Fixed Income

Highlights Duration: The global bond bear market is still intact, although the "leadership" has passed over to the U.S. where growth is the firmest and inflation expectations are rising the fastest. Maintain an overall below-benchmark portfolio duration stance, focusing underweights in countries that can actually tighten monetary policy this year (U.S., Canada, the euro area). ECB: The ECB has started to take notice of the latest batch of softening euro area economic data. Yet it will take a much more prolonged slowdown for the ECB's medium-term economic forecasts to be proven incorrect, which would alter the likely timetable for a tapering of asset purchases by year-end. Canada: The Bank of Canada has adapted a more cautious tone of late, which seems overly pessimistic given the underlying trends in Canadian growth and inflation. Stay underweight Canadian government bonds. Feature We're Sticking With Our Country Allocations One of our key investment themes for 2018 has been that economic growth, monetary policies and bond yields would be far less correlated between countries than was seen in 2017. This would create cross-country fixed income trading and investment opportunities that were much harder to come by last year. With the 10-year U.S. Treasury yield finally reaching the 3% level last week, that story looks to be playing out. Yields are going up elsewhere, but nothing like what is happening in the U.S., where growth remains firm compared to the string of negative data surprises seen in other countries (Chart of the Week). This theme of divergence can also be seen in the recent actions and comments from central bankers. Officials at the U.S. Federal Reserve have continued to signal, with increasing conviction, that additional rate hikes will be needed later this year (although not at this week's FOMC meeting). This is to be expected given that not only is U.S. growth holding up well (Q1 real GDP growth "only" slowed to an above-potential pace of 2.3%), but both core PCE inflation and the Wages & Salaries component of the Employment Cost Index are accelerating at a marginal pace not seen since the 2008 crisis (Chart 2). Chart of the WeekU.S. Economy Outperforming,##BR##USTs Underperforming U.S. Economy Outperforming, USTs Underperforming U.S. Economy Outperforming, USTs Underperforming Chart 2No Reason For The Fed##BR##To Turn Less Hawkish No Reason For The Fed To Turn Less Hawkish No Reason For The Fed To Turn Less Hawkish At the same time, policymakers in other major developed countries have turned somewhat more cautious: The Bank of Japan (BoJ) announced that it will no longer provide a specific date when it expects inflation to reach its target The European Central Bank (ECB) took the highly unusual step of holding a monetary policy meeting last week without actually discussing the monetary policy outlook, according to ECB President Mario Draghi Bank of England (BoE) Governor Mark Carney dampened expectations of a rate hike in May that was nearly fully discounted by markets The Bank of Canada (BoC), which had already delivered several rate hikes when inflation was below its 2% target, chose to keep rates on hold despite inflation finally breaching 2% Sweden's Riksbank pushed out the expected timing of its next rate hike (yet again) to the end of 2018, even with inflation now at target With global growth losing some momentum, it is no surprise that policymakers are trying to not sound too hawkish, which could trigger an unwelcome decline in inflation expectations. Here again, divergences between countries have opened up. Rising oil prices are translating into higher market-based inflation expectations in countries like the U.S. and Canada where growth is still above-potential and leading economic indicators are rising (Chart 3). This is not the case in places like the U.K., Australia and Japan where growth is sluggish, leading indicators are slowing, but with markets still pricing in interest rate increases over the next year (Chart 4). This divergence is a critical underpinning of our current recommended country allocation within government bond markets - overweighting the U.K., Australia and Japan where tighter monetary policy will be difficult to achieve; while underweighting the U.S. and Canada, where rate hikes are still in the cards. Chart 3Shifting Oil/Inflation Correlation... Shifting Oil/Inflation Correlation... Shifting Oil/Inflation Correlation... Chart 4...In Countries Where Growth Is Slowing ...In Countries Where Growth Is Slowing ...In Countries Where Growth Is Slowing The European Duration Call Gets A Bit Trickier The evidence on the euro area is a bit less conclusive on this front, however. The OECD's leading economic indicator has only dipped modestly from its recent peak, and the correlation between oil prices and inflation expectations has not broken down. Draghi stated in his press conference following last week's policy meeting that the ECB Governing Council was focused on "very important" current euro area economic data that had clearly lost momentum in the first quarter of this year. He noted that there were many one-off factors that could have caused the softer growth (weather, labor strikes, the timing of holidays), but that the slump was very broad-based and hit almost all euro area countries. This makes the next few months of data critical to determine the ECB's next policy move, which could be an announcement of a tapering of its asset purchases when the current program ends in September. From our perspective, the sluggish Q1 euro area economic performance looks to be driven by a major slowing of export growth. Industrial confidence remains at a high level and growth in retail sales volumes has remained stable since the middle of 2017 (Chart 5). Yet the annual growth rate of total euro area exports has slumped to less than 3%, with exports to Asia now contracting on a year-over-year basis (bottom two panels). If the export slump continues in the coming months, this could begin to impact hiring activity across the euro area. A rise in unemployment would definitely change the ECB's calculus in altering its policy stance. At the moment, the Governing Council can look at a steadily declining overall euro area unemployment rate - which is approaching the OECD's estimate of the full employment NAIRU - combined with moderate increases in core HICP inflation, wage growth and inflation expectations, as confirmation that trends are still broadly following the path laid out in its latest economic projections (Chart 6). Chart 5An Export-Led Cooling##BR##Of Euro Area Growth An Export-Led Cooling Of Euro Area Growth An Export-Led Cooling Of Euro Area Growth Chart 6ECB Will Not Lift Rates Until##BR##Inflation Expectations Move Back To 2% ECB Will Not Lift Rates Until Inflation Expectations Move Back To 2% ECB Will Not Lift Rates Until Inflation Expectations Move Back To 2% The ECB has made it clear that it views a tapering of its asset purchases and any subsequent interest rate hikes as separate policy decisions. The hurdle to end the bond purchases is much lower than it is for raising interest rates. On the former, as long as unemployment and inflation continue to evolve along the lines of the ECB's projections, then a full tapering of bond purchases will occur by year-end (with an announcement occurring at either of the June or July ECB meetings). On the latter, it will take inflation expectations (as measured by the 5-year EUR CPI swap, 5-years forward) rising back above 2% for the ECB to feel confident that rate increases will be necessary, as was the case during the mid-2000s tightening cycle and the 2011 mini-cycle (bottom panel). For now, we are maintaining our moderate underweight stance on euro area government debt. Looking ahead, we will be watching the correlation between oil prices denominated in euros and inflation expectations, as well as the development of leading economic indicators in the euro area. If the Q1 growth slump widens into a broader downturn, then the ECB could be forced to revise its economic projections lower and continue with the asset purchases into 2019. While that is not our base case scenario, such a development would force us to reconsider our stance on euro area debt. Bottom Line: The global bond bear market is still intact, although the "leadership" has passed over to the U.S. where growth is the firmest and inflation expectations are rising the fastest. Maintain an overall below-benchmark portfolio duration stance, focusing underweights in countries that can actually tighten monetary policy this year (U.S., Canada, the euro area). In Europe, it will take a much more prolonged slowdown for the ECB's medium-term economic forecasts to be proven incorrect, which would alter the likely timetable for a tapering of asset purchases later this year. Canada: Still On Track For More Hikes This Year The BoC has been sending more cautious signals of late regarding its next policy moves, after delivering 75bps of rate hikes since last summer. Some of this simply reflects a more measured tone taken by other central banks in response to signs of global growth losing some momentum, as discussed earlier. Yet in the case of Canada, it is difficult to make a credible case that the central bank should not continue its rate hiking cycle, particularly with inflation now above the midpoint of the BoC's 1-3% target band. Upside Risks To Canadian Growth Versus BoC Projections Yes, the Canadian economy has lost some of the rapid upward momentum seen in 2016 and 2017, led mostly by weakness in exports which are now contracting on a year-over-year basis (Chart 7). This was focused in aircraft, transportation equipment, and energy products. The latter is due to poor weather conditions and transportation bottlenecks involved in getting oil out of Alberta rather than a sign of weakening demand for Canadian oil. The BoC did take a more cautious view on exports in the latest set of economic projections presented in the April Monetary Policy Report (MPR). The central bank now expects real exports to be stagnant in 2018, downgrading the expected contribution to real GDP growth to zero from the +0.6 percentage points presented in the January MPR. This was, by far, the biggest downgrade to any of the GDP growth components in the BoC's forecast, and was main reason why the BoC downgraded its overall 2018 real GDP growth projection to 2.0% from 2.2%. Yet at the same time, the BoC actually upgraded its global growth projection to 3.8% from the 3.6% figure in the January MPR. We suspect that the downgrade to the export contribution to expected 2018 growth was the BoC trying to inject some room for error in its growth forecasts for any negative outcome in the current round of NAFTA trade negotiations with the U.S. and Mexico. Otherwise, it makes no sense to have such a large downgrade without becoming more pessimistic on global growth. Our Geopolitical strategists are now much more optimistic that a NAFTA deal will be reached, rather than having the U.S. exit the agreement as President Trump has threatened. If that happens, the BoC's growth projections may end up being too low. We can see a similar level of "excessive cautiousness" with regards to the BoC's assessment of the Canadian labor market and the outlook for consumption. Consumer spending has also cooled off a bit from very robust levels, although an unusually long and harsh winter likely played a large role there, as evidenced by the suspiciously large plunge in retail sales growth (Chart 8). The fundamental underpinnings for Canadian consumption still look solid, though. Chart 7Canadian Economy Holding Up Well,##BR##Despite Weak Exports Canadian Economy Holding Up Well, Despite Weak Exports Canadian Economy Holding Up Well, Despite Weak Exports Chart 8Solid Income Fundamentals##BR##For The Canadian Consumer Solid Income Fundamentals For The Canadian Consumer Solid Income Fundamentals For The Canadian Consumer Consumer confidence remains near cyclical highs. Wage growth currently sits at 3.2% in nominal terms and 1.5% in real terms. The BoC noted in its Spring Business Outlook Survey that wage pressures are increasing due to greater competition in the labor market (3rd panel) and, to a lesser extent, recent minimum wage increases. The BoC noted in the April MPR that wages were growing "somewhat below what would be expected were the economy operating with no excess labor." Yet that argument appears overly pessimistic - the unemployment rate is currently 0.7 percentage points below the OECD's NAIRU estimate, at a time when nominal wages are growing in excess of 3%. Again, there is a greater chance that the BoC will end up surprised by how strong Canadian wage growth will turn out over the next 6-12 months. Even the persistent structural problems of very high Canadian household debt levels and overheated house prices appear less of an issue at the moment. The household debt/GDP ratio has stabilized as growth in mortgage debt has decelerated since mid-2017 - an outcome that can be attributed to rising mortgage rates, tighter lending standards on mortgage lending and poor housing affordability in the major cities (Chart 9). Meanwhile, the supply side of the housing market is finally improving with housing starts now back to pre-recession levels. National house price inflation has cooled from the overheated 15% growth rates to a more "normal" pace around 5%, according to data from Terranet. There will be a long-term day of reckoning for the highly-indebted Canadian homeowner during the next recession. In the near term, however, the combination of rising supply, lower demand and softer house prices suggest that the Canadian housing market is trending in a direction of becoming less imbalanced. The BoC took note of these developments in the April MPR, using much less cautious language in describing the risk to the inflation outlook from household debt and overheated housing markets. The outlook for Canadian business investment also has the potential to give an upside surprise to the BoC. The Spring Business Outlook Survey showed that firms' capital spending intentions remain very strong (Chart 10), a fact confirmed by the robust growth in import volumes of machinery & equipment (middle panel). Finally, the overall financial condition for Canadian companies is in good shape, according to our new Canadian Corporate Health Monitor (CHM) that was introduced last week.1 The CHM correlates strongly with the overall Business Outlook Survey Indicator (bottom panel), which suggests that the cyclical improvement in the financial health of Canadian companies will support capital spending in the coming quarters - especially if the uncertainty over the NAFTA negotiations fades away. Chart 9A Better Supply/Demand Balance##BR##In Canadian Housing? A Better Supply/Demand Balance In Canadian Housing? A Better Supply/Demand Balance In Canadian Housing? Chart 10Canadian Capex##BR##Is In Good Shape Canadian Capex Is In Good Shape Canadian Capex Is In Good Shape The BoC Will Be Surprised By Canadian Inflation, Too Chart 11Inflation Now Above The BoC's 2% Target Inflation Now Above The BoC's 2% Target Inflation Now Above The BoC's 2% Target With the economy likely to continue expanding at an above-potential pace in the next 6-12 months, the current uptrend in inflation is should continue. Headline CPI inflation is already above the 2% target and core inflation is right at target (Chart 11). The BoC is forecasting that CPI inflation will only remain modestly above 2% until the end of 2018, and will return back to 2% in 2019. Yet there is essentially no spare capacity left in the Canadian economy, based on output gap estimates of both the BoC and International Monetary Fund (IMF). The BoC has slightly revised its projection for the Q1 2018 output gap, leaving it somewhat wider than the previous forecasts due to positive revisions of potential GDP growth (now 1.8% from 1.6% in the January MPR, based on a faster pace of trend labor productivity). These are small changes, however, and real GDP growth is likely to be faster than the BoC is projecting in 2018. Market-based inflation expectations have been steadily rising along with the increase in global energy prices (bottom panel), and we continue to expect inflation breakevens to widen over the balance of 2018. BoC Will Not Disappoint Market Expectations On Rate Hikes The markets are currently discounting a similar pace of rate hikes in Canada and the U.S. over the next year, according to pricing in the Overnight Index Swap (OIS) markets (Chart 12). The BoC's estimate of the neutral policy rate is between 2.5% and 3.5%, which is well above the current policy rate of 1.25%. The OIS market is discounting 75bps of hikes over the twelve months, which would take the policy rate to 2% - still a below-neutral, accommodative level for an economy that is already at full employment and where inflation has risen back to the BoC's target. We expect the BoC to continue to follow its typical pattern of following moves by the Fed with a lag. This is a sensible strategy given how exposed Canadian growth is to U.S. growth through exports, and also given how responsive the Canadian dollar is to the expected rate differentials between the U.S. and Canada. Given our view that the Fed will deliver at least another 50bps of rate hikes over the course of 2018, with the potential for more if inflation continues to accelerate without any growth slowdown, the BoC will likely deliver on the rate hikes currently discounted by markets. This is the main reason why we are maintaining our underweight stance on Canadian Government bonds (bottom panel). The BoC has a much higher potential to actually hike rates by at least as much as the market is expecting, which is not the case in every other developed market country except the U.S., where we are also underweight. This week, however, we are stopping ourselves out of our recommended Tactical Overlay trade in the Canadian BAX interest rate futures curve (long the Dec/18 contract versus the June/18 contract). We introduced that trade back in January, positioning for more rapid BoC rate hikes in the latter half of 2018 that would flatten the BAX futures curve. The recent dovish turn by the BoC has resulted in a steepening of the BAX futures curve, however, and we are stopping ourselves out at a modest loss of -0.12% (Chart 13). Chart 12Stay Underweight##BR##Canadian Government Debt Stay Underweight Canadian Government Debt Stay Underweight Canadian Government Debt Chart 13We Are Stopped Out Of##BR##Our BAX Futures Curve Trade We Are Stopped Out Of Our BAX Futures Curve Trade We Are Stopped Out Of Our BAX Futures Curve Trade Bottom Line: The Bank of Canada has adapted a more cautious tone of late, which seems overly pessimistic given the underlying trends in Canadian growth and inflation. Stay underweight Canadian government bonds. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "BCA Corporate Health Monitor Chartbook: Growth Is Papering Over The Cracks", dated April 24, 2018, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index From Convergence To Divergence From Convergence To Divergence Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Does the 3% level on Treasuries matter to investors? The 2/10 yield curve is typically much steeper when global growth is strong and pro-growth policies are in place. The imperfect inter-relationship between labor market slack, wages and inflation. Feature In last week's report1 we noted that the risk of weakness in equity markets was elevated in the near term. Risks assets balked as the 10-year Treasury yield climbed above 3% early last week. However, easing tensions on the Korean peninsula and another stronger than expected batch of Q1 earnings reports boosted U.S. equity prices later in the week. We will provide a full update on the Q1 earnings season in next week's report. Investors are getting used to a seasonal dip in Q1 U.S. GDP data, and last Friday's release certainly fits the bill. A recent study by the staff at the Federal Reserve Bank of Cleveland2 suggests that the main culprits in this seasonal anomaly are in the private investment and government consumption components of GDP. Output in both categories slowed significantly in Q1 2018. Consumer spending growth exhibited the most significant slow-down, growing at only 1.1% compared to 4% in the prior quarter. But growth in investment spending on equipment also declined sharply, from 11.6% to 4.7%, as did growth in residential investment, from 12.8% to 0% (Chart 1). The latter is due to the sharply accelerating input costs (e.g. lumber prices) faced by homebuilders at the moment. Federal government spending slowed to a 1.7% rate in Q1 from 3.2% in Q4 2017. Chart 1GDP Growth Remains Below Average, But Above Fed's Long Run Target The 3% Milestone The 3% Milestone At 2.9% year-over-year in Q1 2018, real economic growth was above the Fed's view of potential GDP (1.8%) for the fifth consecutive quarter. Given the recent seasonal pattern and the substantial fiscal stimulus coming on stream, the Fed will likely see through the weaker Q1 growth data for the time being. Chart 2Watch The 2.3% To 2.5% Level On TIPS Breakevens Watch The 2.3% To 2.5% Level On TIPS Breakevens Watch The 2.3% To 2.5% Level On TIPS Breakevens BCA's view is that the 3% level on the 10-Year Treasury yield is not an impediment to higher equity prices. The 10-year yield and U.S. equity prices climbed together in the 1950s. The rise in yields in the '50s primarily reflected better economic growth rather than fears of inflation. The run-up in yields since the lows last year reflect both factors (Chart 2). Nonetheless, investors are concerned that higher yields will flip the positive correlation between bond yields and stock prices. Charts 3 and 4 shows the link between the level of both nominal (Chart 3) and real bond yields and equity prices. The implication is that the relationship between stock prices and bond yields tends to stay positive when the nominal bond yield is below 5%. Furthermore, the correlation between real yields and stock prices remains positive (Chart 4). Moreover, since 1980, a move from 2% to 3% on the 10-year Treasury yield has been accompanied by an average gain of 1.2% in the S&P 500, with a median move of 1.8%.3 On average, the S&P 500 posted a modest decline (24 bps) as the 10-year Treasury elevated from 3% to 4%, but the median return (98 bps) was still positive. Our July 2015 Special Report4 explored the impact of rates and inflation on equity prices. Historically, even the move from 4% to 5% on the 10-year is not an impediment to higher stock prices. Chart 3Stock To Bond Correlations Remain Positive With Nominal Yields Below 5% The 3% Milestone The 3% Milestone Chart 4Both Equities And Real Bond Yields Reflect Growth Both Equities And Real Bond Yields Reflect Growth Both Equities And Real Bond Yields Reflect Growth Bottom Line: BCA's stance is that the stock-to-bond ratio will climb this year. Our U.S. Bond Strategy team pegs fair value on the 10-year at 2.78%, but notes that the yield may peak this cycle at between 3.25% and 3.50%.5 BCA's base case remains that U.S. equities will not be subject to an over-aggressive Fed until at least mid-2019 and that increasing bond yields are not a threat. Yield Curve Dynamics Does BCA's stance on the yield curve change our upbeat view on risk assets beyond the next few months of caution?6 In March,7 we discussed 5 episodes in the past 35 years when global growth surged and fiscal, monetary and regulatory policies were aligned to boost the U.S. economy. The current episode of synchronized policy commenced in January 2016. Risk assets perform well when these policy tailwinds are in place, but these assets tend to struggle for 12 months after the tailwinds abate. Although global growth has peaked,8 we expect the era of pro-growth policies to end next year as the Fed raises rates into restrictive territory. BCA expects the 2/10 curve to remain around 50bps until the inflation breakevens are re-anchored between 2.3% and 2.5% as upward pressure on the short end from Fed rate hikes is offset by the upward thrust of the breakevens on the long end.9 The curve should resume its flattening trend after that, but will not invert this year. The 2/10 curve stands at 45 bps as of April 27, 2018. Chart 5 shows that the curve has spent very little time in the 0-50 range in the past 35 years when fiscal, monetary and regulatory factors were aligned and global growth was positive. A steeper curve (50 to 100 bps) developed alongside a pro-growth policy and solid global growth only once in the past 35 years, over 1983 and 1984, and never when the 2/10 curve was between 0 and 100 bps (not shown). Chart 5The 2/10 Curve Is Usually This Steep When Pro-Growth Policies Are In Place The 2/10 Curve Is Usually This Steep When Pro-Growth Policies Are In Place The 2/10 Curve Is Usually This Steep When Pro-Growth Policies Are In Place Bottom Line: The backdrop of accommodative fiscal and monetary policy, attended by easing regulatory policy and positive global growth, will continue to provide a tailwind for risk assets through next year. However, the 2/10 yield curve is typically much steeper when these policies are all aligned. Thus, investors should continue to favor equities over bonds and remain underweight duration over the cyclical horizon with a tactical cautious stance over the next few months. The Wage Puzzle Chart 6Economy At Full Employment, Theoretically Economy At Full Employment, Theoretically Economy At Full Employment, Theoretically The move higher in the 10-year Treasury yield to 3% for the first time since 2013 (and the 2-year Treasury to 2.5% for the first time since 2008) has diverted attention to the Fed and inflation. Core CPI is now at the Fed's 2% target and the market is concerned that inflation will shoot past 2% and quickly escalate to 3%. BCA's view is that inflation will remain at the Fed's target this year, but drift above that goal in 2019, which would elicit a more aggressive response from the central bank. Tighter monetary policy will ultimately end the expansion in early 2020.10 Until then, the markets will focus on the drivers of inflation, including wages. Our work11 notes that inflation is slow to turn higher in long expansions. The U.S. economy reached full employment in late 2016 (Chart 6). In short- and medium-length expansions, it takes only a few months before inflation turns up. However, in long expansions (1960s, 1980s, and 1990s) prices did not turn meaningfully higher until 26 months after the economy reached full employment. This suggests that a more significant hike in inflation - led by a tighter labor market - is close and supports the recent rise in Treasury yields. There is mixed evidence that view is warranted. Wage inflation has moved higher in recent months, but the link between wages and prices has weakened. Chart 7 shows that before 1985, the correlation between wage growth and prices was above 90%. Since 1984, the relationship has waned. The post-1985 correlation is just under 30%. BCA expects this weaker relationship to persist. Chart 7Link Between Wage Inflation And Consumer Inflation Changed After 1985 Link Between Wage Inflation And Consumer Inflation Changed After 1985 Link Between Wage Inflation And Consumer Inflation Changed After 1985 The disconnect between labor market tightness and wages has recently widened. Chart 8 shows several measures of wage pressures and labor market slack. Historically, less slack translates into higher wages, but the relationship in this cycle has been muted. Moreover, pay gains for workers who switch jobs are running well ahead of those who stay in their current positions and are either promoted or given merit raises (Chart 9). The gap between compensation gains of job switchers and job stayers tends to broaden as the business cycle ages and slack in the labor market shrinks. Chart 8A Wide Disconnect Between Labor Market Slack And Wage Gains A Wide Disconnect Between Labor Market Slack And Wage Gains A Wide Disconnect Between Labor Market Slack And Wage Gains Chart 9Job Switchers Seeing Better Raises Job Switchers Seeing Better Raises Job Switchers Seeing Better Raises Demographics and wage rigidity dynamics are also at play. Chart 10 shows that the labor force participation rate is headed lower due to demographics, but recent trends suggest there may be improvements in the coming years. BCA's view is that the participation rate will be flat in the next 12 months and move lower in the coming decade. Chart 10Decline In Labor Force Participation Is Mostly Demographics Decline In Labor Force Participation Is Mostly Demographics Decline In Labor Force Participation Is Mostly Demographics Wage inflation is an early career phenomenon. Recent research from the Federal Reserve Bank of New York12 shows that across all education cohorts, rapid real wage growth occurs early in a worker's career, with positive real wage growth ending in his/her forties. This is followed by a period of flat to declining real wages. By age 55, all education categories experience negative real wage growth, on average (Chart 11). Chart 11Wage Inflation Is An Early Career Phenomenon The 3% Milestone The 3% Milestone Wage rigidity in this cycle suggests that there will be an upward correction in labor compensation. Chart 12 shows that 14.5% of workers did not have wage increases in 2017. Moreover, 18.9% of hourly workers and 9.2% of non-hourly workers saw no increase in pay in the year ending in December 2017 (Chart 13, top panel.) The bottom panel of Chart 13 shows that more than 20% of workers with less than a high school education received no pay increases in the past year; only 10% of college-educated workers experienced the same end. It is important to note that on balance, measures of wage rigidity have increased over time and are not overly sensitive to the business cycle. Chart 12More Than 14% Of Workers Didn't See A Raise In 2017 The 3% Milestone The 3% Milestone Chart 13Wage Rigidity By Type Of Employee Wage Rigidity By Type Of Employee Wage Rigidity By Type Of Employee Bottom Line: BCA recommends that investors monitor a broad range of inflation indicators. Historical evidence suggests that when the labor market tightens, inflation eventually accelerates. However, wages do not always lead inflation at bottoms and maybe a lagging indicator in this cycle.13 In long economic cycles (1980s and 1990s), wage inflation was a lagging indicator. Most of these indicators show that inflation pressures are building, but only gradually. We expect the Fed to raise rates gradually in the next 12 months, but it may turn more aggressive in 2019 as pressures on inflation, driven in part by a tighter labor market, begin to mount. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's U.S. Investment Strategy Weekly Report "Short-Term Caution Warranted," published April 23, 2018. Available at usis.bcaresearch.com. 2 https://www.clevelandfed.org/newsroom-and-events/publications/economic-commentary/2017-economic-commentaries/ec-201706-lingering-residual-seasonality-in-gdp-growth.aspx 3 Please see BCA Research's U.S. Investment Strategy Weekly Report "Yellen's Last Week," published February 5, 2018. Available at usis.bcaresearch.com. 4 Please see BCA Research's U.S. Investment Strategy Special Report, "Stock-To-Bond Correlation: When Will Good News Be Bad News?", published July 6, 2015. Available at usis.bcaresearch.com. 5 Please see BCA U.S. Investment Strategy Weekly Report, "It's Still All About Inflation", January 16, 2018. Available at usis.bcaresearch.com. 6 Please see BCA Research's U.S. Investment Strategy Weekly Report "Short-Term Caution Warranted," published April 23, 2018. Available at usis.bcaresearch.com. 7 Please see BCA U.S. Investment Strategy Weekly Report, "Policy Line Up", March 12, 2018. Available at usis.bcaresearch.com. 8 Please see BCA U.S. Investment Strategy Weekly Report, "Policy Peril?", April 9, 2018. Available at usis.bcaresearch.com. 9 Please see BCA U.S. Bond Strategy Weekly Report, "Back To Basics", April 17, 2018. Available at usbs.bcaresearch.com. 10 Please see BCA Research's Global Investment Strategy Weekly Report, "Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000", published March 30 2018. Available at gis.bcaresearch.com. 11 Please see BCA Research's The Bank Credit Analyst Monthly Report, March 2017. Available at bca.bcaresearch.com. 12 FRBNY: Liberty Street Economics, "U.S. Real Wage Growth: Slowing Down With Age," September 28, 2016. 13 Please see BCA Research's The Bank Credit Analyst, September 2017. Available at bca.bcaresearch.com.

Highlights Global equities are poised for a "blow-off" rally over the next 12-to-18 months. Long-term return prospects, however, are poor. The final innings of the 1991-2001 economic expansion saw a violent rotation in favor of value stocks and euro area equities. We expect history to repeat itself. After sagging by as much as 7% in the second half of 1998 and going nowhere in 1999, the dollar rose by 13% between January 2000 and February 2002. The greenback today is similarly ripe for a second wind. The correlation between the dollar and oil prices was fairly weak in the late 1990s. The correlation is likely to weaken again now that U.S. crude imports have fallen by about 70% from their 2006 highs thanks to the shale boom. The U.S. 10-year Treasury yield peaked at 6.79% in January 2000. Thus far, there is scant evidence that the recent increase in bond yields is having a major effect on either U.S. capital spending or housing demand. This suggests yields can go higher before they enter restrictive territory. Feature Learning From The Past The theme of this year's BCA annual Investment Conference - which will be held in Toronto in September and will feature a keynote address by Janet L. Yellen - is, appropriately enough, entitled "Investing In A Late-Cycle Economy."1 In the spirit of our conference, this week's report looks back at the market environment at the tail end of the 1991-2001 expansion in order to distill some lessons for today. The mid-to-late 1990s was a tale of contrasts. The U.S. was thriving, spurred on by accelerating productivity growth, falling inflation, and a massive corporate capex boom. Southern Europe was also doing well, aided by falling interest rates and optimism about the coming introduction of the euro. On the flipside, Germany - dubbed by many pundits at the time as the sick man of Europe - was still coping with the hangover from reunification. Japan was mired in deflation. Emerging markets were melting down, starting with the Mexican peso crisis in late 1994, followed by the Asian crisis, and finally the Russian default. In the financial world, the following points are worth highlighting (Chart 1): Chart 1AFinancial Markets In The Late 1990s (I) Financial Markets In The Late 1990s (I) Financial Markets In The Late 1990s (I) Chart 1BFinancial Markets In The Late 1990s (II) Financial Markets In The Late 1990s (II) Financial Markets In The Late 1990s (II) Russia's default and the implosion of Long-term Capital Management (LTCM) led to a gut-wrenching 22% decline in the S&P 500 in the late summer and early fall of 1998. This was followed by a colossal 68% blow-off rally over the subsequent 18 months. The collapse of LTCM marked the low point for EM assets for the cycle. The combination of cheap currencies, rising commodity prices, and a newfound resolve to enact structural reforms paved the way for a major EM boom over the following decade. The VIX and credit spreads trended upwards during the late 1990s, even as U.S. stocks climbed higher. Rising equity volatility and wider spreads were partly a reaction to problems abroad. However, they also reflected the deterioration in U.S. corporate health and heightened fears that stock market valuations had reached unsustainable levels. The U.S. stock market peaked in March 2000. However, that was only because the tech bubble burst. Outside of the technology sector, the S&P 500 actually increased by 9.2% between March 2000 and May 2001. Value stocks finally began to outperform growth stocks in 2000, joining small caps, which had begun to outperform a year earlier. European equities also surged towards the end of the bull market, outpacing the U.S. by 34% in local-currency terms and 21% in dollar terms between July 1999 and March 2000. The strong U.S. economy during the late 1990s ushered in a prolonged period of dollar appreciation that lasted until February 2002. That said, the greenback did not rise in a straight line. The dollar fell by as much as 7% in the second half of 1998 as the Fed cut rates in response to the LTCM crisis. It went sideways in 1999 before resuming its upward trend in early 2000. The correlation between the dollar and oil prices was much weaker in the 1990s compared to the first 15 years of the new millennium. After falling from a high of 6.98% in April 1997 to 4.16% in October 1998, the 10-year U.S. Treasury yield rose to 6.79% in January 2000. The Fed would keep raising rates until May of that year. The recession began in March 2001. Now And Then Just as in the tail end of the 1990s expansion, the global economy is doing reasonably well these days. Growth has cooled over the past few months, but should remain comfortably above trend for the remainder of the year. After struggling in 2014-16, Emerging Markets are on the mend, thanks in part to the rebound in commodity prices. During the 1990s cycle, the U.S. was the first major economy to reach full employment. The same is true today. The headline unemployment rate has fallen to 4.1%, just shy of the 2000 low of 3.8%. The share of the working-age population out of the labor market but wanting a job is back to pre-recession levels. The same goes for the share of unemployed workers who have quit - rather than lost - their jobs (Chart 2). One key difference concerns fiscal policy. The U.S. federal budget was in great shape in 2000. The same cannot be said today. Chart 3 shows that the fiscal deficit currently stands at 3.5% of GDP. The deficit is on track to deteriorate to 4.9% of GDP in 2021 even if growth remains strong. Federal government debt held by the public is also set to rise to 83.1% of GDP in 2021, up from 33.6% of GDP in 2000. Unlike in the past, the U.S. government will have less scope to ease fiscal policy when the next recession rolls around. Chart 2An Economy At Full Employment An Economy At Full Employment An Economy At Full Employment Chart 3The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline Further Upside For Global Bond Yields Deleveraging headwinds, excess spare capacity, slow potential GDP growth, and chronically low inflation have all conspired to keep a lid on global bond yields. That is starting to change. Credit growth has accelerated, while output gaps have shrunk. The structural outlook for productivity growth is weaker than it was in the 1990s, but a cyclical pickup is likely given the recent recovery in capital spending. Chart 4 shows that there is a reasonably strong correlation between business capex and productivity growth. On the inflation side, the 3-month annualized change in U.S. core CPI and core PCE has reached 2.9% and 2.8%, respectively. The prices paid component of the ISM manufacturing index hit a seven-year high in March. The New York Fed's Underlying Inflation Gauge has zoomed to 3.1% (Chart 5). The market has been slow to price in the prospect of higher U.S. inflation (Chart 6). The TIPS 10-year breakeven rate is still roughly 20 bps below where it traded in the pre-recession period, even though the unemployment rate is lower now than at any point during that cycle. As long-term inflation expectations reset higher, bond yields will rise. Higher inflation expectations will also push up the term premium, which remains in negative territory. Chart 4Pickup In Capex Brightens ##br##The Cyclical Productivity Outlook Pickup In Capex Brightens The Cyclical Productivity Outlook Pickup In Capex Brightens The Cyclical Productivity Outlook Chart 5Inflation##br## Is Coming... Inflation Is Coming... Inflation Is Coming... Inflation Is Coming... Inflation Is Coming... Chart 6...Which Could Take ##br##Bond Yields Higher ...Which Could Take Bond Yields Higher ...Which Could Take Bond Yields Higher The upward pressure on yields could be amplified if the market revises up its assessment of the terminal real rate. Perhaps in a nod to what is to come, the Fed revised its terminal fed funds projection from 2.8% to 2.9% in the March 2018 Summary of Economic Projections. However, this is still well below the median estimate of 4.3% shown in the inaugural dot plot in January 2012. The U.S. Economy Is Not Yet Succumbing To Higher Rates For now, there is little evidence that higher rates are having a major negative effect on the economy. Business capital spending has decelerated recently, but that appears to be a global phenomenon. Capex has weakened even more in Japan, where yields have barely moved. In any case, the slowdown in U.S. investment spending has been fairly modest. Core capital goods orders disappointed in March, but are still up 7% year-over-year. Likewise, while our capex intention survey indicator has ticked lower, it remains well above its historic average. And despite elevated corporate debt levels, high-yield credit spreads are subdued and banks continue to ease lending standards for commercial and industrial loans (Chart 7). In the household realm, delinquency rates are rising and lending standards are tightening for auto and credit card loans. However, this has more to do with excessively strong lending growth over the preceding few years than with higher interest rates. Particularly in the case of credit card lending, even large movements in the fed funds rate tend to translate into only modest percent changes in debt service payments because of the large spreads that lenders charge on unsecured loans. The financial obligation ratio - a measure of the debt service burden for the average household - is rising but is still close to the lowest levels in three decades. Mortgage debt, which accounts for about two-thirds of all household credit, is near a 16-year low as a share of disposable income (Chart 8). As Ed Leamer perceptively argued in his 2007 Jackson Hole address entitled "Housing Is The Business Cycle," housing is the main avenue by which monetary policy affects the real economy.2 Similar to business capital spending, while the housing data has leveled off to some extent, it still looks pretty good: Building permits and housing starts continue to rise. New and existing home sales rebounded in March. Home prices have accelerated. The S&P/Case Shiller Home Price Index saw its strongest month-over-month gain in February since 2005. The MBA Mortgage Applications Purchase Index is up 11% year-over-year. The percentage of households looking to buy a home in the next six months is at a cycle high. Homebuilder sentiment has dipped slightly, but it remains at rock-solid levels (Chart 9). Chart 7Capital Spending ##br##Still Quite Robust Capital Spending Still Quite Robust Capital Spending Still Quite Robust Chart 8Household Debt Load And Financial Obligations##br## Are At Pre-Housing Bubble Levels Household Debt Load And Financial Obligations Are At Pre-Housing Bubble Levels Household Debt Load And Financial Obligations Are At Pre-Housing Bubble Levels Chart 9The Housing Sector##br## Is Doing Fine The Housing Sector Is Doing Fine The Housing Sector Is Doing Fine Fixed-Income: Hedged Or Unhedged? Bond positioning is quite short, so a temporary dip in yields is probable. However, investors should expect bond yields to rise more than is currently discounted over the next 12 months. BCA's fixed income strategists favor cyclically underweighting the U.S., Canada, and core Europe, while overweighting Australia, the U.K., and Japan in currency-hedged terms. Table 1 shows that the hedged yield on U.S. 10-year Treasurys is only 20 bps in EUR terms, and 38 bps in yen terms. Table 1Global Bond Yields: Hedged And Unhedged Investing In A Late-Cycle Economy: Lessons From The 1990s Investing In A Late-Cycle Economy: Lessons From The 1990s The low level of hedged U.S. yields today means that Treasurys are unlikely to enjoy the same inflows as in the past from overseas investors. This could push yields higher than they otherwise would go. To gain the significant yield advantage that U.S. government debt now commands, investors would need to go long Treasurys on a currency-unhedged basis. For long-term investors, this is a tantalizing investment. The current spread between 30-year Treasurys and German bunds stands at 192 bps. The euro would have to appreciate to 2.15 against the dollar for buy-and-hold investors to lose money by going long Treasurys relative to bunds.3 Such an overshoot of the euro is unlikely to occur, especially since the structural problems haunting Europe are no less daunting than those facing the United States. A Pop In The Dollar? Admittedly, the near-term success of a strategy that buys Treasurys, currency-unhedged, will hinge on what happens to the dollar. As occurred at the turn of the millennium, the dollar could find a bid as the Fed is forced to raise rates more aggressively than the market is pricing in. In this regard, large-scale U.S. fiscal stimulus, while arguably bearish for the dollar over the long haul, could be bullish for the dollar in the near term. My colleague Jennifer Lacombe has observed that flows into U.S.