dollar Rallies" Chart 1From Unrealistic To Even More Unrealistic From Unrealistic To Even More Unrealistic From Unrealistic To Even More Unrealistic We never bought into the notion that a Trump victory would cause investors to flee the dollar. On the contrary, we argued that most of Trump's policies were bond bearish/dollar bullish. In particular, we reasoned that Trump's attempts to browbeat companies into moving production back home would help reduce the U.S. trade deficit, boosting aggregate demand in the process. Efforts to curb illegal immigration would also push up the wages of low-skilled workers. Meanwhile, fiscal stimulus would fire up the labor market at a time when it was already approaching full employment. Fiscal Deficit On Upward Path With nearly four months having passed since the election, what have we learned? First, and foremost, a big increase in the budget deficit still looks likely. As Trump's address to the joint session of Congress on Tuesday night underscored, the president has plenty of specific areas in mind where he would like to increase spending (more money for defense, infrastructure, etc.) and a long list of taxes he would like to cut (corporate and personal income taxes, estate taxes, a new childcare tax credit,2 etc.). We do not take seriously Trump's pledge to pay for increased military spending by cutting annual nondefense discretionary spending by $54 billion relative to the existing CBO baseline. Chart 1 shows that under current budgetary rules, nondefense discretionary spending is set to decline from 3.3% of GDP in 2016 - already close to a historic low - to only 2.7% of GDP in 2026. Cutting that portion of the budget above and beyond what has already been legislated is unrealistic. There simply aren't enough programs like the National Endowment for the Arts that Republicans can take to the woodshed without facing a severe political backlash (Chart 2). As long as big ticket entitlement programs such as Social Security and Medicare remain unscathed - which Treasury Secretary Steven Mnuchin confirmed would be the case earlier this week - overall government spending will rise, not fall. Chart 2Nondefense Discretionary Spending: Where The Money Goes Three Controversial Calls, Five Months On Three Controversial Calls, Five Months On Trump And Trade The one category where Trump would be more than happy to see taxes go up is on imports. The constraint here is political. A unilateral move to legislate large-scale import duties would be in gross violation of WTO rules and could spark a global trade war. Many of Trump's Republican colleagues, as well as a fair number of Democrats, also favor free trade and would resist such an effort. One solution that Trump vaguely alluded to in his speech is to raise duties on imports within the context of a broader tax reform bill. A border adjustment tax, for example, would bring in $1.2 trillion in revenues over ten years.3 As we argued in a Special Report earlier this year, the introduction of a BAT would be highly dollar bullish.4 Pulling Back The Welcome Mat? On immigration, Trump has sent mixed messages. On the one hand, he continues to insist that he will build "the wall" and has maintained his hardline stance on refugee policy. On the other hand, he has backed off his campaign promise to reverse Obama's executive order protecting the so-called "dreamers." This order allows immigrants who came to the U.S. illegally as children to remain in the country indefinitely, provided they do not commit a serious criminal offence. During his speech, Trump signaled a willingness to shift the U.S. immigration system towards one based on merit, similar to what countries such as Canada and Australia already have. This is an excellent idea, but it raises the question of what will happen to the 11 million illegal aliens currently residing in the country, the vast majority of whom are poorly educated. It is important to remember that U.S. immigration laws are already very strict. Trump has given the U.S. Immigration and Customs Enforcement agency (ICE) greater leeway in enforcing these laws, while also pledging to hire 5,000 more border agents and 10,000 additional ICE officers. As such, a "status quo immigration policy" under Trump could prove to be much more restrictive than the one under Obama even if no new legislation is passed. A key implication is that labor shortages in areas such as construction and hospitality services may intensify. Solid U.S. Growth Outlook Favors A Stronger Dollar Meanwhile, the U.S. growth picture remains reasonably bright (Chart 3). This may not be obvious from current Q1 tracking estimates, which are pointing to real GDP growth of below 2%. However, the weak Q1 numbers are mainly due to an unexpectedly large jump in imports and a sharp decline in inventory accumulation. According to the Atlanta Fed's model, taken together these two factors have shaved a full percentage point off growth. Real private final demand is still rising at nearly 3% (Chart 4). If U.S. growth stays solid as we expect, the Fed will raise rates three or four times this year, starting in March. This is slightly more than the market is currently pricing in, which should be enough to ensure that the trade-weighted dollar strengthens by another 5% or so over the remainder of the year (Chart 5). We see the greatest upside for the dollar versus EM currencies, and as we discuss next, against the yen. Chart 3U.S. Economic Data Are Upbeat U.S. Economic Data Are Upbeat U.S. Economic Data Are Upbeat Chart 4Trade And Inventories Detract From ##br##A Bright Q1 Growth Picture Three Controversial Calls, Five Months On Three Controversial Calls, Five Months On Chart 5Real Rate Differentials Are ##br##Driving UpThe Dollar Real Rate Differentials Are Driving Up The Dollar Real Rate Differentials Are Driving Up The Dollar Call #2: "Japan