Fixed Income

Highlights U.S. Politics: We recommend that investors look through the political noise in D.C., which is unlikely to arrest the current cyclical economic upturn. Maintain a pro-growth asset allocation within fixed income portfolios: below-benchmark duration, favoring corporate credit over government bonds, especially in the U.S. Duration Checklists: An update of our Duration Checklists shows that the backdrop remains conducive to rising Euro Area bond yields, while the upward pressures on U.S. yields have diminished somewhat. The majority of the indicators, however, continue to point to higher U.S. Treasury and German Bund yields. Europe: Reduce European duration exposure, but wait for wider spread levels before moving out of European government bonds into U.S. Treasuries. Feature The Economy Trumps Politics Chart of the WeekHas Anything Really Changed? A whiff of panic swept across global financial markets last week, as the political risk bugaboo came back with a vengeance. In the U.S., the deepening morass surrounding President Trump's decision to fire former FBI Director Comey, and the potential links to the ongoing investigation of the White House's ties to Russia, raised concerns that Trump's ambitious pro-growth policy agenda would never make it out of Congress. Even this year's darling in the Emerging Markets, Brazil, suffered a huge financial rout after news broke of corruption allegations against the current president. Amid growing talk of a potential impeachment of Trump, the market action was a classic risk-off move, with equity markets falling, the VIX finally waking from its slumber and safe-haven assets like gold, U.S. Treasuries and the Japanese yen rallying. The euro climbed to new 2017 highs versus the U.S. dollar, without any changes in expectations about potential policy moves from the European Central Bank (ECB), as the market knocked down the probability of a June Fed rate hike (Chart of the Week). Some creative commentators called these market moves "the Trump fade" - the beginnings of a reversal of the so-called "Trump trade" that has sent U.S. equity prices and bond yields higher since the U.S. election on expectations of a large U.S. fiscal stimulus. We remain skeptical, however, that expectations of tax cuts and increased government spending have been the main drivers of the post-election boost in U.S. stock prices and Treasury yields, as the current cyclical upturn in global growth was already underway before Trump's election victory. Our colleagues at the BCA Geopolitical Strategy service note that, despite Trump's terrible overall approval ratings (Chart 2), his support among his Republican voters remains strong (Chart 3). Thus, an impeachment is only likely if the Republicans were to lose control of the House of Representatives in next year's U.S. midterm elections. Fear of that outcome should motivate the GOP to try and push through tax and healthcare reform well ahead of the 2018 midterms, in order to present a positive economic message to voters.1 Unless the evidence against Trump becomes so damning that even the Republicans in Congress have to focus on impeachment instead of policy, investors should ride out any market volatility associated with worries that the Trump economic agenda is at risk. Chart 2Trump's Support Abysmal Chart 3GOP Not Yet Willing To Impeach Trump Even without a boost to growth from D.C., however, we continue to expect the U.S. economy to grow above 2.5% in 2017. This above-trend pace will keep the Fed in play for at least two additional rate hikes before year-end, as it would give policymakers confidence that U.S. inflation expectations would return back the Fed's 2% target. In addition, as we discuss in the next section, the cyclical upturn in the Euro Area economy is showing no signs of cooling off, which will put more pressure on the ECB to begin preparing the markets for an eventual tapering of its asset purchases. The recent decline in bond yields is unlikely to persist much longer. Bottom Line: We recommend that investors look through the political noise in D.C., which is unlikely to arrest the current cyclical economic upturn. Maintain a pro-growth asset allocation within fixed income portfolios: below-benchmark duration, favoring corporate credit over government bonds, especially in the U.S. Checking In On Our Duration Checklists In a Special Report published back in February, we introduced a list of indicators to follow to assess the likely direction of U.S. Treasury and German Bund yields.2 We called these our "Duration Checklists", incorporating data on economic growth, inflation, investor risk aversion and market technicals to judge whether our bias to maintain a below-benchmark duration stance should be maintained. This week, we provide an update on those Checklists. The current message from the Checklists is that there is reduced upward pressure on bond yields from the overall strength of the global economy than existed four months ago. Domestic forces, however, are still pointing to higher yields in the U.S. and, especially, the Euro Area (Table 1). Specifically: Table 1A More Bond-Bearish Backdrop For Bunds Than USTs Global economic activity indicators have lost some momentum. While the global leading economic indicator (LEI) is still rising, our global LEI diffusion index has fallen sharply and is now below the 50 line, indicating that a more countries now have a falling LEI. In addition, the global ZEW index has drifted a touch lower, global data surprises are no longer positive, and the global credit impulse has ticked downward (Chart 4). Only the rising LEI warrants a "check" in our Checklists (i.e. justifies our current below-benchmark duration stance). U.S. & European domestic economic activity remains in good shape. Consumer and business confidence remains at strong levels on either side of the Atlantic, with corporate profit growth still accelerating (Charts 5 & 6). Only the modest decline in the U.S. manufacturing purchasing managers' index (PMI) is worthy of an "x" in our U.S. Checklist, although the index remains well above 50 and is not pointing to a more serious deterioration in the U.S. economy. Chart 4Global Growth Backdrop Has##BR##Turned Less Bond-Bearish Chart 5U.S. Economic Strength##BR##Still Supports Higher UST Yields Chart 6Euro Area Growth Is##BR##Gaining Upward Momentum Inflation pressures have eased a bit, especially in the U.S. The slowing momentum in global energy prices has taken some of the steam out of headline inflation in both the U.S. and Europe. Wage inflation has eased up a bit in the U.S., even with the labor market running at full employment (Chart 7). Wage growth and core inflation have recently ticked higher in the Euro Area, however, while the unemployment rate there has fallen to within less than a percentage point away from the OECD estimate of the NAIRU (Chart 8).3 The only indicators worthy of a "check" are the unemployment gap in both the U.S. and Euro Area, although we will give a potential "check" (with a question mark) to European wage inflation. If the recent uptick gains additional momentum, the case for the ECB to begin moving to a less accommodative policy stance will be much stronger. Chart 7Inflation Pressures On UST Yields Have Eased Chart 8Core Inflation & Wages Bottoming Out In Europe? There is still a pro-risk bias among global investors. U.S. and Euro Area equity markets are still in bullish trends, trading well above their 200-day moving averages. At the same time, corporate credit spreads remain tight and option-implied equity volatility is very low (even after last week's pop in the U.S. on the Trump drama). All indicators are worthy of a "check", suggesting that easier financial conditions can lead to higher bond yields (Charts 9 & 10). We are, however, giving an "x" to the European Checklist for the deviation of the Stoxx 600 from its moving average, as it is now at the +10% extreme that we defined as being potentially bond-bullish as it could foreshadow a near-term correction of an overheated stock market. Chart 9Still Generally A Risk-Seeking Backdrop In The U.S. Chart 10Strong Risk-Seeking Behavior In Europe Bond markets no longer look technically stretched. The sharp move higher in yields at the end of 2016 left all our indicators of yield momentum at bearish extremes (for bond prices). With bond yields pulling back from 2017 highs, however, the momentum measures all look neutral at the moment and are not an impediment to higher yields (Charts 11 & 12). The same goes for duration positioning in the U.S., with the net longs on 10-year Treasury futures now at the highest level since 2007. All of the technical indicators in our Checklists warrant an "check". Chart 11UST Technicals No##BR##Longer Stretched Chart 12Technicals Are No Impediment##BR##To Higher Yields In Europe Summing it all up, our Duration Checklists show that the majority of indicators are still pointing to higher bond yields in the U.S. and Europe, although not as decisively as when we first published the Checklists in February. There are more "check" on the European side of the ledger, however, suggesting that there is more room for European government bond yields to rise relative to U.S. Treasuries. This would indicate a potential trade opportunity to cut allocations to Europe and raise allocations to the U.S. Chart 13UST-Bund Spread Is Now Too Low The recent decline in U.S. yields, however, has narrowed the U.S. Treasury/German Bund spread to levels that make putting on a tightening trade unattractive on a tactical basis. (Chart 13). The gap between the data surprise indices in the U.S. and Euro Area already reflects the recent soft patch for the U.S. economy (middle panel). That spread in the surprise indices now at historically wide levels, suggesting more potential for Treasury yields to rise if the U.S. data begins to rebound soon, as we expect. Also, the gap between U.S. and Euro Area inflation expectations has narrowed alongside the recent downtick in U.S. core inflation (bottom panel), although we expect the decline in U.S. core inflation to be short-lived given the persistent tightness of the U.S. labor market. Net-net, we would prefer to see a wider Treasury-Bund spread before making switching our country exposure out of Europe and into the U.S. We can, however, listen to the message from our Checklists and reduce our duration exposure in Europe. Specifically, we are cutting our allocations to the longer maturity buckets (5 years out to 30 years) by 50% in our model portfolio for Germany, France and Italy, putting the proceeds into the 1-3 year buckets (see the table on Page 12). This will reduce our overall recommended portfolio duration by just over 1/10th of a year, as well as put an additional bear-steepening curve tilt within our European government allocations. We are comfortable with that bias, given the growing risk that the ECB will soon begin signaling a tapering of asset purchases once the current program expires at the end of the year. Bottom Line: An update of our Duration Checklists shows that the backdrop remains conducive to rising Euro Area bond yields, while the upward pressures on U.S. yields have diminished somewhat. The majority of the indicators, however, continue to point to higher U.S. Treasury and German Bund yields. Reduce European duration exposure, but wait for wider spread levels before moving out of European government bonds into U.S. Treasuries. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment", dated May 17 2017, available at gfis.bcaresearch.com 2 Please see BCA Global Fixed Income Strategy Special Report, "A Duration Checklist For U.S. Treasuries & German Bunds", dated February 15 2017, available at gfis.bcaresearch.com 3 Non-Accelerating Inflation Rate Of Unemployment. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Politics will inject further volatility into risk assets, but stocks will outperform bonds and cash on a 6-12 month horizon. The health of the economy and earnings matter more than Trump's political woes for investors and the Fed. The consumer - a key driver of the U.S. economy and corporate earnings - will provide a solid backdrop for the economy through 2017 and beyond. The combination of balance sheet shrinkage and Fed rate hikes will lead to higher bond yields than are currently discounted in the market. It is a different story for the mortgage market, where spreads will be biased to widen during Fed runoff. Feature The Economy Matters More Than Politics The health of the economy and earnings matter more than Trump's political woes for investors and the Fed. When the economy and earnings backdrop was favorable during presidential scandals in the 1920s and the 1990s, the equity markets performed well. In the early 70s, amid soaring inflation and the worst recession since the Great Depression, there was a bear market in equities (Chart 1). Today, the backdrop for the economy and earnings - while not as robust as in the 1920s or late 1990s - provides support for higher stock prices, two more Fed rate hikes and higher Treasury bond yields. Trump's political woes may slow, but not completely halt the GOP's legislative agenda1. Support for Trump among his GOP base remains high at 85%, making impeachment a long shot until after the November 2018 mid-term elections (Chart 2). If the Democrats take the House, they are likely to impeach Trump in 2019. For the Trump and the Republicans in Congress, this means the impetus is even greater to make progress now on tax cuts, tax reform and infrastructure. However, the embattled White House will slow the process as the president's staff often acts as a coordinator among the various factions in Congress. With Trump's team preoccupied with political woes, they will not be effective in this role. Chart 1Economy Will Trump Politics ##br## For Financial Markets Chart 2GOP Base Not Yet Willing To ##br## Impeach Trump The Fed will look through the politics and focus on the health of the economy and will continue to raise rates gradually this year, with the next hike coming in June. Financial conditions have eased since the Fed's 25 basis point rate hike in December, and that alone should be enough to keep the Fed on track to tighten next month. As we have noted in recent reports, even without fiscal stimulus, the U.S. economy will still grow near its long-term potential, tighten the labor market and push up wages and inflation. The Fed has been reticent to include any impact from fiscal stimulus into their policy deliberations thus far. The minutes of the March FOMC meeting noted that "members continued to judge that there was significant uncertainty about the effects of possible changes in fiscal and other government policies". Bottom Line: The lack of progress on legislation may result in a pullback in U.S. equity prices, but absent a material weakening of the U.S. economy or profit picture, the pullback will not turn into a bear market. Checking In On The Consumer The consumer - a key driver of the U.S. economy and corporate earnings - will provide a solid backdrop for the economy through 2017 and beyond. This backdrop will allow the Fed to pursue two rate hikes this year. The weakness in several indicators has worried some investors that the economy may be on the verge of a slowdown or even a collapse. However, a firming economy should sustain corporate earnings growth and, ultimately, higher stock prices. Consumer spending's share of GDP is 68% and increasing (Chart 3). GDP growth excluding consumer spending is more volatile than overall GDP growth. The household sector has contributed 75% to growth since the end of the recession, which is the best performance of any sector. The key drivers of spending point to further gains in the sector, and the imbalances that were present ahead of prior downturns are not evident today. Chart 3Household Share Of GDP Is At An All Time High And Rising Chart 4Consumer Spending Remains In An Uptrend Household spending growth has softened but remains in an uptrend. Broad measures of consumer spending tend to peak two to four years prior to the start of a recession. The lead time is even longer in a long-cycle expansion.2 Investors should not dismiss the weakness altogether, but position portfolios for the late-cycle environment. Personal consumption expenditure growth peaked at 4% year-over-year in Q1 2015. Auto sales, a timelier measure of spending although not as comprehensive, peaked in December 2016 (Chart 4). Applying the 2 to 4 year lead time noted above - and making the assumption that spending has indeed peaked - this points to a recession commencing in the middle of 2019 at the earliest. Household net worth is at an all-time high, and the overall wealth effect on consumer spending has been positive for some time. Our forecast for financial markets and the housing market, though modest, imply that the positive wealth effect will continue. Debt-financed spending remains a viable option for consumers, which was not the case in late 