-listed European equity ETFs, such as those offered by iShares (EZU) and Vanguard (VGK), have reliably led the euro-dollar exchange rate by about six months (Chart 10).4 Recent outflows from these funds augur poorly for the euro. Rising hedging costs could also prompt more investors to buy U.S. fixed-income assets currency-unhedged, which would raise the demand for dollars (Chart 11).5 Chart 10ETF Flows Point To Lower EUR/USD ETF Flows Point To Lower EUR/USD ETF Flows Point To Lower EUR/USD Chart 11The Dollar Could Bounce The Dollar Could Bounce The Dollar Could Bounce The Oil-Dollar Correlation May Be Weakening Investors are accustomed to thinking that the dollar tends to be inversely correlated with oil prices. That relationship has not always been in place. Brent bottomed at just over $9/bbl in December 1998. Crude prices tripled over the subsequent 20 months. The broad trade-weighted dollar actually rose by 5% over that period. The dollar has strengthened by 2.8% since hitting a low on September 8, 2017, while Brent has gained 37% over this period. This breakdown in the dollar-oil correlation harkens back to late 2016: Brent rose by 26% between the U.S. presidential election and the end of that year. The dollar appreciated by 4% during those months. We are not ready to abandon the view that a stronger dollar is generally bad news for oil prices. However, the relationship between the two variables seems to be fading. Chart 12 shows that the two-year rolling correlation coefficient of monthly returns for Brent crude and the broad trade-weighted dollar has weakened in recent years. Chart 12The Negative Dollar-Oil Correlation Has Weakened The Negative Dollar-Oil Correlation Has Weakened The Negative Dollar-Oil Correlation Has Weakened This is not too surprising. Thanks to the shale boom, U.S. oil imports have fallen by about 70% since 2006 (Chart 13). This has made the U.S. trade balance less sensitive to changes in oil prices. The recent surge in oil prices has also been strengthened by OPEC 2.0's decision to reduce the supply of crude hitting the market, ongoing turmoil in Venezuela, and the possibility that Iranian sanctions could take 0.3-0.8 million barrels a day off the market. A reduction in oil supply is bad for global growth at the margin. However, weaker global growth is good for the dollar (Chart 14). OPEC's production cuts also increase the scope for U.S. shale producers to gain global market share over the long haul, which should help the greenback. As such, while a modestly strong dollar over the remainder of the year will be a headwind for oil, it may not be a strong enough impediment to prevent Brent from rising another $6/bbl to reach $80/bbl, as per our commodity team's projections. Chart 13U.S. Oil Imports ##br##Have Collapsed U.S. Oil Imports Have Collapsed U.S. Oil Imports Have Collapsed Chart 14Slowing Global Growth Tends##br## To Be Bullish For The Dollar Slowing Global Growth Tends To Be Bullish For The Dollar Slowing Global Growth Tends To Be Bullish For The Dollar The Outlook For Equities Following the script of the late 1990s, stock market volatility has risen this year, as investors have begun to fret about the durability of the nine year-old equity bull market. Valuations are not as extreme as they were in 2000, but they are far from cheap. The Shiller P/E for U.S. stocks stands at 31, consistent with total nominal returns of only 4% over the next decade (Chart 15). On a price-to-sales basis, U.S. stocks have surpassed their 2000 peak (Chart 16). Such a rich multiple to sales can be justified if profit margins stay elevated, but that is far from a sure thing. Yes, the composition of the stock market has shifted towards sectors such as technology, which have traditionally enjoyed high margins. The explosion of winner-take-all markets has also allowed the most successful companies to dominate the stock market indices, while second-tier companies get pushed to the sidelines (Chart 17). Chart 15Long-Term Investors, Take Note Long-Term Investors, Take Note Long-Term Investors, Take Note Chart 16U.S. Stocks Are Pricey U.S. Stocks Are Pricey U.S. Stocks Are Pricey Chart 17Only The Best Investing In A Late-Cycle Economy: Lessons From The 1990s Investing In A Late-Cycle Economy: Lessons From The 1990s Nevertheless, there continues to be a strong relationship between economy-wide profits and the ratio of selling prices-to-unit labor costs (Chart 18). The latest data suggest that U.S. wage growth has picked up in the first quarter (Table 2). Low-skilled workers, whose wages tend to be better correlated with economic slack than those of high-skilled workers, are finally seeing sizable gains. Chart 18U.S. Profit Margins Could Resume Mean-Reverting... U.S. Profit Margins Could Resume Mean-Reverting... U.S. Profit Margins Could Resume Mean-Reverting... Table 2...If Wage Growth Continues Accelerating Investing In A Late-Cycle Economy: Lessons From The 1990s Investing In A Late-Cycle Economy: Lessons From The 1990s Even if productivity growth accelerates, unit labor costs are likely to rise faster than prices, pushing profit margins for many companies lower. Bottom-up analysts expect annual EPS growth to average more than 15% over the next five years, a level of optimism not seen since 1998 (Chart 19). The bar for positive surprises on the earnings front is getting increasingly high. Go For Value Historically, stocks tend not to peak until about six months before the start of a recession. Given our expectation that the next recession will occur in 2020, global equities could still enjoy a blow-off rally after the current shakeout exhausts itself. But when the music stops, the stock market is heading for a mighty fall. Given today's lofty valuations and the uncertainty about the precise timing of the next recession, we would certainly not fault long-term investors for taking some money off the table. For those who feel compelled to stay fully invested, our advice is to shift allocations towards cheaper alternatives. Value stocks have massively underperformed growth stocks for the past 11 years (Chart 20). Today, value trades at a greater-than-normal discount to growth. Earnings revisions are moving in favor of value names. Just like at the turn of the millennium, it may be value's turn to shine. Chart 19The Bar For Positive Earnings Surprises Has Risen The Bar For Positive Earnings Surprises Has Risen The Bar For Positive Earnings Surprises Has Risen Chart 20Value Stocks: An Attractive Proposition Value Stocks: An Attractive Proposition Value Stocks: An Attractive Proposition Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 For more information about our Investment Conference, please click here or contact your account manager. 2 Edward E. Leamer, "Housing Is The Business Cycle," Proceedings, Economic Policy Symposium, Jackson Hole, Federal Reserve Bank of Kansas City, (2007). 3 To arrive at this number, we multiply the current exchange rate by the degree to which EUR/USD would have to strengthen, on average, every year for the next 30 years in order to nullify the carry advantage of holding Treasurys over bunds. Thus, 1.217*(1.0192)^30=2.15. Granted, investors expect inflation to be about 45 bps lower in the euro area than in the U.S. over the next three decades. However, this would only lift the Purchasing Power Parity (PPP) value of EUR/USD from its current level of 1.32 to 1.51. This would still leave the euro 42% overvalued. 4 Please see Global ETF Strategy Special Report, "Do ETF Flows Lead Currencies?" dated April 18, 2018. 5 When a foreign investor buys U.S. bonds currency-hedged, this entails two transactions. First, the investor must purchase the bond, and second, the investor must sell the dollar forward (which is similar to shorting it). The former transaction increases the demand for dollars, while the latter increases the supply of dollars. Thus, as far as the value of the dollar is concerned, it is a wash. In contrast, if foreign investors buy bonds currency-unhedged, there is no offsetting increase in the supply of dollars, and hence the dollar will tend to strengthen. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Corporate Bonds & The Yield Curve: Corporate bond excess returns fall sharply once the yield curve flattens to below 50 basis points, though they typically remain positive until the yield curve inverts. Interestingly, excess returns for equities relative to Treasuries exhibit the opposite pattern. Corporate Bonds & Leverage: The outlook for top-line corporate revenue growth is strong, but employee compensation costs will also rise this year. We are doubtful that corporate profit growth will keep pace with debt growth for the remainder of year, meaning that leverage is likely to rise. Rising leverage will be a signal to reduce exposure to corporate bonds. Bond Map: We perform a back-test to assess the effectiveness of the Bond Map framework for sector allocation that was introduced in last week's report. Feature It's been a while, but last week's bond market performance was reminiscent of an old fashioned risk-on phase. The 10-year Treasury yield reached its highest level since early 2014, causing a temporary halt in the yield curve's flattening trend. Spread product also responded to investor optimism, and returns from the investment grade corporate bond index now lag the duration-equivalent Treasury index by only 52 basis points year-to-date, up from a mid-March trough of -94 bps (Chart 1). High-Yield index returns also rebounded, and that index is now outpacing Treasuries by +150 bps so far this year. Chart 1Corporate Credit: Annual Excess Returns Corporate Credit: Annual Excess Returns Corporate Credit: Annual Excess Returns But for corporate bond investors, now is not the time for complacency. Out of the criteria we use to signal turns in the credit cycle, we are progressively checking more and more off our list.1 Spreads are already tight relative to history and corporate debt levels are already high. That much has been true for some time. Next up, we await a more restrictive monetary policy and a more severe slow-down in corporate profit growth to below the pace of corporate debt growth. Both of those conditions also need to be met before corporate defaults start to occur and spreads start to widen materially. In this week's report we consider each of those two conditions in turn, noting the triggers that will need to be hit for us to downgrade our current overweight allocation to corporate bonds. Condition 1: Restrictive Monetary Policy Chart 2Monetary Policy Not Yet Restrictive Monetary Policy Not Yet Restrictive Monetary Policy Not Yet Restrictive On the monetary policy front, we expect that monetary conditions will turn restrictive in the not-to-distant future (Chart 2). For the time being, long-maturity TIPS breakeven inflation rates are still below levels that are consistent with the Fed achieving its 2% inflation target. The 10-year TIPS breakeven inflation rate is currently 2.17% and the 5-year/5-year forward TIPS breakeven inflation rate is 2.24%. But once both of those rates reach a range between 2.3% and 2.5%, they will be consistent with well-anchored inflation expectations and the Fed will have one less reason to stay cautious. We will start paring exposure to corporate bonds once both the 10-year TIPS breakeven inflation rate and the 5-year/5-year forward TIPS breakeven inflation rate cross above the 2.3% threshold. The re-anchoring of inflation expectations will also impart further upside to nominal Treasury yields, and we therefore maintain our below-benchmark duration stance and continue to follow the road-map laid out in our February report detailing the two-stage Treasury bear market.2 Another traditional signal of restrictive monetary policy is a flat or inverted yield curve (Chart 2, panel 2). Intuitively, a very flat yield curve tells us that the market expects very few (if any) Fed rate hikes in the future. An inverted yield curve tells us that the market actually anticipates rate cuts. While the yield curve is not yet close to inverting, it is approaching levels that are consistent with much lower (and often negative) excess returns for both investment grade and high-yield corporate bonds, as is discussed below. A third indicator of the stance of monetary policy is simply the spread between the real federal funds rate and an estimate of its equilibrium level - the level consistent with neither an accommodative nor a restrictive policy stance (Chart 2, bottom panel). While the fact that the real fed funds rate is currently quite close to the popular Laubach-Williams estimate of its equilibrium level certainly reinforces our view that policy is almost restrictive, the large degree of uncertainty inherent in this sort of estimate leads us to prefer the market signals from the slope of the yield curve and TIPS breakeven inflation rates when forming an investment strategy. The Yield Curve And Corporate Bond Returns To assess the importance of the yield curve as a predictor of turns in the credit cycle, we split each cycle going back to the mid-1970s into regimes based on the yield curve slope. We then calculate excess returns during each phase for both investment grade and high-yield corporate bonds, as well as the stock-to-bond total return ratio. We use the 3/10 yield curve slope instead of the more often quoted 2/10 slope because it allows for the inclusion of more historical data. This decision did not materially impact the results of our analysis. Chart 3 shows how we divided each cycle into three phases: Chart 3Corporate Bond Performance And The Yield Curve Corporate Bond Performance And The Yield Curve Corporate Bond Performance And The Yield Curve Phase 1 runs from the end of the previous NBER-defined recession until the slope crosses below 50 bps. Phase 2 runs from the time that the slope crosses below 50 bps until it crosses below zero. Phase 3 runs from the time that the yield curve first inverts to the start of the next recession. Notice that we do not include recessionary periods in our analysis, usually the periods with the worst excess corporate bond returns. The results of our analysis are shown in Table 1, and the first obvious result is that corporate bond excess returns are much higher in Phase 1 than in Phase 2, although Phase 2 returns are usually still positive.3 Negative excess returns occur more often than not in Phase 3, after the yield curve has inverted. Table 1Risk Asset Performance In Different Yield Curve Regimes As Good As It Gets For Corporate Debt As Good As It Gets For Corporate Debt The biggest exception to the above observations is that Phase 2 High-Yield returns actually exceeded Phase 1 High-Yield returns in the 2001-07 cycle. In our view, this exception results from the fact that corporate profit growth was well above corporate debt growth in 2005, and did not really decline until 2007, shortly after the yield curve inverted. In contrast, Phase 2 returns were exceptionally weak in the prolonged period between 1994 and 2000. In this instance, corporate profit growth actually fell below corporate debt growth in 1998, well before the yield curve inverted in 2000. This reinforces that both the stance of monetary policy and the trend in corporate leverage matter for corporate bond returns. The latter is discussed in the next section of this report. Another interesting result shown in Table 1 is that the pattern of stock market excess returns over Treasuries is the mirror image of the pattern in corporate bond excess returns. The stock market tends to perform better in Phase 2 than in Phase 1, and often even performs well in Phase 3 after the yield curve has inverted. This means that multi-asset investors should consider paring exposure to corporate bonds relative to Treasuries before they think of reducing exposure to the stock market. Bottom Line: Restrictive monetary policy is one condition that must be met before we reduce exposure to corporate bonds in our recommended portfolio. The first indication of this will likely be the re-anchoring of long-maturity TIPS breakeven inflation rates in a range between 2.3% and 2.5%. We will start paring exposure to corporate bonds when that occurs. The slope of the yield curve is already at levels that are consistent with very low excess returns. Though we demonstrate that an inverted yield curve is historically linked to even lower returns. Conviction that the yield curve is about to invert will be another trigger to further reduce corporate bond exposure in the future. Condition 2: Rising Leverage The second condition that will cause us to take even more credit risk off the table is when gross leverage for the nonfinancial corporate sector - calculated as total debt over pre-tax profits - enters an uptrend. Chart 4 shows that periods of spread widening almost always coincide with rising gross leverage, or put differently, periods when the rate of debt growth exceeds the rate of profit growth. Profit growth has kept pace with debt growth during the past few quarters, causing leverage to flatten-off and allowing corporate spreads to narrow. Going forward, the outlook for top-line corporate revenue growth (a.k.a. net value added) remains favorable, owing to an ISM index that is well above the 50 boom/bust line and still climbing (Chart 5). But on the expense side of the ledger, employee compensation - the largest expense for the corporate sector - is also poised to increase in the months ahead. Unit labor costs jumped sharply in the fourth quarter of 2017 (Chart 5, panel 2), and with the unemployment rate at 4.1% and the economy still adding jobs at a robust pace - nonfarm payrolls have increased by an average of +211k during the past six months - a further acceleration in employee compensation is likely this year. Chart 4Corporate Leverage Has Flattened Off Corporate Leverage Has Flattened Off Corporate Leverage Has Flattened Off Chart 5Wage Growth Will Hamper Profits Wage Growth Will Hamper Profits Wage Growth Will Hamper Profits The key question then becomes whether corporations will be able to offset rising compensation costs by lifting prices. This remains uncertain, but early indications are not favorable. Our Profit Margin Proxy - the growth in the corporate sector's implicit selling price deflator relative to the growth in unit labor costs - does an excellent job tracking pre-tax profits (Chart 5, bottom panel). At the moment, this indicator signals that profit growth will moderate in the coming quarters. Bottom Line: The outlook for top-line corporate revenue growth is strong, but employee compensation costs will also rise this year. We are doubtful that corporate profit growth will keep pace with debt growth for the remainder of year. A decline in the rate of profit growth to below the rate of corporate debt growth will be another signal to reduce exposure to corporate bonds. The Bond Map Back-Test Last week we introduced the BCA Bond Map, a graphical depiction of the current risk/reward trade-off on offer from the different sectors of the U.S. bond market.4 To summarize, in our excess return Bond Map we plot the number of days of average spread tightening required for each sector to earn 100 bps of excess return on the vertical axis, and the number of days of average spread widening required for each sector to lose 100 bps versus Treasuries on the horizontal axis (Chart 6). The diagram is then split into four quadrants based on the location of the Bloomberg Barclays Aggregate index, which we have modified to also include junk bonds. The upper-left quadrant, which we label "Best