Overcomes Deflation" Many of the forces that have exacerbated deflation in Japan, such as corporate deleveraging and falling property prices, have run their course (Chart 6). The population continues to age, but the impact that this is having on inflation may have reached an inflection point. For most of the past 25 years, slow population growth depressed aggregate demand by reducing the incentive for companies to build out new capacity. This generated a surfeit of savings relative to investment, helping to fuel deflation. Now, however, as an ever-rising share of the population enters retirement, the overabundance of savings is disappearing. The household saving rate currently stands at 2.8% - down from 14% in the early 1990s - while the ratio of job openings-to-applicants has soared to a 25-year high (Chart 7). Chart 6Japan: Easing Deflationary Forces Japan: Easing Deflationary Forces Japan: Easing Deflationary Forces Chart 7Japan: Low Household Saving Rate ##br##And A Tightening Labor Market Japan: Low Household Saving Rate And A Tightening Labor Market Japan: Low Household Saving Rate And A Tightening Labor Market Chart 8Investors Still Not Entirely ##br##Convinced Japan Is Eradicating Deflation Investors Still Not Entirely Convinced Japan Is Eradicating Deflation Investors Still Not Entirely Convinced Japan Is Eradicating Deflation Government policy is finally doing its part to slay the deflationary dragon. The Abe government shot itself in the foot by tightening fiscal policy by 3% of GDP between 2013 and 2015. It won't make the same mistake again. The Bank of Japan's efforts to pin the 10-year yield to zero also seem to be bearing fruit. As bond yields in other economies have trended higher, this has made Japanese bonds less attractive. That, in turn, has pushed down the yen, ushering in a virtuous circle where a falling yen props up economic activity, leading to higher inflation expectations, lower real yields, and an even weaker yen. Stay Short The Yen Consistent with this narrative, market-based inflation expectations have risen over the past five months. But with inflation swaps still pricing in inflation of only 0.6% over the next 20 years, there is plenty of scope for real rates to fall further (Chart 8). This implies that investors should maintain a structurally short position in the yen. A weaker yen will help boost Japanese stocks, at least in local-currency terms. As a relative play, investors should consider overweighting Japanese exporters versus domestically-exposed sectors. Multinational manufacturers stand to gain the most, as they will benefit from increased overseas sales, while the highly automated, capital-intensive nature of their operations will limit the burden of rising real wages. Call #3: "Global Banks Finally Outperform" Global bank shares have risen by 25% since we made this call, outperforming the MSCI All Country World Index by 14% (Chart 9). The thesis that we outlined five months ago still remains intact (Charts 10 and 11): Chart 9Global Bank Shares Have Bounced Global Bank Shares Have Bounced Global Bank Shares Have Bounced Chart 10Factors Supporting Bank Stocks Factors Supporting Bank Stocks Factors Supporting Bank Stocks Chart 11Global Banks Are Still Fairly Cheap Global Banks Are Still Fairly Cheap Global Banks Are Still Fairly Cheap Improving business and consumer confidence should continue to support credit demand. Stronger economic growth will reduce nonperforming loans. Capital ratios have improved significantly, reducing the risk of further equity dilution. Yield curves have steepened since last summer, which should flatter net interest margins. Despite the run-up in share prices over the past five months, valuations remain attractive. Looking across regions, European banks stand out as being particularly attractive over a cyclical horizon of about 12 months. BCA's European Corporate Health Monitor continues to improve, foreshadowing further progress in mending loan books (Chart 12). The ECB's lending survey indicates that a majority of banks are seeing stronger loan demand (Chart 13). This suggests that credit growth is not about to stall anytime soon. Meanwhile, euro area banks are trading at a miserly 0.8-times book value, which gives valuations plenty of upside. Chart 12Euro Area: Improving Corporate Health Euro Area: Improving Corporate Health Euro Area: Improving Corporate Health Chart 13Euro Area: Banks See Rising Loan Demand Euro Area: Banks See Rising Loan Demand Euro Area: Banks See Rising Loan Demand Political Risks Chart 14This Will Not Get Le Pen Into The Elysee Palace This Will Not Get Le Pen Into The Elysee Palace This Will Not Get Le Pen Into The Elysee Palace The risk is that European political developments sabotage this thesis. Our view here is "near-term sanguine, long-term cautious." We continue to think that populism is in a long-term secular bull market. However, unlike in the case of Brexit or Trump, populist leaders in continental Europe will have to wait until the next economic downturn (probably in two or three years) before they seize power. To that extent, the prevailing - though admittedly rather myopic - consensus view is correct: Marine Le Pen will not become president this year. Keep in mind that the National Front underperformed during regional elections in December 2015, just weeks after the terrorist attacks in Paris. Despite a recent uptick in the polls, support for Le Pen is actually lower now than it was back then (Chart 14). As long as the French economy continues to show signs of tentative improvement, the establishment parties will succeed in keeping Le Pen out of power. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "Three (New) Controversial Calls," dated September 30, 2016, available at gis.bcaresearch.com. 2 Despite the populist sounding nature of this proposal, the Tax Policy Center estimates that 70% of the childcare credits will go to households earning $100,000 and up. See Lily L. Batchelder, Elaine Maag, Chye-Ching Huang, and Emily Horton, "Who Benefits from President Trump's Child Care Proposals?" Tax Policy Center (February 27, 2017) for details. 3 James R. Nunns, Leonard E. Burman, Jeffrey Rohaly, Joseph Rosenberg, and Benjamin R. Page, "An Analysis of the House GOP Tax Plan," Tax Policy Center (September 16, 2016). 4 Please see Global Investment Strategy Special Report, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 20, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Portfolio Strategy Add the S&P asset manager & custody banks index to the high-conviction overweight list. Prospects for higher interest rates bode well for a catch up phase with the rest of the financials sector. Initiate a long S&P consumer staples/short S&P technology pair trade, a truly out of consensus call. Housing-related equities are likely to gain ground as housing activity should stay resilient amidst rising borrowing costs. Recent Changes S&P Asset Managers & Custody Banks - Added to our high-conviction overweight list on February 16th. Long S&P Consumer Staples/Short S&P Technology - Initiate this pair trade today. Table 1Sector Performance Returns (%) Overbought, But... Overbought, But... Feature Momentum continues to drive the broad market trend. The drag from a reduction in global liquidity courtesy of depleting foreign exchange reserves continues to be overwhelmed by economic optimism. The latter is fueling a major rotation from bonds to stocks, which is the dominant market force. Valuations have taken a backseat, emblematic of blow-off phases. Two weeks ago we introduced our Complacency-Anxiety Indicator, which hit a new high. Another way to measure greed overwhelming fear is the relentless rise of the forward P/E over the VIX. The spread between these two measures can also gauge complacency. This Indicator has also soared to an all-time high (Chart 1). Chart 2 applies this methodology for the broad S&P sectors, using forward P/E and implied equity volatility, and then standardizes the result to remove biases from perennially low and high P/E sectors. A low reading suggests lower risk, and vice versa. Chart 1Buy At Your Own Risk Buy At Your Own Risk Buy At Your Own Risk Chart 2Sector Vulnerabilities And Opportunities Overbought, But... Overbought, But... At the moment, financials, telecom, utilities, REITs and health care have the lowest implicit vulnerability, while cyclical sectors carry the most risk. How long can this overshoot phase last? There are obviously no easy answers. However, from a purely technical perspective and in the absence of any major monetary, economic and/or geopolitical shocks, an examination of our Composite Technical Indicator (CTI) suggests some running room remains. Our CTI is driven primarily by momentum components. Overbought conditions are signaled once it hits one standard deviation above the mean. Currently, the TI remains slightly below this threshold (Chart 3). Even then, it can cross decisively into the danger zone before the S&P 500 eventually sells off in a meaningful fashion. Chart 3Overbought Conditions Can Persist Overbought Conditions Can Persist Overbought Conditions Can Persist Importantly, when the CTI swings quickly from deeply oversold to overbought levels, there can be a multi month lead before the broad market crests or suffers a sustained setback (Chart 3), and the bulk of those moves are associated with economic recessions and/or growth disappointments. The implication is that even though extended broad market valuations virtually guarantee paltry long-term returns and economic expectations are now sky-high, technical conditions suggest that momentum may continue to carry the day for a while longer. That does not mean investors should abandon a largely defensive portfolio structure, given that this is where the reward/risk tradeoff is most attractive and timing corrections is inherently difficult. Two weeks ago we recommended buying both gold and packaging stocks. As part of our ongoing rebalancing, this week we are further tweaking our portfolio. We recommend a pair trade to position for the inevitable sub-surface mean reversion heralded by our Indicators in the coming 3-6 months. Asset Managers: Shifting To High-Conviction Status The interest rate and market-sensitive S&P asset managers & custody banks index (AMCB) has lagged most other financials sub-indexes at a time when macro forces are lining up bullishly, particularly in view of the sector's attractive ranking on a forward P/E to volatility basis. While the capital markets and banks groups are seen as having higher torque to these positive forces, these three groups tend to move together. Lately, a divergence has opened, but a number of factors point to an imminent AMCB catch up phase (Chart 4), especially given that AMCB is not levered to overall credit growth, which has dried up. Fed Chair Yellen's testimony last week was interpreted to be slightly more on the hawkish side. That, coupled with the recent upside surprise in core inflation, raises the possibility of more 2017 tightening than currently discounted. That would provide further relief for custody banks, as ultra-low interest rates have been an anchor on this group's profitability as fees earned on funds held in trust have been minimal. The increase in short-term Treasury yields heralds a share price rally (Chart 5, top panel). Chart 4Catch Up Ahead Catch Up Ahead Catch Up Ahead Chart 5Time To Rally Time To Rally Time To Rally Moreover, the boost in economic expectations signals scope for an increase in fee generating activity, such as M&A, stock issuance and even stock lending. BCA's Global Economic Sentiment Index also indicates that the share price ratio has undershot (Chart 5). Most importantly, the