2007 before the onset of the recession. Banks have not changed their lending standards for most consumer loans and demand for these loans will stay solid despite the Fed rate increases that we expect. The Bank Credit Analyst's March 2017 report showed that even a 100-basis point rate rise from the current levels would not lift the interest payments to burdensome levels by historical standards. Incomes will continue to climb and importantly, consumer income expectations have also hit new highs. With the economy at the Fed's assessment of full employment, wage growth is accelerating, albeit more modestly than in previous recoveries. Our recent report3 found that wages tend to rise about two years after the output gap has formed a bottom. A narrowing output gap leads to a tighter labor market and higher incomes. As measured by the quit rate, job security is at a fresh cycle high (not shown). Many consumer indicators are in better shape today than they were in 2007 or at similar points in the other long cycles4 (Charts 5 and 6). We define the long cycle economic expansions as those lasting 8-10 years. The two expansions that meet the definition are 1981-1990 and 1992-2001.5 Consumer spending is running in line with incomes, unlike in the mid-2000s. Chart 5Key Consumer Metrics ##br## Remain Favorable Chart 6There Is Still Plenty Of Support ##br## For Solid Consumer Spending Mortgage equity withdrawal, a crucial source of debt-fueled consumer spending prior to 2007, has been non-existent in this cycle. Spending on essentials are close to all-time lows. In 2007 they were at record highs and had moved up dramatically in the prior half-decade amid escalating debt levels, rising energy prices and consumer interest rates. We are concerned by the historically high percentage of household incomes (17%) dedicated to medical care. An aging population, ever rising healthcare costs and uncertainty surrounding the future of Obamacare may drive medical spending even higher. Household debt levels as a percentage of disposable income peaked in 2008 at over 120%, but are back under 100%, i.e. at the level that existed prior to the 2007-2009 recession. The level of household debt compares favorably to similar points in the long cycles of the 1980s and 1990s. Financial obligations are at multi-decade lows (Chart 6, bottom panel). Bottom Line: The fundamentals supporting consumer spending remain solid. A healthy consumer means the economy can meet the Fed's modest GDP forecast for 2017, keeping the central bank on track to tighten twice more in 2017. This outlook supports our view for stocks over bonds in the next 6-12 months. The Fed's Balance Sheet: It's Diet Time Chart 7Fed Set To Begin Tapering In Early 2018 The minutes from the March FOMC meeting indicated that a change in the Fed's reinvestment policy will likely be appropriate "later this year". The minutes suggested that the FOMC is split on whether to simply terminate all reinvestment for both Treasurys and MBS, or to "taper" reinvestment over time. Our base case is that the Fed will follow up a June rate hike with another one in September, at which point policymakers will provide some details on their plans for balance sheet runoff to begin in January of 2018. Investors are rightly concerned about the potential impact of the runoff, especially given that memories of the 2013 "taper tantrum" are still fresh. There is disagreement among academics about whether quantitative easing (QE) directly depressed bond yields by restricting the supply of high-quality fixed income assets, or whether the impact on yields was solely via the "signaling effect" (i.e. that QE implied that short-rates will be held at a low level for a very long time). Either way, balance sheet runoff will likely have some impact on bond yields. A good starting point is to employ an empirical estimate of the impact of QE. The IMF has modeled long-term Treasury yields based on a number of economic and financial variables, including inflation expectations, demographics, growth, current accounts and budget balances. The model also includes the stock of assets held by the Fed as a share of GDP. If the Fed were to begin running off its holdings of both Treasurys and MBS at the beginning of 2018 by terminating all reinvestment, then the amount of bank reserves held at the Fed would likely evaporate by 2021. This represents a fall of roughly 10 percentage points of GDP (Chart 7). Given the IMF interest rate model's coefficient of -0.9, it implies that long-term Treasury yields and mortgage rates would rise by 90 basis points from the "portfolio balance" effect alone. However, it is more complicated than that. The impact on yields is likely to be tempered by three factors: The Fed may opt to avoid going "cold turkey" on reinvestment, choosing instead to scale back gradually. Fed President William Dudley recently commented that the Fed wants balance sheet reduction to "run in the background", such that it is not a major event for markets. Some academic experts are recommending that the Fed maintain a fairly large balance sheet by historical standards because of the need in financial markets for short-term, risk-free assets that would diminish if there are fewer excess bank reserves available. Banks, for example, are required by regulators to hold more high-quality assets than they did in the pre-Lehman years. The implication is that the balance sheet may never fully revert to historic norms relative to GDP. As the FOMC dials back monetary stimulus it will be concerned with overall monetary conditions, including short-term rates, long-term rates and the dollar. If long-term rates and/or the dollar rise too quickly, policymakers will moderate the pace of rate hikes and use forward guidance to talk down the long end of the curve so as to avoid allowing financial conditions get too tight, too quickly (i.e. the term premium would rise, but would be partly offset by a lower expected path for the fed funds rate). Thus, the path of short-term rates is dependent on the dollar and the reaction of the long end of the curve. It is difficult to estimate how it will shake out, but a recent report from the Federal Reserve Bank of Kansas City estimated that a $675 billion reduction in the size of the Fed's balance sheet is equivalent to a 25 basis point increase in the fed funds rate (although the authors admit that the confidence band around this estimate is extremely wide).6 We expect that the impact of runoff alone will be much less than the 90 basis point estimate discussed above. Still, the combination of balance sheet shrinkage and Fed rate hikes will lead to higher bond yields than is currently discounted in the market. We could also see some upward pressure on global term premia when the ECB announces the next tapering of its QE purchase program, possibly this autumn. However, it will be years before the ECB will be in a position to reduce the size of its balance sheet. As for the Bank of Japan, we doubt that the central bank will ever shed its JGB holdings. What about the shape of the Treasury curve? Our fixed-income strategists believe that the shape of the curve will be determined by the normal cyclical dynamics we have seen in the past. We are still in a window in which the Treasury curve will steepen as yields rise. A little later in the Fed cycle, the curve will bear-flatten as the long-end begins to rise at a slower pace than the front end. We do not see balance sheet adjustment as changing these dynamics much. Similarly, with respect to credit spreads, the state of nonfinancial corporate sector balance sheets and the overall stance of monetary policy will continue to be the main drivers of the credit cycle. If unwinding the balance sheet leads to a premature tightening of financial conditions, then the Fed will proceed more slowly on rate hikes. The crucial indicator to watch is core PCE inflation. Credit spreads will remain fairly well contained until core PCE inflation reaches the Fed's 2% target. At that point, the pace of monetary normalization will ramp up, putting spreads at risk of widening. It is a different story for the mortgage market, where spreads will be biased to widen during Fed runoff. While spreads have already widened a bit, in our view they still do not adequately compensate for the additional MBS supply that will hit the market when the Fed takes a step back. Historically, there is a reasonably tight correlation between MBS spreads and the spread between mortgage rates and Treasury yields (Chart 8). Thus, it is reasonable to expect mortgage rates to rise by more than Treasury yields. Chart 8MBS Spreads Set To Widen As Fed Tapers While the Fed's balance sheet reduction by itself may not have a big impact on the dollar, we still believe the currency has more upside because of the divergence in the overall monetary policy stance between the U.S. on one side and the ECB and Bank of Japan (BoJ) on the other. The BoJ will hold the 10-year JGB near to zero for quite some time. The ECB will also not be in a position to tighten for a long time, outside of removing negative short rates and tapering QE purchases a bit further in 2018. Meanwhile, we think the Fed will tighten by more than is currently discounted. Admittedly, the economic data have disappointed so far in 2017 and CPI inflation has softened which, at the margin, would cause some FOMC members to back away from rate hikes. Nonetheless, policymakers are focused more on the labor market than GDP to gauge the health of the expansion and the amount of economic slack. Despite the dismal Q1 GDP figures, following unimpressive growth in 2016, the unemployment rate has already fallen below what the FOMC expected the rate will be at the end of this year! A tightening labor market means that the economy is still growing above a trend pace. Unless there is a clear deceleration in wage growth as measured by the ECI or the Productivity and Cost report, the FOMC will likely hike rates by more than the 38 basis points currently discounted over the next 12 months. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 See Geopolitical Strategy Report, "Break Glass In Case Of Impeachment," May 17, 2017. Available at gps.bcaresearch.com 2 See The Bank Credit Analyst, March 2017. Available at bca.bcaresearch.com 3 See U.S. Investment Strategy Weekly Report, "Still Awaiting the Next Pullback", May 15, 2017. Available at usis.bcaresearch.com 4 See The Bank Credit Analyst, March 2017. Available at bca.bcaresearch.com 5 We did not include the 1960s in this analysis because the Fed waited too long to tighten and allowed inflation to get out of hand. 6 Forecasting the Stance of Monetary Policy Under Balance Sheet Adjustments. The Macro Bulletin, Federal Reserve Bank of Kansas City. Troy Davig and A. Lee Smith. May 10, 2017.

Highlights Increased regulatory scrutiny on the domestic financial sector may continue to create some headline risks and financial volatility, but the real economic impact should be marginal. The recent regulatory crackdown has mainly caused liquidity issues in the domestic market rather than any sort of real growth issue. Chinese shares listed overseas will continue to grind higher. Domestic A shares will remain largely trendless. Domestic corporate bonds are starting to look attractive after the most recent panic selloff. Feature Chinese domestic stocks and bonds have taken a beating of late as the authorities ramped up scrutiny to rein in excesses in the country's financial sector. While it is warranted to control accumulated financial risk - especially associated with shadow banking activity - the "campaign" style administrative crackdown has caused widespread confusion and mini-panics among domestic investors. The actions and corresponding reactions illustrate the authorities' primitive control tools, which are increasingly at odds with the rapidly developing financial sector, and how blanket actions can spur undue financial volatility and provoke unintended consequences. For now, we expect the economic fallout to be limited, unless the financial crackdown causes further spikes in interest rates and a sudden halt in credit flows. Chinese shares listed overseas will continue to grind higher in the absence of a major policy mishap that short-circuits the broad growth improvement and the profit cycle upturn. Domestic A shares will remain largely trendless, while the more richly valued bubbly segments of the market will continue to deflate. Domestic corporate bonds are starting to look attractive after the most recent panic selloff. What Do They Want To Achieve? Policymakers' primary focus has been on cracking down on excessive speculation in financial markets and restricting lending activities that are not in compliance with legal and regulatory requirements. Financial sector deregulation in recent years has increasingly blurred the lines between banks, insurance companies, brokers and trust companies, and regulators are constantly challenged to monitor all the increasingly sophisticated moving parts. From the banking sector's point of view, regulators are concerned that lenders have been aggressively boosting their exposure to other banks and non-bank financial institutions instead of providing credit to the "real economy." Overall commercial banks' claims on other banks and non-bank financial institutions have increased from 12% of their total assets in 2006 to over 25% as of January 2017, while their liabilities to other banks and non-bank financial firms have increased from 7% to 12% (Chart 1). Smaller banks are even more dependent on interbank financing for loanable funds. Interbank transactions and repo activities account for about 14% of smaller lenders' total source of funding, compared with 2% for large banks (Chart 2). Some small banks regularly borrow at lower costs through the interbank market or use negotiable certificate of deposits to purchase "wealth management products" offering higher returns issued by other banks or financial institutions. The duration mismatch leads to constant pressure to roll over these short-term financial instruments. The increasing interdependence among the country's financial institutions also creates the risk of a chain reaction in the financial system should some type of credit event erupt. Chart 1Increasing Interdependence Among Financial Institutions The Chinese authorities have long regarded preventing systemic financial risk as a top priority, and the recent growth improvement has provided a window of opportunity for some housecleaning without a major adverse impact on the economy. Therefore, it is unlikely that regulators will back off from tightening regulatory supervision going forward. Overall, the authorities will continue to discourage overtrading within the financial system, and enforce full disclosure of off-balance-sheet items and shadow lending activities. The saving grace is that tightened macro prudential measures have already begun to curtail banks' aggressive expansion to non-bank financial institutions. Commercial banks' claims to these firms have slowed sharply since last year's peak (Chart 3). Meanwhile, the recent rise in interbank rates should also further discourage the perceived "risk-free" funding arbitrage to play the interest rate gap between long- and short-dated financial assets. All of this reduces the pressure of an escalation in the regulatory crackdown. Chart 2Smaller Banks Depend More On##br## Wholesale Funding Chart 3Banks' Exposure To Non-Bank Financial Firms ##br##Has Been Scaled Back Should Investors Be Concerned? In essence, banks' rising claims to other financial institutions means a lengthening of the credit intermediation channel, in which financing goes from credit providers through multiple layers of intermediaries to reach final borrowers in the real economy. In other words, banks, instead of lending directly to borrowers, channel loans to trust companies or securities brokers, who in turn transfer the funds to the real economy through "shadow banking" activities such as trust loans or various forms of "wealth management products", typically at higher rates. From this perspective, cracking down on lending excesses within the financial system in of itself should not have a material impact on credit flows to final corporate borrowers. In fact, streamlining the financial intermediation channel holds the promise of increasing accessibility to bank credit for the corporate sector and reducing its funding cost, which should benefit the overall economy in the long run. In the near term, liquidity tightening and the regulatory crackdown could push up interest rates and disrupt credit flows, which should be closely monitored to assess near-term negative impact on the economy. So far, the impact does not appear material. Chart 4Regulatory Crackdown ##br## Has Not Interrupted Credit Flows Interbank rates have increased by about 100 basis points across the board since the beginning of this year, and 10-year government bond yields have risen by 50 basis