Bets", contains those sectors that offer less risk and greater excess return potential than the benchmark. The upper-right quadrant, which we label "Exciting", contains those sectors that offer higher risk than the benchmark but also higher potential returns. The bottom-left ("Boring") quadrant contains those sectors with low risk of losses but also low probability of gains, and the bottom-right ("Avoid") quadrant contains those sectors with higher risk than the benchmark and lower expected returns. As can be seen in Chart 6, the current excess return Bond Map shows that Local Authorities, Foreign Agencies and investment grade corporate bonds offer the best combination of risk and expected return. No sectors currently plot in the "Avoid" quadrant. Chart 6Excess Return Bond Map (As Of April 20, 2018) As Good As It Gets For Corporate Debt As Good As It Gets For Corporate Debt This week, we publish the results of a back-test of the real time performance of our Bond Map. To do this we produced the Bond Map at the beginning of each calendar year starting in 2006 and then calculated average excess returns for each quadrant. For example, if three sectors were in the "Best Bets" quadrant at the beginning of the year, we calculated 12-month excess returns for each sector and then averaged them together to get an excess return for "Best Bets" sectors that year.5 Table 2 shows the average and standard deviation of calendar year excess returns for each quadrant, using a sample that spans from 2006-2017. As would be expected, the "Exciting" quadrant displays the highest average excess return, but also the highest standard deviation. Conversely, the "Boring" quadrant delivers the lowest average return and the lowest risk. The performance of the "Best Bets" quadrant is somewhere in between, delivering a greater average return than the "Boring" quadrant with less risk than the "Exciting" quadrant. Although the Sharpe Ratio for the "Best Bets" quadrant turns out to be worse than the Sharpe ratio for both the "Exciting" and "Boring" quadrants. This provides some support for the investment strategy of favoring either the "Exciting" or "Boring" quadrants depending on your assessment of the macro environment. The "Avoid" quadrant actually delivered negative excess returns on average, with elevated risk. Table 2Excess Return Bond Map Track Record (2006-2017) As Good As It Gets For Corporate Debt As Good As It Gets For Corporate Debt For comparison we also show the average and standard deviation of excess returns for the Bloomberg Barclays Aggregate index, augmented with High-Yield. The benchmark delivered excess returns only slightly greater than the "Boring" quadrant, with significantly more risk. The total return version of the Bond Map is shown in Chart 7. This is identical to the excess return Bond Map, except it shows the number of days of average increase/decrease in yields for each sector to lose/earn 5% total return. We perform the identical back-test as with the excess return map, and display the results in Table 3. Chart 7Total Return Bond Map (As Of April 20, 2018) As Good As It Gets For Corporate Debt As Good As It Gets For Corporate Debt Table 3Total Return Bond Map Track Record (2006-2017) As Good As It Gets For Corporate Debt As Good As It Gets For Corporate Debt Here we see the interesting result that the average total returns are higher in the "Best Bets" quadrant than in the "Exciting" quadrant, but strangely the "Best Bets" quadrant also delivered greater volatility. The "Boring" quadrant delivered the best Sharpe Ratio, while the "Avoid" sector delivered both lower average returns and greater volatility than the "Boring" quadrant. For comparison, the average total returns for the Aggregate index (plus High-Yield) were lower than the total returns from any of the four quadrants, but also with less volatility. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 We define the "turn" in the credit cycle as when corporate defaults start to occur and corporate spreads enter a sustained widening phase. 2 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 2018, available at usbs.bcaresearch.com 3 For the Phase 1 period in Cycle 2 we use an interval of June 1983 to July 1988 because High-Yield excess returns are only available starting in June 1983. In reality, the Phase 1 period should have started when the prior recession ended in December 1982. Using the correct interval (starting in December 1982) investment grade corporate bond excess returns are +131 bps and the stock-to-bond ratio returns are +5.19%, both annualized. 4 Please see U.S. Bond Strategy Weekly Report, "Back To Basics", dated April 17, 2018, available at usbs.bcaresearch.com 5 We started our back-test sample in 2006 even though our sector data goes back to 2000. Because our bond map relies on historical estimates of spread/yield volatility, we wanted a sample of at least five years of data before starting the test. With each passing year more back-data is incorporated into our spread/yield volatility estimates, which should improve the Bond Map's accuracy over time. Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Global corporate bond markets have seen both ups and downs so far in 2018. Credit spreads in the developed markets and emerging markets, both for investment grade (IG) and lower quality credit tiers, tightened in January. This was followed by a sharp widening of spreads in the two months after the "VIX spike" in early February. Spreads have begun narrowing again in April, but remain above levels that began the year in all major countries with one notable exception - U.S. high-yield. Feature The volatility in corporate credit is a reflection of the growing list of investor worries, coming at a time when yields and spreads still remain near historically low levels in almost all markets. Topping that list is the fear that low unemployment and rising inflation rates will force the major central banks to maintain a more hawkish (or, at least, less dovish) policy bias in the medium term, even with the global economy losing some upside momentum so far this year after a robust 2017. Add in other concerns over U.S. trade policy (i.e. tariffs), U.S. fiscal policy (i.e. wider deficits, more U.S. Treasury issuance) and even signs of potential stresses in global funding markets (i.e. wider LIBOR-OIS spreads), and it is no surprise that more uncertain investors have become less comfortable with the risks stemming from credit exposure. This can be seen in the volatility of mutual fund and ETF flows into riskier bond categories like U.S. high-yield (HY), which saw a whopping -$19.8bn in outflows in Q1/2018, but has already seen +$3.8bn in inflows in April - possibly in response to the surprisingly strong results seen in Q1 U.S. corporate earnings reports.1 Against this backdrop of more uncertainty in credit markets, we are presenting our latest update of the BCA Corporate Health Monitor (CHM) Chartbook. The CHMs are composite indicators of balance sheet and income statement ratios (using both top-down and bottom-up data) that are designed to assess the financial well-being of the overall non-financial corporate sectors in the major developed economies. A brief overview of the methodology is presented in Appendix 1 on page 16. In this CHM Chartbook, we introduce new country coverage to our CHM universe, adding a bottom-up measure for Japan and both top-down and bottom-up CHMs for Canada. After these new additions, we now have CHMs covering 92% of the Barclays Bloomberg Global Corporate Bond Index universe, based on country market capitalization weightings. The broad conclusion from the latest readings on our CHMs is that global credit quality has enjoyed a cyclical improvement in response to the coordinated growth seen in 2017, but with important geographical differences (Chart 1): Chart 1Global Corporates: Now Supported##BR##By Growth, Not Central Banks Global Corporates: Now Supported By Growth, Not Central Banks Global Corporates: Now Supported By Growth, Not Central Banks Credit quality in the U.S. has improved on the back of the solid performance of U.S. profits over the past year, but high leverage and low interest coverage suggest corporates are highly vulnerable to any slowing in economic growth Underlying credit quality in euro area corporates remains supported by low interest rates and the easy money policies of the European Central Bank (ECB), but the CHMs are trending in the wrong direction due to poor profitability metrics - most notably, a very depressed return on capital - and rising leverage among core European issuers U.K. corporate health continues to benefit from a very robust short-term liquidity position, although sluggish profitability and weak interest coverage suggest potential medium-term problems beneath the surface Japanese corporates are in good shape, enjoying strong interest coverage and low leverage, although absolute levels of profitability remain much lower than the other countries in our CHM universe Canadian corporate health has enjoyed some modest cyclical improvement, but low absolute levels on profitability and interest coverage, combined with high leverage, point to underlying risks. Looking ahead, the tailwinds that have supported corporate health and the performance of global corporate debt in the past couple of years - a coordinated cyclical upturn driving solid earnings growth, with low inflation allowing monetary policies to stay accommodative - are becoming headwinds. Inflation expectations are moving higher in most countries, fueled by low unemployment rates and rising oil prices. This is most evident in the U.S., where the additional boost to growth from fiscal stimulus will keep the Fed on its rate hiking path over the next year. A mild inflation upturn is also visible in the euro area and Japan, where the ECB and Bank of Japan (BoJ) are already contributing to a less favorable liquidity backdrop for corporates by reducing the pace of their asset purchases. That trend is projected to continue over the next year, to the detriment of credit market returns that have been boosted by those unusual monetary policies (see the bottom panel of Chart 1). At some point within the 6-12 months, more hawkish central banks will act to slow global economic growth, triggering a more fundamental underperformance of corporates versus government bonds. For now, the backdrop remains supportive, but the clock is ticking as the end of this credit cycle draws closer. U.S. Corporate Health Monitors: A Cyclical Improvement, But Underlying Problems Persist Our top-down CHM for the U.S. has been flashing "deteriorating health" for fourteen consecutive quarters dating back to the middle of 2014 (Chart 2). Yet there has been a modest cyclical improvement seen in many of the individual CHM ratios over the past couple of years - most importantly, return on capital and profit margins - helping push the top-down level to close to the zero line. It is important to note that, due to delays in the reporting of the data used in the top-down U.S. CHM, the latest reading is only from the 4th quarter of 2017.2 A move into "improving health" territory in the 1st quarter of 2018 would require additional increases in cyclical profitability measures. This will be difficult to achieve with U.S. economic growth cooling off a bit in the first three months of 2018 (although the enactment of the Trump corporate tax cuts will likely help support the after-tax measure of margins used in the top-down CHM as 2018 progresses). From a longer-term perspective, the fact that the top-down CHM return on capital metric is well off the post-crisis peak is a disturbing development, given that non-financial corporate profit margins have been stable over the same period. This suggests a more fundamental problem with weak U.S. productivity growth and lower internal rates of return on marginal investments for companies, which is a longer-term concern for U.S. corporate health when the economic growth backdrop becomes less friendly. The bottom-up versions of the U.S. CHMs for IG corporates (Chart 3) and HY companies (Chart 4) have also both improved, with the HY indicator sitting right at the zero line. This confirms that the signal from our top-down CHM is being reflected in both higher-rated and lower quality companies. Yet the longer-term problems of high leverage and low returns on capital are not going away. In particular, HY interest and debt coverage remains near multi-decade lows. Chart 2Top-Down U.S. CHM:##BR##A Cyclical Pause Of A Structural Deterioration Top-Down U.S. CHM: A Cyclical Pause Of A Structural Deterioration Top-Down U.S. CHM: A Cyclical Pause Of A Structural Deterioration Chart 3Bottom-Up U.S. Investment Grade CHM:##BR##A Bit Better, But Still Deteriorating Bottom-Up U.S. Investment Grade CHM: A Bit Better, But Still Deteriorating Bottom-Up U.S. Investment Grade CHM: A Bit Better, But Still Deteriorating What is rather worrying is the fact that IG interest coverage has fallen in recent years, despite high profit margins and historically low corporate borrowing rates. This indicates that the stock of debt has now expanded to a point where the interest expense required to service that debt is eating up a greater share of corporate earnings, even at a time when profit growth is still quite strong. This will raise downgrade risk if corporate borrowing rates were to increase significantly or the U.S. experiences a major economic downturn. Interest costs would rise while earnings deteriorate, which would push interest coverage to historic lows, as was discussed in a recent report from our flagship Bank Credit Analyst service.3 For now, we are still recommending playing the growth phase of the business cycle by staying overweight U.S. corporate debt within global fixed income portfolios (Chart 5). The time to scale back positions will come after U.S. inflation expectations rise to levels consistent with the Fed's inflation target (i.e. when both the 5-year/5-year forward U.S. TIPS breakeven and the outright 10-year TIPS breakevens reach 2.4-2.5%). This will give the Fed confidence to follow through on its rate hike projections, pushing the funds rate to restrictive levels. In turn, that will dampen future corporate profit expectations and raise risk premiums on U.S. corporate bonds. With those breakevens now sitting at the highest point in four years (2.19%), that tipping point for credit markets is drawing nearer. Chart 4Bottom-Up U.S. High-Yield CHM:##BR##A Strong Cyclical Improvement Bottom-Up U.S. High-Yield CHM: A Strong Cyclical Improvement Bottom-Up U.S. High-Yield CHM: A Strong Cyclical Improvement Chart 5The Beginning Of The End Of##BR##The U.S. Credit Cycle The Beginning Of The End Of The U.S. Credit Cycle The Beginning Of The End Of The U.S. Credit Cycle Euro Corporate Health Monitors: Getting Better Thanks To The Economy & The ECB Our top-down Euro Area CHM remains in "improving health" territory, as it has for the entire period since the 2008 crisis. The trend in the indicator has been steadily worsening since 2015, however, and the top-down CHM now sits just below the zero line (Chart 6). The steady deterioration of the top-down CHM is due to declines in profit margins, return on capital and debt coverage. This is offsetting the high and rising levels of short-term liquidity and interest coverage, which are being supported by the easy money policies of the ECB (negative short-term interest rates, liquidity programs designed to prompt low-cost bank lending, and asset purchase programs that include buying of corporate bonds). Compared to the top-down CHMs we have constructed for other countries, there is an even longer lag on data availability from euro area government statisticians. Our top-down euro area CHM is only available to the 3rd quarter of 2017 and, therefore, does not reflect the strong performance of the euro area economy at the end of last year. Our bottom-up versions of the euro area CHMs for IG (Chart 7) and HY (Chart 8), which are based on individual earnings data that is more timely, both show that corporate health continued to improve at the end of 2017. Return on capital for euro area IG issuers (both domestic issuers and foreign issuers in the European bond market) is between 8-10%, similar to the level in the bottom-up U.S. IG CHM but higher than the equivalent measures in our U.K., Japan and Canada CHMs. Both interest coverage and liquidity ratios for euro area IG are also close to U.S. IG levels. The euro area HY CHM is also showing improvement though declining leverage, although these results should be interpreted with caution as the sample size is relatively small. Chart 6Top-Down Euro Area CHM:##BR##Health Improving At A Diminishing Rate Top-Down Euro Area CHM: Health Improving At A Diminishing Rate Top-Down Euro Area CHM: Health Improving At A Diminishing Rate Chart 7Bottom-Up Euro Area##BR##Investment Grade CHMs: Steady Improvement Bottom-Up Euro Area Investment Grade CHMs: Steady Improvement Bottom-Up Euro Area Investment Grade CHMs: Steady Improvement Within the Euro Area, our bottom-up CHMs show that the gap has closed between issuers from the core countries versus those in the periphery, but all still remain in the "improving health" zone. (Chart 9). Return on capital, interest coverage and debt coverage are higher in the core, while liquidity is better in the periphery despite more highly levered balance sheets. Chart 8Bottom-Up Euro Area High-Yield CHMs:##BR##Steady Improvement As Leverage Declines Bottom-Up Euro Area High-Yield CHMs: Steady Improvement As Leverage Declines Bottom-Up Euro Area High-Yield CHMs: Steady Improvement As Leverage Declines Chart 9Bottom-Up Euro Area IG CHMs:##BR##Core Vs. Periphery Bottom-Up Euro Area IG CHMs: Core Vs. Periphery Bottom-Up Euro Area IG CHMs: Core Vs. Periphery While all of our euro area CHMs are indicating healthier balance sheets, that fact is already discounted in the low yields and tight spreads for both IG and HY issuers (Chart 10). Euro area corporates are also benefitting from the supportive bid of the ECB, which buys credit as part of its asset purchase program. We expect the ECB to fully taper its government bond purchases by the end of 2018, while continuing to reinvest the proceeds of maturing debt in 2019 and beyond. It is less clear what the ECB will do with its corporate bond buying program, and there has been some speculation that the ECB could leave its corporate program untouched while tapering the government purchases. That would be a scenario that could be keep euro area credit spreads tight, although the momentum in the euro area economy will likely be the more important driver of credit valuations. If the soft patch in growth seen in the first few months of 2018 continues in the coming months, euro area credit spreads would likely widen, although by less than if the ECB was not buying corporates. We have preferred to own U.S. corporates over Euro Area equivalents for much of the past year. The gap between our top-down CHMs for the U.S. and Europe has proven to be an excellent directional indicator for the relative performance of U.S. credit vs. Europe (Chart 11). That CHM gap continues to favor U.S. credit, although that has not yet flowed through into any meaningful outperformance of U.S. IG and HY corporates. Chart 10European Credit:##BR##Spreads & Yields Have Bottomed Out European Credit: Spreads & Yields Have Bottomed Out European Credit: Spreads & Yields Have Bottomed Out Chart 11Relative Top-Down CHMs##BR##Still Favor The U.S. Over Europe Relative Top-Down CHMs Still Favor The U.S. Over Europe Relative Top-Down CHMs Still Favor The U.S. Over Europe U.K. Corporate Health Monitor: Still No Major Causes For Concern The top-down U.K. CHM remains firmly in the "improving health" zone, led by cyclical improvements in profit margins and interest coverage, combined with very strong short-term liquidity (Chart 12). Return on capital remains near 20-year lows around 6%, however, mirroring levels seen in this ratio in the CHMs for other countries. Profit margins remain at 20%, near the middle of the historical range. U.K. credit has benefitted from highly stimulative monetary policy settings by the Bank of England (BoE) - especially after the 2016 Brexit shock when the central bank not only lowered policy rates, but announced bond buying programs for both Gilts and U.K. corporates. The BoE has begun to take back some of that monetary easing by raising rates 50bps since last November. However, we remain skeptical that the central bank will be able to deliver much additional tightening over the rest of 2018 given sluggish growth, falling realized inflation and lingering Brexit uncertainties weighing on business confidence. An environment of mushy domestic growth and a stand-pat central bank would typically be good for risk assets like corporate credit. Yet both yields and spreads have been drifting higher in recent months, mirroring the trends seen in other global corporate bond markets (Chart 13). It is difficult to paint a scenario of renewed outperformance of U.K. credit versus Gilts without a fresh catalyst like accelerating growth or monetary easing. Yet the combination of accommodative monetary policy with a solid credit backdrop leads us to maintain a neutral recommendation on U.K. corporate debt. Chart 12U.K. Top-Down CHM:##BR##Steady Improvement U.K. Top-Down CHM: Steady Improvement U.K. Top-Down CHM: Steady Improvement Chart 13U.K. Credit: Yields & Spreads##BR##Are Drifting Higher U.K. Credit: Yields & Spreads Are Drifting Higher U.K. Credit: Yields & Spreads Are Drifting Higher Japan Corporate Health Monitor: A Small, But Very Healthy, Market We introduced our Japan CHM in a recent Weekly Report.4 We only have a bottom-up version of the indicator at the moment, as there is not the same consistency of top-down data sources as are available in other countries. Furthermore, the Japanese corporate bond market is small, as companies have historically chosen to borrow money (when needed) through bank loans and not bond issuance. This means that we have a much more limited amount of data available with which to build a Japan CHM, which covers only 43 companies and only goes back to 2006. The Japan CHM has been in "improving health" territory for the past decade, driven by very healthy liquidity levels and rising return on capital and interest coverage (Chart 14). While the trend in the latter two ratios differs from what is shown in all CHMs for other countries, it is noteworthy that Japan's return on capital has risen to a "high" level (6%) that is similar to the current historically low levels in the U.S. and Europe. The comparison is even less flattering when looking at profit margins, which have been steadily improving over the past five years but are only around 6% - less than half the levels seen in the bottom-up IG CHMs for the U.S. and Europe. Turning to the corporate spread, it has slightly widened in 2018, but by a far smaller amount than seen in other corporate bond markets (Chart 15). We have shown that Japanese corporate spreads are highly correlated to the level of the yen. The direct effect is obvious, as a stronger yen will hurt the competitiveness and profitability of the exporter-heavy Japanese non-financial corporate sector. Yet a strong yen is also a reflection of the market's belief in the next move by the BoJ with regards to Japanese monetary policy. On the front, we continue to expect the BoJ to maintain a very dovish policy stance, with no change in the central bank's interest rate targets (both for short-term interest rates and the 10yr JGB yield). The bigger issue will be if the current softness in the Japanese economic data turns into a broader trend, which would damage corporate profits and likely result in some widening of Japanese credit spreads.  