asset preference shift from bonds to stocks reverses another major drag on profitability (Chart 5, third panel). Fixed income products carry lower margins than equity products, so as equity assets under management grow, profit margins should expand. If so, then we would anticipate a relative valuation re-rating, especially if the pace and scale of financial sector deregulation disappoints. The latter has been a key factor propelling capital markets and banks, and any disappointment could cause a capital rotation into the lagging AMCB index. Bottom Line: We are already overweight the S&P asset management & custody banks index, and added it to our high-conviction list in a daily Sector Insight on February 16th. New Pair Trade This week we are recommending what can be considered a highly contrarian pair trade: long the S&P consumer staples sector and short the S&P technology sector. It may be difficult to swallow executing such a non-consensus position while the broad market is going gangbusters. However, the objective message from our Indicators and increasing odds of a vicious, un-telegraphed correction, argue that the reward/risk trade-off is too attractive to ignore. As outlined in last week's Cyclical Indicator Update, the technology sector's relative earnings profile has deteriorated, because the corporate sector is not spending much yet and tech companies have suffered a serious loss of pricing power. Conversely, the consumer staples sector has a better chance of earnings outperformance, according to our model (Chart 6). Both sectors appear to have discounted the opposite outcome. Moreover, from a technical perspective, tech stocks are overbought and consumer staples are extremely oversold (Chart 6). Even a simple technical/momentum renormalization would imply a sharp jump in the share price ratio. Both sectors lose competitiveness when the U.S. dollar rise, but given that the technology sector's share of foreign sales (58%) is much higher than that of consumer staples (28%), the pain is disproportional. Importantly, consumer staples exports are accelerating, whereas tech exports are shrinking (Chart 7). Chart 6Contrasting Profiles Contrasting Profiles Contrasting Profiles Chart 7The Strong Dollar Is Worse For Tech The Strong Dollar Is Worse For Tech The Strong Dollar Is Worse For Tech Non-durable consumer goods are less sensitive to emerging market prospects, and thus when their currencies weaken, momentum in the consumer staples/tech share price ratio tends to accelerate (EM currencies shown inverted and advanced, bottom panel, Chart 7). Moreover, a strong U.S. dollar tends to reduce input costs for many consumer staples vendors, both through lower commodity prices and a reduced cost of imported goods sold. We have shown that tech stocks fare poorly toward the latter stages of a U.S. dollar bull market, when consumer staples start to shine. This dynamic reflects the economic fallout abroad from a strong U.S. dollar, particularly on developing economies, as well as the drag on U.S. corporate profits, and by extension, capital spending. While the U.S. dollar and stocks have risen in tandem in recent months, that cannot continue indefinitely, and when the correlation breaks down, the defensive consumer staples sector should outperform. In terms of economic dynamics, this share price ratio tends to accelerate when consumer spending outperforms capital spending. Consumer confidence is outpacing business confidence (Chart 8, top panel), signaling such an environment ahead. That sentiment mismatch has already translated into faster consumption than business investment on tech goods (Chart 8, second panel). Unless the gap between the return on and cost of capital reverses course and widens anew, then this trend is likely to persist. As a result, the surge in consumer staples vs. technology pricing power will continue, ultimately flattering the share price ratio through relative profit performance (Chart 8, bottom panel). The message is that consumer staples profits can have the upper hand over tech even when overall GDP growth is positive, provided the underlying driver is consumption rather than capital spending. From an external standpoint, it is notable that consumer staples have a better track record than tech stocks during inflationary periods. Chart 9 shows that the uptrend in long-term inflation expectations and increase in actual inflation both forecast a revival in this pair trade. Chart 8Unsustainable Divergences Unsustainable Divergences Unsustainable Divergences Chart 9Inflation Pressures? Buy This Ratio Inflation Pressures? Buy This Ratio Inflation Pressures? Buy This Ratio Rising inflation ultimately heralds tighter monetary policy, which is a precursor to elevated broad market volatility and a rise in the discount rate, to the detriment of long duration sectors. History shows that the high priced tech sector is more vulnerable than the safe haven staples sector in such an environment. In sum, the time is ripe for a contrary pair trade favoring consumer staples vs. technology. Notable risks to this trade are that the U.S. dollar weakens meaningfully and/or global capital spending re-accelerates decisively, relative to consumer spending. Bottom Line: We recommend a market neutral long consumer staples/short technology pair trade. The time horizon for this trade is 3-6 months. Will Housing Stocks Go Through The Roof? Housing-related stocks have delivered positive earnings surprises, but anxiety about rising mortgage rates challenges the outlook. While the latter is a risk, cheap valuations and consumers' underappreciated ability to absorb rising borrowing costs offset these concerns. Sensitivity analysis shows that even a 200 basis point (bps) spike in interest rates from current levels would fail to push housing affordability back to the long-term average (Chart 