points - both of which pale in comparison to the significant improvement in overall business activity. Nominal GDP growth expanded by 11.8% in the first quarter, compared with 9.6% in Q4, 2016. Furthermore, the central bank early this week re-started its medium-term lending facility (MLF), which was designed to avoid liquidity overkill in the domestic financial sector. Overall, the risk of overtightening of liquidity is not high. The regulatory crackdown since early this year has not had a meaningful impact on credit expansion. Banks' claims to other financial institutions have slowed sharply, but overall loan growth has been rather stable. Importantly, medium- and long-term loans to the corporate sector, pivotal for overall capital spending, have in fact accelerated (Chart 4). In short, increased regulatory scrutiny on the domestic financial sector may continue to create some headline risks and financial volatility, but the real economic impact should be marginal. We expect the authorities to remain highly vigilant and avoid policy overkill. Reading Market Tea Leaves There have been some notable divergences among different classes of Chinese stocks (Chart 5). Chinext, the domestic small-cap venture board, has suffered heavy losses of late, while large-cap A shares have been much more resilient. Meanwhile, offshore Chinese shares have barely felt any pressure at all. H shares have moved higher of late, while Chinese firms listed in the U.S. have decisively broken out. The divergence between onshore and offshore Chinese stocks' performance confirms the recent regulatory crackdown has mainly caused liquidity issues in the domestic market rather than any sort of real growth issue. Barring major policy mistakes, we expect the Chinese economy to stay buoyant, as discussed in detail in our recent report.1 As such, a few investment conclusions can be drawn. Tighter liquidity will likely continue to place downward pressure on domestic stock prices, but the downside is limited by overall buoyant activity and improving profits. We expect the broad-A share market will remain narrowly range-bound. Overseas-listed Chinese shares are not subject to domestic liquidity constraints, and will likely continue to grind higher supported by growth improvement, profit recovery and low valuation multiples. The small-cap Chinext market has long been viewed as the more speculative segment of the domestic financial market, with higher multiples and greater volatility than large-cap A shares. As such, this market will remain vulnerable to domestic liquidity tightening. Even after the most recent selloff, the bourse's trailing price-to-earnings ratio and price-to-book ratio are still at 38.4 and 4.6, respectively, much higher than for broader onshore and offshore Chinese stocks. The recent selloff in the onshore corporate bond market has also been driven by liquidity pressure, which in our view is overdone. While it's true that economic acceleration justifies higher yields, corporate spreads have also widened sharply, which is at odds with the broad growth acceleration and profit recovery. In addition, after the most recent selloff, Chinese corporate spreads are significantly higher than in most other major markets (Chart 6). In the near term, tighter liquidity may continue to induce more selling pressure in the domestic bond market. Cyclically we expect Chinese corporate bond spreads to narrow. Chart 5Diverging Market Trends Chart 6The Sharp Spike In Chinese Corporate ##br##Spreads Is Overdone Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Has China's Cyclical Recovery Peaked?" dated May 5, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Four separate indicators provide compelling evidence for a 'mini-cycle' in activity. 1. The bond yield. 2. The credit impulse. 3. The steel equity sector price. 4. The consumer price index (CPI). Right now, the mini-cycle is about 4 months into downswing whose average duration tends to be about 8 months. Hence, the surprise in the coming months could be that inflation comes in below expectations. Feature Central to our European investment philosophy is the existence of what we call a 'mini-cycle' in global activity. Right now, this cycle is about 4 months into a mini-downswing whose average duration tends to be about 8 months. Within this global mini-cycle the irony is that Europe itself has been a paragon of stability. Quarter on quarter growth has remained within a remarkably narrow 1.2-2.2%1 band for eight consecutive quarters. And the dispersion of growth across euro area countries now stands at a historical minimum. We expect the euro area's relative stability to persist given the recent bottoming of the euro area 6-month bank credit impulse. Nevertheless, for the European investment and inflation outlook, the global growth cycle is as important, or more important, than the domestic cycle. In highly integrated and correlated international markets, the absolute direction of European asset prices takes its cue from a global rather than a local conductor. The pace of consumer price inflation also tends to be a global rather than a local phenomenon. For example, through the past 10 years, the inflation cycles in the euro area, U.K. and U.S. have been near identical (Chart I-2). Chart Of the WeekThe Steel Sector Has A Clear Mini-Cycle Chart I-2The Inflation Cycle Is Global, Not Local In this light, the ECB now correctly assesses that "the risks surrounding the euro area outlook relate predominantly to global factors." As we go on to show below, the surprise in the coming months could be that inflation comes in below expectations. This would slow the ECB's exit from its current ultra-accommodative monetary policy. But because these downside inflation surprises were coming from outside the euro area, it would force other central banks to become even more dovish relative to current expectations. On this basis, we are very comfortable to maintain our relative return positions in European investments: expect euro currency outperformance; T-bond/German bund yield spread convergence; and euro area Financials outperformance versus global Financials. For absolute return positions, expect the relatively benign backdrop for bonds to continue into the summer months. Mini-Cycles: The Evidence Mounts In previous reports, we presented two pieces of evidence for economic mini-cycles. First, the global bond yield shows a remarkably regular wave like pattern with each half-cycle averaging about 8 months (Chart I-3). Second, the acceleration and deceleration of bank credit flows - as measured in the credit impulse - also exhibits a remarkably regular wave like pattern, with each half-cycle also lasting about 8 months (Chart I-4). Chart I-3The Bond Yield Has A Clear Mini-Cycle Chart I-4The Credit Impulse Has A Clear Mini-Cycle We proposed that the bond yield and credit impulse cycles are inextricably embraced in a perpetual feedback loop: a higher bond yield weighs on credit flows; this slows economic growth which then shows up in activity data; in response, the bond market lowers the bond yield; the lower bond yield boosts credit flows, which lift economic growth; and so on... But as each stage in the sequence comes with a delay, the bond yield and credit impulse mini-cycles should be 'out of phase'. And this is precisely what the empirical evidence shows (Chart I-5). Chart I-5The Bond Yield And Credit Impulse Mini-Cycles Are Out Of Phase Now, to build an even stronger case for mini-cycles we will add a third and fourth piece of compelling evidence. The third piece of evidence is the steel equity sector price, which is an excellent real-time indicator of the growth cycle, and shows exactly the same mini-cycle profile as the bond yield (Chart of the Week). The fourth piece of evidence is the consumer price index (CPI) which also presents an identical mini-cycle profile (Chart I-6). Chart I-6The Consumer Price Index Has A Clear Mini-Cycle As with the bond yield and the steel equity sector price, we have de-trended the CPI to better show the underlying cyclicality. But in the case of the CPI, our chosen de-trending rate of 2% has special significance: 2% is the inflation target for most central banks. Hence, if the de-trended CPI is rising, inflation is running above the 2% target; if the de-trended CPI is falling, inflation is running below the 2% target. In this regard, the mini-cycle in the CPI carries a disturbing asymmetry. Observe that in recent mini-upswings, inflation has just about reached the 2% target. But in each and every mini-downswing, inflation has substantially undershot the 2% target. Based on the regularity of the mini-cycle through the past 10 years, we can estimate that we are about half way into a mini-downswing. If so, the surprise in the coming months could be that inflation comes in below expectations, frustrating the ECB. Still, as the disinflationary surprises will emanate from outside the euro area, other major central banks might be even more frustrated. And this supports our aforementioned relative positions in European investments. What Is Your Most Provocative Non-Consensus View? The observation that inflation has struggled to reach 2% in mini-upswings, but substantially undershot 2% in each and every mini-downswing is very telling. The strong suggestion is that the recent modest uplift in inflation towards 2% could just be a mini-cyclical rather than structural phenomenon. The death of debt super-cycles combined with an incipient wave of Artificial Intelligence (AI) led automation still constitutes a very powerful structural deflationary force, which should not be underestimated. The technical pattern of bond yields also supports this thesis. Chartists will point out that the global bond yield is still in a well-defined pattern of lower highs and lower lows - which is to say a well-established downward channel (Chart I-7). And that it would take the yield to rise by a quarter (about 40 bps) to breach this channel. The German 30-year bund yield gives a very similar message (Chart I-8). Chart I-7Still In A Structural Downtrend: The Global Bond Yield... Chart I-8...And The German 30-Year Bund Yield At meetings, clients often ask for the most non-consensus investment view - something to which the street attributes a 10% chance, but to which I attribute a 50% or higher chance. Given the asymmetrical mini-cycle behaviour of both inflation and bond yields and the powerful structural forces of deflation shown in the preceding charts, here is my provocative answer: Perhaps the structural low in bond yields is not behind us; perhaps it is to come in the next major global downturn. But this is a personal view. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 At an annualized rate. Fractal Trading Model* There are no new trades this week, leaving us with four 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. Fractal Trading Model * 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 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. Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations

Highlights Venezuela's economic implosion accelerated with the oil price crash. The petrodollar collapse is suffocating consumption as well as oilfield investment, creating a "death spiral" of falling production. The military has already begun assuming more powers as Maduro becomes increasingly vulnerable, and will likely take over before long. OPEC's cuts may help Maduro delay, but not avoid, deposition. Civil unrest/revolution could cause a disruption in oil production, profoundly impacting oil markets. Feature The wheels on the bus go round and round, Round and round, Round and round ... The story of Venezuela's decline under the revolutionary socialist government of deceased dictator Hugo Chavez is well known. The country went from being one of the richest South American states to one of the poorest and from being reliant on oil exports to being entirely dependent on them (Chart 1). The straw that broke the back of Chavismo was the end of the global commodity bull market in 2014 (Chart 2). Widespread shortages of essential goods, mass protests, opposition political victories, and a slide into overt military dictatorship have ensued.1 Chart 1Venezuela Suffers Under Chavismo Chart 2Commodity Bull Market Ended The acute social unrest at the end of 2016 and beginning of 2017 raises the question of whether Venezuela will cause global oil-supply disruptions that boost prices this year.2 One of the reasons we have been bullish oil prices is the fact that the world has little spare production capacity (Chart 3). This means that political turmoil in Venezuela, Libya, Nigeria, or other oil-producing countries could take enough supply out of the market to accelerate the global rebalancing process and drawdown of inventories, pushing up prices. The longer oil prices stay below the budget break-even levels of the politically unstable petro-states (mostly $80/bbl and above), the more likely some of them will be to fail. Venezuela, with a break-even of $350/bbl, has long been one of our prime candidates (Chart 4).3 Venezuela is on the verge of total regime collapse and a massive oil production shutdown. This is not a low-probability outcome. However, the fact that the military is already taking control of the situation, combined with our belief that OPEC and Russia will continue cutting oil production to shore up prices, suggest that the regime may be able to limp along. Therefore a continuation of the gradual decline in oil output is more likely than a sharp cutoff this year. Investors should stay short Venezuelan 10-year sovereign bonds and be aware of the upside risks to global oil prices. A Brief History Of PDVSA State-owned oil company PDVSA is the lifeblood of Venezuela. It once was a well-run company that allowed foreign investment with a reasonable government take, but now it is shut off from direct foreign investment. In 1996-1997, prior to Chavez being elected in late 1998, Venezuela was a rampant cheater on its OPEC quota, producing 3.1-3.3 MMB/d versus a quota of ~2.4 MMB/d in 1996 and ~2.8 in 1997. The oil-price crash that started in late 1997 and bottomed in early 1999 (remember the Economist's "Drowning In Oil" cover story on March 4, 1999 predicting $5 per barrel crude prices?) was a critical event propelling the rise of Chavez (Chart 5). One of the planks in Chavez's platform was that Venezuela had to stop cheating on OPEC quotas because that strategy had helped cause the oil-price decline and subsequent economic misery. Without the oil-price crash, Chavez would not have had such strong public support in the run-up to the 1998 elections, which he won. Chavez did in fact rein in Venezuela's production to 2.8 MMB/d in 1999, which had a positive impact on oil prices and reinforced OPEC. In 2002 and 2003, there were two labor strikes at PDVSA and a two-day coup that displaced Chavez. When Chavez returned to power, he fired 18,000 experienced workers at PDVSA and replaced them with political loyalists. Since then, the total number of employees at PDVSA has swelled from about 46,000 people in 2002, when PDVSA was producing 3.2 MMB/d, to about 140,000 people today, when it is producing slightly below 2 MMB/d. Average oil revenue per employee was over $500,000/person in 2002 at $20 oil, versus about $100,000/person today at $50 oil. Suffice it to say, PDVSA is stuffed to the gills with political patronage, and a strike or a revolution inside PDVSA against President Nicolas Maduro is unlikely. However, if opposition forces manage to seize control of government, the Chavistas in control of PDVSA may attempt to shut down operations to deprive them of oil revenues and blackmail them into a better deal going forward. Chart 5Oil Bust Catapulted Chavez Venezuela is estimated to have the world's largest proved oil reserves at about 300 billion barrels (Chart 6). In addition, there are 1.2-1.4 trillion barrels estimated to rest in heavy-oil deposits in the Orinoco Petroleum Belt (at the mouth of the Orinoco river) that is difficult to extract and has barely been touched. Chart 7Venezuela Cuts Forced By Economic Disaster These reserves are somewhat similar to Canada's oil sands. It is estimated that 300-500 billion barrels are technically recoverable. In the early 2000s, there were four international consortiums involved in developing these reserves: Petrozuata (COP-50%), Cerro Negro (XOM), Sincor (TOT, STO) and Hamaca (COP-40%). However, Chavez nationalized the Orinoco projects in 2007, paying the international oil companies (IOCs) a pittance. XOM and COP contested the taking and "sued" Venezuela at the World Bank. XOM sought $14.7 billion and won an arbitrated decision for a $1.6 billion settlement in 2014. Venezuela continues to litigate the case and the amount awarded to investors has apparently been reduced by a recent ruling. Over the past decade, as Venezuelan industry declined due to dramatic anti-free market laws, including aggressive fixed exchange rates absurdly out of keeping