Chart 14Japan Bottom-Up CHM:##BR##Very Healthy Japan Bottom-Up CHM: Very Healthy Japan Bottom-Up CHM: Very Healthy Chart 15Japanese Corporates##BR##Will Continue To Outperform JGBs Japanese Corporates Will Continue To Outperform JGBs Japanese Corporates Will Continue To Outperform JGBs Canada Corporate Health Monitor: In Good Shape On A Cyclical Basis In this CHM Chartbook, we are introducing new CHMs for Canada. Like Japan, this is another relatively small market. Canadian corporates represent a slightly larger share of the Bloomberg Barclays Global Investment Grade Corporate Bond Index (5%) than Japan (3%). The average credit rating of the Canadian corporate bond index is A2/A3, which is higher quality than that of the U.S. IG index with but with similar credit spreads over their respective government bonds. However, due to the lack of liquidity and market accessibility, Canadian corporates are considered a niche market that has not gained much attention from global investors. We created both a top-down and bottom-up version of the Canada CHM. For the bottom-up CHM, we gathered data on 85 companies from both the Bloomberg Canadian dollar-denominated IG and HY indices. We combined IG and HY bonds into one set of data given the small sample sizes of each category, which also allows us to compare it to the top-down Canadian CHM that does not distinguish by credit quality. Both Canadian CHMs are firmly in the "improving health" territory (Chart 16). Unsurprisingly, these CHMs have shown a reasonably strong correlation to oil prices, which are a key driver of the Canadian economy through the energy sector. This can be seen in the deterioration in the CHMs after global oil prices collapsed in 2014/15, and the subsequent improvement as oil prices have recovered over the past couple of years. Going through the individual CHM components, leverage has been steadily rising and currently sits around 100%. While Canada's problems with high household debt levels are well known, the Bank for International Settlements (BIS) noted in its March 2018 Quarterly Review that high Canadian corporate leverage could also pose a future problem for the Canadian economy.5 Among the other CHM ratios, return on capital and profit margin have fallen for nearly a decade, although there has been some moderate improvement of late thanks to higher oil prices. Debt coverage and interest coverage are also showing some very moderate recovery due to low interest rates - a trend also observed in other countries where central banks have maintained easy monetary policy. Canadian corporate bond valuations are not cheap at the moment, with the index spread around decade-lows of 100bps (Chart 17). BCA's commodity strategists expect global oil prices to continue climbing over the next year, which should support Canadian corporate valuations versus government bonds given past correlations. We also expect the Bank of Canada to continue to slowly raise interest rates over the next year, as well, mimicking moves we also anticipate from the U.S. Federal Reserve. Given the cyclical signs of improving corporate health from our Canadian CHMs, and our bearish views on Canadian government bonds, we are upgrading our recommended allocation on Canadian corporates to overweight while downgrading governments. This is strictly a carry trade, however, as we do not anticipate spreads narrowing much from current levels. Chart 16Canada CHMs:##BR##Cyclical Improvements, Structural Problems Canada CHMs: Cyclical Improvements, Structural Problems Canada CHMs: Cyclical Improvements, Structural Problems Chart 17Canadian Corporates:##BR##No Cyclical Case For Spread Widening Yet Canadian Corporates: No Cyclical Case For Spread Widening Yet Canadian Corporates: No Cyclical Case For Spread Widening Yet Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com Appendix 1: An Overview Of The BCA Corporate Health Monitors The BCA Corporate Health Monitor (CHM) is a composite indicator designed to assess the underlying financial strength of the corporate sector for a country. The Monitor is an average of six financial ratios inspired by those used by credit rating agencies to evaluate individual companies. However, we calculate our ratios using top-down (national accounts) data for profits, interest expense, debt levels, etc. The idea is to treat the entire corporate sector as if it were one big company, and then look at the credit metrics that would be used to assign a credit rating to it. Importantly, only data for the non-financial corporate sector is used in the CHM, as the measures that would be used to measure the underlying health of banks and other financial firms are different than those for the typical company. The six ratios used in the CHM are shown in Table 1 below. To construct the CHM, the individual ratios are standardized, added together, and then shown as a deviation from the medium-term trend. That last part is important, as it introduces more cyclicality into the CHM and allows it to better capture major turning points in corporate well-being. Largely because of this construction, the CHM has a very good track record at heralding trend changes in corporate credit spreads (both for Investment Grade and High-Yield) over many cycles. Top-down CHMs are now available for the U.S., euro area, the U.K. and Canada. The CHM methodology was extended in 2016 to look at corporate health by industry and by credit quality.6 The financial data of a broad set of individual U.S. and euro area companies was used to construct individual "bottom-up" CHMs using the same procedure as the more familiar top-down CHM. Some of the ratios differ from those used in the top-down CHM (see Table 1), largely due to definitional differences in data presented in national income accounts versus those from actual individual company financial statements. The bottom-up CHMs analyze the health of individual sectors, and can be aggregated up into broad CHMs for Investment Grade and High-Yield groupings to compare with credit spreads. In 2018, we introduced bottom-up CHMs for Japan and Canada. With the country expansion of our CHM universe, we now have coverage for 92% of the Bloomberg Barclays Global Aggregate Corporate Bond Index (Appendix Chart 1). Table 1Definitions Of Ratios##BR##That Go Into The CHMs BCA Corporate Health Monitor Chartbook Update: Growth Is Papering Over The Cracks BCA Corporate Health Monitor Chartbook Update: Growth Is Papering Over The Cracks Appendix Chart 1We Now Have CHM Coverage For 92% Of##BR##The Developed Market Corporate Bond Universe BCA Corporate Health Monitor Chartbook Update: Growth Is Papering Over The Cracks BCA Corporate Health Monitor Chartbook Update: Growth Is Papering Over The Cracks 1 http://lipperalpha.financial.thomsonreuters.com/2018/04/high-yield-bond-funds-attract-investor-attention/ 2 The majority of data used in the top-down U.S. CHM comes from the Federal Reserve's quarterly Financial Accounts Of The United States Z1 release (formerly known as the Flow of Funds), which is typically published in the third month following the end of a quarter. Thus, those data inputs for Q1/2018 will not be available until June. 3 Please see Section II of the March 2018 edition of The Bank Credit Analyst, available at bca.bcaresearch.com. 4 Please see BCA Global Fixed Income Strategy Weekly Report, "Sticking With The Plan", dated March 13th 2018, available at gfis.bcaresearch.com. 5 https://www.bis.org/publ/qtrpdf/r_qt1803.htm 6 Please see Section II of The Bank Credit Analyst, "U.S. Corporate Health Gets A Failing Grade", dated February 2016, available at bca.bcaresearch.com. Appendix 2: U.S. Bottom-Up CHMs For Selected Sectors APPENDIX 2: ENERGY SECTOR APPENDIX 2: ENERGY SECTOR APPENDIX 2: MATERIALS SECTOR APPENDIX 2: MATERIALS SECTOR APPENDIX 2: COMMUNICATIONS SECTOR APPENDIX 2: COMMUNICATIONS SECTOR APPENDIX 2: CONSUMER DISCRETIONARY SECTOR APPENDIX 2: CONSUMER DISCRETIONARY SECTOR APPENDIX 2: CONSUMER STAPLES SECTOR APPENDIX 2: CONSUMER STAPLES SECTOR APPENDIX 2: HEALTH CARE SECTOR APPENDIX 2: HEALTH CARE SECTOR APPENDIX 2: INDUSTRIALS SECTOR APPENDIX 2: INDUSTRIALS SECTOR APPENDIX 2: TECHNOLOGY SECTOR APPENDIX 2: TECHNOLOGY SECTOR APPENDIX 2: UTILITIES SECTOR APPENDIX 2: UTILITIES SECTOR The GFIS Recommended Portfolio Vs. The Custom Benchmark Index BCA Corporate Health Monitor Chartbook Update: Growth Is Papering Over The Cracks BCA Corporate Health Monitor Chartbook Update: Growth Is Papering Over The Cracks Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Our analysis is often focused on China, commodities prices and Asia's business cycle. The key points of these discussions are applicable to the majority of EM countries and their financial markets. Yet, there are some countries that are not exposed to China, commodities or global trade. India and Turkey are two prominent examples from the EM space that fall into this category. This week we re-visit our analysis on these economies and their financial markets. Feature India: Inflation Holds The Key Indian government bonds sold off sharply over the past eight months, with the yield gap widening significantly relative to EM local currency bonds (Chart I-1, top panel). During this time, the country's stock market has been underperforming the EM benchmark notably (Chart I-1, bottom panel). Rising Indian inflation was a main culprit behind the selloff. However, the most recent print for headline CPI was down (Chart I-2). Diminished inflation worries have recently led to a modest drop in bond yields. Chart I-1India Relative To EM: Bonds And Stocks India Relative To EM: Bonds And Stocks India Relative To EM: Bonds And Stocks Chart I-2Indian Inflation Has Accelerated Indian Inflation Has Accelerated Indian Inflation Has Accelerated The key question for investors is if inflation will rise or stay tame. This, by extension, will determine whether Indian stocks will outperform their EM counterparts. Risks: Inflation, Fiscal Balance And Bond Yields Odds point to upside inflation surprises ahead, and a potential rise in bond yields: The supply side of the economy has been stagnant. Chart I-3 illustrates that Indian consumption has been outpacing investments since 2012, creating a significant accumulated gap. Capex is now picking up (Chart I-4, top panel) but the fact that past investment was low means that the output gap could become positive sooner than later. Chart I-3Consumption Is Outpacing Investments Consumption Is Outpacing Investments Consumption Is Outpacing Investments Chart I-4Timid Pick Up In Capex Insufficient Pickup In India's Supply Side Insufficient Pickup In India's Supply Side Crucially, in order for the capex rebound to be robust and sufficient to expand the economy's productive capacity, Indian commercial banks need to finance corporate investments aggressively. The bottom panel of Chart I-4 shows that this is not yet the case. On the fiscal front, the Indian central government released a mildly expansionary 2018-2019 budget, and is pushing for fiscal consolidation beyond 2019. Importantly, this was the last budget announcement of the ruling National Democratic Alliance (NDA) coalition before the 2019 general elections. It therefore entails a 10% increase in government expenditures. Growing government expenditures are often inflationary in India; hence a 10% rise in government spending could boost inflation modestly (Chart I-5). Additionally, there are also non-trivial risks that the Bharatiya Janata Party (BJP) government might end up spending beyond the official budget announcement in order to appease voters in the run-up to the 2019 general elections. The risks of overspending extend to state governments as well. The latter plan to raise their employees' housing rental allowances (HRA). Depending on the magnitude and timing of these increases, inflation could accelerate significantly and have spillover effects. Turning to bond yields, excess demand for credit by borrowers against a restricted supply of financing by banks is also creating a ripe environment for higher bond yields: The combined Indian central and state fiscal deficit is very wide, signaling strong demand for credit by the government (Chart I-6, top panel). Yet broad money creation by banks has generally been weak (Chart I-6, bottom panel). Chart I-5Indian Government ##br##Expenditure Is Inflationary Indian Government Expenditure Is Inflationary Indian Government Expenditure Is Inflationary Chart I-6Large General Fiscal Deficit ##br##Amid Slow Money Creation Large General Fiscal Deficit Amid Slow Money Creation Large General Fiscal Deficit Amid Slow Money Creation Chart I-7 illustrates that the combined central and state government fiscal deficit plus the annual change in the total broad stock of money is negative. This signals that new money creation might be insufficient. Commercial banks' holdings of government bonds is also falling (Chart I-8, top panel). Indian banks are at the margin beginning to turn their focus to private sector lending (Chart I-8, bottom panel). Chart I-7Insufficient New Funding ##br##For The Economy India: Insufficient Funding For The Economy India: Insufficient Funding For The Economy Chart I-8Indian Commercial Banks Are Shifting ##br##Focus To The Private Sector Indian Commercial Banks Are Shifting Focus To The Private Sector Indian Commercial Banks Are Shifting Focus To The Private Sector This is expected as commercial banks' holdings of government bonds have reached 29% of total deposits, which is significantly above the minimum required Statutory Liquidity Ratio (SLR) of 19.5%. Given the ongoing improvement in private sector growth and hence demand for credit, Indian banks are now more inclined to augment their loan portfolios. Non-bank financial corporations such as insurance companies could offset banks' lower demand for government securities, but the former are not as large players as banks to make a meaningful impact. They own only 24% of government bonds compared to the banks' 42% ownership. Mutual funds and other non-bank finance corporations' ownership of government bonds is even smaller than that of insurance companies. Chart I-9India's Cyclical Profile India's Cyclical Profile India's Cyclical Profile Bottom Line: Upside risks to government spending, the budget balance and inflation will likely keep upward pressure on domestic bond yields. That amid high equity valuations might lead to lower share prices in absolute terms. India Can Still Outperform The EM Benchmark While Indian government bonds could sell off and stocks could fall in absolute terms, India is in a better position relative to its EM counterparts. Our view remains that we will see a material slowdown in Chinese growth this year - which is negative for commodities prices and EM economies. This scenario will be beneficial for India at the margin relative to other EM bourses. Importantly, Indian economic activity is gaining upward momentum: Overall loan growth has picked up meaningfully, and consumer loan growth in particular is accelerating at a double-digit pace (Chart I-9, top panel). Motorcycle sales have resumed their upward trend (Chart I-9, panel 2). Commercial vehicle sales are now accelerating robustly (Chart I-9, panel 2) and manufacturing production has picked up noticeably (Chart I-9, panel 3). Bottom Line: We recommend investors keep an overweight position in Indian equities versus the EM benchmark. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Turkish Markets Are In Freefall The lira has been in freefall and local bond yields have spiked (Chart II-1) following the Turkish government's announcement that it wants to stimulate growth even further by implementing a new investment incentive package worth $34 billion, or 5% of GDP. Our view is that the recent lira depreciation as well as the selloff in stocks and bonds have further room to go. Stay short/underweight Turkish risk assets. The Turkish economy is clearly overheating and inflation has broken out into double digit territory (Chart II-2). This comes as no surprise, given high and accelerating wage growth together with stagnant productivity gains (Chart II-3, top panel). Unit labor costs are surging in both manufacturing and services sectors (Chart II-3, bottom panel). Demand is booming, as such firms will likely succeed in hiking selling prices further, reinforcing the wage-inflation spiral. Chart II-1Turkey: Currency Is Falling And ##br##Bond Yields Are Rising Turkey: Currency Is Falling And Bond Yields Are Rising Turkey: Currency Is Falling And Bond Yields Are Rising Chart II-2Turkey: Genuine Inflation Breakout Turkey: Genuine Inflation Breakout Turkey: Genuine Inflation Breakout Chart II-3Turkey: Wage Growth Is Too High Turkey: Wage Growth Is Too High Turkey: Wage Growth Is Too High Most alarmingly, Turkish policymakers are doing the opposite of what is currently needed - instead of tightening, they have been easing policy: On the fiscal side, government expenditures excluding interest payments have accelerated significantly (Chart II-4). On the monetary policy side, Turkey's banking system has been relying on enormous amounts of liquidity provisions by the central bank (Chart II-5, top panel) to sustain its ongoing credit boom and hence economic growth. Chart II-4Turkey: Fiscal Policy Is Easing Turkey: Fiscal Policy Is Easing Turkey: Fiscal Policy Is Easing Chart II-5Turkey: Monetary Policy Is Too Accommodative Turkey: Monetary Policy Is Too Accommodative Turkey: Monetary Policy Is Too Accommodative On the whole, the central bank's net liquidity injections into the banking system continue to increase rapidly. The nature of the central bank's reserves provisions to commercial banks has shifted away from open market operations and more towards direct lending to banks (Chart II-5, bottom panel). Yet, the essence remains the same: to provide liquidity to banks so that the latter can continue expanding their balance sheets. Adding all the liquidity facilities - the intraday, overnight and late window facilities - the Central Bank of Turkey's (CBT) outstanding funding to banks is TRY 90 billion, or 3% of GDP, abnormally elevated on a historical basis. All this entails that monetary policy is too loose. Consistently, even though local currency bank loan growth has moderated, it still stands at 18% (Chart II-6). With the newly announced government stimulus plan, bank loan growth will likely accelerate from an already high level. As debt levels rise, so are debt servicing costs (Chart II-7). Notably, debt (both domestic/local currency and external debt) servicing costs will continue to escalate as the currency plunges. The reason is that Turkish private sector external debt stands at 40% of GDP, with 13% of GDP being short-term, the highest among EM countries. Currency depreciation will make external debt more expensive to service. Chart II-6Turkey: Rampant Credit Growth Turkey: Rampant Credit Growth... Turkey: Rampant Credit Growth... Chart II-7Higher Debt Servicing Costs ...Means Higher Debt Servicing Costs ...Means Higher Debt Servicing Costs Lastly, the Turkish authorities are expanding the Credit Guarantee Fund, what we would call the "free money" program. The aim of this fund is to incentivize banks to lend more, making the government essentially assume credit risk on loans extended to small and medium enterprises. Under this scheme, the government is effectively giving a green light to flood the economy with more money/credit. This will only heighten inflationary pressures and lead to much more currency devaluation. So far, the scheme has been responsible for the creation of TRY 250 billion, or 8% of