10). Moreover, mortgage payments as a percentage of incomes and effective borrowing costs would also remain below their respective historic means even with such a spike. Importantly, housing market fundamentals are improving. Lumber prices are on fire. Lumber has been the best performing commodity year-to-date. This is a real time indicator of housing demand (Chart 11). Similarly, railroad carloads of lumber are also firming, signaling that the price rise is demand-driven rather than a speculative bet in the trading pits. Sustained house price inflation, solid housing turnover and the acceleration in building permits reinforce that housing activity remains robust (Chart 11). Chart 10Higher Rates Are Not A Show Stopper Higher Rates Are Not A Show Stopper Higher Rates Are Not A Show Stopper Chart 11Lumber Strength Is Housing Bullish Lumber Strength Is Housing Bullish Lumber Strength Is Housing Bullish The credit tap to sustain strong activity is still open. According to the latest Fed Senior Bank Loan Officer Survey, banks are willing and able to extend residential mortgage credit (bottom panel, Chart 11). This contrasts with many other credit categories, where banks are tightening the screws and credit demand is faltering: C&I loans have shrunk over the past three months, as has total bank credit. First time home buyers are also reappearing and anecdotes of increased house flipping activity signal a vibrant market with unobstructed access to credit. All of this should continue to support earnings-led outperformance from both homebuilders and home improvement retailers (HIR). The bullish outlook for the S&P homebuilding index rests on four pillars. The latest National Association of Home Builders (NAHB) survey revealed that sales expectations remain over 20 points above the boom/bust line and just shy of recent cyclical highs (Chart 12). Homebuilders are clearly still seeing strong traffic. New home prices are still expanding at a healthy clip (Chart 12). Sales growth and new home price inflation are tightly linked. The mortgage application purchase index has picked up steam despite the mortgage rate increase, confirming that first time homebuyers are entering the market after a long hiatus as the financial motivation to buy vs. rent has improved. This optimism is causing an aggressive re-rating in earnings estimates from chronically bearish levels (Chart 12), a harbinger of further gains in relative share prices. The S&P HIR index also has a concrete foundation. Higher lumber prices flow straight to the bottom line, because HIR companies typically earn a set margin on lumber-related sales. Moreover, higher housing turnover is a boon for industry sales volumes (Chart 13). Historically, home sales momentum has been an excellent leading indicator of renovation activity. Chart 12Buy Homebuilders... Buy Homebuilders... Buy Homebuilders... Chart 13... And Building Supply Retailers ... And Building Supply Retailers ... And Building Supply Retailers Encouragingly, the NAHB remodeling survey is still in expansion territory, and tends to follow the trend in home sales, underscoring that home renovation activity is set to improve (Chart 13). Our HIR model encapsulates many of these key drivers, and has climbed anew (Chart 13). The message is that profits, and share prices, are on track to outperform. Adding it all up, the housing backdrop remains attractive, and even a steady increase in borrowing costs should not disrupt momentum. The time to become concerned will be if inflation becomes a serious risk, causing the Fed to get 'tight' and credit availability to dry up. The next few interest rate hikes won't move the monetary settings to that phase yet. Until then, we recommend erring on the bullish side. Bottom Line: We reiterate our high-conviction overweight in the S&P home improvement retail index (HD, LOW) and continue to recommend an above benchmark allocation in the S&P homebuilding index (PHM, DHI, LEN). Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

The S&P asset manager and custody bank index is in a prime position for a catch up rally. This interest rate and market-sensitive financial sector group has lagged most others at a time when macro forces are lining up bullishly. Fed Chair Yellen slightly more hawkish commentary this week raised the possibility of an earlier than expected interest rate hike. That would provide further relief for custody banks, as ultra-low interest rates have been an anchor on profitability. Moreover, the boost in global economic sentiment indicates increased scope for fee generating activity, such as M&A, issuance and even stock lending. Most importantly, the asset preference shift from bonds-to-stocks represents a potential boost to profit margins (bottom panel), which would warrant a valuation re-rating. We are already overweight, and are adding this group to our high-conviction list today. The ticker symbols for the stocks in this index are: BLBG: S5AMCB - BK, BLK, STT, AMP, NTRS, TROW, BEN, IVZ, AMG. Asset Managers: Shifting To High Conviction Status Asset Managers: Shifting To High Conviction Status