with black market rates, the government nationalized more and more private assets in order to get the wealth they needed to maintain profligate spending policies. The underlying point of these policies is to garner support from low-income Venezuelans, the Chavista political base. In addition to the Orinoco nationalization, the government appropriated equipment and drilling rigs from several oilfield service companies that had stopped working on account of not being properly paid. In 2009, Petrosucre (a subsidiary of PDVSA) appropriated the ENSCO 69 jackup rig, although the rig was returned in 2010. In 2010, the Venezuelan government seized 11 high-quality land rigs from Helmerich & Payne, resulting in nearly $200MM of losses for the company. These rigs were "easy" for Venezuela to appropriate because they did not require much private-sector expertise to operate. As payment failures continued, relationships with the country's remaining contractors continued to be strained. In 2013, Schlumberger (SLB), the largest energy service company in the world, threatened to stop working for PDVSA due to lack of payment in hard currency. PDVSA paid them in depreciating Venezuelan bolivares, but tightened controls over conversion into U.S. dollars. Some accounts receivables were partially converted into interest-bearing government notes. Promises for payment were made and broken. SLB has taken over $600MM of write-downs for the collapse of the bolivar (Haliburton, HAL, has taken ~$150MM in losses). With accounts receivable balances now stratospherically high at approximately $1.2 billion for SLB, $636 million for HAL (plus $200 million face amount in other notes), and $225 million for Weatherford International, the service companies have already taken write-offs on what they are owed and have refused to extend Venezuela additional credit. Unlike the "dumb iron" of drilling rigs, the service companies provide highly technical proprietary goods and services, from drill bits and fluids to measuring services. The lack of these proprietary technical services diminishes PDVSA's ability to drill new wells and properly maintain its legacy production infrastructure. Venezuela's production started falling in late 2015 - well before OPEC and Russia coordinated their January 2017 production cuts (Chart 7). Drought contributed to the problem in 2016 by causing electricity shortages and forced rationing of electricity (60-70% of Venezuela's electricity generation is hydro); water levels at key dams are still very low, but the condition has eased a bit in 2017. After watching crude oil production fall from 2.4 MMB/d in 2015 to 2.05 MMB/d in 2016, OPEC gave Venezuela a production quota of 1.97 MMB/d for the first half of 2017, which is about what they were expected to be capable of producing. In essence, Venezuela was exempt from production cuts, like other compromised OPEC producers Libya, Nigeria and Iran. So far, Venezuela has produced 1.99 MMB/d in the first quarter, according to EIA. Venezuela's falling production is not cartel behavior but indicative of broader economic and political instability. Venezuela is losing control of oil output, the pillar of regime stability. Bottom Line: The double-edged sword for energy companies is that if the regime utterly fails, the country's 2MM b/d of production may be disrupted. However, if government policy shifts - whether through the political opposition finally gaining de facto power or through the military imposing reforms - Venezuela could ramp up its production, perhaps by 1MMB/d within five years, and more after that if Orinoco is developed. How Long Can Maduro Last? Chavez's model worked like that of Louis XIV, who famously said, "après nous, le déluge." Chavez benefited from high oil prices throughout his reign and died in 2013 just before the country's descent into depression began (Chart 8). He won his last election in 2012 by a margin of 10.8%, while Maduro, his hand-picked successor, won a special election only half a year later by a 1.5% margin, which was contested for all kinds of fraud (Chart 9). Chart 8A Hyperflationary Depression Thus Maduro has suffered from "inept successor" syndrome from the beginning, compounding the fears of the ruling United Socialist Party of Venezuela (PSUV) that the succession would be rocky. Maduro lacked both the political capital and the originality to launch orthodox economic reforms to address the country's mounting inflation and weak productivity, but instead doubled down on Chavez's rapid expansion of money and credit to lift domestic consumption (Chart 10).4 Chart 10Excessive Monetary And Credit Expansion Chart 11Exports Recovered, Reserves Did Not The economic collapse was well under way even before commodities pulled the rug out from under the government.5 Remarkably, the recovery in export revenue since 2010 did not occasion a recovery in foreign exchange reserves - these two decoupled, as Venezuela chewed through its reserves to finance its growing domestic costs (Chart 11). This means Venezuela's ability to recover even in the most optimistic oil scenarios is limited. Another sign that the economic break is irreversible is the fact that, since 2013, private consumption has fallen faster than oil output - a reversal of the populist model that boosted consumption (Chart 12). Chart 12Consumption Falls Faster Than Oil Output Chart 13Oil-Price Crash Hobbles Maduro Critically, the external environment turned against Maduro and PSUV as oil prices declined after June 2014. In November 2014 Saudi Arabia launched its market-share war against Iran and U.S. shale producers, expanding production into a looming global supply overbalance. Brent crude prices collapsed to $29/bbl by early 2016 (Chart 13). This pushed Venezuela over the brink.6 First, hyperinflation: Currency in circulation - already expanding excessively - has exploded upward since 2014. The 100 bolivar note has exploded in usage while notes of lower denominations have dropped out of usage. Total deposits in the banking system are growing at a pace of over 200%, narrow money (M1) at 140%, and consumer price index at 150% (see Chart 10 above). Real interest rates have plunged into an abyss, with devastating results for the financial system. The real effective exchange rate illustrates the annihilation of the currency's value. Monetary authorities have repeatedly devalued the official exchange rate of the bolivar against the dollar (Chart 14). However, the currency remains overvalued, which creates a huge gap between the official rate and the black market rate, which currently stands at about 5,400 bolivares to the dollar. Regime allies have access to hard USD, for which they charge high rents, and the rest suffer. Chart 14Official Forex Devaluations Chart 15Domestic Demand Collapses Second, the real economy has gone from depression to worse: Exports peaked in October 2008, nearly recovered in March 2012, and plummeted thereafter. Imports have fallen faster as domestic demand contracted (Chart 15). Venezuela must import almost everything and the currency collapse means staples are either unavailable or exorbitantly expensive. Venezuelan exports to China reached 20% of total exports in 2012 but have declined to about 14% (Chart 16). This means that Venezuela has lost a precious $10 billion per year. The state has also been trading oil output for loans from China, resulting in an ever higher share of shrinking oil output devoted to paying back the loans, leaving less and less exported production to bring in hard currency needed to pay for production, imports, and debt servicing. Both private and government consumption are shrinking, according to official statistics (Chart 17). Again, the consumption slump removes a key regime support. Chart 16Chinese Demand Is Limited Chart 17Public And Private Consumption Shrink Third, Venezuela is rapidly becoming insolvent: Venezuela's total public debt is high. It stood at 102% of GDP as of August 2014, and GDP has declined by 25%-plus since then. Total external debt, which becomes costlier to service as the currency depreciates, was about $139 billion, or 71% of GDP, in Q3 2015 (Chart 18). It has risen sharply ever since the fall in export revenues post-2011. The destruction of the currency by definition makes the foreign debt burden grow. Chart 18External Debt Soars... Chart 19...While Forex Reserves Dwindle The regime's hard currency reserves are rapidly drying up - they have fallen from nearly $30 billion in 2013 to just $10 billion today (Chart 19). Without hard cash, Venezuela will be unable to meet import costs and external debt payments. In Table 1, we assess the country's ability to make these payments at different oil-price and output levels. Assuming the YTD average Venezuelan crude price of $44/bbl, export revenue should hit about $32 billion this year, while imports should hover around $21 billion, leaving $11 billion for debt servicing costs of roughly $10 billion (combining the state's $8 billion with PDVSA's $2 billion). Thus if global oil prices hold up - as we think they will - the regime may be able to squeak by another year. In short, the regime could have about $11 billion in revenues left at the end of the year if the Venezuela oil basket hovers around $44/bbl and production remains at about 2 MMB/d. That is a "minimum cash" scenario for the regime this year, though it by no means guarantees regime survival amid the widespread economic distress of the population. Chart 20Foreign Asset Sales Will Continue If production drops to 1.25 MMb/d or lower as a result of the economic crisis - or if Venezuelan oil prices settle at $28/bbl or below - the regime will be unable to meet its import costs and debt payments. It will have to sell off more of its international assets as rapidly as it can (Chart 20), restrict imports further, and eventually default. Moreover, the calculation becomes much more negative for Venezuela if we assume, conservatively, $10 billion in capital outflows, which is far from unreasonable. Outflows could easily wipe out any small remainder of foreign reserves. So far, the government has chosen to deprive the populace of imports rather than default on external debt, wagering that the military and other state security forces can suppress domestic opposition for longer than the regime can survive under an international financial embargo. This strategy is fueling mass protests, riots, and clashes with the National Guard and Bolivarian colectivos (militias). An extension of the OPEC-Russia production cuts in late May, which we expect, will bring much-needed relief for Venezuela's budget. Thus, there is a clear path for regime survival through 2017 on a purely fiscal basis, though it is a highly precarious one - the reality is that the state is bound to default sooner or later. Moreover, the socio-political crisis has already spiraled far enough that a modest boost to oil prices this year will probably be too little, too late to save Maduro and the PSUV in its current form. As we discuss below, the question is only whether the military takes greater control to perpetuate the current regime, or the opposition is gradually allowed to take power and renovate the constitutional order. Bottom Line: Even if oil production holds up, and oil prices average above $44/bbl as we expect, the country's leaders will have to take extreme measures to avoid default. Domestic shortages and military-enforced rationing will compound. As economic contraction persists, social unrest will intensify. Will The Military Throw A Coup? Explosive popular discontent this year shows no sign of abating. It is a continuation of the mass protests and sporadic violence since the economic crisis fully erupted in 2014. However, as recession deepens - and food, fuel, and medicine shortages become even more widespread - unrest will spread to a broader geographic and demographic base. Protests since September 2016 have drawn numbers in the upper hundreds of thousands, possibly over a million on two occasions. Security forces have increasingly cracked down on civilians, raising the death toll and provoking a nasty feedback loop with protesters. Reports suggest that the poorest people - the Chavista base - are increasingly joining the protests, which is a new trend and bodes ill for the ruling party's survival. Already the public has turned against the United Socialist Party, as evinced by the December 2015 legislative election results and a range of public opinion polls, which show Maduro's support in the low-20% range. In the 2015 vote, the opposition defeated the Chavistas for the first time since 1998. The Democratic Unity Roundtable won a majority of the popular vote and a supermajority of the seats in the National Assembly. Since then, however, Maduro has used party-controlled civilian institutions like the Supreme Court and National Electoral Council - backed by the military and state security - to prevent the opposition's exercise of its newfound legislative power. Key signposts to watch will be whether Maduro is pressured into restoring the electoral calendar. The opposition has so far been denied local elections (supposedly rescheduled for later this year) and a popular referendum on recalling Maduro. So it has little reason to expect that the government will hold the October 2018 elections on time. The government is likely to keep delaying these votes because it knows it will lose them. In the meantime, the opposition has few choices other than protests and street tactics to try to pressure the government into allowing elections after all. Further, oil prices are low, so the regime is vulnerable, which means that the opposition has every incentive to step up the pressure now. If it waits, higher prices could give Maduro a new infusion of revenues and the ability to prolong his time in power. The question at this point is: will the military defect from the government? The military is the historical arbiter of power in the country. Maduro - who unlike Chavez does not hail from a military background - has only managed to make it this far by granting his top brass more power. Crucially, in July 2016, Maduro handed army chief Vladimir Padrino Lopez control over the country's critical transportation and distribution networks, including for food supplies. He has also carved out large tracts of land for a vast new mining venture, supposed to focus on gold, which the military will oversee and profit from.7 What this means is that the government and military are becoming more, not less, integrated at the moment. The army has a vested interest in the current regime. It is also internally coherent, as recent political science research shows, in the sense that the upper-most and lower-most ranks are devoted to Chavismo.8 Economic sanctions and human rights allegations from the U.S. and international community reinforce this point, making it so that officials have no future outside of the regime and therefore fight harder for the regime to survive.9 Still, there are fractures within the military that could get worse over time. Divisions within the ranks: An analysis of the Arab Spring shows that militaries that defected from the government (Egypt, Tunisia), or split up and made war on each other (Syria, Libya, Yemen), exhibited certain key divisions within their ranks.10 Looking at these variables, Venezuela's military lacks critical ethno-sectarian divisions, but does suffer from important differences between the military branches, between the army and the other state security forces, and between the ideological and socio-economic factions that are entirely devoted to Chavismo versus the rest. Thus, for example, it is possible that Bolivarian militias committing atrocities against unarmed civilians could eventually force the military to change its position to preserve its reputation.11 Popular opinion: Massive protests have approached 1 million people by some counts (of a population of 31 million) and have combined a range of elements within the society - not only young men or violent rebels/anarchists. Also, public opinion surveys suggest that supporters of Maduro have a more favorable view of the army, and opponents have a less favorable view.12 This implies that Maduro's extreme lack of popular support is a liability that will weigh on the military over time. Military funds shrinking: Because of the economic crisis, Maduro has been forced to slash military spending by a roughly estimated 56% over the past year (Chart 21). The military may eventually decide it needs to fix the economy in order to fix its budget. Autonomous military leader: That General Lopez has considerable autonomy is another variable that increases the risk of military defection or fracture. As the country slides out of control Lopez will likely intervene more often. He already did so recently when the Chavista-aligned Supreme Court tried to usurp the National Assembly's legislative function. The attorney general, Luisa Ortega Diaz, broke with party norms by criticizing the court's