GDP worth of new credit. The new tranche of this program announced in January of this year entails another TRY 55 billion. While smaller than the previous tranche, it is still significant at 1.8% of GDP. Fiscal and monetary policies are overly simulative and the country's twin deficits - both fiscal and current account - are widening (Chart II-8). The current account deficit now exceeds 6% of GDP. With foreign holdings of equities and government bonds already at historic highs (Chart II-9), it is questionable whether Turkey has the capacity to attract more capital inflows to finance a widening current account deficit on a sustainable basis. Chart II-8Turkey: Large Twin Deficits Turkey: Large Twin Deficits Turkey: Large Twin Deficits Chart II-9Turkey: Foreign Holdings Of ##br##Stocks And Bonds Are Large Turkey: Foreign Holdings Of Stocks And Bonds Are Large Turkey: Foreign Holdings Of Stocks And Bonds Are Large Remarkably, despite extremely strong exports due to robust growth in the euro area, the current account deficit in Turkey has been unable to narrow at all. This confirms the excessive domestic demand boom. Chart II-10The Turkish Lira Is Not Cheap The Turkish Lira Is Not Cheap The Turkish Lira Is Not Cheap Even after undergoing large nominal depreciation, Chart II-10 demonstrates that the Turkish lira is still not cheap, according to unit labor cost-based real effective exchange rate, which in our opinion is the best valuation measure for currencies. With wage and general inflation in the double digits and escalating, it will take much more nominal deprecation for the lira to become cheap. At this point, the Turkish authorities are clearly over-stimulating growth while disregarding inflation. The current policy stance will all but ensure that the lira depreciates much further. Excessive money creation is extremely bearish for the local currency. To put the amount of outstanding money into perspective and gauge exchange rate risk, one can compute the ratio of foreign exchange reserves to broad money (local currency money supply). Chart II-11 illustrates that the current net level of foreign exchange reserves (excluding banks' foreign currency deposits at the central bank) including gold currently stands at US$30 billion, which is equivalent to a mere 11% of broad local currency money M3. The ratio for other EM countries is considerably higher (Chart II-12). Chart II-11Turkey: Central Bank FX ##br##Reserves Level Is Inadequate Turkey: Central Bank FX Reserves Level Is Inadequate Turkey: Central Bank FX Reserves Level Is Inadequate Chart II-12Foreign Exchange Reserves Adequacy In EM Country Perspectives: India And Turkey Country Perspectives: India And Turkey Given the inflationary backdrop and the risk of further currency depreciation, interest rates will have to rise. With time this will inevitably trigger another upward non-performing loan (NPL) cycle. Banks are very under-provisioned for non-performing loans (NPLs). Even worse, banks have been reducing the ratio of NPL provisions to total loans in order to book strong profits. NPLs and NPL provisions are set to rise substantially, and banks' equity will be considerably eroded as a result. Lastly, as Chart II-13 demonstrates, rising interest rates are bearish for bank share prices. Investment Implications The government is doubling down on pro-growth policies and is disregarding inflation. Hence, inflation will spiral out of control and the central bank will fall even more behind the curve. This is extremely bearish for the lira. We are reiterating our short position on the lira. We remain short the lira versus the U.S. dollar, but the lira will likely also continue to plummet versus the euro as well. As such, we are also reiterating our underweight/short stance on Turkish stocks in general, and banks in particular (Chart II-14). Chart II-13Turkey: Higher Interest Rates ##br##Will Hurt Bank Stocks Turkey: Higher Interest Rates Will Hurt Bank Stocks Turkey: Higher Interest Rates Will Hurt Bank Stocks Chart II-14Stay Short/Underweight Turkish Stocks Stay Short/Underweight Turkish Stocks Stay Short/Underweight Turkish Stocks A weaker lira will undermine returns for foreign investors on Turkish domestic bonds and assures widening sovereign and corporate credit spreads. Dedicated EM fixed income and credit portfolios should continue to underweight Turkey within their respective EM universes. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights U.S. Treasury Curve: The U.S. Treasury curve has flattened to new cyclical lows as the market has moved to fully price in the Fed's interest rate forecasts. Inflation expectations must rise further for those forecasts to be fully realized, however. Expect renewed U.S. curve steepening through higher inflation expectations and longer-term Treasury yields in the next 3-6 months. UST-Bund Spread Update: Stay in our recommended 10yr UST-Bund spread widening trade. as Treasury yield increases will not be matched in Bunds given slowing euro area economic momentum and a more balanced tone from the ECB. Global IG Corporate Sector Allocation: Our investment grade (IG) sector allocations, taken from our relative value models, have added positive performance since our last update in August. Feature The unpredictable, and at times unruly, behavior of financial markets over the first few months of 2018 has been exhausting for investors. A calm January was followed by the early February volatility spike and, more recently, huge intraday swings based on the ebb and flow of news on U.S. trade and foreign policy. Yet when looking at the year-to-date returns for various asset classes, the numbers do not seem unusually alarming given the amount of surrounding noise. Chart of the WeekA Long Road Back From The VIX Spike A Long Road Back From The VIX Spike A Long Road Back From The VIX Spike The S&P 500 index is only down -0.7%, while both equities in both the euro area and emerging markets (EM) equities are up +1.8% and +1.1%, respectively (using MSCI data in U.S. dollar terms). Credit markets are also delivering rather boring performance so far in 2018, from U.S. high-yield (+1.2% excess return over government debt) to euro area investment grade and EM hard currency corporates (both with an -0.1% excess return in U.S. dollar terms). Admittedly, these numbers look far less flattering considering the robust rally in risk assets in January. Yet the year-to-date returns simply do not line up with our impression of how investors' feel about how this year has gone so far. The perception is much gloomier than the actual outcome. Right now, markets are looking for guidance and direction and finding little of both. A big problem is that global bond yields, most notably in the U.S., have not fallen much from the highs for the year - even with global growth clearly losing some steam in the first quarter of 2018. The reason? Global inflation is in a mild cyclical upswing, a product of persistently tight labor markets and rising oil prices (Chart of the Week). The "leadership" in government bond markets has shifted away from accelerating global growth and an upward repricing of future central bank tightening, to rising inflation and unchanged monetary policy expectations. The notion of central bankers not being friendly to the markets remains our key theme for this year. We continue to expect that policymakers will not respond to the latest softer patch of economic data and will focus more on the reacceleration of inflation. This is especially true with risk assets stabilizing and volatility measures like the U.S. VIX index continuing to drift lower and, more importantly, the "volatility of volatility" (as measured by the VVIX index) now back to the levels that prevailed before the early February volatility spike (bottom panel). Although as BCA's strategists discussed at our View Meeting yesterday, volatility can quickly return with a vengeance given softer global growth momentum, and with the geopolitical calendar heating up next month (the U.S. government must make its final decision on the China trade tariffs and investment restrictions).1 This led the group to downgrade our recommended global equity exposure and upgrade our global bond exposure on a tactical (0-3 months) basis, although our more medium-term cyclical allocations (6-12 months) were unchanged (overweight stocks versus bonds). From the point of view of global bond markets, we may now be in period of mild "stagflation" with softening growth and rising inflation. We remain of the view that the former is temporary and the latter is not. This backdrop will keep global bond yields under upward pressure for at least the next few months, with better expected performance of corporate debt over governments - albeit with the potential for higher volatility given more elevated geopolitical risks. What Next For The U.S. Treasury Curve? The Treasury curve flattened to a new cyclical low last week, with the spread between 2-year and 10-year bonds now sitting at 45bps. On the surface, this flattening seems consistent with a Fed that is maintaining a "cautiously hawkish" message and that its rate hike plans for 2018 are unchanged despite more volatile financial markets. Chart 2This UST Curve Flattening Is Different This UST Curve Flattening Is Different This UST Curve Flattening Is Different What makes this current episode different from other bouts of Treasury curve flattening over the past five years, however, is the starting point for the absolute of bond yields. According to our two-factor valuation model for the 10-year Treasury yield, yields are now just a touch above fair value, which is currently 2.78%. That yield valuation was at least +25bps before the previous flattening episodes between 2014 and 2017 (Chart 2). That distinction is critical in differentiating a bull flattener from a bear flattener. Simply put, longer-dated Treasuries are not yet cheap enough to suggest that investors should extend duration risk to benefit from any additional curve flattening from here. In fact, we see a greater risk that Treasury curve re-steepens a bit from here, as there is more room for longer-term inflation expectations to move higher than there is for the front-end of the curve to reprice an even more hawkish Fed. The recent softening of cyclical global economic data has been occurring while realized inflation rates have been slowly rising from depressed levels (Chart 3). Yet in the U.S., the slowing of growth seen in the first quarter of the year remains very modest compared to that seen in Europe or Japan, while core inflation rates (for both the CPI index and the PCE deflator) have accelerated back to 2%. The Atlanta Fed's GDPNow forecasting model is calling for Q1/2018 growth of 1.9%, while the New York Fed's Nowcast model is predicting Q1 growth of 2.8%. While both forecasts are a deceleration from the 3% rates seen in the previous three quarters in 2017, neither is below U.S. potential GDP growth, which the U.S. Congressional Budget Office now estimates to be 1.9%. Even in China, where the economy had been slowing as policymakers have aimed to tighten monetary policy and slow credit growth, cyclical indicators such as the Li Keqiang index (the preferred indicator of our China strategists) have shown a bit of a rebound of late. Right now, underlying U.S. growth and inflation momentum are still pointing towards the Fed delivering on its current projection of an additional 50bps of rate hikes in 2018, taking the funds rate to 2.25%, with even a chance of an additional hike if inflation continues to accelerate. This is essentially fully priced with a 2-year Treasury yield just under 2.4%, however, and the real funds rate is now at neutral according to measures like the Fed's r-star. Therefore, additional flattening pressures from the front end of the curve are unlikely unless the Fed is willing to signal a faster pace of rate hikes than currently laid out in its economic projections (the "dots"). At the same time, the 10-year TIPS inflation breakeven remains 25-35bps below the 2.4-2.5% range that would be consistent with the market expecting U.S. inflation to sustainably return to the Fed's 2% inflation target on the headline PCE deflator. Hence, a steeper Treasury curve is far more likely than a flatter Treasury curve from current levels. Where could this view go wrong? Perhaps the Trump administration's trade skirmishes with China could broaden into a full-on trade war that could cause deeper damage to U.S. equities, dampen growth expectations and drive longer-term yields lower. Coming at a time when there is a significant short position in the U.S. Treasury market, this could look similar to the prolonged bull-flattening seen in 2015-16. During that episode, duration exposure flipped from a big net short to very net long according to measures like the J.P. Morgan Duration Survey (Chart 4, top panel), while the market priced out all expected Fed rate hikes (2nd panel). However, that also occurred alongside a 50bp decline in inflation expectations (3rd panel) and a big deceleration of U.S. growth (bottom panel), both related to a weakening global economy and collapsing oil prices. It is uncertain if the current U.S.-China trade skirmish would have an equivalent impact on both the U.S. economy and the Treasury curve, especially given a starting point of stronger global growth a far more positive demand/supply balance in world oil markets. Chart 3A Whiff Of Stagflation? A Whiff Of Stagflation? A Whiff Of Stagflation? Chart 42018 Is Not 2015/16 2018 Is Not 2015/16 2018 Is Not 2015/16 In sum, we are sticking to our view that the Treasury curve is more likely to bear-steepen through higher longer-term yields than flatten bearishly through more discounted Fed hikes or flatten bullishly through much weaker growth and inflation. We continue to recommend a below-benchmark duration stance in the U.S., within an underweight allocation in a currency-hedged global government bond portfolio. We are also are sticking with our tactical trade of staying short the 10-year U.S. Treasury versus the 10-year German Bund, even with the spread now looking a bit too wide on our fundamentals-based valuation model (Chart 5). The unrelenting string of disappointing economic data in the euro area has already resulted in a far more cautious tone from European Central Bank (ECB) officials regarding the potential for quick rate hikes after the expected end of the asset purchase program at the end of this year. The gap between the U.S. and euro area data surprise indices has proven to be a good directional indicator for the Treasury-Bund spread (Chart 6, bottom panel). Given our views on the potential for renewed bear-steepening in the Treasury curve, which is unlikely to be matched in the German curve in the next 3-6 months, we see no reason to take profits yet on our spread trade. Chart 5UST-Bund Spread Now A Bit Too Wide... UST-Bund Spread Now A Bit Too Wide... UST-Bund Spread Now A Bit Too Wide... Chart 6...But Too Soon For Spread Tightening ...But Too Soon For Spread Tightening ...But Too Soon For Spread Tightening Bottom Line: The U.S. Treasury curve has flattened to new cyclical lows as the market has moved to fully price in the Fed's interest rate forecasts. Inflation expectations must rise further for those forecasts to be fully realized, however. Expect renewed U.S. curve steepening through higher inflation and longer-term Treasury yields in the next 3-6 months. Stay in our recommended 10-year Treasury-Bund spread widening trade, as Treasury yield increases will not be matched in Bunds given slowing euro area economic momentum and a more balanced tone from the ECB. A Brief (And Belated) Performance Update For Our Corporate Bond Sector Allocations It has been some time (August 2017) since we last published a performance update for our investment grade (IG) corporate sector allocations for the U.S., euro area and U.K. As a reminder, those allocations come from our relative value model, which is designed to measure the valuation of each individual sector compared to the overall Barclays Bloomberg corporate bond index for each region. The methodology takes each sector's individual option-adjusted spread (OAS) and regresses it in a panel regression with all the other sectors in each region, as a function of the sector's duration, convexity (duration squared) and credit rating - the primary risk factors for any corporate bond. Using the common coefficients from that regression, a risk-adjusted "fair value" spread is calculated. The difference between the actual OAS and the fair value OAS is our valuation metric from the model for each region. The latest output from the models can be found in the tables and charts in the Appendix starting on Page 14. We also show the duration-times-spread (DTS) for each sector in those tables, using that as our primary way to measure the volatility of each sector. The scatterplot charts in the Appendix show the tradeoff between the valuation residual from our model and each sector's DTS. Chart 7Performance Of Our IG Sector Allocations Stagflation-ish Stagflation-ish We then apply individual sector weights based on the model output and our desired level of overall spread risk that we wish to take in our recommended credit portfolio. At our last update in August 2017, we made a decision to keep the overall (weighted) DTS of our sector tilts roughly equal to the overall IG corporate DTS for each region. With credit spreads looking tight at the time, credit spread curves flat relative to history, and with the Fed in the midst of a tightening cycle, we did not see a case for taking aggressive spread risk (i.e. having a high aggregate DTS) in the portfolio. The performance of our latest sector recommendations since our last update in August 2017, and in the first quarter of 2018, are shown in Chart 7. We show both the total return and excess return of each sector versus duration-matched government bonds. Since that last review, our U.K. sector allocations have performed the best, delivering an additional 12bps of total return and 10bps of excess return versus the U.K. IG corporate index. Our euro area corporate allocations have added 2bps of total return and 3bps of excess return, while our U.S. allocations have modestly underperformed both on total return (-1bp) and excess return. We also show the performance numbers for just the first quarter of 2018 in Chart 7, and we will present the return numbers on this quarterly basis in the future as part of our regular model bond portfolio performance reviews. The sector allocations offered a modest underperformance in Q1 2018, with -5bps of total return and -8bps of excess return coming mostly from euro area and U.K. allocations. The U.S. allocations actually outperformed by +3bps on a total return basis in Q1. The return numbers for our U.S. sector allocations can be found in Table 1. Since our last update in August, the best performing sectors (in excess return terms) for our U.S. portfolio allocation were the overweights to all Energy sub-sectors (+35bps combined), Cable & Satellite (+4bps) and Banks (+4bps). Of those names, only the Independent Energy sub-sector delivered a positive excess return (+3bps) in Q1 2018. Table 1U.S. Investment Grade Performance Stagflation-ish Stagflation-ish The return numbers for our euro area sector allocations can be found in Table 2. Since our last update in August, the best performing sectors (in excess return terms) for our euro area portfolio allocation were the overweights to Financials (+35bps, coming mainly from Banks, Senior Debt and Insurance) and Integrated Energy (+13bps). Those overweights also delivered small positive excess returns (+3bps and +1bps, respectively) in Q1 2018. The return numbers for our U.K. sector allocations can be found in Table 3. Since our last update, the best performing sector (in excess return terms) was the overweight to Financials (+6bps, coming mostly from Banks). Looking ahead, credit spread curves remain very flat by historical standards (Chart 8), which suggests there is not enough spread compensation for extending credit risk to lower quality tiers. Thus, we are sticking with keeping our target DTS for our combined sector allocations equal to that of the overall IG index for each region. We will update our sector allocations in an upcoming Weekly Report. Table 2Euro Area Investment Grade Performance Stagflation-ish Stagflation-ish Table 3U.K. Investment Grade Performance Stagflation-ish Stagflation-ish Chart 8Credit Quality Curves Remain Very Flat Credit Quality Curves Remain Very Flat Credit Quality Curves Remain Very Flat Bottom Line: Our investment grade (IG) sector allocations, taken from our relative value models, have added positive performance since our last update in August. We continue to recommend a cautious approach to sector allocation, targeting index levels of spread risk (in aggregate) in the U.S. euro area and U.K. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Expect Volatility ... Of Volatility", dated April 11, 2018, available at gps.bcaresearch.com. Appendix Appendix Chart 1U.S. Corporate Sector Valuation And Recommended Allocation* Stagflation-ish Stagflation-ish Appendix Chart 1U.S. Corporate Sector Risk Vs. Reward* Stagflation-ish Stagflation-ish Appendix Table 2Euro Area Corporate Sector Valuation And Recommended Allocation* Stagflation-ish Stagflation-ish Appendix Chart 2Euro Area Corporate Sector Risk Vs. Reward* Stagflation-ish Stagflation-ish Appendix Table 3U.K. Corporate Sector Valuation And Recommended Allocation* Stagflation-ish Stagflation-ish Appendix Chart 3U.K. Corporate Sector Risk Vs. Reward* Stagflation-ish Stagflation-ish Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Stagflation-ish Stagflation-ish Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Duration & The Fed: With market rate expectations still not as elevated as the Fed's projections, the outlook for Treasury price return during the next 12 months is poor. Maintain a below-benchmark duration stance. Duration & The CBO: The scope for further upward revisions to potential GDP growth forecasts is limited. This will cap the market's expected equilibrium fed funds rate and ultimately the pace of Fed rate hikes. The Bond Map: This week we introduce a framework for quickly comparing the risk/reward tradeoff on offer from each U.S. bond sector. Feature If we had to choose a fundamental first principle of bond investing, it would be that investors should determine what change in the short-term interest rate is currently priced into the market and then decide whether the central bank will move the interest rate by more or less than what is discounted. Using a 12-month investment horizon, Chart 1 shows that the difference between market expectations for the change in the federal funds rate and the actual change in the federal funds rate closely tracks the price return from the Bloomberg Barclays Treasury index.1 It also shows that the market has underestimated the Fed's hawkishness since early 2016, leading to a negative price return for Treasuries. This stands in stark contrast to earlier in the recovery when the market consistently anticipated more rate hikes than were ultimately delivered (Chart 2). Chart 1The Fundamental Question The Fundamental Question The Fundamental Question Chart 2Investors Have Been Surprised By Fed Investors Have Been Surprised By Fed Investors Have Been Surprised By Fed With all that in mind, in this week's report we consider whether the Fed will continue to deliver hawkish surprises during the next 12 months. Or whether market expectations have finally caught up with reality. The Near-Term Rate Hike Outlook The first step in our "back to basics" bond analysis is to assess what rate hike outlook is currently priced into the yield curve. Using overnight index swap (OIS) forwards, we calculate that the market expects the federal funds rate to be 68 basis points higher in one year's time. Alternatively, we can calculate that the market expects a federal funds rate of 2.23% by the end of this year, 2.63% by the end of 2019, and 2.69% by the end of 2020 (Chart 3). The federal funds rate is currently 1.69%. Adopting the 12-month time horizon used in Chart 1, we can say that the market expects 2-3 rate hikes between now and next April. This is slightly below the Fed's current projections. As of the March FOMC meeting, 12 out of 15 FOMC participants anticipated delivering either 2 or 3 more rate hikes before the end of the year. With another 2-3 hikes anticipated in 2019, it is clear that the FOMC is somewhat more hawkish than the market. But even with a more hawkish outlook than the market, the FOMC still expects core inflation to modestly overshoot its 2% target during the next two years (Chart 4). We view this as a reasonable expectation. While core PCE inflation increased at a year-over-year pace of only 1.6% through February, we showed last week that base effects will cause it to jump sharply in March.2 A month-over-month increase of 0.1% in March translates to a year-over-year growth rate of 1.85%. A month-over-month increase of 0.2% translates to a year-over-year growth rate of 1.95%. As long as the economic recovery is sustained it is not far-fetched to expect that inflation will reach the Fed's target before the end of the year. Chart 3Market Versus Fed Dots Market Versus Fed Dots Market Versus Fed Dots Chart 4Fed Projects An Inflation Overshoot Fed Projects An Inflation Overshoot Fed Projects An Inflation Overshoot Once inflation reaches (or exceeds) the Fed's 2% target, it will necessitate a change in communication from the central bank. Specifically, with the Fed's inflation goal having been achieved, it would be inappropriate for it to maintain an "accommodative" monetary policy. The Fed discussed this eventuality for the first time at the March FOMC meeting, as evidenced by this passage from the minutes: Some participants suggested that, at some point, it might become necessary to revise statement language to acknowledge that, in pursuit of the Committee's statutory mandate and consistent with the median of participants' policy rate projections in the SEP, monetary policy eventually would likely gradually move from an accommodative stance to being a neutral or restraining factor for economic activity.3 The bottom line is that with inflation quickly approaching the 2% target, the Fed is unlikely to deviate from its gradual pace of rate hikes. With market rate expectations still not as elevated as the Fed's projections, the outlook for Treasury price return during the next 12 months is poor. Maintain a below-benchmark duration stance. The Importance Of The Equilibrium Fed Funds Rate Chart 5Potential GDP Growth ##br##Revisions Are Cyclical Potential GDP Growth Revisions Are Cyclical Potential GDP Growth Revisions Are Cyclical Another factor that will govern the cyclical outlook for Fed rate hikes is the equilibrium level of the federal funds rate. That is, the level of interest rates that is consistent with neither an accommodative nor a restrictive policy stance. The level that is expected to keep inflation more or less stable. From the most recent Summary of Economic Projections we know that most FOMC members think that the equilibrium fed funds rate is in the vicinity of 3%, while the bottom panel of Chart 3 shows that market prices embed a somewhat lower forecast. The importance of the equilibrium rate is that if it turns out to be higher than the market expects, then the central bank will be forced to deliver more rate hikes than are anticipated, leading to negative bond price returns, as shown in Chart 1. But how do we judge the appropriate level of the equilibrium fed funds rate? One way is to recognize that the equilibrium fed funds rate is theoretically linked to the rate of potential GDP growth. In fact, we observe that market expectations for the equilibrium fed funds rate - as measured by the 5-year/5-year forward OIS rate - closely track the Congressional Budget Office's (CBO) forecast for potential GDP growth during the next 5 years (Chart 5). Notice that the increase in the 5-year/5-year OIS rate since mid-2016 coincides with upward revisions to the CBO's potential GDP growth projections. Chart 6Determinants Of The Growth##br## Of Real Potential GDP Back To Basics Back To Basics This brings up another important point. Because potential GDP growth is not easily measurable, it is often revised higher during periods when GDP growth strengthens and lower during periods of weaker growth (Chart 5, bottom 2 panels). This raises the possibility of further upward revisions if GDP growth remains strong. We certainly wouldn't rule out that possibility, but we also view the scope for further upward revisions to potential GDP growth as fairly limited. Chart 6 shows the breakdown of the CBO's potential GDP growth forecast between its two components: The size of the labor force Labor force productivity The CBO currently projects potential GDP growth of 2% (annualized) for the next 5 years, split between 0.6% annual growth in the size of the labor force and 1.4% annual growth in labor force productivity. Since projections for the size of the labor force are largely driven by slow-moving demographic factors, they are less subject to revision than are projections for the more nebulous productivity component. But with the CBO already embedding a forecast of 1.4% for annual productivity growth, how much higher can we reasonably expect it to be revised? The current forecast is already consistent with the productivity growth that was realized during the 2002-07 period. Any further upward revisions would cause productivity growth to approach the 2% level that was realized during the I.T. revolution of the 1990s. That seems overly optimistic. Bottom Line: The scope for further upward revisions to potential GDP growth forecasts is limited. This will cap the market's expected equilibrium fed funds rate and ultimately the pace of Fed rate hikes. A Quick Note On The Tactical House View Yesterday morning, BCA strategists decided to downgrade our tactical (0-3 month) view on global equities from overweight to neutral, while simultaneously upgrading the tactical view on global bonds from underweight to neutral.4 All cyclical (6-12 month) views remain unchanged. The two main reasons for the tactical shift are the moderation in global growth, which was flagged in this publication last week, and the long list of potential geopolitical risks that could roil markets in May and June.5 Of course any flare-up of geopolitical risk would lead to a near-term spread widening and a flight-to-quality into Treasury bonds. But while investors should certainly be aware of the near-term risks, we are not altering our cyclical portfolio recommendations. Unanticipated inflation remains the number one risk for bond markets. A re-anchoring of the 10-year TIPS breakeven inflation rate will apply 17 bps to 27 bps of upward pressure to the nominal 10-year Treasury yield, and we are likewise inclined to wait for inflation expectations to re-normalize before positioning for any sustained widening in corporate spreads. Navigating The Bond Map This week we introduce a new framework for judging the relative risk/reward trade-off between different sectors of the U.S. bond market. We dub this framework the Bond Map, as it gives us a quick glimpse of how different sectors stack up against one another. In this section we describe how the Bond Map is created, and we will introduce further applications of the Bond Map in the coming weeks. The Total Return Bond Map Chart 7 presents our Total Return Bond Map. The vertical axis of the Map represents the potential reward available in each sector. Specifically, the numbers on the vertical axis correspond to the number of days of average yield decline that are required for each sector to earn a total return of 5% over a 12-month period. For example, it would take 10 days of average yield decline for the Treasury index to deliver a 5% return, it would only take 4 days for the investment grade Corporate index to deliver the same return. Therefore, unsurprisingly, the potential for reward is greater in the investment grade corporate bond index than in the Treasury index. To calculate the number of days to earn 5%, we start with the following formula that relates the total returns for the index to its average yield, duration and convexity. Total Return = Yield - Duration * (Change in yield) + 0.5*Convexity*(Change in yield)2 We set the total return threshold to 5% and use 1-year trailing yield volatility as an estimate for the squared change in yields. This allows us to calculate the change in yields required for the index to return 5%. Lastly, we adjust the change in yields by the yield volatility of each index. Starting in 2000, we look at a sample consisting only of days when the average yield of the index declined, and we calculate the average magnitude of the yield decline on those days. We then divide the yield change required to gain 5% by the average magnitude of the daily yield decline. The result is a measure of the probability of earning a 5% return that should be roughly comparable between different bond sectors. The horizontal axis is the mirror image of the vertical axis. It is the number of days of average yield increase required for the index to lose 5%. This is calculated using the same process described above, except we use a total return target of -5% and calculate average daily yield changes using only days when yields increase. Once again, the result is a measure of the probability of losing 5% that is roughly comparable between different sectors. One way to interpret the Total Return Bond Map is to split it into quadrants centered on the Bloomberg Barclays U.S. Aggregate Index. Sectors that plot in the upper-right quadrant are exciting sectors that provide a high probability of earning 5% but also a high probability of losing 5%. Conversely, sectors in the bottom-left quadrant are the boring sectors that provide a low probability of losses, but also a low probability of gains. More interesting are those sectors that plot in the upper-left and bottom-right quadrants. Those sectors in the upper-left (High-Yield bonds and Municipal bonds adjusted for the top marginal tax rate) provide both a higher probability of gains and a lower probability of losses than the Aggregate. Conversely, those sectors in the bottom-right quadrant (Treasuries) provide both a lower probability of gains and a higher probability of losses. One counterintuitive result that springs from the Total Return Bond Map is that the High-Yield index appears less risky than the Treasury index. But upon closer inspection the reason for this appears obvious. The average yield on the junk index needs to rise by approximately 250 bps for the index to lose 5%. Because of its lower carry buffer, the average Treasury index yield needs to rise by only about half as much. At the same time, while the volatility of junk yields is higher than the volatility of Treasury yields, it is not twice as high and therefore does not fully offset the yield advantage in high-yield bonds. The main reason for this is the negative correlation between Treasury yields and high-yield spreads. Usually when Treasury yields are rising, high yield spreads are tightening, and vice-versa. This moderates the volatility in junk yields. To see how the sectors in the Total Return Bond Map move around over time, Chart 8 presents what the Total Return Bond Map looked like on January 1, 2010. We see that high-yield bonds looked even more attractive in early 2010, as did 30-year conventional MBS and Aaa-rated non-Agency CMBS. Chart 7Total Return Bond Map (As Of April 12, 2018) Back To Basics Back To Basics Chart 8Total Return Bond Map (As Of January 1, 2010) Back To Basics Back To Basics The Excess Return Bond Map Chart 9 presents the same Bond Map as above, except now we consider excess returns relative to duration-matched Treasuries rather than total returns for each index. We also set our excess return threshold for gains and losses at +/- 100 bps, rather than the 5% we used for total returns. All other calculations remain the same, except that we use spreads and spread volatilities as our inputs rather than yields. Chart 9 shows that the investment grade corporate, local authority and foreign agency sectors look most attractive in excess return space. While no sectors plot in the bottom-right "avoid" quadrant relative to the Bloomberg Barclays Aggregate. Chart 10 once again shows the same Bond Map as of January 1, 2010, and once again the attractiveness of Aaa-rated non-Agency CMBS is apparent. Meanwhile, conventional 30-year MBS looked unattractive in excess return space in early 2010. In the Excess Return Bond Map, you will notice that some sectors actually have a negative number of days of spread tightening required to earn +100 bps. This simply means that spreads could actually widen somewhat and, because of the large carry buffer, the sector would still produce excess returns of +100 bps. Bottom Line: This week we introduced a framework for quickly comparing the risk/reward tradeoff on offer from each U.S. bond sector. While this framework does not impose a macro view, it does seem to provide a good starting point for assessing relative risk-adjusted value in U.S. bonds. We will continue to refine the approach and search for applications in the coming weeks. Chart 9Excess Return Bond Map (As Of April 12, 2018) Back To Basics Back To Basics Chart 10Excess Return Bond Map (As Of January 1, 2010) Back To Basics Back To Basics Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Market expectations are calculated from the overnight index swap curve. 2 Please see U.S. Bond Strategy Weekly Report, "Risk Review", dated April 10, 2018, available at usbs.bcaresearch.com 3 SEP = Summary of Economic Projections 4 A summary of all BCA house views can be accessed here: www.bcaresearch.com/trades/ 5 For details on the trend in global growth please see U.S. Bond Strategy Weekly Report, "Risk Review", dated April 10, 2018, available at usbs.bcaresearch.com. For details on potential geopolitical risks during the next few months please see Geopolitical Strategy Weekly Report, "Expect Volatility ... Of Volatility", dated April 11, 2018, available at gps.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Apart from rising geopolitical tensions, our main macro themes remain a growth slowdown in China and a rise in U.S. core inflation. This combination bodes ill for EM financial markets. Continue underweighting EM stocks, credit and currencies versus their DM peers. Subsiding NAFTA risks argue for overweighting Mexican stocks within an EM equity portfolio. This is in line with our recent upgrade of Mexican local and U.S. dollar sovereign bonds as well as the peso's outlook versus their EM peers. A new trade: Fixed-income trades should bet on yield curve steepening in Mexico by paying 10-year swap rates and receiving 2-year rates. Close overweight Russian markets positions in the wake of escalating U.S. sanctions. Feature Before discussing Mexico and Russia, we offer an update on our thoughts on the overall market outlook. EM: Looking Under The Hood Investor sentiment remains buoyant on global risk assets, and the buy-on-dips mentality remains well entrenched. On the surface, investors are not finding enough reasons to turn negative on global or EM risk markets. Nevertheless, when looking under the EM hood, we see several leading and coincident indicators that are beginning to flash red. Not only do geopolitics and the U.S.-China trade confrontation pose downside risks, there are also several macro developments that are turning from tailwinds to headwinds for EM risk assets. Specifically: EM manufacturing and Asian trade cycles have probably topped out. The relative total return (carry included) of three equally weighted EM1 (ZAR, BRL and CLP) and three DM (AUD, NZD and CAD) commodities currencies versus an equally weighted average of two safe-haven currencies - the Japanese yen and Swiss franc - has relapsed since early this year, coinciding with the rollover in the EM manufacturing PMI index (Chart I-1). This currency ratio is herein referred to as the risk-on/safe-haven currency ratio. Chart I-1Risk On / Safe-Haven Currency Ratio And EM Manufacturing PMI bca.ems_wr_2018_04_12_s1_c1 bca.ems_wr_2018_04_12_s1_c1 The risk-on/safe-haven currency ratio also correlates with the average of new and backlog orders components of China's manufacturing PMI (Chart I-2). The latter does not herald an upturn in this currency ratio at the moment. Share prices of global machinery, chemicals and mining companies have so far underperformed the overall global equity index in this selloff, as exhibited in Chart I-3. Chart I-2China's Industrial Cycle Has Rolled Over bca.ems_wr_2018_04_12_s1_c2 bca.ems_wr_2018_04_12_s1_c2 Chart I-3Global Cyclicals Have Underperformed, Though Not Tech Global Cyclicals Have Underperformed, Though Not Tech Global Cyclicals Have Underperformed, Though Not Tech Potential trade wars, the setback in technology stocks and a resurgence of volatility in global equity markets have recently dominated news headlines. Yet, the underperformance of China-exposed global sectors and sub-sectors signifies that beneath the surface Chinese growth is weakening. Meanwhile, global tech stocks have not yet underperformed much (Chart I-3, bottom panel), implying the selloff has not been driven by this high-flying sector. The combination of weakening global trade amid still-robust U.S. domestic demand bodes well for the U.S. dollar, at least against EM and commodities currencies. U.S. and EU imports account for only 13% and 11% of global trade, respectively (Chart I-4). Meanwhile, aggregate EM including Chinese imports account for 30% of world imports. Hence, global trade can slow even with U.S. and EU domestic demand remaining robust. We addressed the twin deficit issue in the U.S. in our February 21 report,2 and will add the following: If U.S. fiscal stimulus coincides with abundant global growth, the greenback will weaken. If on the contrary, the U.S. fiscal expansion overlaps with weakening global trade, U.S. growth will be priced at a premium and the U.S. dollar will appreciate especially against the currencies of economies where growth will fall short. The majority of EM exchange rates will likely be in the latter group. The relative performance of EM versus DM stocks correlates with the relative volume of imports between China and the DM (Chart I-5). The rationale is that EM countries and their publically listed companies are much more leveraged to China's business cycle than DM. The opposite is true for DM-listed companies. Our view is that China's industrial recovery and growth outperformance versus DM since early 2016 is about to end. This, if realized, should undermine EM equities and currencies versus their DM counterparts. Last week, we published a Special Report on the Chinese real estate market.3 We documented that despite a drawdown in housing inventories over the past two years, both residential and non-residential inventories remain very elevated. This, along with poor affordability and the implementation housing purchase restrictions for investors, will dampen housing sales, which in turn will lead to a contraction in property development and construction activity. Chart I-4Global