Highlights Key Portfolio Highlights Improved world economic growth and rising inflation expectations have buoyed global equities (Chart 1). The downside is that financial conditions are tightening and U.S. dollar-based liquidity is contracting, which is growth restrictive (Chart 2). The massive outperformance of the financials and industrials sectors since the U.S. election implies that U.S. markets have been largely politically-motivated. Positive economic surprises remain mostly sentiment/confidence driven, rather than from upside in hard economic data (Chart 3). That unusually large gap implies that a big jump in 'hard data' surprises is already discounted and represents a latent risk, as it did in the spring of 2011 just before the summertime equity market swoon. Federal income tax receipts are contracting, suggesting that an economic boom is not forthcoming (Chart 4). In fact, there has never been a contraction in tax receipts without a corresponding slump in employment growth. Corporate sector pricing power gains have not been evenly distributed. Deep cyclicals gains came off a low base and may already be experiencing a relapse. Conversely, defensive and interest rate-sensitive sectors are demonstrating the most strength (Chart 5). Our macro models are not signaling that investors should position as if robust and self-reinforcing economic growth lies ahead. Our Deep Cyclical indicators are the weakest, while defensive and interest rate-sensitive models are grinding higher (Chart 6). Deep cyclical sectors are very overvalued and overbought, while defensives are deeply undervalued and oversold (Charts 7 and 8). Mean reversion is an apt theme for the next few months. The most attractive combination of macro, valuation and technical readings are in the consumer staples, health care sectors. The financials sector is a close second, but it is overbought. The least attractive combinations are in energy, materials and industrials. Prospects for elevated market volatility, stronger economic growth in developed vs developing economies, a tighter Fed and expensive U.S. dollar are consistent with maintaining a largely defensive portfolio structure (Charts 9-12). Chart 1Pricing Power Revival... Pricing Power Revival... Pricing Power Revival... Chart 2... But A Liquidity Drain ... But A Liquidity Drain ... But A Liquidity Drain Chart 3Show Me The Money Show Me The Money Show Me The Money Chart 4Yellow Flag Yellow Flag Yellow Flag Chart 5Pricing Recovery Is Not Broad Based Pricing Recovery Is Not Broad Based Pricing Recovery Is Not Broad Based Chart 6Indicator Snapshot Indicator Snapshot Indicator Snapshot Chart 7Focus On Value Focus On Value Focus On Value Chart 8Mean Reversion Ahead Mean Reversion Ahead Mean Reversion Ahead Chart 9Fundamentals Favor Defensives... Fundamentals Favor Defensives... Fundamentals Favor Defensives... Chart 10... As Do Market Signals ... As Do Market Signals ... As Do Market Signals Chart 1112-Month Performance After Fed Hikes Cyclical Indicator Update Cyclical Indicator Update Chart 1224-Month Performance After Fed Hikes Cyclical Indicator Update Cyclical Indicator Update Chart 13Staples Will Cushion A Volatility Resurgence Staples Will Cushion A Volatility Resurgence Staples Will Cushion A Volatility Resurgence Chart 14Media Stocks Like A Strong Currency Media Stocks Like A Strong Currency Media Stocks Like A Strong Currency Chart 15Unduly Punished Unduly Punished Unduly Punished Chart 16Strong Fundamental Support Strong Fundamental Support Strong Fundamental Support Chart 17Less Production... Less Production... Less Production... Chart 18... Means More Rigs ... Means More Rigs ... Means More Rigs Chart 19End Of Sugar High End Of Sugar High End Of Sugar High Chart 20A Toxic Mix A Toxic Mix A Toxic Mix Chart 21Tech Stocks Don't Like Inflation Tech Stocks Don't Like Inflation Tech Stocks Don't Like Inflation Chart 22Time To Disconnect Time To Disconnect Time To Disconnect Feature S&P Consumer Staples (Overweight - High Conviction) The Cyclical Macro Indicator (CMI) has been grinding higher for several months, even climbing through last year's share price shellacking. The CMI has been supported by the uptrend in relative consumer spending on essential items and consumer preference for saving vs. spending. More recently, a pricing power recovery in a number of groups has provided an assist as has a rebound in staples export growth. Booming consumer confidence and business confidence have held the CMI in check. The strong U.S. currency, particularly bilaterally against China, also implies a reduction in the cost of imported goods sold, and has also been an indication of relative valuation expansion because it often signals increased financial market volatility (Chart 13 on page 6). The attractive valuation starting point this cycle, and historic outperformance when the Fed raises interest rates (Chart 13 on page 6), were key factors behind our upgrade to high conviction status in January. Technical conditions are completely washed out. Sector breadth and momentum have reached oversold extremes. That signals widespread bearishness, which is positive from a contrary perspective. Chart 23 S&P Consumer Staples S&P Consumer Staples S&P Consumer Discretionary (Overweight) Our CMI is forming a tentative trough, supported by rebounding relative outlays on media services, low prices at the pump, a budding recovery in mortgage equity withdrawal and firming wage growth. The biggest drags over the past few months have come from higher Treasury yields and consumers increased propensity to save. However, rising job certainty and a vibrant residential real estate market suggest that consumers should loosen their purse strings. The VI has deflated toward the neutral zone, although remains moderately expensive from a long-term perspective. Our TI started to rebound from oversold levels. History shows that a recovery in the TI from one standard deviation below the mean has heralded a playable relative performance rally. Overweight positions should remain concentrated in housing-related equities and the media space, both of which benefit from U.S. dollar appreciation (Chart 14 on page 6). Chart 24 S&P Consumer Discretionary S&P Consumer Discretionary S&P REITs (Overweight - High Conviction) Our new REIT CMI has ticked lower, but the share price ratio has over-exaggerated this small move down. REITs have traded as if the back up in global bond yields will persist indefinitely, and that they are the only factor that drives relative performance. Improving cash flows and cheap valuations suggest that REITs can decouple from bond yields. Banks have tightened standards on commercial real estate loans, but this appears more likely to limit supply growth than create a slowdown. Commercial property prices are hitting new highs and our REIT Demand Indicator (RDI) has climbed into positive territory, signaling higher rental inflation. The latter is already outpacing overall CPI by a wide margin (Chart 15 on page 7). While REITs are back to fair value from a long-term perspective, on a shorter term basis the sector is very undervalued (Chart 15 on page 7), particularly with Treasury yields now in undervalued territory. Our REIT TI is extremely oversold, at a point which forward relative returns typically shine on a 12 and 24 month basis, even excluding the dividend yield kicker. Chart 25 S&P Real Estate S&P Real Estate S&P Health Care (Overweight) Our CMI continues to grind higher, opening a massive divergence with relative performance. This gap can be explained by the political attack on the pharmaceutical industry, the sector's heavyweight, rather than by a downturn in relative earnings drivers. Pharmaceutical shipments are hitting new highs and pricing power continues to grow at a robust mid-single digit rate. Future pricing gains may slow if government gets more heavily involved in setting prices, but this is already discounted. Pricing power in the rest of the sector remains strong, while wage inflation is tame. Health care spending is still growing as a share of total spending, but the pace is decelerating. Typically, this backdrop signals outperformance for health care insurers, who may also receive a risk premium reduction from a potential revamp of the Affordable Care Act, albeit the timing will likely be drawn out. Relative valuations are very attractive. The sector has been used as a source of capital to fund purchases in areas expected to benefit from increased fiscal stimulus. That is an overreaction, and flows should be restored to reflect the sector's appealing investment profile, particularly given the sector's track record during Fed tightening cycles (Chart 16 on page 7). The TI is deeply oversold. Breadth measures are beginning to recover from completely washed out levels. These conditions reinforce that an exploitable undershoot has occurred. Chart 26 S&P Health Care S&P Health Care S&P Financials (Neutral) Our Financial CMI has surged, underscoring that the advance in relative performance reflects more than just a reaction to anticipated sector deregulation by the Trump Administration. Leading indicators of capital formation, such as the stock-to-bond ratio, have jumped sharply. Moreover, the yield curve has steepened in recent months, bolstering the CMI. An improvement in overall profit growth and the tight labor market suggest that the credit cycle may not become a profit drag until the economy begins to cool. While not yet evident, the restrictive move in oil, the dollar and bond yields warn that disappoint may emerge in the coming months. It is notable that bank loan growth has dropped to nil over the last 3 months. C&I loan growth is contracting over that time period. Banks are hiring more aggressively, yet are tightening lending standards, suggesting productivity disappointment ahead. Despite the share price jump, value remains attractive after 8 years of financial repression. Our TI is overbought and breadth is beginning to recede, which is often a precursor to a consolidation phase. We are not willing to move beyond a market weight allocation at this juncture. Chart 27 S&P Financials S&P Financials S&P Energy (Neutral) Our CMI has plunged, probing all-time lows. Rising oil inventories and spiking wage inflation are exerting severe gravitational pull on the CMI, more than offsetting the budding recovery in domestic production. Refining margins are probing six year lows as the Brent/WTI spread has evaporated. Nevertheless, OPEC is finally curtailing production, joining non-OPEC producers (Chart 17 on page 8), which should ultimately help eat into excess global oil supply. History shows that once supply growth peaks, the rig count typically firms. That is a plus for energy services (Chart 18 on page 8), even though rising oil production will prove self-limiting for oil prices. High yield spreads have narrowed significantly from nosebleed levels, but industry balance sheets remain bruised. Net debt is historically elevated, EBITDA has yet to return to its glory days, and interest coverage remains anemic and vulnerable to any downside energy price surprises. The surge in our VI reflects depressed cash flow, and is overstating the degree of overvaluation. The TI has returned to the neutral zone, and will need to hold at current levels otherwise a relapse in the share price ratio toward previous lows is probable. Selectivity is still warranted in the energy complex. We remain underweight refiners and overweight the energy services index. Chart 28 S&P Energy S&P Energy S&P Utilities (Neutral) Our utilities sector CMI is stabilizing. That is a surprise, given the rebound in inflation expectations and firming global leading economic indicators, which are typically bearish for this defensive, fixed-income proxy. The latter negative exogenous factors are being offset by falling wage inflation, better pricing power and rising electricity output growth. Power demand is linked with manufacturing activity, underscoring that there is an element of cyclicality to sector profits. The share price ratio has held up better than most other defensive sectors since the U.S. election, perhaps on the hope that an overhaul of the tax code will benefit this domestic sector. Regardless, valuations have retreated from the extremely expensive zone where we took profits and downgraded to neutral last summer, but are not yet at a level that warrants re-establishing overweight positions. An upgrade could occur once our TI becomes fully washed out, provided that occurs within the context of additional CMI strength and a peak in global growth and inflation momentum. Chart 29 S&P Utilities S&P Utilities S&P Industrials (Underweight - High Conviction) The CMI has edged lower after a modest recovery in recent months. The strong U.S. dollar, relapse in short-term pricing power measures and sector productivity contraction are offsetting improvement in global PMI surveys. The lack of confirmation of an industrial sector revival from emerging markets is also holding back the CMI. There continues to be a deflationary undercurrent in the form of more rapid capacity than industrial sector output growth, suggesting that durable pricing power gains may remain elusive (Chart 19 on page 9). The post-election surge in share prices is slowly being unwound, as the sector was quick to discount expectations for massive domestic fiscal stimulus. Our valuation gauge is not at an extreme, although a number of individual groups are trading at historically rich multiples, such as machinery and railroads. Participation is beginning to fray around the edges, as our relative advance/decline line has rolled over, as has breadth. Our TI is pulling back from overbought levels, warning that a further correction in the share price ratio looms. It would be nearly unprecedented for the share price ratio to trough before our TI hits oversold levels. Industrials fare poorly when the Fed tightens. Chart 30 S&P Industrials S&P Industrials S&P Materials (Underweight) The CMI has nosedived, reflecting China's diminishing fiscal thrust and the recent tightening in monetary policy. Commodity price inflation peaked in mid-December concurrent with the Fed raising rates, signaling that emerging markets end-demand, in general and Chinese in particular, is likely past its prime. The nascent rebound in EM currencies represents a positive offset, but not by enough to turn around the CMI. Select heavyweight EM manufacturing PMIs are still below the boom/bust line. Relative valuations are becoming extended according to our VI, and stretched technical conditions are waving a red flag. Keep in mind the materials sector has an abysmal performance history after the Fed starts tightening (Chart 20 on page 9). The heavyweight chemical index (75% of the sector) bears the brunt of the downside risks owing to excess capacity (Chart 20 on page 9). On the flipside, overweight exposure in gold mining (via the GDX:US ETF) and the niche containers & packaging sub-indexes is recommended. Chart 31 S&P Materials S&P Materials S&P Technology (Underweight) The CMI has rolled over, driven lower by contracting relative pricing power, decelerating new orders-to-inventories growth, lack of capital expenditure traction and the appreciating greenback. Tech stocks thrive in a disinflationary/deflationary environment and suffer during inflationary periods (Chart 21 on page 10). Inflation is making a comeback, so it will be an uphill battle for tech companies to successfully raise selling prices at a fast enough pace to keep profits on a par with the broad corporate sector. While a capital spending cycle would be a welcome development, the narrowing gap between the return on and cost of capital warns against extrapolating improvement in business sentiment just yet. Our S&P technology operating profit model warns that tech profits are likely to trail the broad market as the year progresses, a far cry from what is embedded in analysts' forecasts. The good news is that valuations are not demanding nor are technical conditions overbought, which should cushion the magnitude and sharpness of downside risks. Chart 32 S&P Technology S&P Technology S&P Telecom Services (Underweight) Our CMI for telecom services has gained ground of late, primarily on the back of a sharp decline in wage inflation. However, we recently downgraded exposure to underweight, because of a frail spending backdrop. Our telecom services sales model is extremely weak (Chart 22 on page 10). Softening outlays on telecom services have reinvigorated the industry price war, and our pricing power gauge is sinking like a stone (Chart 22 on page 10). Telecom carrier capital expenditures have been running at a healthy clip, which could further pressure profit margins. Undervaluation exists, but this has been a chronic feature for the sector over the past decade, and does not foretell of cyclical upside or downside risks. Our TI has plunged into the sell zone, but remains above levels that would signal that a countertrend rally is imminent. Chart 33 S&P Telecommunication Services S&P Telecommunication Services Size Indicator (Overweight Small Vs. Large Caps) The small/large cap ratio is correcting short-term overbought conditions. The dip in the U.S. dollar has provided a fundamental reason for corrective action in this domestically-oriented asset class. However, we doubt a trend change is at hand. Our style CMI is climbing steadily. Small company business optimism has soared, partly because of an increase in planned price hikes, but also from an anticipated reduction in the regulatory burden. If small company price hikes persist, then rising labor costs will be more easily absorbed. That is critical to narrowing the profit margin gap between small and large firms. A stronger domestic vs. global economy and the potential for trade barriers is also unambiguously positive for small firms that do the bulk of their business at home. Despite the surge in the share price ratio post-U.S. election, our valuation gauge is not yet at an overvalued extreme. The lack of extreme overvaluation suggests that positive momentum will persist, perhaps similar to the 2004-2006 period, when the share price ratio stayed in overbought territory for years. Chart 34 Size Indicator (Small Vs. Large Caps) Size Indicator (Small Vs. Large Caps)