ruling. Maduro was forced to order the court to reverse it, at least nominally restoring the National Assembly's authority. Lopez supposedly had encouraged Maduro to backtrack in this way, contrary to the advice of two notable Chavistas, Diosdado Cabello and Vice President Tareck El Aissami. Ultimately, military rule for extended periods is common in Venezuelan history. Chavez always deeply integrated the party and military leadership, so the regime could persist through greater military assertion within it, or the military could take over and initiate topical political changes. Finally, if Lopez is ready to stage a coup, he may still wait for oil prices to recover. It makes more sense to let the already discredited ruling party suffer the public consequences of the recession than to seize power when the country is in shambles. Previous coup attempts have occurred not only when oil prices were bottoming but also when they bounded back after bottoming (Chart 22). It would appear that the Venezuelan military is as good at forecasting oil prices as any Wall Street analyst! For oil markets, the military's strong grip over the country suggests that even if Maduro and the PSUV collapse, the party loyalists at PDVSA may not have the option of going on strike. The military will still need the petro dollars to stay in power, and it will have the guns to insist that production keeps up, as long as economic destitution does not force operations to a halt. Bottom Line: There is a high probability that the military will expand its overt control over the country. As long as the leaders avoid fundamental economic reforms, the result of any full-out military coup against Maduro may just mean more of the same, which would be politically and economically unsustainable. Chart 22Coups Can Come After Oil Price Recovers Chart 23Stay Short Venezuelan Sovereign Bonds Investment Implications Any rebound in oil prices as a result of an extension of OPEC's and Russia's production cuts at the OPEC meeting on May 25 will be "too little, too late" in terms of saving Maduro and the PSUV. They may be able to play for time, but their legitimacy has been destroyed - they will only survive as long as the military sustains them. To a great extent, the ruling party has already handed the keys over to the military, and military rule can persist for some time. Hence oil production is more likely to continue its slow decline than experience a sudden shutdown, at least this year. This is because it is likely that military control will tighten, not diminish, when Maduro falls. Incidentally, the military is also more capable than the current weak civilian government of forcing through wrenching policy adjustments that are necessary to begin the process of normalizing economic policy - such as floating the currency and cutting public spending. But any such process would bring even more economic pain and unrest in the short term, and it has not begun yet. Even if the ruling party avoids defaulting on government debts this year - which is possible given our budget calculations - it is on the path to default before long. We remain short Venezuelan 10-year sovereign bonds versus emerging market peers. This trade is down 330 basis points since initiation in June 2015, but Venezuelan bonds have rolled over and the outlook is dim (Chart 23). Within the oil markets, our base case is that global oil producers have benefitted and will benefit from the marginally higher prices derived from Venezuela's slow production deterioration. Should a more sudden and severe production collapse occur, the upward price response would be much more acute. A sustained outage of Venezuelan production would send oil prices quickly towards $80-$100/bbl as a necessary price signal to curb demand growth, creating a meaningful recessionary force around the globe. Oil producers, specifically U.S. shale producers that can react quickly to these price signals, would stand to benefit temporarily from the higher prices, but would again suffer from falling oil prices in the inevitable post-crisis denouement. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com 1 For the military takeover, please see "Venezuelan Debt: The Rally Is Late," in BCA Emerging Markets Strategy, "EM: From Liquidity To Growth?" dated August 24, 2016, available at ems.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "The Energy Spring," dated December 10, 2014, available at gps.bcaresearch.com; BCA Commodity and Energy Strategy Weekly Report, "Tactical Focus Again Required In 2017," dated January 5, 2017, available at ces.bcaresearch.com; and Energy Sector Strategy Weekly Report, "The Other Guys In The Oil Market," dated April 5, 2017, available at nrg.bcaresearch.com. 4 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Venezuelan Chavismo: Life After Death," dated April 2, 2013, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy, "Strategic Outlook 2013," dated January 16, 2013, and Monthly Report, "The Reflation Era," dated December 10, 2014, available at gps.bcaresearch.com. 6 Please see BCA Emerging Markets Strategy Weekly Report, "Assessing Political And Financial Landscapes In Argentina, Venezuela And Brazil," dated January 6, 2016, available at ems.bcaresearch.com. 7 For Lopez's taking control, please see "Venezuelan Debt: The Rally Is Late" in BCA Emerging Markets Strategy Weekly Report, "EM: From Liquidity To Growth?" dated August 24, 2016, available at ems.bcaresearch.com. For the gold mine, please see Edgardo Lander, "The Implosion of Venezuela's Rentier State," Transnational Institute, New Politics Papers 1, September 2016, available at www.tni.org. 8 The junior officers have advanced through special military schools set up by Chavez, while the senior officials have been carefully selected over the years for their loyalty and ideological purity. Please see Brian Fonseca, John Polga-Hecimovich, and Harold A. Trinkunas, "Venezuelan Military Culture," FIU-USSOUTHCOM Military Culture Series, May 2016, available at www.johnpolga.com. 9 Please see David Smilde, "Venezuela: Options for U.S. Policy," Testimony before the United States Senate Committee on Foreign Relations, March 2, 2017, available at www.foreign.senate.gov. 10 Please see Timothy Hazen, "Defect Or Defend? Explaining Military Responses During The Arab Uprisings," doctoral dissertation, Loyola University Chicago, December 2016, available at ecommons.luc.edu. 11 Civilian deaths caused by the National Guard and Chavez's loyalist militias triggered the aborted 2002 military coup. Please see Steven Barracca, "Military coups in the post-cold war era: Pakistan, Ecuador and Venezuela," Third World Quarterly 28: 1 (2007), pp. 137-54. 12 See footnote 8 above.

Highlights Duration: The opposing forces currently pulling on global bonds - softer growth and core inflation readings vs. tightening labor markets - are keeping yields locked into narrow trading ranges. We expect the strength of the global upturn to reassert itself, leading to higher government bond yields and corporate credit outperformance over the balance of 2017. U.K./Canada/Australia: Economic data, as well as our bond market indicators, are giving conflicting signals for the outlook for yields in the U.K., Canada & Australia. Our analysis of the relative growth and inflation dynamics in the three countries leads us to recommend a 2-year/30-year yield curve box trade, positioning for a relatively flatter curve in Canada and a relatively steeper curve in the U.K. Portugal Trade Update: Improving growth indicators, and declining measures of banking sector risk, in Portugal have resulted in a sharp narrowing of government spreads versus Germany. We are exiting our short 10-year Portugal/long 10-year Germany Tactical Overlay trade this week, at a loss of -1.6%. Feature Chart of the WeekMarket Volatility Is Low For A Good Reason What was once a fairly straightforward narrative for global bond markets earlier this year is now being challenged. Growth data has cooled a bit in the U.S. and China, while commodity prices have fallen, suggesting that the global economy may be losing steam even with leading indicators still rising and the European economy looking robust. At the same time, core inflation measures have ticked lower despite the signs of tighter labor markets throughout the developed world. These moves on the margin have stalled the upturn in global bond yields, resulting in lower fixed income market volatility that is likely playing a role in keeping realized equity market volatility at depressed levels (Chart of the Week). We continue to see the recent pullback in U.S. data as being temporary in nature. The economy should improve in the coming months given the still-solid trends in U.S. corporate profits and household income and the still-low level of interest rates. The signs of a building China slowdown are potentially more worrisome, especially on the inflation front given how much Chinese demand has boosted commodities and overall traded goods prices over the past year. Although we are not expecting a major Chinese downturn that could spill over more broadly to the world economy, it is likely that the next leg up in inflation in the developed economies will come from diminished spare capacity and rising core inflation, rather than a commodity-driven reacceleration of headline inflation. We continue to recommend a strategic underweight overall portfolio duration stance, as we expect the Fed to deliver on its planned rate hikes before year-end and the European Central Bank (ECB) to soon begin signaling a tapering of its asset purchases next year. We continue to favor corporate credit over sovereign debt, particularly in the U.S., given the strength of the current global upturn, but staying up in credit quality (i.e. focusing on Investment Grade and higher-rated credit tiers in High-Yield). Stuck On Neutral: Considering Trades Between Canada, Australia & The U.K. Over the past few months, we have upgraded our stance on government bond exposure in the U.K., Canada and Australia - all to neutral and all for essentially the same reason. There was not a compelling enough case to expect any of the central banks in those countries to move interest rates before year-end, in either direction, given the lack of sustainable inflation pressures and mixed messages on growth. With policymakers stuck on hold for the foreseeable future, keeping our recommended bond weightings at benchmark was the logical (albeit unexciting) choice. Even the mixed messages sent by our own bond indicators highlight the difficulty in making a decisive market call at the moment. Our Central Bank Monitors for Canada and Australia have recently flipped into the "tighter policy required" zone, joining the U.K. Monitor which has been there for some time (Chart 2).1 This would suggest moving to an underweight stance in anticipation of tighter monetary policy in those countries that is currently not priced into money market curves (bottom panel). Yet the best performing bond market of the three over the past two years has been the U.K. - a trend that started before last year's Brexit vote when the U.K. economy was in relatively good shape and the Bank of England (BoE) was starting to send hawkish messages. Gilts now look the most overvalued judging by the current negative real yields on offer (Chart 3), yet our U.K. Central Bank Monitor is showing signs of topping out, further adding to the confusion. Chart 2Markets Don't Expect Anything From BoE/BoC/RBA Chart 3Gilts Look Most Expensive Having mixed directional signals, however, does not imply that there are not trade opportunities within these markets. Even if the BoE, the Bank of Canada (BoC) and the Reserve Bank of Australia (RBA) are not in a hurry to begin hiking interest rates, domestic growth and inflation pressures are building at a different pace within these economies, creating potential cross-market trade opportunities. Economic Growth: Canada has the strongest leading economic indicator, manufacturing PMI and consumer sentiment, but the softest business confidence (Chart 4) - perhaps because of concerns over the future protectionist trade policies of U.S. President Donald Trump. In the U.K., a combination of falling real wage growth and persistently high levels of political uncertainty after Brexit are weighing on consumer sentiment, yet business confidence is the strongest of the three countries. Meanwhile, overall confidence in Australia is the weakest, even with manufacturing in a strong upturn. Most worryingly, real consumer spending is slowing rapidly in all three countries, although it is holding up relatively better in Canada. Inflation: The differences in price pressures are less pronounced (Chart 5). Inflation rates are similar among the three economies as Australian core CPI inflation appears to have finally bottomed out in the first quarter of this year after falling steadily since 2014. All three countries are witnessing decelerating wage growth, however, even with solid job growth in Canada over the past year. Spare capacity measures like the output gap and unemployment gap show the U.K. economy being closest to full employment (Chart 6). Spare capacity is steadily being absorbed in Canada, although the BoC attributes this to a slower pace of potential GDP growth, according to last month's BoC Monetary Policy Report (MPR).2 Chart 4Canadian Economic Data Looks Strongest Chart 5No Major Inflation Differences Home Prices & Debt: The housing markets remain an issue in Canada and Australia, where home prices look severely overvalued with household debt at elevated levels (Chart 7). The governments in both countries are trying to use regulatory and macro-prudential solutions to cool red-hot housing demand, but rapid growth in housing wealth remains a source of stimulus for consumers at the moment. The situation is different in the U.K., where home valuations and debt levels are nowhere near as elevated as in the other two countries (although London homeowners may disagree). Chart 6No Spare Capacity In The U.K. Chart 7Household Debt A Concern In Canada & Australia Exports: Each country is also exposed to a different major economy via the export channel. The OECD leading economic indicators for the U.S., Euro Area and China (the largest export markets for Canada, the U.K. and Australia, respectively) are all ticking higher, suggesting that export demand should pick up for Canada, the U.K. and Australia in the near term (Chart 8). However, Australian exports to China have already expanded at a 60% annual rate and our Emerging Market and China strategists are expecting some cooling of Chinese growth in the latter half of this year; slower export growth should be expected. Chart 8An Unsustainable Surge In Aussie##BR##Export Demand From China After adding up all the pieces, it is still difficult to select one government bond market over the others in absolute terms. The U.K. would appear to have the least bond-friendly backdrop, with higher inflation and very low real interest rates. Yet the BoE is worried about many factors - Brexit uncertainties on trade and business confidence, declining real household income growth - that should prevent them from shifting to a less accommodative monetary stance before year-end that would involve reduced Gilt purchases and/or outright interest rate hikes. Conversely, Australia seems to have the most bond-bullish climate - a still-negative output gap, plunging consumer confidence, very low inflation and the heaviest exposure to a Chinese economy that is set to cool off. Yet while core inflation remains low at 1.5%, it appears to be bottoming out and the RBA is currently forecasting that its preferred measure of underlying inflation will move up to 2% - the low end of its 2-3% target range - by early 2018, according to their just-released Statement on Monetary Policy.3 In Canada, the BoC continues to take a very cautious view on Canadian growth, despite the robust 4% real GDP growth seen in the first quarter of this year. Sluggish growth in exports and capital spending is expected to be a drag on growth this year, according to the April BoC MPR. Yet the central bank is now "decidedly neutral" and is no longer considering a rate cut as it was earlier this year according to BoC Governor (and BCA alumnus) Stephen Poloz.4 Given all the various factors pushing and pulling on these three economies and central banks, it is perhaps no surprise that yield moves have been highly correlated across these bond markets over the past several months (Chart 9). The most attractive near-term risk/reward opportunities now appear to be in relative yield curve trades rather than directional allocations or cross-country spread trades. Specifically, we see an opportunity to play for a steeper Gilt curve, and a relatively flatter Canadian government bond curve, via a 2-year/30-year box trade. Given the strong readings on current and leading economic indicators in Canada, combined with our view that the recent patch of slower U.S. growth will prove to be temporary, we see the greatest potential for upside growth surprises in Canada. The BoC is likely to wait before delivering rate hikes until there is decisive evidence of accelerating inflation, especially given the potential economic risks deriving from the Canadian housing bubble. However, better-than-expected growth will exert more flattening pressure on the Canadian yield curve than the U.K. or Australian curves, where downside growth risks are greater. Already, the very front end of the Canadian curve is starting to disengage from the U.K. and Australian curves, with the 2-year/5-year flattening modestly in Canada and the other markets showing steepening curves at similar maturities (Chart 10, top panel). We expect that relative flattening pressure to exert itself further out the yield curve for Canadian government debt over the latter half of 2017. Chart 9Yields Are Highly Correlated... Chart 10...Curve Slopes, Slightly Less Correlated In the U.K., the long end of the Gilt curve has rallied to very rich levels, with the 10-year/30-year slope now trading near the bottom of the range that has prevailed since 2014 (bottom panel). Much of that has been driven by a decline in longer-term inflation expectations that has accompanied the more stable British Pound. While the uncertainty surrounding the upcoming Brexit negotiations with the European Union will likely weigh on business confidence and investment spending in the U.K., the immediate impact of the robust Euro Area economy on U.K. exports should provide a boost to U.K. economic growth. Coming at a time when the U.K. is at, or even beyond, full employment, this should put some mild upward pressure on inflation expectations further out the curve, leading to steepening pressures on a relative basis to Canada. This can already be seen in looking at the 2-year/30-year yield curve box between the Canada and the U.K. in Chart 11. In all three panels, we show the steepness of the Canadian bond curve minus that of the Gilt curve, alongside the differentials in actual inflation, and market-based inflation expectations from the index-linked markets, between Canada and the U.K. As can be seen in the top two panels, the Canadian curve looks too steep relative to the U.K. curve given the higher rates of headline and core inflation in the U.K. The bottom panel shows that the 2-year/30-year box is in line with the relative inflation expectations within the two countries. We see this as a sign that U.K. inflation expectations are too low relative to actual U.K. inflation, leaving the Gilt curve too flat relative to the Canadian curve. While this would appear to argue for a relative trade between inflation-linked bonds in Canada and the U.K., the poor liquidity of the small Canadian linker market makes this a difficult trade for most investors to put on. We prefer to express the view via yield curves, particularly with the 2-year/30-year Canada-U.K. box currently priced in the bond forwards to move sideways over the rest of the year (Chart 12). This means that betting on a steeper Gilt curve relative to Canada does not incur negative carry - important for a trade with a more medium-term horizon like this. Chart 11Gilt 2/30 Curve Too Flat Relative To Canada Chart 12Enter A 2/30 Canada-U.K. Box Trade This week, we are adding this 2-year/30-year Canada-U.K. position to our strategic model portfolio at -7bps. The initial target is for the box to return to -50bps - the bottom of the range that has prevailed since 2015. A deeper decline would occur if the BoC begins to signal a rate hike in Canada at some point that puts even more flattening pressure on the Canadian curve, although that is not our base case expectation over the rest of 2017. The risk to the trade would come from a deceleration of U.K. inflation that eliminates the current divergence between realized and expected inflation. What about Australia? We anticipate that there will be an opportunity to move to an eventual overweight position in Australian bonds in the coming months to position for the slowing of Chinese growth, and the related demand for Australian exports, that we expect. We are choosing to stay neutral for now, however, given the current uptick in Australian inflation that muddies the water on any call on RBA monetary policy. Bottom Line: Economic data, as well as our bond market indicators, are giving conflicting signals for the outlook for yields in the U.K., Canada & Australia. Our analysis of the relative growth and inflation dynamics in the three countries leads us to recommend a 2-year/30-year yield curve box trade, positioning for a flatter curve in Canada and a steeper curve in the U.K. Tactical Overlay Housekeeping: Cutting Losses On Portugal Shorts One of our long-held positions in our Tactical Overlay trade portfolio has been a short position in Portugal 10-year government bonds versus a long position in 10-year German Bunds. We put the trade on last summer as part of a broader allocation at the time out of Peripheral European sovereign debt into core European debt. The logic was straightforward - the combined stress of decelerating economic growth and struggling banking systems in the Periphery (made worse by the ECB's negative interest rate policies) would result in some spread widening in Italy, Spain and Portugal. While that story remains true in Italy, both leading economic indicators and measures of financial sector risk like credit default swap (CDS) spreads for senior banks have a decline in Spain and Portugal. While we have already upgraded our recommended allocation to Spanish debt in our model portfolio, we had been reluctant to consider a similar move in Portugal given our concerns about its economy and, more importantly, its banking system. But with leading economic indicators starting to perk up and bank CDS spreads in Portugal falling sharply, and with German Bund yields rising alongside growing market nervousness of a potential ECB taper, Portugal-Germany spreads have tightened sharply. We are belatedly cutting our losses on this position this week and closing out the position at a loss of -1.6%. We plan on publishing a deeper dive on Portugal in the coming weeks to update our views on the country and its bond markets. Bottom Line: Improving growth indicators, and declining measures of banking sector risk, in Portugal have resulted in a sharp narrowing of government spreads versus Germany. We are exiting our short 10-year Portugal/long 10-year Germany Tactical Overlay trade this week, at a loss of -1.6%. 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 Special Report, "BCA Central Bank Monitor Chartbook", dated March 28 2017, available at gfis.bcaresearch.com. 2 http://www.bankofcanada.ca/wp-content/uploads/2017/04/mpr-2017-04-12.pdf 3 http://www.rba.gov.au/publications/smp/2017/may/pdf/statement-on-monetary-policy-2017-05.pdf 4 https://www.bloomberg.com/news/articles/2017-04-12/poloz-sees-faster-canada-return-to-full-capacity-key-takeaways The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Fed: The Fed is likely to lift rates in June, which could roil markets if economic data do not improve between now and then. Municipal Bonds: Weak state & local government revenue growth reflects the fall-out from the mid-2014 commodity price collapse. Now that energy sector capex has recovered, state & local government revenues will soon follow. Economy & Inflation: Consumer confidence remains elevated, and this should lead to a snapback in consumer spending in the second quarter. Stronger growth and a tight labor market should also cause core inflation to soon resume its uptrend, driven by accelerating wage growth. Feature How stubborn are Fed policymakers? This is an important question for markets at the moment. The Fed has clearly articulated that its base case economic outlook will result in two more rate hikes before the end of 2017, and even traditionally dovish Chicago Fed President Charles Evans said he "could be fine with two more rate hikes this year."1 Meanwhile, broad indexes of financial conditions suggest that markets can absorb another rate increase (Chart 1). Everything appears to be set up for the FOMC to lift rates by another 25 basis points when it meets next month, and this remains our expectation. The only problem is that the flow of economic data has turned decisively negative (Chart 2). Most recently, core CPI disappointed expectations by increasing only 0.1% in April, causing the year-over-year growth rate to fall to 1.9%. It was only three months ago that core CPI was growing 2.3% year-over-year. True to form, President Evans also noted last week that "downside risks [to inflation] still predominate". Chart 1Green Light From Financial Conditions Chart 2Red Light From Data Surprises The risk from a market point of view is that the Fed holds true to its promise and lifts rates in June, despite the fact that recent data have disappointed and inflation remains well below target. In that scenario, it is possible that markets come to the conclusion that the Fed is running an overly tight policy, resulting in a bear-flattening of the yield curve and a near-term sell-off in spread product. Chart 3Stay Positioned For Higher Yields As we have highlighted numerous times in the context of our Fed Policy Loop,2 with inflation below target, the Fed will be quick to adopt a more dovish stance when faced with a sharp tightening of financial conditions. This will put a floor under risk assets. Further, as was discussed in last week's report,3 negative data surprises are not likely to persist for much longer. But until that turnaround occurs, there is a heightened risk of a near-term widening in credit spreads if the Fed sticks to its guns. Ultimately, the Fed will continue to support credit spreads, and we remain overweight spread product on a 6-12 month investment horizon. Our 6-12 month outlook for Treasury yields is also unchanged, even though recent yield movements reflect the "hawkish Fed" scenario described above. The nominal 10-year yield has risen in recent weeks, driven entirely by real yields that have moved higher alongside increasingly hawkish rate hike expectations (Chart 3). The compensation for inflation protection has actually declined, in reaction to disappointing inflation data and perceptions of a more hawkish Fed. Even in the event that financial conditions tighten and the Fed is forced to adopt a more dovish policy stance, we would expect the decline in real yields to be offset by an increase in the cost of inflation compensation, which still has considerable upside (see section titled "The Consumer Is Strong, But Where's The Inflation?" below). We therefore continue to recommend a below-benchmark duration stance. Finally, futures market positioning is now solidly net long, suggesting that yields are biased higher during the next three months (Chart 3, bottom panel). Bottom Line: Risk assets could sell off in the near-term if economic data do not turn around and the Fed proceeds with a June hike. However, Fed policy will ultimately encourage tighter credit spreads and a higher cost of inflation compensation on a 6-12 month horizon. Remain at below-benchmark duration and overweight spread product. Municipal Bonds: Not Just About Taxes The uncertain outlook for fiscal policy is the immediate concern in municipal bond markets. While we expect some sort of tax bill will make its way through Congress before the end of the year, as of now, we don't have much clarity on what that bill will include. Lower corporate and individual tax rates seem likely, and the administration has also expressed a desire to curb deductions. Unfortunately, for now that's about all we can say for certain. Lower tax rates would be negative from the perspective of municipal bond investors, but fewer deductions would increase demand for munis, assuming the municipal bond tax exemption is not scrapped altogether. We haven't even mentioned the potential replacement of Obamacare and a possible federal infrastructure bill! For now, the muni market seems content to shrug off this uncertainty. Muni / Treasury (M/T) yield ratios are approaching their post-crisis lows across the entire curve (Chart 4), though longer maturity yield ratios remain elevated compared to pre-crisis levels (Chart 5). We recently recommended that investors favor long over short maturities on the Aaa muni curve.4 Chart 4Yield Ratios At Post-Crisis Lows Chart 5More Value In Long Maturities As for tax reform, although nothing is known for certain, we do expect that the administration's desire for increased infrastructure investment will keep the muni tax exemption in place. We also anticipate lower corporate and individual tax rates. How much of an impact will lower tax rates have on M/T yield ratios? Even that is hard to pin down, although we note that historically there has only been a loose relationship between yield ratios and the top marginal income tax rate (Chart 6). Chart 6The Municipal Treasury Yield Ratio & Tax Rates Further, elevated yield ratios since the financial crisis are much more driven by concerns about credit quality than changes in tax policy. With the potential for municipal bankruptcy more present than ever in investors' minds, as long as the muni tax exemption is not repealed, we think that trends in state & local government balance sheet health will continue to drive yield ratios. On that latter point, there is growing reason for optimism. Revenue Growth Ready To Rebound Periods of rising state & local government net savings have historically coincided with tightening M/T yield ratios, and vice-versa. Net savings increases when revenue growth exceeds expenditure growth. However, expenditure growth has been outpacing revenue growth since early 2015 and net savings have declined as a result (Chart 7). Unsurprisingly, state & local governments have reduced their pace of hiring in an effort to protect budgets (Chart 7, panel 3). Ratings downgrades have also spiked, but the message from our Municipal Health Monitor is that they will soon subside (Chart 7, bottom panel).5 We concur, and in fact believe that state & local government revenue growth has reached an inflection point and is poised to head higher. Breaking out the different sources of state & local government revenue we see that the recent deceleration has been concentrated in income tax and sales tax revenues (Chart 8). Property tax growth has been steady, if unspectacular. Transfers from the federal government have also decelerated since early 2015, but have been flat recently. Transfer revenue is at risk of falling if the federal government is able to pass a healthcare bill that includes the block-granting of Medicaid payments. But there is still a long road ahead before any proposed healthcare bill becomes law, and a lot can change in the interim. Chart 7A Setback In State & Local Savings Chart 8State & Local Revenue By Source What seems clear at the moment is that personal income growth is heading higher and consumer spending is firm (please see the following section of this report, titled "The Consumer Is Strong, But Where's The Inflation?", for a discussion of the outlook for income and consumer spending growth). Both suggest that income and sales tax revenue growth have bottomed for the time being. Chart 9State & Local Revenue By State Using data from the Rockefeller Institute, we can also examine state & local government revenue by state. Then, if we split out the nine states that are most heavily dependent on the energy and mining sectors,6 we observe that commodity-dependent states have dragged overall state & local government revenue growth lower since commodity prices collapsed in mid-2014 (Chart 9). Further, we see that revenue growth in commodity-dependent states is heavily influenced by nonresidential investment in the energy and mining sectors (Chart 9, bottom panel). Now that commodity prices have recovered from the 2014 bust and energy sector investment is coming back on line, we would expect state & local revenue growth to follow with a lag. Investment Implications Although we expect state & local government revenue growth to accelerate from here, yield ratios already reflect quite a lot of good news. Also, heightened policy uncertainty means there is an increased risk that yield ratios will widen sharply in the coming months. For now, we recommend only a neutral allocation to Municipal bonds within U.S. fixed income portfolios. However, an interesting opportunity could lie in focusing municipal bond exposure on those aforementioned commodity-dependent states, where revenues are likely to grow more quickly as energy capex rebounds, and whose bonds might still trade at a discount because of lower current revenues. Looking at Charts 10 & 11, we notice that the General Obligation (GO) bonds of energy-dependent Texas offer a yield advantage of 15 bps versus the overall Aaa muni curve at the 10-year maturity point. This is close to the same yield advantage offered by Massachusetts GO bonds, even though Massachusetts is rated Aa1 and Texas carries a Aaa rating. Other Aaa-rated states (Virginia, Georgia, Maryland, North Carolina, South Carolina and Tennessee) trade at much lower yields. Not only that, but Texas has also seen the strongest population growth during the past 12 months of all the states in our sample (Chart 11), and employment growth in Texas should continue to rebound alongside rising oil prices (Chart 12). Our Commodity & Energy Strategy service maintains a $60/bbl year-end oil price target.7 Chart 10Grab The Premium In Texas GOs Part I Chart 11Grab The Premium In Texas GOs Part II Chart 12Texas Bouncing Back Bottom Line: Weak state & local government revenue growth reflects the fall-out from the mid-2014 commodity price collapse. Now that energy sector capex has recovered, state & local government revenues will soon follow. Commodity-dependent states should benefit disproportionately. Texas GOs in particular look attractive on a risk/reward basis. The Consumer Is Strong, But Where's The Inflation? Consumer Spending Chart 13Consumer Spending Looks Solid The post-election surge in consumer confidence does not look as though it's about to reverse. At least not according to the University of Michigan Consumer Sentiment Survey, which was released last week. The expectations component of that survey, which closely tracks real consumer spending (Chart 13), rose from 87 in April to 88.1 in May, suggesting that weak first quarter consumer spending will prove to be nothing more than a blip. We like to think about consumer spending as a combination of income growth and the savings rate. On income growth, survey measures are also pointing to an imminent acceleration (Chart 13, panel 2). Meanwhile, the savings rate will likely remain elevated compared to pre-crisis levels, but is unlikely to move meaningfully higher from here. In our February 21 report,8 we noted that while tightening bank lending standards correlated with a higher savings rate prior to the financial crisis, that relationship has since completely broken down (Chart 13, panel 3). Since the housing bust, the supply of credit is no longer the chief constraint on consumer borrowing. Households are now much more concerned with maintaining the health of their own balance sheets. For this reason, we do not view the recent tightening of consumer lending standards as a meaningful impediment to consumer spending. Similarly, we do not think the recent decline in demand for consumer credit (according to the Fed's Senior Loan Officer Survey) will soon translate into much weaker consumer spending. In prior cycles, we see that loan demand tended to fall several years prior to the next recession, while the savings rate did not spike until the recession actually hit (Chart 13, bottom panel). Inflation & TIPS As was mentioned above, the Consumer Price Index for April was also released last week. Not only was the core CPI print disappointing, but the decline was broad based across the four major components of core CPI: shelter, core goods, core services excluding shelter, and medical care (Chart 14). The tick lower in shelter inflation is not surprising, and in fact should continue now that rental vacancies have put in a bottom. We would also expect core goods inflation to stay low, given that the U.S. dollar remains in a bull market. More worrisome is the large drop in core services inflation excluding shelter (Chart 14, panel 3). This component of core inflation correlates most closely with wage growth, and we would expect this component to drive core inflation higher as the labor market tightens and wage growth accelerates. It is worth noting that while wage growth has also weakened during the past few months, leading wage growth indicators are still trending up (Chart 15). Pipeline measures of inflationary pressures, such as the core Producer Price Index and the Supplier Deliveries and Prices Paid components of the ISM Manufacturing index, are the other bright spots in the inflation outlook (Chart 16). While the 10-year TIPS breakeven rate has fallen all the way to 1.85% from its post-election high of 2.08%, these pipeline measures suggest the decline will prove fleeting. Chart 14Core CPI By Major Component Chart 15Wage Growth Will Recover Chart 16Pipeline Measures Still Positive We continue to expect that the 10-year TIPS breakeven inflation rate will reach 2.4% to 2.5% by the time that core PCE inflation returns to the Fed's 2% target, sometime near the end of this year. Bottom Line: Consumer confidence remains elevated, and this should lead to a snapback in consumer spending in the second quarter. Stronger growth and a tight labor market should also cause core inflation to soon resume its uptrend, driven by accelerating wage growth. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 https://www.bloomberg.com/news/articles/2017-05-12/evans-says-risks-to-fed-inflation-outlook-still-on-the-downside 2 Please see U.S. Bond Strategy Weekly Report, "Caught In A Loop", dated September 29, 2015, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy / Global Fixed Income Strategy Weekly Report, "Past Peak Pessimism", dated May 9, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Portfolio Allocation Summary, "Reflation Window Still Open", dated April 4, 2017, available at usbs.bcaresearch.com 5 For further details on our Municipal Health Monitor, please see: U.S. Bond Strategy Special Report, "Trading The Municipal Credit Cycle", dated October 18, 2016, available at usbs.bcaresearch.com 6 These states are: Alaska, Louisiana, Montana, New Mexico, North Dakota, Oklahoma, Texas, West Virginia and Wyoming. 7 Please see Commodity & Energy Strategy Weekly Report, "Oil: Be Long, Or Be Wrong", dated May 11, 2017, available at ces.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, "The Odds Of March", dated February 21, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The risk to EM currencies is to the downside over the next 12 months - i.e., they will depreciate more than their carry. In this context, investors in local currency bonds should consider hedging against currency depreciation. The cross-currency basis spread can be used to calculate exchange rate-hedged yield on local currency bonds for U.S. dollar and euro-based investors. On a currency-hedged basis, Korean, Russian and Mexican local bonds offer the highest yield, while Turkish, South African and Chinese fixed-income securities stand at the opposite end of the spectrum. Feature The Big Picture: A Stampede Into EM Bonds There has been a stampede into EM risk assets since early this year. Fixed-income investors' search for yield is understandable, given DM bond yields are very low. However, we believe investors are underappreciating currency and other risks embedded in EM that are likely to manifest in the next 6-12 months. In other words, the fact that DM bond yields are low in of itself does not justify chasing EM bonds and currencies. Investment in EM should primarily be based on the merits of EM fundamentals. With respect to EM local bonds, total returns for international investors are greatly influenced by exchange rate moves. Not only does currency depreciation undermine returns for foreign investors, but in many high-yielding fixed income markets, bond yields also rise when their respective country's currency depreciates, and vice versa (Chart I-1). Furthermore, Chart I-2 demonstrates that high or rising interest rates historically have not precluded bear markets in EM currencies. On the contrary, historically, it was exchange rate that determined the direction and level of local interest rates: a strong currency led to lower interest rates and a weak currency warranted rising interest rates. This was especially true with the recent darlings of investors, the Brazilian real and South African rand. Chart I-1EM Local Bond Yields And ##br##Currencies: Negative Correlation Chart I-2In EM, Currencies Drive ##br##Interest Rates Not Vice Versa In our weekly reports, we have argued at length why EM currencies are set to depreciate considerably, and we will not repeat the rationale in this report. Instead, our focus this week is on hedging mechanisms and the concept of cross-currency basis swap. Specifically, we calculate what yields would be on offer to U.S. dollar- and euro-based investors in EM local currency bonds after hedging the EM exchange rate risk. This can be done via cross-currency basis swaps. We also demonstrate the mechanism behind the hedge, and present the relative attractiveness of local yields across the EM universe after hedging. EM local currency bonds are only comparable to each other as well as to U.S. Treasurys and German bunds after hedging exchange rate risk. We conclude that Korea, Russia and Mexico local bond markets offer the highest hedged yields, while Turkey, South Africa and China provide the lowest hedged yield. Bottom Line: The risk to EM currencies is to the downside in the next 12 months - i.e., they will depreciate more than their carry. In this context, investors in local currency bonds should consider hedging against currency depreciation. Cross-Currency Basis Swap The cross-currency basis spread is the price of a cross-currency basis swap. This spread is directly quoted in the marketplace. The swap allows two parties involved to temporarily access each other's currencies without having to take on foreign currency exposure. Chart I-3 demonstrates an equal-weighted average basis spread for nine EM currencies (Mexico, Russia, Korea, Malaysia, Turkey, South Africa, China, Hungary, Poland) and the aggregate EM exchange rate versus the greenback. Chart I-4 does the same but against the euro - i.e., EM cross-currency basis spread versus the euro, and the EM aggregate exchange rate against the euro. Chart I-3EM Versus U.S. Dollar And Cross-Currency Basis Swap With Dollar Chart I-4EM Versus Euro And Cross-Currency Basis Swap With Euro A few considerations are in order: A negative basis spread means that U.S. dollar investors are paid to hedge their EM currency exposure - i.e., they can enhance their U.S. dollar yield by forgoing their EM local yield and hedging their EM exchange rate risk. The aggregate EM basis spread was very wide in 2011 before the EM bear market began. This meant that not many investors hedged their EM currency exposure before the second half of 2011. From 2011 through to mid-2016, various EM cross-currency basis spreads narrowed. The narrowing occurred at an uneven pace, at times in sync with EM rallies and at other times with EM selloffs. This suggests that fixed-income investors were periodically hedging their EM currency exposure via basis swaps until the middle of 2016. Since the middle 2016 - the point when confidence in EM fixed-income rally was cemented - the basis swap spread has widened. This entails that EM fixed-income investors have been reluctant to hedge their currency risk via basis swaps. This corroborates the lingering complacency among the investment community with respect to EM risk. Chart I-5EM Domestic Bond Yields ##br##Over U.S. Treasurys Are Low There is no strong and stable correlation between the EM basis swap spread and EM exchange rate moves (appreciation/depreciation). However, the persisting negative sign of the basis spread implies stronger secular demand for hedged U.S. dollar funding from EM companies and banks than demand for hedged EM currency exposure among foreign investors and companies. Remarkably, the spread of EM local bond yields over 5-year U.S. Treasurys is at the bottom of the trading range that has prevailed over the past seven years (Chart I-5). Provided that EM exchange rate risk is currently considerable, the current level of EM local yields does not warrant blind yield chasing. Hedging Mechanism While obtaining funds in the spot foreign exchange market and hedging via forwards is possible, liquidity in forwards becomes very poor beyond 12 months. Cross-currency basis swaps allow hedging up to multiple years, effectively locking in yields until the maturity of the bond. The following illustrates the transactions involved in the hedging process. A fixed-income portfolio manager (PM) starts with $1 U.S. dollar. This investor enters into a cross-currency basis swap with Counterparty A who, let's say, owns Malaysian ringgits. The PM gives $1 and receives 4.3 MYR, where 4.3 is the spot exchange rate. The PM also agrees to swap back 4.3 MYR for $1 at maturity. The PM then takes the 4.3 MYR and purchases a Malaysian 5-year local currency government bond yielding 3.7% (Chart I-6). During the lifetime of the swap, the PM receives U.S. LIBOR from Counterparty A. In return, she/he must pay Counterparty A KLIBOR (the Kuala-Lumpur interbank offered rate, presently 3.9%) plus the basis spread, which is currently -50 basis points. The PM collects 3.7% yield from the ownership of Malaysian government bonds (Chart I-7). Thus, a negative basis spread of 50 basis points implies that the PM would be paying less than KLIBOR, which is the ordinary rate for borrowing ringgits. At the maturity of the swap contract, the PM redeems the bond and pays 4.3 MYR back to Counterparty A. In exchange, Counterparty A returns $1 U.S. dollar (Chart I-8). Chart I-6Hedging Mechanism: Step 1 Chart I-7Hedging Mechanism: Step 2 Chart I-8Hedging Mechanism: Step 3 The transaction allowed the international fixed-income investor to gain exposure to local currency Malaysian government bonds with almost no currency risk, as the PM received all of the payments in U.S. dollars. On a net basis, the investor receives the following yield: U.S. LIBOR + local yield - (KLIBOR + BASIS), or 2.3% = 2.0% + 3.7% - (3.9%-0.5%). Importantly, this yield is in U.S. dollars, meaning the PM has secured the principal investment and the yield on it in U.S. dollars while gaining exposure to Malaysian local currency sovereign bonds. The latter entails that the portfolio will gain/lose from changes in prices of Malaysian government bonds. Besides, the investor still has some currency exposure on the quarterly flows of interest payments. However, this is miniscule in comparison to the notional. Currency-Hedged Local Bond Yields Using the method described above to calculate hedged returns for individual countries, we ranked the resulting yields for EM countries with available data. Unfortunately, some markets like Brazil do not have a cross-currency basis swap market. Chart I-9 ranks currency-hedged yield for U.S. dollar investors for investments in 5-year local currency fixed-income bonds. Chart I-9EM Local Bonds: Currency-Hedged Yields For U.S. Dollar Investors We also did the same calculation for the euro using German bunds as a proxy. For pairs that do not have direct cross-currency basis swaps with the euro or U.S. dollar, we use the euro/U.S. dollar cross-currency basis to do the conversion. Chart I-10 classifies EM countries according to their hedged euro yield for euro-based international fixed-income investors. Chart I-10EM Local Bonds: Currency-Hedged Yields For Euro-Based Investors For 5-year local bonds, the highest hedged yields are offered by Korea, Russia and Mexico. In contrast, the lowest hedged yields for 5-year domestic local bonds are offered by Turkey, South Africa and China. These hedged yields are calculated on our best estimate of transactions happening at the mid-point of the bid-ask spread. The EM cross-currency swap market is often illiquid. Coupled with the fact that the hedging process requires multiple transactions, the hedged return can be quite lower. To conclude, the highest-yielding local bond markets do not always offer the highest yield when taking currency hedging into account. A caveat is in order: Applying hedging via basis swaps eliminates exchange rate risk, but it does not eliminate risk from fluctuations in bond prices (capital gains/losses). Therefore, in the event that EM local bond yields rise as their currencies depreciate, hedging via basis swaps will not protect against capital losses. Therefore, basis swap hedging should be used by long-term fixed-income investors who have deployed a lot of capital in EM local bond markets and share our concerns on EM exchange rates. These investors typically have a higher tolerance for asset price swings compared with traders who have little tolerance for short-term losses. The latter should sell out of EM domestic bonds altogether. Investment Implications This exercise reinforces our existing overweights in Korean, Russian and Mexican bonds within the EM local currency bond universe. Similarly, it also corroborates our underweights in Turkish and South African domestic bond markets. Although we expect most EM currencies will depreciate versus both the U.S. dollar and the euro in the next 12 months, the Korean won (as well as other low-yielding Asian currencies such as the TWD and the SGD), the Russian ruble and the Mexican peso are less vulnerable, and will outperform other EM currencies. By contrast, the TRY and the ZAR are among the most vulnerable, even after adjusting for their high carry. A plunge in these currencies will also force their local bond yields higher. Hence, capital losses on local bonds even after hedging exchange rate risk could be substantial in these countries. Furthermore, we also continue to recommend overweight positions in local currency bonds in Poland, Hungary, India and Chile within the EM universe. Henry Wu, Research Analyst henryw@bcaresearch.com

Highlights Duration: U.S. growth expectations have become overly pessimistic. A Q2 rebound will lead to higher global bond yields and a steeper U.S. Treasury curve. UST / Bund Spread: The extreme divergence between the European and U.S. economic surprise indexes is not sustainable, especially in the face of weakening Chinese economic data. The Treasury / Bund spread is biased wider in the near term, though could tighten in the second half of this year as the ECB shifts to a less accommodative policy. USD Hedging Costs: Declining hedging costs driven by interest rate differentials and negative basis swap spreads make international bond investment very attractive for U.S. investors. Feature Chart 1Global Recovery Will Persist The synchronized global recovery that took hold in the second half of 2016 has stalled so far this year. Measures of economic sentiment, such as the Global ZEW survey and our own Boom/Bust Indicator, have rolled over from high levels and global bonds have clawed back some of last year's lost returns (Chart 1). Year-to-date, the Bloomberg Barclays Global Government Bond index has returned +3%, after having lost more than 9% between the July trough in the Global ZEW index and the end of last year. In our view, a repeat of early 2016's global growth slowdown and bond market rally, which saw the Global ZEW index fall below zero and the Global Government Bond index return 11.6% in 2016H1, is not in the cards. The global economy is on much firmer footing than at this time last year. U.S. Growth: Past Peak Pessimism First quarter U.S. GDP growth was a disappointing 0.7%, but is poised to bounce back strongly in Q2. The volatile inventories component subtracted 0.9% from overall Q1 growth, harsh weather wreaked havoc on the March employment report and there continue to be problems with residual seasonality depressing first quarter GDP data.1 The outlook is much brighter moving forward. The latest employment report showed that the U.S. economy added a healthy 211k jobs in April and our model is pointing toward a further acceleration (Chart 2). Economic growth can be thought of as a combination of aggregate hours worked and labor productivity (Chart 3). With aggregate hours worked growing at 1.7% year-over-year and labor productivity growth having averaged 0.6% (annualized) per quarter since 2012, real U.S. GDP growth of around 2.3% seems like a reasonable forecast. Chart 2Labor Market Still Strong Chart 3Look For Above 2% Growth There is even some reason to suspect that labor productivity could strengthen during the next few quarters. A recent IMF paper2 attributed weak post-crisis productivity growth to a combination of structural and cyclical factors, but also noted that weak investment in physical capital may be responsible for lowering total factor productivity growth by nearly 0.2 percentage points per year in advanced economies during the post-crisis period. With leading indicators pointing to still further gains in fixed investment (Chart 3, bottom panel), we would not be shocked to see productivity growth enjoy a modest late-cycle rebound. Chart 4Stronger Productivity = Steeper Curve All else equal, a late-cycle rebound in productivity growth would slow the increase in unit labor costs. Unit labor costs are a combination of wages (compensation-per-hour) and productivity (output-per-hour), and have historically tracked changes in the slope of the U.S. yield curve (Chart 4). Faster wage growth tends to coincide with Fed tightening, and slower wage growth with Fed easing. For this reason, all wage measures perform reasonably well tracking changes in the yield curve. But unit labor costs perform best because they also incorporate productivity growth, and low productivity growth can flatten the yield curve by pulling down long-dated yields. Rapid increases in compensation-per-hour and muted productivity growth have combined to give the yield curve a strong flattening bias during the past several years. Any increase in productivity growth would slow the uptrend in unit labor costs relative to other wage measures, allowing the yield curve to steepen. In fact, we continue to recommend that investors position for a steeper U.S. yield curve by going long the 5-year Treasury note and shorting a duration-matched barbell consisting of the 2-year and 10-year notes. This trade produces positive returns when the 2/10 slope steepens (Chart 4, panel 3), but has also returned +19 bps since we initiated the position last December, even though the curve has flattened since then. The reason for the trade's strong performance in an unfavorable curve environment is that the 5-year yield had been unusually elevated compared to the rest of the curve. Our model of the 2/5/10 butterfly spread versus the 2/10 slope showed that the 5-year note was one standard deviation cheap on the curve as recently as mid-March (Chart 4, bottom panel). This undervaluation has mostly dissipated and the 5-year note now appears only slightly cheap. For our curve trade to outperform from here, it will likely require the 2/10 slope to steepen.3 Bottom Line: With weak Q1 GDP now in the rearview mirror, we are likely past the point of peak pessimism on U.S. growth. Expect global bond yields to rise and the U.S. yield curve to steepen as the economic data start to reflect an environment of above-trend growth, in the neighborhood of 2% - 2.5%. European Growth & The Risk From China While the U.S. data have disappointed in recent weeks, as evidenced by the U.S. Economic Surprise Index having dipped below zero (Chart 5), the European economy has consistently bested expectations (Chart 5, panel 2). As a result, the Treasury / Bund spread has narrowed from high levels during the past few months. In practice, economic surprise indexes tend to mean revert because positive data surprises beget increasingly optimistic expectations. Eventually, overly optimistic expectations become too high a hurdle and the data start to disappoint. In our view, U.S. expectations have become unduly pessimistic while the Eurozone surprise index appears overdue for a correction. Against this back-drop, we expect the Treasury / Bund spread to widen in the near term as the large divergence between the U.S. and European surprise indexes starts to narrow. Further making the case for a wider Treasury / Bund spread is the recent performance of the Chinese economy. Our Foreign Exchange Strategy service recently observed that growth differentials between the U.S. and Europe are highly correlated with indicators of Chinese growth.4 This should not be overly surprising since Europe trades more with China and other Emerging Markets than does the United States. Along those lines, the IMF has calculated that a 1% growth shock to Emerging Markets impacts European growth by nearly 40 basis points, while it impacts U.S. growth by only 10 basis points.5 The worry at the moment is that Chinese monetary conditions have started to tighten, and China's Manufacturing PMI is rolling over alongside weaker commodity prices. These trends usually coincide with the underperformance of Europe relative to the U.S. (Chart 6). Chart 5Surprise Indexes Will Converge Chart 6Look To China To Trade UST / Bund Spread Our China Investment Strategy service highlights the importance of the trade-weighted RMB as a driver of Chinese growth.6 The RMB's 30% appreciation between 2012 and 2015 applied a massive deflationary force to China's economy, while its more recent depreciation helped boost producer prices, enhance profit margins and reduce the real cost of funding (Chart 7). Chart 7Monetary Conditions ##br##Still Fairly Stimulative More recently, the pace of the RMB's depreciation has slowed and this likely explains the weakness in China's Manufacturing PMI and commodity prices. Our China strategists are quick to note that while the pace of RMB depreciation has slowed, it is still not appreciating, and real interest rates deflated by the producer price index remain negative. In other words, monetary conditions have become somewhat less stimulative, but they should still be supportive of further economic growth. Although the Chinese economic data are likely to moderate in the coming months, barring the major policy mistake of aggressive tightening, Chinese growth will avoid a collapse and remain reasonably buoyant. Similarly, we would also expect European growth expectations to soften in the coming months, but growth is very likely to remain above trend and the ECB is still on track to adopt a less accommodative policy stance over the next year. In the most likely scenario, a few hints will be given at the June ECB meeting, and then an announcement that asset purchases will be tapered in 2018 will be made at the September meeting. The market will correctly assume that rate hikes will follow the taper, and this re-pricing of rate expectations will open up a window in the second half of this year when the Treasury / Bund spread can tighten. However, it is still too soon to adopt this position. Bottom Line: The extreme divergence between the European and U.S. economic surprise indexes is not sustainable, especially in the face of weakening Chinese economic data. The Treasury / Bund spread is biased wider in the near term, though could tighten in the second half of this year as the ECB shifts to a less accommodative policy. U.S. Bond Investors Should Expand Their Borders Divergences that have opened up between U.S. short-term interest rates and short-term rates in other developed countries mean that U.S. bond investors now face much lower currency hedging costs. In addition, increasingly negative cross-currency basis swap spreads have become a permanent feature of the post-crisis investment landscape, and unless significant regulatory changes occur, we expect they are here to stay. Combined, both of these factors make it incredibly attractive for U.S. bond investors to swap their U.S. dollars for foreign currencies and invest in foreign government bonds. In this week's report we explain why this is an attractive trade for U.S. investors and why it will likely remain so for quite some time. What Is The Basis Swap Spread? An excellent definition of the cross-currency basis comes from the Bank for International Settlements (BIS) who define it as "the difference between the direct dollar interest rate in the cash market and the implied dollar interest rate in the [currency] swap market".7 In essence, the existence of a negative basis swap spread should mean that there is an opportunity to arbitrage the difference between interest rates in the cash market and implied interest rates in the currency swap market. However, post-crisis regulatory constraints on bank balance sheets appear to have made this arbitrage prohibitive. Banks are either unable or unwilling to arbitrage the basis swap spread back to zero, and this increases the cost of U.S. dollars in FX swap markets. As a quick example, we can calculate the 10-year German Bund yield hedged into U.S. dollars using currency forwards. Hedged yield = Unhedged yield - Cost of hedging Where: Cost of hedging = forward exchange rate / spot exchange rate In this case, we define the exchange rates as euros per 1 U.S. dollar. By covered interest rate parity, we can also calculate the cost of hedging as: Cost of hedging = (1 + euro interest rate + basis swap spread) / (1 + USD interest rate) Using current 3-month interest rates, this means that the cost of hedging from euros into U.S. dollars is: Cost of hedging = (1 - 0.36% - 0.3%) / (1 + 1.18%) = -1.82% This means that the 10-year German Bund yield rises from 0.42% to 2.24%, from the perspective of a U.S. dollar investor, after hedging the currency on a 3-month horizon. In other words, U.S. investors can significantly increase the average yield of their portfolios by lending U.S. dollars over short time horizons and investing the proceeds into non-U.S. bonds. In Chart 8 we show the difference this currency hedging makes for German, Japanese and French 10-year government bonds. Current hedged 10-year yields for all the major bond markets are also shown on page 13 of this report. But for how long can this trade continue? In short, it can continue for as long as U.S. short-term interest rates increase relative to non-U.S. short-term interest rates and for as long as basis swap spreads move further into negative territory. At the moment there is no widespread agreement on what drives the day-to-day fluctuations in the basis swap spread. The BIS has posited a model where dollar strength weakens the capital positions of bank balance sheets, causing them to back away from providing liquidity to the FX swap market, and leading to increasingly negative basis swap spreads (Chart 9, top panel). Chart 8Higher Yields Via Currency Hedging Chart 9Basis Swaps, Reserves And The Dollar Meanwhile, Zoltan Pozsar from Credit Suisse has identified a link between basis swap spreads and reserves on the Fed's balance sheet (Chart 9, bottom panel).8 Specifically, as the Fed winds down its balance sheet it will be draining cash reserves from the banking system and replacing them with Treasury securities. This could cause money to leave the FX swap market and flow into Treasuries. The result is less liquidity in the FX swap market and increasingly negative basis swap spreads. Interestingly, the run-up to the debt ceiling in the U.S. has presented a test of this view. To stay under the debt ceiling the U.S. Treasury department has drawn down its cash account at the Fed and removed T-bill supply from the market. The result has been a temporary increase in reserve balances. As the theory would have predicted, basis swap spreads have moved closer to zero as reserves have increased. Going forward, the Fed is very likely to start winding down its balance sheet later this year. In all likelihood this will serve to pressure basis swap spreads even further below zero. Meanwhile, short-term interest rates in the U.S. will probably continue to rise more quickly than in most other developed markets. This means that the cost of hedging should become increasingly negative for U.S. investors. In Chart 10 we show that as the cost of hedging becomes more negative, total returns from a USD-hedged position in German bunds tend to outpace total returns from a position in U.S. Treasuries. Similarly, Chart 11 shows that USD-hedged Japanese government bonds (JGBs) also tend to outperform U.S. Treasuries when the cost of hedging falls. Chart 10Hedging Costs & Bond Returns: Germany Chart 11Hedging Costs & Bond Returns: Japan We should note that the relationships between hedging costs and relative total returns shown in Charts 10 & 11 are not perfect, and there will be instances when Treasuries can outperform even if hedging costs continue to decline. However, in the long run, as long as short-term U.S. interest rates continue to rise more quickly than short-term interest rates in the Eurozone or Japan, and especially if the Fed's upcoming balance sheet contraction leads to more deeply negative basis swap spreads, then U.S. investors should continue to boost their yields by lending dollars and investing in bunds and JGBs. Bottom Line: Declining hedging costs driven by interest rate differentials and negative basis swap spreads make international bond investment very attractive for U.S. investors. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Our U.S. Investment Strategy service took up the issue of residual seasonality in a recent report. Please see U.S. Investment Strategy Weekly Report, "Spring Snapback?", dated April 24, 207, available at usis.bcaresearch.com 2 IMF Staff Discussion Note, "Gone with the Headwinds: Global Productivity", https://www.imf.org/en/Publications/Staff-Discussion-Notes/Issues/2017/04/03/Gone-with-the-Headwinds-Global-Productivity-44758 3 Our outlook for the U.S. yield curve was discussed in detail in a recent report. Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report, "ECB: All About China?", dated April 7, 2017, available at fes.bcaresearch.com 5 IMF Multilateral Policy Issues Report: 2014 Spillover Report https://www.imf.org/external/np/pp/eng/2014/062514.pdf 6 Please see China Investment Strategy Weeky Report, "Has China's Cyclical Recovery Peaked?", dated May 5, 2017, available at cis.bcaresearch.com 7 http://www.bis.org/publ/work592.pdf 8 https://ftalphaville.ft.com/2017/04/13/2187317/where-would-you-prefer-your-balance-sheet-banks-or-the-federal-reserve/ Fixed Income Sector Performance Recommended Portfolio Specification

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