Trade Is More Leveraged To EM Not DM Global Trade Is More Leveraged To EM Not DM Global Trade Is More Leveraged To EM Not DM Chart I-5EM Underperforms When Chinese Imports Lag DM Ones EM Underperforms When Chinese Imports Lag DM Ones EM Underperforms When Chinese Imports Lag DM Ones Combined with a slowdown in infrastructure investment due to tighter controls on local government finances, this poses downside risks to China's demand for commodities, materials and industrial goods. This is the main risk to EM stocks and currencies, and the primary reason we continue to maintain our negative stance on EM risk assets. Last but not least, it is widely believed that Chinese households are not indebted and that there is a lot of pent-up demand for household credit. Chart I-6 reveals that this conjecture is simply not true - the household debt-to-disposable income ratio has surged to 110% of disposable income in China. The same ratio is currently 107% in the U.S. Given borrowing costs in general and mortgage rates in particular are higher in China than in the U.S. (the mortgage rate is 5.2% in China versus 4.4% in the U.S.), interest payments on debt account for a larger share of households' disposable income in China than in America right now. In the U.S., the surprise on the macro front in the coming months will likely be both rising wage growth and core inflation. Chart I-7 highlights that average hourly earnings in manufacturing and construction have been accelerating. This underscores that wages are rising fast in these cyclical sectors. This will spread to other sectors sooner rather than later. Core inflation in America is rising and has already moved above 2% (Chart I-8). The rise is broad-based as all different core consumer price measures are rising and heading toward 2%. Chart I-6Chinese Households Are As Leveraged As Americans Chinese Households Are As Leveraged As Americans Chinese Households Are As Leveraged As Americans Chart I-7U.S. Wages Are Accelerating U.S. Wages Are Accelerating U.S. Wages Are Accelerating Chart I-8U.S. Core Inflation Is Above 2% U.S. Core Inflation Is Above 2% U.S. Core Inflation Is Above 2% While this does not entail that the U.S. is heading into runaway inflation, rising core inflation and wage growth will likely lead many investors to believe that the Federal Reserve cannot back off too fast from rate hikes, particularly when the U.S. fiscal thrust remains so positive, even if the drawdown in share prices persist. This may especially weigh on EM risk assets, where growth will be subsiding due to their links with Chinese imports. Bottom Line: Our main macro themes remain a slowdown in China and a rise in U.S. core inflation. This combination bodes ill for EM financial markets. Continue underweighting EM stocks, credit and currencies versus their DM peers. Upgrade Mexican Equities To Overweight In our March 29 report,4 we upgraded our stance on the Mexican peso, local currency bonds and U.S. dollar sovereign credit from neutral to overweight. The main rationale was receding odds of NAFTA abrogation and the country's healthy macro fundamentals. In addition, we instituted a new currency trade: long MXN / short BRL and ZAR. Continuing with this theme, we today recommend upgrading Mexican stocks to overweight within an EM equity portfolio: The odds of NAFTA retraction are rapidly subsiding as the U.S. is shifting its focus to China. Hence, chances are that NAFTA negotiations will be completed this summer, and a deal will be signed off before Mexico's presidential elections on July 1st. A more benign outcome together with an early end to NAFTA negotiations will reduce uncertainty and the risk premium priced into Mexican financial markets. This will help the latter outperform their EM peers. A final note on Mexican politics: The leftist presidential candidate Andres Manuel Lopez Obrador has high chances of winning the presidential elections in July. Yet Our colleagues at BCA's Geopolitical Strategy service believe political risks are overstated.5 The basis is that Obrador will balance the left-leaning preferences of his electorate with the prudent policies needed to produce robust growth. While political uncertainty in Mexico is subsiding, it is rising in many other EM countries such as Russia, China and Brazil. In brief, geopolitical dynamics favor Mexico versus the rest of EM. We expect dedicated EM managers across various asset classes to rotate into Mexico from other EM countries. We outlined two weeks ago that a stable exchange rate will bring down inflation, opening a door for the central bank to cut interest rates no later than this summer. As local interest rate expectations in Mexico continue to subside both in absolute terms as well as relative to EM, Mexican share prices will outpace their EM peers (Chart I-9). Consistently, tightening Mexican sovereign credit spreads versus EM overall should also foster this nation's equity outperformance (Chart I-10). Chart I-9Relative Equity Performance Tracks Relative ##br##Local Bond Yields Relative Equity Performance Tracks Relative Local Bond Yields Relative Equity Performance Tracks Relative Local Bond Yields Chart I-10Relative Equity Performance Tracks Relative ##br##Sovereign Spreads Relative Equity Performance Tracks Relative Sovereign Spreads Relative Equity Performance Tracks Relative Sovereign Spreads Domestic demand growth has plunged following monetary and fiscal tightening in the past two years (Chart I-11). As both fiscal and monetary policy begin to ease, domestic demand will recover later this year. Chances are that share prices will sniff this out and begin their advance/outperformance sooner than later. Consumer staples and telecom stocks together account for 50% of the MSCI Mexico market cap, while the same sectors make up only 11% of overall EM market cap. Hence, Mexico's relative equity performance is somewhat hinged on the outlook for these two sectors in general and consumer staples in particular. EM consumer staple stocks have massively underperformed the EM benchmark since early 2016 (Chart I-12, top panel), and odds are this sector will outperform in the next six to 12 months as defensive sectors outperform cyclicals. This in turn heralds Mexico's relative outperformance versus the EM benchmark, which seems to be forming a major bottom (Chart I-12, bottom panel). Chart I-11Mexico: Economic Downturn Is Well Advanced Mexico: Economic Downturn Is Well Advanced Mexico: Economic Downturn Is Well Advanced Chart I-12Mexican Bourse Is A Play On Consumer Staples Mexican Bourse Is A Play On Consumer Staples Mexican Bourse Is A Play On Consumer Staples Unlike many EM countries, the Mexican economy is much more leveraged to the U.S. than to China. One of our major themes remains favoring U.S. growth plays versus Chinese ones. Finally, Mexican equity valuations have improved quite a bit both in absolute terms and relative to EM. Chart I-13 shows our in-house CAPE ratios for Mexican stocks in absolute terms and relative to the EM overall benchmark: Mexican equity valuations are not cheap but they are no longer expensive. Consistent with upgrading our economic outlook on Mexico, fixed-income investors should bet on yield curve steepening in local rates. We initiated this strategy on January 31 but hedged the NAFTA risk by complementing it with a yield curve flattening leg in Canada. Now, we are closing that trade and initiating a new one: fixed-income traders should consider paying 10-year swap rates and receiving 2-year swap rates. The yield curve is as flat as it typically gets (Chart I-14, top panel). Moreover, 2-year swap rates are not yet pricing enough rate cuts (Chart I-14, bottom panel) but will soon begin gapping down pricing in a large (potentially close to 200 basis points) rate cut cycle. Chart I-13Mexican Equities Are No Longer Expensive Mexican Equities Are No Longer Expensive Mexican Equities Are No Longer Expensive Chart I-14Bet On Yield Curve Steepening In Mexico Bet On Yield Curve Steepening In Mexico Bet On Yield Curve Steepening In Mexico Bottom Line: In line with our recent upgrade of Mexican local and U.S. dollar bonds as well as the currency outlook versus their EM peers, this week we recommend EM dedicated equity portfolios shift to an overweight position in Mexican stocks. Fixed-income trades should bet on yield curve steepening by paying 10-year swap rates and receiving 2-year rates. Investors who are positive on global risk assets should consider buying Mexican local bonds outright. Russia: Geopolitics Trumps Economics Chart I-15Russian Assets Relative To EM Benchmarks:##br## Various Asset Classes Russian Assets Relative To EM Benchmarks: Various Asset Classes Russian Assets Relative To EM Benchmarks: Various Asset Classes The sudden crash in Russian financial markets this week following the imposition of new U.S. sanctions has reminded us that geopolitics can often eclipse economics. Our overweight recommendation on Russian assets versus their EM peers was based on two pillars: (1) healthy and improving macro fundamentals and an unfolding cyclical economic recovery; and (2) easing tensions between Russia and the West. Clearly, the second part of our assessment is wrong, or at least premature. While BCA's Geopolitical Service team maintains that on a 12-month horizon tensions between Russia and the West will subside, the near-term risks are impossible to assess. For this reason we are closing our overweight allocation in Russian financial markets and recommend downgrading it to neutral. In particular, we are shifting Russia to a neutral allocation within the EM equity, sovereign and corporate credit and local currency bonds portfolios (Chart I-15). Consistently, we are closing the following trades: Long Russian / short Malaysian stocks (27.6% gain); Long Russian energy / short global energy stocks (2.8% gain); Long RUB / short MYR (3.1% loss); Short COP / long basket of USD & RUB (16.2% loss); Long RUBUSD / short crude oil (29.1% loss). Sell Russian 5-year CDS / buy South African 5-year CDS (317 basis points gain); Long Russian and Chilean / short Chinese Corporate Credit (12% gain); Long Russian 5-year bonds / short Brazilian 5-year bonds (flat). Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 We have removed the Russian ruble from the version of this chart shown in March 29, 2018 EMS report to assure that the recent idiosyncratic developments - the selloff triggered by the U.S. sanctions - in Russia's financial markets do not impact the reading of this indicator. 2 Pease see Emerging Markets Strategy Weekly Report "EM Local Bonds And U.S. Twin Deficits", dated February 21, 2018, Page 14. 3 Pease see Emerging Markets Strategy Weekly Report "China Real Estate: A Never-Bursting Bubble?", dated April 6, 2018, Page 14. 4 Pease see Emerging Markets Strategy Weekly Report "EM: Perched On An Icy Cliff", dated March 29, 2018, available at ems.bcaresearch.com. 5 Pease see Geopolitcial Strategy Weekly Report "Expect Volatility... Of Volatility", dated April 11, 2018, available at gps.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The ECB admits that its policy is considerably more accommodative than it would be absent the need to integrate the weaker euro area economies. But a strategy designed to integrate some is alienating others, both within the euro area and outside it. The yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts will narrow, one way or the other. It follows that the 10% undervaluation of the euro will eventually correct. And German consumer services will structurally outperform the consumer goods exporters. Feature Let's begin with some facts, which are difficult to dispute. Fact 1: The euro area is running a €400 billion trade surplus with the rest of the world, equivalent to 4% of euro area GDP. €300 billion of this surplus resides in Germany.1 Fact 2: The trade surplus is a direct result of the undervaluation of the euro (Chart of the Week). This we know, because the surplus has evolved as a perfect mirror image of the euro's undervaluation as calculated by the ECB itself. The central bank admits that the euro is undervalued by around 10%2 (Chart I-2). Chart of the WeekThe Euro Area's Huge Trade Surplus Is Due To The Undervalued Euro The Euro's Huge Trade Surplus Is Due To The Undervalued Euro The Euro's Huge Trade Surplus Is Due To The Undervalued Euro Chart I-2The Euro Is Undervalued By 10% The Euro Is Undervalued By 10% The Euro Is Undervalued By 10% Fact 3: The substantial undervaluation of the euro is the unavoidable result of the of the ECB's extreme experiment with bond buying and zero and negative interest rates. This we know, because the euro's undervaluation is a near perfect function of the yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts (Chart I-3 and Chart I-4). Chart I-3The Euro Is Undervalued Because Of The ##br##ECB's Ultra-Accommodative Policy The Euro Is Undervalued Because Of The ECB's Ultra-Accommodative Policy The Euro Is Undervalued Because Of The ECB's Ultra-Accommodative Policy Chart I-4The Euro Has Tracked Expected##br## Relative Monetary Policy The Euro Has Tracked Expected Relative Monetary Policy The Euro Has Tracked Expected Relative Monetary Policy Nevertheless, a reasonable riposte to facts 1-3 is that the ECB does not target the euro exchange rate. The ECB sets policy to achieve its price stability mandate, which it defines as an inflation rate of "below, but close to, 2%", the same definition as the Federal Reserve uses. Given that the ECB is further from its price stability mandate than the Fed is, the ECB has to set much more accommodative policy. And there the story might end. 2% Inflation In The Euro Area Is Different To 2% Inflation In The U.S. Except that the story has a twist. The price stability mandates of the ECB and Fed appear very similar, but they are not. The ECB mandate is much harder to achieve, because of two further facts. Fact 4: The definitions of consumer prices in the euro area and the U.S. are quite different. The euro area's Harmonized Index of Consumer Prices (HICP) excludes the consumption costs of owner-occupied housing, whereas the U.S. consumer price basket includes it at a very substantial 25% weight. The omission of owner-occupied housing costs - which consistently tend to rise faster than other prices - makes it much more difficult for overall inflation to reach 2%. Indeed, excluding shelter, core inflation in the U.S. today is running at 1.2%, the same rate as in the euro area (Chart I-5 and Chart I-6). Chart I-5Core Inflation Is Higher##br## In The United States... Core Inflation Is Higher In The United States... Core Inflation Is Higher In The United States... Chart I-6...But On A Like-For-Like Basis, Core Inflation##br## Is Not Higher In The United States ...But On A Like-For-Like Basis, Core Inflation Is Higher In The Euro Area! ...But On A Like-For-Like Basis, Core Inflation Is Higher In The Euro Area! Fact 5: The ECB has a single mandate of price stability, whereas the Fed has a dual mandate of price stability and maximizing employment. Some people even argue that the Fed has a triple mandate which includes financial stability. The point is that for Fed policy, price stability is only one of several considerations, creating flexibility; whereas for ECB policy, price stability is the only consideration, creating inflexibility. Nevertheless, a reasonable riposte to facts 4-5 is that we must just accept that the ECB and Fed operate within different frameworks. If the ECB's framework necessitates ultra-accommodative monetary policy today, then so be it. And there the story might end. Why Should Americans Pay For European Integration? Except that the story has another twist. The ECB framework wasn't always what it is today. Fact 6: On May 8 2003, the ECB changed its definition of price stability from "inflation below 2%" to "inflation below, but close to, 2%". Thereby, the addition of three small words transformed the flexibility of a 0-2% inflation range to the inflexibility of a 2% point target. Why did the ECB change its objective and make it so much more difficult? Here is the answer, straight from the horse's mouth: "The founding fathers of the ECB thought about the adjustment within the euro area, the rebalancing of the different members. To rebalance these disequilibria, since the countries do not have the exchange rate, they have to readjust their prices. This readjustment is much harder if you have zero inflation than if you have 2%" - Mario Draghi So there you have it - the ECB admits that it changed its objective to ease the integration burden on weaker euro area economies. The undisputed consequence is structurally easier monetary policy than would be the case without the integration burden. The ECB also admits that an unavoidable result is a structurally undervalued euro, meaning a substantial competitive advantage for the euro area versus its major trading partners, including the United States. To which President Trump might rightly ask: why should American competitiveness shoulder the burden for European integration? Trump's crosshairs may be trained on Germany, which is running the largest export surplus. But he should redirect his focus to the ECB. The majority of German export hyper-competitiveness is no fault of Germany, it is due to the structural undervaluation of the euro (Chart I-7). Moreover, while an undervalued euro benefits exporters, it hurts euro area household real incomes by raising the prices of dollar-denominated energy and food imports, whose demand is inelastic. German households are also deeply unhappy about the negligible interest on their savings. Chart I-7The Majority Of Germany's Hyper-Competitiveness Is Due To The Undervalued Euro The Majority Of Germany's Hyper-Competitiveness Is Due To The Undervalued Euro The Majority Of Germany's Hyper-Competitiveness Is Due To The Undervalued Euro The Way Forward, And Some Investment Considerations Ultra-accommodative policy was not the game changer that is sometimes claimed. The euro area's strong recovery started more than a year before the ECB even mooted its extreme accommodation. The turning point came in 2013 when euro area banks stopped aggressively de-levering their balance sheets ahead of the bank stress test (Chart I-8). Chart I-8The Euro Area Recovery Started In 2013 When Banks Ended Their Aggressive De-Levering The Euro Area Recovery Started In 2013 When Banks Ended Their Aggressive De-Levering The Euro Area Recovery Started In 2013 When Banks Ended Their Aggressive De-Levering Mario Draghi admits that policy today is considerably more accommodative than it would be absent the need to integrate the weaker euro area economies. But a strategy designed to integrate some is alienating others, both within the euro area and outside it. The ECB has a legal obligation to achieve price stability as its sole objective, but the precise definition of price stability is up to the central bank. To reintroduce some flexibility, it has two options: 'cross-sectional' flexibility, by reintroducing an inflation target range; or 'longitudinal' flexibility by a more relaxed interpretation of the 'medium term' timeframe required to achieve its point target. Of these two options, we expect a gradual move to greater longitudinal flexibility, especially as 'medium term' is already open to considerable interpretation. This will create three structural investment opportunities. The yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts will narrow, one way or the other. It follows that the 10% undervaluation of the euro - as calculated by the ECB itself - will eventually correct. As the euro area's structural over-competitiveness gradually corrects, the decade-long outperformance of consumer goods exporters versus consumer services will reverse, especially in Germany (Chart I-9 and Chart I-10). Overweight German consumer services versus consumer goods exporters. Chart I-9Consumer Services Have ##br##Underperformed In Europe... Consumer Services Have Underperformed In Europe... Consumer Services Have Underperformed In Europe... Chart I-10...But Are Starting To Turn ##br##Around In Germany ...But Are Starting To Turn Around In Germany ...But Are Starting To Turn Around In Germany Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Q4 2017 at an annualised rate. 2 Please see https://www.ecb.europa.eu/stats/balance_of_payments_and_external/hci/html/index.en.html The ECB uses three metrics to assess the euro area's competitiveness versus its major trading partners: GDP deflators, CPIs, and unit labour costs. The average of the three metrics suggests that the euro is undervalued by around 10%.The assessment of euro undervaluation assumes that the major euro area economies entered the monetary union at a broadly correct level of competitiveness against each other and against their other major trading partners. This assumption seems valid, given that the net external position of these economies were all in equilibrium at the onset of monetary union. Fractal Trading Model* This week, we note that the rally in the Spanish 10-year government bond is extended and ripe for a countertrend reversal. Implement this as a pair-trade: short the Spanish 10-year bond, long the German 10-year bund. The profit target and symmetrical stop-loss is 1%. Lever up to increase potential return. We are also pleased to report that our short Helsinki OMX / long Eurostoxx600 trade achieved its 3% profit target and is now closed. This leaves five open trades. 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-11 Spain 10-Year Gov. Bond Price Spain 10-Year Gov. Bond Price The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##Br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations