Global

Highlights Expanding trade volumes - led by EM growth - will continue to support commodity demand, particularly for base metals. In the first four months of this year, EM import growth averaged 8.4% year-on-year (yoy), led by an expansion of almost 13% in EM Asia. This compares with yoy growth averaging just 0.3% in the DM imports over the January - April period. EM exports grew 5.1% yoy in this interval vs. 2.7% for DM outbound trade. Overall, EM growth led world trade volumes 4% higher yoy, versus 0.8% growth over the January - April interval last year. We expect trade volumes to continue to grow as long as the Fed doesn't tighten monetary conditions too much in the U.S. Energy: Overweight. Benchmark crude oil prices continue their lackluster performance, as high-frequency inventory data in the U.S. fail to convince markets OPEC 2.0 cuts are succeeding in draining global inventories. We expect this to reverse, and remain long Dec/17 $50 vs. $55/bbl call spreads in WTI and Brent. Base Metals: Neutral. Expanded global trade, led by EM Asia, will be supportive of base metals prices. However, we do not expect higher trade volumes to prompt a surge in base metals. We remain neutral base metals generally. Precious Metals: Neutral. Palladium has consistently outperformed platinum in post-GFC markets, as has gold (see below). We remain neutral the precious-metals complex, but are keeping our long gold portfolio hedge in place. Ags/Softs: Underweight. The USDA's crop report will be released Friday. Weather-related crop distress in the grains could start showing up in the data. We remain bearish, but recommend staying on the sidelines. Feature Chart of the WeekStrong Growth In Global Trade Volumes##BR##Will Be Supportive Of Base Metals EM Trade Volumes Continue Trending Higher, Supporting Metals EM Trade Volumes Continue Trending Higher, Supporting Metals Growth in EM imports and exports continues to lead the expansion of global trade volumes. This is important, as the growth in trade supports EM income growth, which, in turn, supports commodity demand. EM growth is the principal source of commodity demand growth globally, particularly for oil and base metals. Global trade volumes expanded yoy in April, with imports up 3.7% and exports up 3.2%, down slightly from the pace in 1Q17, according to the CPB World Trade Monitor (Chart of the Week). The notional value of trade for the year ended in April was $16.3 trillion. The uptrend in global trade begun in 4Q16 continues, however, which we noted earlier this month. As was the case with oil, this expansion of global trade volumes, particularly out of the EM economies, will be supportive of base metals demand generally.1 Similar to EM oil demand, we find EM exports and imports are highly correlated with world base metals demand post-GFC (Chart 2). This is not unexpected, given the prominence of Chinese base metals demand, which accounts for roughly half of base metals demand globally. Given the low level of growth in DM imports and exports, we conclude that the bulk of the increase in global trading volumes is increasingly accounted for by trade within the EM economies with each other. This can be seen in Chart 3, which shows growth of EM imports and exports surpasses DM trade performance, shown in Chart 4. Chart 2World Base Metals Demand,##BR##Highly Correlated With EM Trade Volumes World Base Metals Demand, Highly Correlated With EM Trade Volumes World Base Metals Demand, Highly Correlated With EM Trade Volumes Chart 3Increased Trade Within##BR##EM Economies Powers Global Trade Growth Increased Trade Within EM Economies Powers Global Trade Growth Increased Trade Within EM Economies Powers Global Trade Growth Chart 4DM Growth Not##BR##Keeping Up With EM Growth DM Growth Not Keeping Up With EM Growth DM Growth Not Keeping Up With EM Growth Going Through The Trade Numbers For the year ended in April 2017, yoy world import levels grew 2.5% on average each month. DM imports averaged 1.8% yoy growth, while EM imports grew at twice that level. The notional value of DM imports was $9.6 trillion for the year ended in April. EM notional imports were $6.7 trillion, with EM Asia accounting for $4.7 trillion of this. For exports, world trade volumes grew at an average rate of 2.3% yoy each month for the 12 months ending in April, with DM growth coming in at 1.6%, and EM growth clocking in at 3.1% on average, just shy of double the rate of DM growth. The notional value of DM exports was $8.8 trillion for the year ended in April. EM notional exports were $7.4 trillion, with EM Asia responsible for $4.9 trillion of this. For April alone, DM imports were up 1.8% yoy, while EM imports were up 6.5%, down from a 9.1% average rate in 1Q17. DM exports in April were up 1.7% yoy, down from a 3% average rate in 1Q17, while EM exports rose 5%, equal to the 1Q17 average rate. Import volumes for EM Asia led global growth by a wide margin vs. other EM markets, particularly in Latin America and the Middle East (Chart 5). Average yoy import growth for the year ended in April was 6.6% for EM Asia, with yoy growth for April alone registering 10.4%. EM Asia also leads export volume growth (Chart 6), with average yoy outbound trade up 7.1% yoy. Chart 5EM Asia Dominates Import Growth YoY... EM Asia Dominates Import Growth YoY... EM Asia Dominates Import Growth YoY... Chart 6...And EM Export Growth ...And EM Export Growth ...And EM Export Growth As always, the evolution of China's economy will have an outsized influence on trade and EM growth. We continue to expect China's growth to moderate but not slow sharply, in line with our colleagues at our sister publication China Investment Strategy. The recent credit tightening likely will abate, given the central bank has reversed its credit contraction and injected liquidity into the interbank system in recent weeks, according to BCA's China Investment Strategy service.2 We agree with China Investment Strategy's assessment that, "The Chinese economy will likely continue to moderate, but the downside risk appears low at the moment and overall business activity will remain buoyant."3 Update On Global Inflation Vs. EM Trade Volumes World base metals demand is highly correlated with global consumer price inflation. In fact, these variables are cointegrated, meaning they share a common long-term trend. A 1% increase in world base metals demand can be expected to produce a 0.32% increase in U.S. CPI, a 0.25% increase in the Euro Area Harmonized CPI, and a 0.43% increase in China's CPI. Like the relationships between EM oil demand and EM trade volumes, which we presented earlier this month, the relationships between world base metal demand and EM trade volumes also allows us to track EM income levels. This is because the income elasticity of base metals demand also is ~ 1.0 for EM economies, according to the OECD, meaning a 1% increase in EM income can be expected to produce an increase in base metals demand of ~ 1%.4 Likewise, consumer inflation worldwide also is highly correlated with EM trade volumes post-GFC.5 In the regressions we ran for U.S., Euro Area and China CPI as a function of EM trade volumes, we find a 1% increase in EM imports can be expected to produce a 0.51% increase in the U.S. CPI, a 0.41% increase in the Euro Area harmonized CPI, and a 0.67% increase in the China CPI. A 1% increase in EM exports produces increases of 0.47%, 0.35% and 0.65%, respectively. These relationships can be seen in Charts 7, 8, and 9. Chart 7U.S. CPI Highly Correlated##BR##With EM Trade Volumes... U.S. CPI Highly Correlated With EM Trade Volumes... U.S. CPI Highly Correlated With EM Trade Volumes... Chart 8...Along With The Euro Area##BR##Harmonized CPI... ...Along With The EMU Harmonized CPI... ...Along With The EMU Harmonized CPI... Chart 9...And##BR##China's CPI ...And China's CPI ...And China's CPI Bottom Line: World base metals demand will continue to be supported by continued growth in EM trade volumes this year. While these volumes are up nicely, the rate of growth is moderating somewhat, suggesting global base metals demand will hold up this year, but won't surge ahead. We certainly do not see base metals prices falling precipitously this year, given the growth in EM imports and exports, which started to revive toward the end of last year. We remain neutral base metals, but will be watching the interplay between base metals demand and EM trade volumes for any sign global demand is being re-ignited. Inflation appears to be quiescent globally, but we would expect it to start ticking up if we see an uptick in base metals demand and EM trade volumes. Precious Metals Update PGM Notes Price relationships within the precious-metals complex, particularly vis-à-vis Platinum Group Metals (PGMs), have undergone profound transformations since the end of the Global Financial Crisis (GFC). These changes have been bolstered by technology shifts in the automotive sector as well. Two trading relationships - palladium's relationship to platinum, and platinum's relationship to gold - best illustrate these changing fundamentals. Unlike gold and platinum prices, palladium is heavily influenced by automotive sales, in this case, gasoline-powered automobile sales. Gasoline-powered cars use palladium in their pollution-control catalysts. Such usage was up 5% last year to 7.4mm oz, according to Thomson Reuters GMFS data.6 Autocatalyst demand accounts for slightly more than three-quarters of palladium demand, according to GFMS data.7 Importantly, the two largest car markets in the world - the U.S. and China - are predominantly gasoline-powered, and sales in both have been strong, although the rate of growth has slowed (Chart 10). This is supportive of palladium prices, particularly as the metal registered a 1.2mm physical deficit last year. There is an increase in Chinese platinum-based auto catalyst demand for diesel cars, due to tightening regulation on emissions, but still is a small share of the total demand for platinum. Post-GFC, the value of palladium relative to platinum has consistently strengthened (Chart 11). Chart 10U.S. Sales Growth Down,##BR##But China Remains Strong U.S. Sales Growth Down, But China Remains Strong U.S. Sales Growth Down, But China Remains Strong Chart 11Platinum Eclipsed By##BR##Palladium And Gold Platinum Eclipsed By Palladium And Gold Platinum Eclipsed By Palladium And Gold Platinum's Discount To Gold Endures Platinum traded premium to gold until the GFC (Chart 11). Since then, gold has behaved more like a currency, with its price mostly dependent on financial variables (USD, real U.S. interest rates, and equity risk premium). Importantly, the yellow metal has traded premium to platinum since the GFC ended. While platinum prices are somewhat sensitive to the same financial factors as gold, and also can be modeled as a function of these financial variables, the metal also has a real-demand driver: diesel-powered car sales. These vehicles use platinum in their pollution-control catalysts. Autocatalysts accounted for 3.3mm oz of platinum sales last year, or 42% of demand, according to Thomson Reuters GFMS. Most of this goes to diesel catalysts, which are mainly sold in Europe. Diesel-powered car sales have been trending lower (Chart 12) in Europe, where they are the dominant type of car sold. The second largest demand segment for platinum is jewelry sales, which fell 12% last year to 2.2mm oz, following a 3.6% decline the prior year. Both gold and platinum will be responsive to the same set of financial variables, meaning a stronger USD along with higher real rates will be bearish for both, and vice versa. However, given platinum is also sensitive to the diesel-powered auto market, its price evolution has a component strongly influenced by physical platinum demand and supply. Supply comes from mines and recycling, which increases when steel prices rise. Sales of diesel-powered cars are falling in Europe partly due to the Volkswagen emissions-testing scandal and a longer-lasting trend of cities attempting to lower pollution by restricting where diesel-powered vehicles can drive (e.g., Athens, Madrid, Paris and Mexico City are eliminating diesel traffic by 2025).8 In addition, high steel prices will increase platinum recycling volumes this year (people scrap their cars more when steel prices are high). High steel prices also incentivize the scraping of gasoline-powered vehicles, which use palladium in their pollution-control catalysts. Platinum competes at the margin in the pollution-control catalyst market with palladium. The ratio between palladium and platinum is at its highest level since 2002 (Chart 11). The premium of platinum against palladium (platinum minus palladium) went from $1200/oz. in 2010 to close to parity recently (Chart 13). Chart 12EU Sales Still Growing,##BR##But Diesel Loses Share EU Sales Still Growing, But Diesel Loses Share EU Sales Still Growing, But Diesel Loses Share Chart 13Platinum's Premium To##BR##Palladium Disappears Platinum's Premium To Palladium Disappears Platinum's Premium To Palladium Disappears Continue To Favor Palladium We are more favorably disposed toward palladium than platinum. Given palladium's price is dominated by sales of gasoline-powered cars, which should, all else equal, do well relative to diesel-powered auto sales, even with a globally synchronized economic upturn. With the U.S. Fed expected to continue tightening, gold and platinum will face financial headwinds that will restrain price appreciation. Palladium, on the other hand, will be less sensitive to these headwinds, although higher interest rates in the U.S. relative to the rest of the world will restrain demand for goods purchased on credit like autos. While we remain neutral the precious metals complex generally, we recently recommended a long spot-gold position as a portfolio hedge against rising inflation and inflation expectations.9 Even though inflation has remained quiescent, and markets are trading as if the odds of a return of inflation are extremely low, BCA's Global Investment Strategy argues "the combination of faster growth and dwindling spare capacity will cause inflation to rise. This is particularly the case for the U.S., where the economy has already reached full employment."10 We believe the strengthening of household incomes resulting from the tight U.S. labor market likely will keep the Fed on track to continue with its rates-normalization policy, vs. market expectations of a mere 21 basis points in cumulative Fed rate hikes over the next 12 months. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Strong EM Trade Volumes Will Support Oil," published June 8, 2017, available at ces.bcaresearch.com. The CPB World Trade Monitor is published monthly by the CPB Netherlands Bureau for Economic Policy Analysis. Please see https://www.cpb.nl/en/worldtrademonitor for data and documentation. We use CPB's volumetric data for imports and exports in our analysis, which are indexed to 2010 = 100; we converted these data to USD values to see how the composition of imports and exports is changing so as to better see how the relative shares of EM and DM are evolving. 2 Please see BCA Research's China Investment Strategy Weekly Report "Chinese Financial Tightening: Passing The Phase Of Maximum Strength," published by on June 22, 2017, available at cis.bcaresearch.com. 3 Please see BCA Research's China Investment Strategy Weekly Report "A Chinese Slowdown: How Much Downside," published on June 8, 2017, available at cis.bcaresearch.com. 4 As we noted in our research earlier this month, the read-through on this is EM trade volumes are closely tied to income levels, given this income elasticity in non-OECD economies. Please see "The Price of Oil - Will It Start Rising Again?" OECD Economics Department Working Paper No. 1031, p. 6 (2013). In our modeling, we assume the GFC ended in 2010. Our oil results vis-à-vis EM income elasticities can be found in BCA Research's Commodity & Energy Strategy Weekly Report "Strong EM Trade Volumes Will Support Oil," published June 8, 2017, available at ces.bcaresearch.com. 5 We originally published these results for EM oil demand vs. EM trade volumes in the June 8, 2017 article referenced above in footnote 1, in BCA Research's Commodity & Energy Strategy Weekly Report "Strong EM Trade Volumes Will Support Oil," available at ces.bcaresearch.com. The average R2 coefficient of determination for the regressions on imports was 0.89, while the average for the regressions on exports was 0.89. 6 Palladium supply totalled 8.6mm oz, while demand came in at 9.8mm oz, according to the Thomson Reuters - GFMS Platinum Group Metals Survey 2017. 7 In our modelling, we treat palladium as an industrial metal, given the overwhelming influence auto demand - particularly gasoline-powered vehicles - has on its price. Please see BCA Research's Commodity & Energy Strategy Weekly Report "2016 Commodity Outlook: Precious Metals," published by December 3, 2015, available at ces.bcaresearch.com. 8 A number of cities are looking to ban diesel cars entirely from their central districts. Please see https://www.theguardian.com/environment/2016/dec/02/four-of-worlds-biggest-cities-to-ban-diesel-cars-from-their-centres. 9 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Go Long Gold As A Strategic Portfolio Hedge," published May 4, 2017, available at ces.bcaresearch.com. 10 Please see BCA Research's Global Investment Strategy Weekly Report "Stocks Are From Mars, Bonds Are From Venus?," published June 23, 2017, available at gis.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016 EM Trade Volumes Continue Trending Higher, Supporting Metals EM Trade Volumes Continue Trending Higher, Supporting Metals

Our new Revealed Preference Indicator (RPI) is the latest installment in our ongoing research into trading rules that can augment our top-down macro approach to asset allocation. The RPI borrows from Paul Samuelson's "revealed preference" theory of consumer behavior to market behavior. It combines the idea of market momentum with valuation and the monetary policy backdrop. A trading rule for the stock/bond allocation based on the RPI outperforms traditional technical, monetary, and valuation indicators. It provides a powerful bullish signal if positive equity market momentum lines up with positive signals from policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. This model adds value on its own, but we feel that it is best used in conjunction with other indicators designed to improve performance around major market turning points. Future research will experiment with combining the RPI with other indicators to further enhance performance. In the meantime, we will present the RPI's signals each month in Section III of the monthly publication. As with all indicators and models, however, the RPI is only one input to our decision process. We base our asset allocation decision on a combination of indicators, macro themes, detailed data analysis and judgment. In 1938, economist Paul Samuelson published a paper entitled, "A Note on the Pure Theory of Consumer's Behavior," in which he outlined an alternative to the well-known economic principle, utility theory. He dubbed his work "revealed preference theory."1 His goal was to redefine utility - a measure of consumer satisfaction with a good or service - by observing behavior. He posited that when consumers reveal their preferences by buying one item rather than another, they reveal the way in which they maximize happiness or satisfaction. For instance, one can measure preferences via experiments in which a subject is given $200 and the choice between two brands of shoes at different prices. Repeating the exercise at different levels of income and relative prices generates "preference axioms." Samuelson's theory has many more layers of complexity, but this Special Report focuses on modelling investors' preferences through observed behavior. Borrowing from Samuelson's reasoning, we developed a methodology to identify investors' axioms of preference for equities and bonds at different levels of incomes and prices. Then we compared investors' real actions with those anticipated by our methodology. This allowed us to generalize our findings and analyze the effects on a portfolio of equities and bonds. The main finding of our statistical exercise is that asset allocators can profit from understanding how short-term moves are linked to the market's revealed preferences at different times during the economic cycle. We then use the results to construct an indicator and a trading rule that not only outperforms a buy-and-hold strategy by a wide margin, it outperforms other traditional trading rules as well. Building A Revealed Preference Model Our primary objective in constructing a revealed preference indicator (RPI) is to understand: (1) how market preferences shape the behavior of investors; and (2) how they ultimately affect future returns. To do so, we broke down our analysis into three key areas: Part I identifies market preferences for different levels of income and price in the economy. Part II defines a general investment strategy that utilizes historic preferences and short-term market movements as a market timing tool. Part III optimizes the RPI and compares its historical track record with a buy-and-hold asset allocation and trading rules based on other indicators. Part I - Developing The Framework The first step in building the RPI is to establish the proper control variables. We limited our basket of investable "goods" to U.S. equities and 10-year Treasurys. We also need a variable that is analogous to the income measure that Samuelson used in his study. For the choice facing investors who are deciding between buying two financial assets, we believe that a measure of market "liquidity" is more appropriate than income. By this we do not mean the ease by which financial assets can be bought and sold. Rather, it is "funding liquidity", or how easily it is to borrow to invest. BCA often uses the four phases of the Fed cycle, as interest rates fluctuate around the equilibrium level, as a measure of funding liquidity (Chart II-1):2 Chart II-1Fed Funds Rate As A Proxy For Income Fed Funds Rate As A Proxy For Income Fed Funds Rate As A Proxy For Income Phase I = Policy is accommodative but the fed funds rate is rising. Phase II = Policy is tight and the Fed is still tightening. Phase III = Policy is tight but the Fed is cutting rates. Phase IV = Policy is easy and the Fed is cutting rates. The rationale for using the fed funds-rate cycle as a proxy for income is that, when interest rates are below equilibrium, monetary conditions are accommodative. Leverage is easy to obtain because there is plenty of liquidity (income) to fund investments. When conditions are tight, funding liquidity is relatively scarce. To measure relative prices, we first divided the S&P 500 price index by its 12-month moving average and second, we took the inverse of the 10-year Treasury yield divided by 12-month moving average.3 We then used the ratio of these two deviations-from-trend to construct a relative price measure (Chart II-2). This ratio provides a single measure of how expensive stocks and bonds are, not only to each other, but to their own history as well. We then grouped the relative price data into four sets of percentiles, or buckets, shown in Table II-1. Stocks are expensive and bonds cheap at the top of the table, while the reverse is true at the bottom. Chart II-2Constructing A Single Price Measure For Equities And Bonds Constructing A Single Price Measure For Equities And Bonds Constructing A Single Price Measure For Equities And Bonds Table II-1Distribution Of Relative Price July 2017 July 2017 Table II-2A presents the average historical monthly percent change in stock prices for each combination of the four relative price and liquidity buckets over the entire dataset. In the fourth phase of the Fed cycle (when monetary conditions are easy and the Fed is still cutting interest rates), and when relative prices are in the first bucket (i.e. stocks are expensive), the average stock price increase during the month was slightly above 1% percent. Table II-2B provides the same breakdown for the average change in bond yields (shown in basis points, not returns). Tables II-2A and II-2B are recalculated at each point in time - meaning that we used an expanding sample to calculate the price buckets, and updated the results for the ensuing price or yield movements as new data are added. That way, we completely avoid the advantage of hindsight. To simplify our methodology, we coded the results to end up with the stock and bond returns for the 16 different combinations of Fed and relative price buckets. Table II-3 uses the results from Tables II-2A and II-2B in the last period of history as an example. The "Liquidity" and "Price" columns indicate the bucket (e.g. price in bucket 1 and liquidity in bucket 1). The "Stocks" and "Bonds" columns are coded as "1" if the asset appreciated during the month given the indicated liquidity/price bucket, and a "0" if it depreciated that month. Table II-2AEquity Market Reactions At Given Levels Of Price And Liquidity July 2017 July 2017 Table II-2BTreasury Market Reactions At Given Levels Of Price And Liquidity July 2017 July 2017 Chart II-3Revealing What Investors Prefer July 2017 July 2017 Part II - Habits Create Expectations It is important to keep in mind that the objective of our revealed preference model is not to use the revealed market preferences as forecasts but rather to examine what happens when investors decide to follow or ignore them. Our hypothesis in building this model is that, when investors go against their historical preferences, the result should be interpreted as short-term noise. It is only when preferences and (subsequent) short-term market moves are aligned that we should heed the signal and invest accordingly. Table II-3 can be thought of as the market's revealed preference. Again, keep in mind that we allowed revealed preferences to change over time by recalculating it under our stretching-sample approach. The following steps detail how we used investor preferences to create a trading rule that verifies our hypothesis empirically: Step 1 - Expected vs. Actual: The first step is to examine how actual equity prices and bond yields behaved relative to their expected trajectory. We created two variables - one for equities and one for bonds. If revealed preference last month (t-1) suggested that the asset's return should be positive in the subsequent month (t), and it indeed turned out to be positive in period t, then we coded month t as "1." If both the revealed preference and the actual outcome were negative, we coded it as "-1." If they did not match, the code is "0" (in other words, the market did not follow the typical historical revealed preference). Thus we have two time series, one for bonds and one for stocks, which are made up of 1s, -1s and zeros. Step 2 - Bullish, Bearish, and Neutral: We combined the coded series for stocks and bonds to encompass the nine possible outcomes in our model (i.e. both bonds and stocks can have a value in any month of 1, 0 or -1, providing 9 different combinations). Table II-4 presents the nine outcomes along with the asset allocation that would have maximized investor returns based on our historical analysis. For example, investors were paid to be overweight equities when equities and bonds have a code of "1" and "-1," respectively (top row in Table II-4). In other words, stocks tended to outperform bonds when revealed preferences from the month before predicted rising stock prices and rising bond yields, and these predictions were confirmed. Table II-4Understanding The Signals From Preferences July 2017 July 2017 If revealed preference is not confirmed for both bonds and stocks, then it is best for investors to stand aside with a benchmark allocation. Step 3 - "If It Don't Make Dollars, It Don't Make Sense": To test whether our theory would add strategic value, we computed a trading rule to see how well it performed against a benchmark portfolio of 50% equities and 50% Treasurys. The trading rule was computed as follows: when the revealed preference for equities is positive (at time t-1) and this signal is confirmed in t, then in t+1 we allocate 100% to the S&P 500 and 0% to Treasurys. When the revealed equity preference signal is correctly bearish, we removed all exposure to equities and allocated 100% to Treasurys. When the signal was neutral, we kept a benchmark allocation of 50% equities and 50% Treasurys. Chart II-3 shows that this trading rule outperforms the benchmark, confirming our initial hypothesis - one should fade the short-term movements when investors go against their preferences, and only follow the signals when those movements align with historical preferences. History shows that investors tend to underperform in terms of the stock/bond allocation when they deviate from their revealed preference. Chart II-3Correctly Gauging How Investors Behave Pays Off Correctly Gauging How Investors Behave Pays Off Correctly Gauging How Investors Behave Pays Off Part III - Validating The Results One drawback is that this trading rule would require frequent portfolio allocation changes every month, as shown in Chart II-4. As such, we constructed a smoothed version by imposing the rule that asset allocation is unchanged unless the model provides a new signal for two months in a row (Chart II-5).4 These restrictions not only dramatically reduced the frequency of the asset allocation adjustments, but it also augmented historical cumulative excess returns (Chart II-6). Chart II-4Revealed Preference Indicator Is Inherently Volatile Revealed Preference Indicator Is Inherently Volatile Revealed Preference Indicator Is Inherently Volatile Chart II-5Removing Some Of The Noise Removing Some Of The Noise Removing Some Of The Noise Any new indicator of course must be able to outperform a buy-and-hold strategy to be useful but it is also interesting to see how its performance ranks compared to a set of random portfolios. This way, we can identify if the indicator truly provides additional information. Random portfolios are generated using a monthly allocations of 100% or 0% to equities, with the remainder in Treasurys. Chart II-7 shows the performance of the smoothed indicator versus a set of 1,000 randomly generated portfolios. Chart II-6Once Smoothed, The RPI Truly Shines Once Smoothed, The RPI Truly Shines Once Smoothed, The RPI Truly Shines Chart II-7The RPI Adds A Significant Amount Of Information The RPI Adds A Significant Amount Of Information The RPI Adds A Significant Amount Of Information We compared the indicator's trading rule to simple moving averages or BCA's other indicators. We also wanted to ensure that the RPI adds value beyond investing based strictly on the four phases of the liquidity cycle or based on relative value alone. We therefore compared the track record of the RPI trading rule to rules that are based on: (1) the deviation of the S&P 500 from its 12-month moving trend; (2) BCA's monetary conditions indicator; (3) BCA's valuation indicator; (4) BCA's technical indicator; (5) the four phases of the Fed cycle; and (6) the relative price index. Charts II-8A and II-8B highlights that RPI indeed impressively dominates the other trading rules. The one exception is that, during the Great Recession, the model's performance fell to roughly match the performance of a S&P 500 technical trading rule. Chart II-8AThe RPI Outperforms The Sum Of Its Parts... July 2017 July 2017 Chart II-8B...As Well As Other Indicators July 2017 July 2017 Part IV - Conclusions The RPI is the latest installment in our ongoing research into trading rules that can augment our top-down macro approach to asset allocation. Quite simply, it combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. This model adds value on its own, but we feel that it will best be used in conjunction with other indicators designed to improve performance around major market turning points. Future research will experiment with combining the RPI with other indicators to further enhance performance. In the meantime, we will present the RPI's signals each month in Section III of the monthly publication. As with all indicators and models, however, the RPI is only one input to our decision process. We base our asset allocation decision on a combination of indicators, macro themes, detailed data analysis and judgment. The indicator's current reading for stocks versus bonds, at benchmark, is more conservative than our official recommendation. The benchmark reading reflects the fact that equities are overvalued and that investors have deviated from their preferences in their past two quarters. David Boucher Associate Vice President Quantitative Strategist 1 For more information, please see P. A. Samuelson, "A Note on the Pure Theory of Consumer's Behavior," Economica 5:17 (1938), pp. 61-71. 2 Please see U.S. Investment Strategy Special Report "Stocks And The Fed Funds Rate Cycle," dated December 23, 2013, available at usis.bcaresearch.com 3 We tested a few other measures, most notably the stock-to-bond total return ratio (measured by comparing each asset's total returns), but the chosen measures provided the best and most robust results. 4 We conducted a statistical exercise to validate and optimize the allocations in Table 4 to provide a smoother performance.

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

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

Highlights Risk Budgeting: We are introducing a more formal risk measurement element to our model global bond portfolio. This is to identify if our individual views are potentially creating too much volatility, in aggregate, but also as a way to express the conviction of our individual recommendations through allocation of a "risk budget". Tracking Error Of Our Portfolio: We are setting our maximum allowable tracking error, or excess volatility of our portfolio versus our benchmark index, at 100 basis points. Our current tracking error is just under ½ of that limit. We estimate that our highest conviction views at the moment - staying below-benchmark on duration risk, overweighting U.S. corporates, underweighting both U.S. Treasuries and Italian government debt - contribute nearly 4/5ths of our overall portfolio tracking error. Feature Last September, we introduced a model portfolio framework to Global Fixed Income Strategy.1 This was done to better communicate our investment research into actionable ideas more in line with the day-to-day decisions and trade-offs made by professional bond managers. We followed that up with the addition of performance measurement tools to more accurately track the returns of our model bond portfolio versus a stated benchmark.2 We are now initiating the final piece of our model bond portfolio framework in this Special Report - introducing a risk management component to identify cumulative exposures and guide the relative sizes of our suggested tilts. Our goal is to translate our individual investment recommendations into the language of a "risk budget", i.e. how much of the desired volatility of the portfolio would we suggest placing into any single trade idea. This will allow our readers to apply our proposed tilts - based on how much conviction (i.e. "risk") we allocate to each position - to their own portfolios which may have different risk limits and return expectations. For example, our current recommendation to overweight U.S. corporate debt, both Investment Grade (IG) and High-Yield (HY) represents nearly 1/3 of our estimated total portfolio risk, by far our largest source of potential volatility both in absolute terms and versus our benchmark index (Table 1). Overweighting U.S. corporates, both versus U.S. Treasuries and Euro Area equivalents, is one of our highest conviction trades at the moment. A client who may choose to run a lower risk portfolio can still follow our recommendation by placing enough into U.S. corporates so that 33% of the desired portfolio volatility will come from those positions. Table 1Risk Allocation In Our Model Bond Portfolio Adding A Risk Management Framework To Our Model Bond Portfolio Adding A Risk Management Framework To Our Model Bond Portfolio In the rest of this Special Report, we will discuss some of the various ways to measure fixed income portfolio risk, apply them to our model portfolio, and introduce some measures to monitor our aggregate portfolio volatility. Going forward, we will closely watch our established metrics and position sizes to ensure that the combination of our individual investment recommendations that we discuss on a week-to-week basis does not create a portfolio that is potentially more volatile than desired. Risk Measurement In Fixed Income Portfolios While investors are typically focused on meeting return targets for their portfolios, the other side of the equation - managing portfolio volatility - is often less stressed. This is especially true during bull markets for any asset class. Investors may become complacent if returns meet or exceed their targets when, in fact, excess returns may have actually been earned through overly risky positions that could have easily not worked in the investors' favor. In the current macro environment, where many financial asset prices are at new highs with stretched valuations and with most of the major global central banks incrementally moving towards less accommodative monetary policy stances, risk management should be even more important for investors. Overly concentrated positioning could now lead to considerable portfolio losses, especially if measuring risk with a metric that is flawed or incomplete, which can lead to a false sense of security. With that in mind, we consider some typical risk measurement metrics used by fixed income investors: Duration: Duration is usually the most popular risk metric for fixed income portfolios as it measures interest rate sensitivity. Duration is defined as the percentage change in a portfolio or asset resulting from a one percentage point change in interest rates. While it provides a solid base understanding of interest rate risk, it does make a simplifying assumption that there is a linear relationship between interest rates and bond prices. Value-At-Risk: Value-At-Risk (VaR) is a statistical technique that measures the loss of an investment, or of an entire portfolio, over a certain period with a given level of confidence. However, there are two considerable flaws with this approach. First, the VaR output suggests a portfolio can lose at least X%, it does not actually indicate how big the potential loss could be. Instead, using a measure such as Historical VaR, if a portfolio has a long enough track record, can better quantify potential losses. Second, VaR is highly susceptible to estimation errors. Certain assumptions on correlations and the normality of return distributions can have a substantial impact on VaR readings. Table 2Value At Risk Of Our Benchmark Adding A Risk Management Framework To Our Model Bond Portfolio Adding A Risk Management Framework To Our Model Bond Portfolio In Table 2, we show the Historical VaR (HVAR) of our benchmark index, calculating the potential monthly loss using data going back to 2005. On that basis, the worst expected monthly loss for our benchmark is -1.6% (using a 95% confidence interval) and -2.1% (using a 99% confidence interval). Tracking Error: Tracking error measures the volatility of excess returns relative to a certain benchmark. It is a standard risk measure used by a typical "real money" bond manager with a benchmark performance index, like a mutual fund. Tracking error does not offer information on alpha generation (i.e. how much you can expect to beat your benchmark based on your current investments), it simply indicates how much more volatile a portfolio is expected to be versus its benchmark. As our model portfolio returns are measured on a relative basis to our stated bond benchmark index, tracking error is quite appropriate as our main risk metric. A Historical Examination Of Our Portfolio When we first created our model portfolio, we also introduced a benchmark index against which we could measure our performance. Our customized benchmark differs from typical multi-sector measures like the Barclays Global Aggregate Index in that it has a broader scope, including sectors that can have credit ratings below investment grade such as High Yield corporates. The benchmark does, however, exclude smaller regions that we only occasionally discuss such as Sweden, Portugal, Norway and New Zealand. These smaller markets offer comparatively poor liquidity and we want our benchmark to be as investible as possible. Nevertheless, our customized benchmark has been highly correlated to the Barclays Global Aggregate Index over the past decade. As our portfolio has not had a full year of return data, its history is quite limited. Still, in our first performance review conducted two months ago, we indicated that our portfolio had been very closely tracking our customized benchmark. We have since increased our positions in our highest conviction views and our tracking error has risen noticeably and now sits at just over 40bps (Chart 1). Within our model portfolio, we are setting an expected excess return target of 100bps per year. That means that we are setting a goal of beating our benchmark index returns by one full percentage point per year. Given that we are measuring our performance versus currency-hedged benchmarks that are primarily rated investment grade or better, 100bps of annual excess return is a reasonable target. We are also setting a limit where the excess return/tracking error ratio should aim to be equal to 1 each year. This is under the simple assumption that we want an equal amount of return over our benchmark for our expected excess volatility versus our benchmark. On that basis, we are setting our tracking error "limit" at 100bps per year. That suggests that our current tracking error is relatively low. However, correlations between the individual components of our benchmark index have been rising over the past couple of years (Chart 2). Therefore, running a relatively low overall level of risk at a time where diversification among the positions within our portfolio is now harder to achieve, and when the valuations on most government bond and credit markets look rich, is prudent. Chart 1Higher Tracking Error, But Still Well Below Our Target Higher Tracking Error, But Still Well Below Our Target Higher Tracking Error, But Still Well Below Our Target Chart 2Correlations Across Fixed Income Sectors Have Been Rising Correlations Across Fixed Income Sectors Have Been Rising Correlations Across Fixed Income Sectors Have Been Rising This is another way that we can control the overall riskiness of our model portfolio. Not only by how much of our risk budget (tracking error) that we want to allocate to each of our recommended positions, but also how big of a risk budget do we want to run at any given point in time. If we see more assets trading at cheap valuations, then we could choose to run a higher tracking error than when most assets look expensive. Bottom Line: We are introducing a more formal risk measurement element to our model global bond portfolio. This is to identify if our individual views are potentially creating too much volatility, in aggregate, but also as a way to express the conviction of our individual recommendations through allocation of a "risk budget". We are setting our maximum allowable tracking error, or excess volatility of our portfolio versus our benchmark index, at 100 basis points. Measuring The Contribution To Risk From Our Market Tilts In our model portfolio, we include a wide range of geographies and sectors from the global fixed income universe. Understanding the risk contribution of each position to the overall portfolio provides a clearer picture as to where our potential risks lie, and by how much. To measure the risk contribution of each of our individual recommendations to our overall portfolio volatility, we used the following formula: wA * E CovAB * wB Where W = the weight of any single asset in our portfolio and COV is the covariance between the asset and other assets in the portfolio. As such, an asset's contribution to risk is a function of its weight in the portfolio and its covariance with the other assets. Importantly, since we are measuring our model portfolio performance in terms of excess returns, we examined each position's contribution to risk relative to the benchmark. All calculations begin in late 2005, when return data is available for all of the assets in our portfolio. The results are summarized in Table 1 on Page 1. Our portfolio tilts are based off of our four highest conviction themes. They include: Stronger global growth led by the U.S. The U.S. economy should expand at a faster pace in the latter half of the year on the back of a rebound in consumption and strong capital spending, all supported by solid income growth and easy financial conditions. We have expressed this theme through our overweight allocation to U.S. corporate debt. While our U.S. Corporate Health Monitor is flashing that balance sheets are becoming increasingly strained, easy monetary conditions and an expansionary economic backdrop should continue to support excess returns for U.S. corporates. More Fed rate hikes than expected. We expect U.S. economic and corporate profit growth to remain robust due to accommodative monetary conditions, diminishing slack and resilient consumption. As such, the Fed will continue tightening policy by more than what markets are currently pricing in. This theme is expressed through an underweight position in U.S. Treasuries, which accounts for 17% of our volatility versus 24% for that of the benchmark. This wide spread relative to the benchmark is a substantial source of our tracking error, but one that we are comfortable running given our view that U.S. Treasury yields are too low. Chart 3Realized Bond Volatility Has Been Declining Realized Bond Volatility Has Been Declining Realized Bond Volatility Has Been Declining Rising tapering risks in Europe. Our expectation is that the European Central Bank (ECB) will be forced to announce a slower pace (tapering) of bond buying starting next year, given the current robust economic expansion in Europe that is rapidly absorbing spare capacity. An ECB taper announcement is expected to lead to rising longer-term global bond yields, mostly via rising term premia. We are expressing that view in our portfolio through our overall underweight interest rate duration stance. Our current portfolio duration is 5.6 years versus our benchmark duration of 7.0 years. That is a large tilt that represents a significant portion of our tracking error, but given our view that U.S. Treasuries also look overvalued, running a large overall duration underweight does correlate to our conviction level. Rising geopolitical risks and banking sector issues in Italy. Geopolitical risks remain elevated leading up to parliamentary elections in 2018, and Italian banks remain undercapitalized with non-performing loans still in an uptrend. Therefore, we are underweight Italian debt, though this is a smaller deviation of portfolio risk versus our benchmark (around 2%), given the smaller size of Italy in our benchmark. Purely looking at geography and sector selection, our four highest conviction views make up almost 80% of the active portfolio risk that we are "running" in our model portfolio. That number may seem high but, as described earlier, our realized portfolio volatility has been quite low (Chart 3). That suggests that there could be some degree of underlying diversification within our recommended portfolio given lower correlations of certain assets to the rest of the portfolio. This is a topic that we will investigate more deeply in future Weekly Reports. Bottom Line: We estimate that our highest conviction views at the moment - staying below-benchmark on duration risk, overweighting U.S. corporates, underweighting both U.S. Treasuries and Italian government debt - contribute nearly 4/5ths of our overall portfolio tracking error. Patrick Trinh, Associate Editor Patrick@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Special Report, "Introducing Our Recommended Global Fixed Income Portfolio", dated September 20 2016, available at gfis.bcaresearch.com 2 Please see BCA Global Fixed Income Strategy Special Report, "An Initial Look At The Performance Of Our Model Bond Portfolio", dated April 18 2017, available at gfis.bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Table 4 Adding A Risk Management Framework To Our Model Bond Portfolio Adding A Risk Management Framework To Our Model Bond Portfolio

Highlights Investors have soured on hedge funds, withdrawing US$ 70 billion net last year. This is unsurprising because hedge funds have greatly underperformed global equities since the Global Financial Crisis, and have struggled to achieve a return of even cash plus 4% because of low volatility and high cross-asset correlation. But hedge funds still have a place in a balanced multi-asset portfolio. They have a good track record of outperforming equities in recessions. We favor macro funds as a recession hedge. This strategy has outperformed even bonds in the past three recessions, and is the only hedge fund class with positive skew and low kurtosis. Outside of a recession, we favor event-driven funds for their lower-beta equity exposure and idiosyncratic return profile. Feature Chart 1 The hedge fund industry has received a considerable amount of bad press over the past couple of years due to its poor performance and high fees. Since 2010, the average annual return from hedge funds has been just 4%, while global equities have returned almost 9% a year. Fees have been trimmed back from the traditional 2/20, but still average 1.5% of assets and 17% of performance.1 As a result, investors last year withdrew a net US$ 70.1 billion from hedge funds, the first year ever of net withdrawals, apart from the Global Financial Crisis years of 2008-9 (Feature Chart). According to a survey by Preqin, 84%2 of investors cited unfavorable terms and conditions as the reason for withdrawing their money. But are investors right to have turned sour on hedge funds? Does the asset class no longer have a place in a diversified multi-asset portfolio? Can hedge funds still provide a useful hedge against the sharp drawdown in risk assets likely in the next recession? As so often, the general picture obscures the details. Hedge funds invest using wildly different strategies. In this report, we analyze the historical risk and return characteristics of different categories of hedge funds, and test their resilience during historical recessions and equity bear markets. We also examine the characteristics of each main hedge fund strategy individually, and asses its usefulness in asset allocation. Our conclusions are that, in general, hedge funds represent an expensive way to generate a return that in recent times has failed to beat a target of cash plus 4%. Hedge funds suffer from style drift (tending to take on increasing risk as an equity bull market continues), and therefore do not always provide acceptable returns in downturns. Moreover, manager selection is difficult, especially for smaller funds without the manpower or expertise to handle it well. However, we find that: Event-driven funds (for example, activist and M&A arbitrage strategies) do have a good long-term track record of generating alpha; Macro funds have historically provided attractive downside protection in recessions. Investors, therefore, should not abandon their allocations in hedge funds. In a world where valuations for most asset classes (equities, bonds, private equity, real estate etc.) are stretched, and where the probability of a global recession in the next two to three years is relatively high, a thoughtful and well-scaled investment in hedge funds still makes sense. A note on the data we used in this report. All the hedge fund returns are based on the equally-weighted monthly indices (HFRI)3 produced by Hedge Fund Research, Inc. Funds included in these indices must (1) report returns net of all fees, and (2) have at least $50 million under management or have been actively trading for at least 12 months. HFR makes significant efforts to avoid survivor bias. When a fund is removed from the index, the performance remains in the index until the point of liquidation or when the manager requests removal from the database. HFR makes stringent efforts to receive data of a fund's performance right up until the point of liquidation. Likewise, when a new fund is added to the index, its performance up to that date does not affect the historical performance of the index. Finally, if a non-liquidated fund does not report to the HFR database for three consecutive months, the fund is subject to removal from the HFRI, but its historical data remains. Analyzing Historical Returns Hedge funds have produced an impressive return of 10.1% a year since 1990, when reliable data starts. This compares to 6.9% for global equities and 6.2% for global bonds over the same period (Table 1). But all of this outperformance came before 2010. Over the past seven years, hedge funds have returned only 4% a year, compared to 8.5% for equities and 3.8% for bonds. Table 1Risk And Return Analysis Hedge Funds: Still Worth Investing In? Hedge Funds: Still Worth Investing In? There has clearly been a structural decline in hedge fund returns over time. Each five-year period since 1990 has seen a lower return than the previous five years, and the trend decline in returns is seen across all the major categories of hedge fund strategy (Table 2 and Chart 2). This is probably because the rapid growth in the hedge fund industry caused arbitrage opportunities to dry up and because, as individual funds got larger, they had less flexibility to invest. Table 2Risk And Return Analysis - By Period Hedge Funds: Still Worth Investing In? Hedge Funds: Still Worth Investing In? Chart 2Structural Or Cyclical? Structural Or Cyclical? Structural Or Cyclical? Hedge funds are supposed to be vehicles that "hedge" downside risk in periods of market stress and so can consequently generate a consistent return in excess of the risk-free rate. As one would expect, their performance, therefore, tends to be closer to that of bonds than of equities and, unsurprisingly, they have a close correlation with the performance of bonds over equities (Chart 3). But they have struggled in recent years to beat even their generally accepted benchmark of Libor + 4% (Chart 2 panel 1). Chart 3Are Hedge Funds Just 2/20 Bonds? Are Hedge Funds Just 2/20 Bonds? Are Hedge Funds Just 2/20 Bonds? From a risk perspective, all hedge fund strategies have a volatility somewhere between that of equities and bonds. Hedge fund return distribution is non-normal. Three of the four hedge fund strategies have exhibited negative skew, i.e. a higher-than-normal probability of negative returns. However, relative value is the only strategy with a large excess kurtosis, meaning that investors should expect extreme returns in periods of market stress. Macro has been the only strategy with a positive skew and a lower excess kurtosis than global equities. What Happened In Recessions? Hedge funds are, in theory, designed to give positive returns even during recessions and equity bear markets. Indeed they did so during the recessions of July 1990-March 1991 and March-November 2000. But, with the exception of global macro funds, they failed dismally to achieve a positive return in the December 2007-June 2009 recession (Table 3). Note, however, that all categories of hedge funds did outperform equities in the most recent recession. Table 3Recession Performance Hedge Funds: Still Worth Investing In? Hedge Funds: Still Worth Investing In? Global macro has clearly been the best hedge fund strategy at giving downside protection during recessions. It was the only category to outperform bonds during all three recessions in our analysis (Chart 4). The strategy's global cross-asset mandate and extensive use of derivatives enables it to achieve an option-like return distribution. Its nimbleness at switching exposures depending on the macro environment is clear from its sharp change of correlation with bonds and equities between recessions and expansions (Chart 5). This phenomenon is also seen to a lesser extent for event-driven and relative-value strategies. On the other hand, equity-hedge strategies have rising correlations with equities during recessions, mainly because of their net long bias. The cause of each equity bear market also has an impact on which hedge fund strategies perform the best (Chart 6). For example, relative-value strategies did well in the 1990-91 bear market, which was not accompanied by a deep economic recession. Conversely, event-driven funds severely underperformed during the 2007-2009 bear market because M&A deal activity dried up. Accordingly, investors looking to preserve capital in the next equity bear market need to pick a strategy after careful consideration of the likely cause of the next turndown. Chart 4 Chart 5 Chart 6 Hedge Fund Strategies Hedge funds encompass a wide range of investment styles, with managers using a myriad of different strategies to try to generate alpha. Below, we analyze the four main hedge fund strategies, explain the dynamics of their sub-categories and the relative attractions of their styles, and draw some conclusions about which are likely to be most appropriate in which environments. We also touch on whether using a fund of funds ever makes sense. Equity Hedge This strategy (Table 4) takes a long-short approach in equities, working under dedicated mandates with regard to capitalization, style and sector. The core strength of the group is superior bottom-up stock-picking coupled with long-short systematic risk hedging. Alpha generation is greater in less efficient, segmented markets with barriers to the free flow of information. Relative performance of this category (Chart 7) tends to be strongest when: There is significant dispersion of performance between sectors and stocks, giving hedge funds increasing opportunities for long-short trades; Value stocks outperform, since many long-short funds tend to be long cheap stocks and short expensive ones; Small caps outperform large caps. Many relative-value funds focus their long positions in smaller firms and their short positions in larger ones since small-cap stocks are less covered by sell-side analysts, resulting in more pricing inefficiencies. As a result of these biases and their generally net long positions, long-short equity hedge funds tend to have the strongest correlations with global equity markets and to perform worst in equity bear markets. Table 4Equity Hedge Strategies Hedge Funds: Still Worth Investing In? Hedge Funds: Still Worth Investing In? Chart 7Equity Hedge: High Beta Equity Exposure Equity Hedge: High Beta Equity Exposure Equity Hedge: High Beta Equity Exposure Event Driven This strategy (Table 5) pursues more opportunistic mandates and its returns are usually contingent on the successful completion of a specific corporate event. These funds tend to have a shorter investment horizon and use hedging techniques to isolate the event's impact on returns by reducing systematic risk. Alpha generation is dependent on the manager's ability to predict the outcome of corporate events. Activist and distressed funds focus more on value creation through operational turnarounds and hence have a longer investment period. The health of the M&A market (Chart 8) is the single biggest factor determining relative performance versus the hedge fund composite since it dictates exit valuations for most of the sub-strategies. We do not expect a recession until 2019 at the earliest, so deal volumes are likely to remain buoyant, which should help merger arbitrage funds generate good returns. Table 5Event Driven Strategies Hedge Funds: Still Worth Investing In? Hedge Funds: Still Worth Investing In? Chart 8Event Driven: Dependent On M&A Health Event Driven: Dependent On M&A Health Event Driven: Dependent On M&A Health The strategy also has a close correlation with credit spreads. This is partly because M&A deals tend to increase as the cost of funding the acquisition declines in an economic expansion. But it is also because distressed and restructuring funds have become more prominent over the years and their performance is linked to improving credit conditions. Macro This group (Table 6) utilizes a wide range of strategies taking exposure to movements in macroeconomic factors and their impact on asset classes. These funds tend to use leverage extensively and also dynamic risk-management techniques. Macro funds try to structure tactical positions to anticipate inflection points, and have a track record of generating significant outperformance in periods of stress. This means that this category has low kurtosis and skew, and has proved to be the best strategy for downside protection in recessions. Apart from in recessions, macro funds tend to outperform (Chart 9) only in times of credit-market stress (high-yield spread widening). But their recession-hedging properties are attractive, as seen by their negative correlation with equities and positive correlation with bonds during downturns. These tactical shifts in correlation led it to be the best strategy in three out of past four equity bear markets. Table 6Macro Strategies Hedge Funds: Still Worth Investing In? Hedge Funds: Still Worth Investing In? Chart 9Macro: Best Recession Hedge Macro: Best Recession Hedge Macro: Best Recession Hedge We generally prefer systematic rules-based funds over actively managed discretionary funds, as systematic funds offer better downside protection in recessions. However, systematic funds tend to underperform in trendless sideways-moving markets. Relative Value This group (Table 7) predominantly takes long/short positions in the rates and credit space. Most of the trades are arbitrage driven and depend on long-run mean reversion, thereby profiting from short-term deviations from fair value. Individual trades tend to have small profits, and so managers rely on leverage to magnify returns. With leverage comes the potential for extreme swings, as seen in this strategy's extremely high kurtosis. A famous example is the failure of Long Term Capital Management,4 which, at its peak, had an AUM of US$ 125 billion but just US$ 5 billion in equity capital. During 1995 and 1996 returns averaged 40% a year after fees. But, in the Asian financial crisis and the Russian default of 1997-1998, assets shrank to less than $1 billion in a matter of months. Relative-value funds have outperformed the hedge fund composite since the Global Financial Crisis largely as a result of low interest rates, which have reduced the cost of gearing up their positions (Chart 10). A rise in interest rates would represent a major headwind for this strategy. Table 7Relative Value Strategies Hedge Funds: Still Worth Investing In? Hedge Funds: Still Worth Investing In? Chart 10Relative Value: Rising Rates Are A Headwind Relative Value: Rising Rates Are A Headwind Relative Value: Rising Rates Are A Headwind Equity and interest rate volatility are also bad for relative-value fixed-income funds. Spikes in volatility render risk management models less effective. Additionally, relative value funds have exposures to the corporate credit space within their convertible arbitrage and corporate arbitrage sub-strategies. Hence, this group tends to underperform when high-yield spreads widen. Funds Of Funds Chart 11FOFs: Underperforming All The Way FOFs: Underperforming All The Way FOFs: Underperforming All The Way This group has seen a secular decline in AUM from USD$ 1.2 trillion to US$ 340 billion over the past 10 years.5 Returns have been poor relative to hedge funds as a whole (Chart 11), mainly because of their double layer of fees. However, funds of funds continue to have some attractions for smaller investors that are unable to meet minimum subscriptions for hedge funds or do not have the ability to handle their own manager selection. Funds of funds typically charge 1-1.5% on top of the underlying hedge funds' fees (and sometimes also a 10% performance fee). However they can often use their size to negotiate with hedge funds for a better deal on fees and innovative fee structures: for example, a larger proportion of the fee based on performance coupled with a high hurdle rate. This way they can partly reduce the aggregate fee burden (Chart 11, Panel 3). For larger investors such as pension plans and university endowments there is a choice between using a fund of funds and running their own in-house multi-strategy program. If we assume that the average fund of funds charges 1% in management fees, an investor looking to allocate $100 million should prefer to do this via a fund of funds if the cost of running an in-house program would be more than $1 million a year. Investment Implications In theory, given their focus on absolute return, hedge funds should underperform somewhat in an expansion and outperform significantly in a recession. They will tend to perform relatively poorly when volatility is low and cross-asset correlations high, as has been the case over the past eight years. However, as intervention by global central banks fades over the coming years - and with the risk of a recession on the horizon - volatility is likely to mean-revert closer to historical averages, which should create more opportunities for alpha. The hedge fund industry could come into its own again. But picking the right managers and strategy is crucial. There is a large dispersion between the performance of top and bottom decile hedge fund managers: in 2016, for example, top-decile funds made an average return of +32.7%, bottom-decile managers -15.5%.6 Intra-correlation between hedge fund strategies has recently fallen to a new low (Chart 12), so it is also important to choose the right strategy. Investors should have a preference for smaller hedge funds. These can be more nimble, allowing them to liquidate assets more readily in a downturn, and to have easier access to smaller, more inefficiently priced markets. They are likely to continue their recent outperformance (Chart 13) in an environment more dependent on security selection. We have two broad strategy recommendations contingent on the market environment (Chart 14): In a recession. Overweight macro funds, given their track record of impressive downside protection in recessions and equity bear markets. Now should be an attractive entry point given that the group has underperformed the hedge fund composite by 35% since the financial crisis. Over the cycle. Overweight event-driven funds, which have historically been an effective equity play with idiosyncratic exposures and lower beta risk. Deal activity is likely to remain strong thanks to companies' large cash balances and, for U.S. companies, prospective corporate tax reforms which will allow them to repatriate retained earnings held overseas. Chart 12Strategy Picking Is Crucial Strategy Picking Is Crucial Strategy Picking Is Crucial Chart 13 Chart 14Overweight Event Driven And Macro Overweight Event Driven And Macro Overweight Event Driven And Macro Aditya Kurian, Research Analyst Global Asset Allocation adityak@bcaresearch.com 1 Source: Hedge Fund Research. 2 Source: Preqin Investor Outlook: Alternative Assets H1 2017. 3 Source: HFRI Hedge Fund Indices, Defined Formulaic Methodology. 4 Source: http://www.investmentreview.com/print-archives/winter-1999/the-story-of-long-term-capital-management-752/ 5 Source: BarclayHedge. 6 Source: Hedge Fund Research.

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

Highlights Global Growth: Global bond yields have fallen in a coordinated fashion among the major economies, even with only a modest cooling of growth momentum and realized inflation outcomes. With little sign of an imminent downturn in growth on the horizon, government bonds now look a bit expensive. Global Inflation: Inflation expectations in the major economies have fallen too far relative to underlying non-energy inflation pressures. With oil prices likely to begin rising again as the demand-supply balance in global energy markets tightens up, both realized inflation and expectations should move higher in the latter half of the year, especially in the U.S. Bond Market Strategy: Markets are pricing in too few rate hikes in the U.S., leaving U.S. Treasuries exposed to higher yields in the next 3-6 months. Yields should also rise in core Europe, although not by as much as in the U.S. with the ECB not yet ready to turn less dovish. Stay underweight U.S., neutral core Europe and overweight Japan in global government bond portfolios. Feature Have bond investors now become too pessimistic on global growth and inflation prospects? This is a question worth asking after the sharp decline in longer-dated government bond yields witnessed since the peak in mid-March. The benchmark 10-year yield has fallen during that period by -43bps in the U.S., -21bps in Germany, -24bps in the U.K., -45bps in Canada and -54bps in Australia. Granted, there has been a bit of softer news on both growth and, more importantly, inflation readings in several economies in the past couple of months. Those pullbacks, however, have been relatively modest compared to the severe bull-flattening bond rally seen in most developed economies (Chart of the Week). Chart of the WeekAn Overreaction From Bond Investors An Overreaction From Bond Investors An Overreaction From Bond Investors Global leading economic indicators are still pointing to faster growth over the latter half of the year, led by easing financial conditions given booming equity and credit markets. With most major economies either at full employment (U.S., U.K., Japan, Australia) or approaching full employment (Euro Area, Canada), accelerating growth will ensure that the recent downtick in global inflation will not persist for long - especially if oil prices begin to move higher again as our commodity strategists expect. This week brings several major central bank meetings with an opportunity to change the bullish tone in the bond markets. The Federal Reserve, the Bank of England (BoE) and the Bank of Japan (BoJ) all meet, although only the Fed is expected to deliver another rate hike that is now heavily discounted in the markets. The BoE's hands are now effectively tied, even with high U.K. inflation, after last week's election outcome where the ruling Conservatives lost their majority government, thus ensuring even more uncertainty over the contours of the Brexit process. The BoJ is also stuck in a bind, with surprisingly strong Japanese economic growth but shockingly weak inflation. This is also the situation that the European Central Bank (ECB), Bank of Canada and Reserve Bank of Australia are facing, to a lesser extent: solid domestic growth but without enough inflation to force any immediate tightening of monetary policy. These sorts of mixed messages and conflicting signals also exist in the bond markets in the developed world, as we discuss in this Weekly Report. Our conclusion is that yields have now priced in too much pessimism and the balance of risks points to yields rising again in the months ahead, led by U.S. Treasuries. A Big Move In Yields For Such A Small Change In Growth... Looking at the change in government bond yields within the major developed markets since the peak on March 13th (Table 1) shows a few important facts: Table 1A Bull Flattening Of Global Yield Curves Since March Alternative Facts In The Bond Market Alternative Facts In The Bond Market The largest yield declines were in the U.S., Canada & Australia; The smallest declines were in the U.K., the Euro Area and Japan - unsurprisingly, the countries where central banks are engaged in large bond purchase programs; Lower market-based inflation expectations have played a role in the bond rally, coinciding with softer energy prices and declines in realized inflation outcomes; Real yields (i.e. nominal yields minus inflation expectations) have fallen sharply in the U.S., Canada & Australia; Yield curves have bull-flattened everywhere; Breaking the curve moves into real yield and inflation expectations components shows that both contributed to the flatter yield curves. The U.S. Treasury action stands out compared to the others. There has also been a 103bp flattening in the 2-year/10-year TIPS real yield curve, while the TIPS breakeven curve has steepened by 64bps. This is the result of the -89bp drop in 2yr breakevens, which now sit at 1.38% - well below the current U.S. headline CPI inflation rate of 2.2%. Even allowing for any potential liquidity issues that can distort the precise interpretation of shorter-dated TIPS breakevens, the market appears to be expecting a bigger drop in inflation in the next couple of years than both the Fed and the Bloomberg consensus of economic forecasters (Table 2).1 This U.S. move stands out relative to the other countries, where there has been very little change in 2-year inflation expectations (using CPI swaps instead of breakeven rates from inflation-linked bonds). With the headline U.S. unemployment rate now at a cyclical low of 4.3%, and with the broader U-6 measure, now down to a decade low of 8.4%, we anticipate a recovery in realized inflation, and TIPS breakevens, in the next few months. The source for the broader downturn in global inflation expectations is a bit of a mystery. While some cyclical global growth indicators like manufacturing PMIs have fallen a bit in some countries, most notably the U.S. and China, they are still at strong levels above 50 that point to faster economic growth (Chart 2). Leading economic indicators (LEIs) are also still pointing to some acceleration in the latter half of 2017 although, admittedly, the list of countries with rising LEIs has been diminishing in recent months. We see that as a potential sign of slower growth next year, but not for the rest of 2017. Table 2Consensus Growth & Inflation Forecasts Alternative Facts In The Bond Market Alternative Facts In The Bond Market Chart 2Global Economic Upturn Still Intact bca.gfis_wr_2017_06_14_c2 bca.gfis_wr_2017_06_14_c2 Bottom Line: Global bond yields have fallen in a coordinated fashion among the major economies, even with only a modest cooling of growth momentum and realized inflation outcomes. With little sign of an imminent downturn in growth on the horizon, government bonds now look a bit expensive. ...And Inflation Of course, some of the decline in inflation expectations can be attributed to softer readings on realized inflation over the past few months. Yet the markets seem to have overreacted a bit to that move, as well. The run of stronger-than-expected inflation outcomes has taken a breather in both the developed and emerging world, as evidenced by the rolling over of the Citigroup inflation surprise indices (Chart 3). Yet those indices remain at high levels and are not pointing to a meaningful, extended pullback in realized inflation. Chart 3Global Inflation Data Has Cooled A Bit Global Inflation Data Has Cooled A Bit Global Inflation Data Has Cooled A Bit The pullback in global energy prices since March has played a role in softer headline inflation in most countries. That decline has been part of a broader move lower in commodity prices that is likely related to less reflationary monetary and fiscal policies out of the world's biggest commodity consumer, China. However, our colleagues at BCA Commodity & Energy Strategy have noted that export and import volumes in the emerging economies accelerated sharply in the first quarter of 2017. Given that there is a strong correlation between trade volumes and oil demand in the emerging markets, this bodes well for a rebound in global oil demand. Combined with the "OPEC 2.0" production cuts, the demand-supply balance in world oil markets is likely to turn positive in the months ahead, which will allow oil prices to return to a range close to $60/bbl by year-end.2 A move in oil prices back to that level would help arrest the downturn in overall commodity price indices, and help stabilize goods CPI inflation in the developed economies in the latter half of 2017 (Chart 4). This should help boost global inflation expectations, and eventually bond yields, as the downturn in energy prices has shown very little pass-through into non-energy inflation in the developed world (Chart 5). Chart 4Disinflationary Impulse##BR##From Energy Will Soon Fade... Disinflationary Impulse From Energy Will Soon Fade... Disinflationary Impulse From Energy Will Soon Fade... Chart 5...Although The Impact On##BR##Inflation Has Been Modest ...Although The Impact On Inflation Has Been Modest ...Although The Impact On Inflation Has Been Modest Yet that stability of non-energy inflation visible in the charts masks many of the cross-currents seen across countries and within countries. Services CPI inflation remains strong in the U.S. at 3%, and has accelerated to 2% in both the U.K. and the Euro Area (Chart 6). Yet at the same time, both services and core inflation are falling rapidly towards 0% in Japan, despite a solid economic upturn and tight labor market. The situation is even more confusing in Canada, where wage inflation has fallen to below 1% but services inflation has picked up to 3%. Australia is in a similar boat, with services inflation above 3% but wages growing at only 2%. The divergence between the inflation outcomes across the countries can also be seen in our headline CPI diffusion indices, which measure the number of CPI sectors that are witnessing accelerating rates of inflation. The diffusion indices in the U.S., Japan and Canada are all at low levels, with the majority of CPI components seeing slowing rates of inflation, yet overall inflation seems to be holding up well despite the breadth of the "downturn", at least based on past correlations (Chart 7). The opposite is true in the Euro Area and Australia, where a majority of inflation components are growing faster, yet overall inflation is only moving slowly higher. Only in the U.K. is there a clear robust rise in the breadth of inflation (90% of CPI components accelerating) and overall inflation (headline CPI expanding at around 3%). Chart 6Underlying Inflation Has Not##BR##Slowed Much (Except In Japan) Underlying Inflation Has Not Slowed Much (Except In Japan) Underlying Inflation Has Not Slowed Much (Except In Japan) Chart 7Mixed Signals From The##BR##Global CPI Diffusion Indices Mixed Signals From The Global CPI Diffusion Indices Mixed Signals From The Global CPI Diffusion Indices Given all these diverging signals within the national inflation data, we are surprised that there has been such a uniform decline in inflation expectations across the major bond markets. That leads us to look to the oil price decline as the main cause of the lower expectations, rather than a more pernicious drop caused by expectations of slowing economic growth and cooling domestic inflation pressures. Given the BCA view that oil prices have likely reached bottom and will begin to move higher, the decline in global inflation expectations is likely to also end soon. Bottom Line: Inflation expectations in the major economies have fallen too far relative to underlying non-energy inflation pressures. With oil prices likely to begin rising again as the demand-supply balance in global energy markets tightens up, both realized inflation and expectations should move higher in the latter half of the year, especially in the U.S. Bond Market Strategy For The Second Half Of 2017 The outlook for government bond yields in the remaining months of the year will be driven by decent global growth and rising inflation expectations. Our Central Bank Monitors continue to point to the need for tighter monetary policy in every major developed market excluding Japan (Chart 8), leaving bond yield exposed to any unexpected moves from central bankers. This is especially problematic in the U.S., where fed funds futures now discount only a 25-30% probability of a Fed rate hike in September and December after the expected hike at this week's FOMC meeting (Chart 9). With the U.S. OIS curve pricing in only 48bps of hikes over the next 12 months, the Treasury market is exposed to a Fed moving more aggressively in meetings later in 2017. Chart 8Our Central Bank Monitors Still##BR##Calling For Tighter Policy (Ex Japan) Our Central Bank Monitors Still Calling For Tighter Policy (Ex Japan) Our Central Bank Monitors Still Calling For Tighter Policy (Ex Japan) Chart 9Markets Will Be Surprised##BR##By The Fed Later This Year Markets Will Be Surprised By The Fed Later This Year Markets Will Be Surprised By The Fed Later This Year In Europe, the ECB talked up a more positive economic growth story at last week's policy meeting, eliminating the language suggesting that rate cuts would be necessary because the growth recovery was still fragile. No signal was given about slowing the pace of ECB asset purchases, which was not a surprise given the still-low readings on core inflation in the Euro Area. The ECB did slightly downgrade its inflation projections for the next two years, with core inflation now expected to rise to 1.8% by 2019. Our Months-to-Hike measure for the Euro Area now out to 29 months, indicating that the first ECB rate hike is now expected in November of 2019 (Chart 10). Our view remains that the ECB will look to taper asset purchases before contemplating any rate hikes, and will likely signal a move to slow the pace of bond buying at the September policy meeting. While we agree that a rate hike is unlikely until 2019, the current market pricing does leave European bond markets exposed to any upside surprises in inflation over the next year. For now, we continue to recommend a neutral allocation to core European government bonds, with a curve steepening bias, while focusing Peripheral exposure on Spain relative to Italy. We envision moving to underweight Europe over the summer if the growth and inflation data continue to point to an eventual ECB taper, especially given the strong comparisons between Europe now and the pre-Taper Tantrum period in the U.S. in 2012-13 (Chart 11). Chart 10No ECB Hikes##BR##Expected Until 2019 No ECB Hikes Expected Until 2019 No ECB Hikes Expected Until 2019 Chart 11Bunds Still Following The U.S.##BR##Post-QE Experience Bunds Still Following The U.S. Post-QE Experience Bunds Still Following The U.S. Post-QE Experience In Japan, we expect the BoJ to continue to target a 0% 10yr JGB yield for some time, in order to ensure that there is enough currency weakness to keep headline inflation from decelerating (Chart 12). This will especially be true if our call for higher U.S. interest rates comes to fruition and USD/JPY begins moving higher again. We continue to recommend an overweight position on Japan with government bond portfolios, given the low yield beta of JGBs to the other bond markets (Chart 13). Chart 12The BoJ Will Do "Whatever It Takes"##BR##To Keep The Yen Soft The BoJ Will Do "Whatever It Takes" To Keep The Yen Soft The BoJ Will Do "Whatever It Takes" To Keep The Yen Soft Chart 13Stay Overweight##BR##Low-Beta JGBs Stay Overweight Low-Beta JGBs Stay Overweight Low-Beta JGBs Finally, we continue to recommend long CPI swaps positions in both the Euro Zone and Japan, and an overweight in U.S. TIPS versus nominal Treasuries, as a way to play for the rebound in global inflation expectations that we are expecting over the balance of 2017. However, given the disturbing downturn in core inflation readings in Japan, we are implementing a tight stop-loss level at 0.4% on our long 10yr Japan CPI swaps position (Chart 14). Chart 14Stay Long CPI Swaps##BR##In Europe & Japan (With A Stop) Stay Long CPI Swaps In Europe & Japan (With A Stop) Stay Long CPI Swaps In Europe & Japan (With A Stop) Bottom Line: Markets are pricing in too few rate hikes in the U.S., leaving U.S. Treasuries exposed to higher yields in the next 3-6 months. Yields should also rise in core Europe, although not by as much as in the U.S. with the ECB not yet ready to turn less dovish. Stay underweight U.S., neutral core Europe and overweight Japan in global government bond portfolios. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 The FOMC projections for growth in the headline Personal Consumption Expenditure (PCE) deflator from the latest set of forecasts released in March called for inflation of 1.9% in 2017 and 2.0% in 2018. The gap between the headline measures of CPI inflation and PCE deflator inflation has averaged about 50bps in recent years, so that implies that the Fed is expecting CPI inflation to be much higher than the 1.38% 2-year TIPS breakeven. 2 Please see BCA Commodity & Energy Strategy Weekly Report, "Strong EM Trade Volumes Will Support Oil", dated June 8 2017, available at ces.bcaresearch.com. Recommendations Alternative Facts In The Bond Market Alternative Facts In The Bond Market Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The ECB's meeting was in line with expectations, the governing council increased its growth forecast, decreased its inflation forecast, removed it easing bias, but maintained that easy policy was key to support its objectives. Going forward, growth will have to remain just as strong for European inflation dynamics to emerge. Financial conditions between the U.S. and the euro area are moving in favor of U.S. growth, and thus, the USD. EUR/USD momentum is stretched, but it can rise further. EUR/USD at 1.15 in the coming weeks is a risk to our view. However, EUR/USD forecasts have already been ratcheted upward, and their capacity to lift the euro is losing steam. Feature The European Central Bank hit the mark yesterday with a performance that was bang on in terms of expectations, as illustrated by the euro's muted response. The governing council increased its growth forecast by 0.1% each year and curtailed its inflation forecast by an average of 0.2% until 2019, inclusively (Table I-1). Moreover, while the ECB statement removed its future easing bias, in the press conference ECB President Mario Draghi made it crystal clear that this was because deflationary risks were evaporating, but the economy still needed extremely easy conditions in order to stay on the trajectory envisioned by the ECB. Chart I- As a result, despite this adjustment in forward guidance, the ECB elected to keep its asset purchases in place, even leaving the door open for time extensions and size increases if conditions warrant. After all, in the eyes of the ECB - and it is an assessment we share - the great performance of the European economy has been and remains dependent on the continuation of a very easy policy stance. In this optic, we study the outlook for growth dynamics in Europe, especially in relation to the U.S., as this is what will determine the future path of relative policy. If European policy can move in a more hawkish fashion relative to the Federal Reserve as well as current expectations, then the euro bear market will be over. Growth And Financial Conditions For the euro to rally further, the ECB has to be able to beat market expectations and the Fed has to continue to underwhelm. So far this has not happened, but markets are forward looking and are behaving as if both central banks will follow these paths. To expect a tightening of ECB policy relative to the Fed's, European growth will have to continue outperforming U.S. growth. As we argued last week, the slack in the European jobs market is much greater than that in the U.S.1 Without outstanding growth, European inflationary dynamics will remain hampered by low wage growth. Meanwhile, the Fed is facing an environment congruent with high rates (Chart I-1), something that markets are ignoring as they are only anticipating two more hikes into June 2019, beyond the one anticipated next week. So what kind of future growth dynamics are we anticipating? World growth may not be about to plunge, but global activity is set to soften as China and the U.S. have been tightening monetary conditions in an environment replete with excess capacity. Indicators are already responding to this policy shift. Our diffusion index of global leading economic indicators has already rolled over sharply, a precursor to softening global LEIs (Chart I-2). This is a bigger problem for Europe than the U.S. Since 2010, the beta of euro area LEIs to global LEIs has been around 0.8, while for the U.S. the sensitivity is around 0.2. Thus, deteriorating growth conditions are a greater handicap for Europe, a region still much more reliant on trade and manufacturing as sources of growth. Chart I-1The Fed And Its Mandate The Fed And Its Mandate The Fed And Its Mandate Chart I-2Global Growth Passing Its Zenith Global Growth Passing Its Zenith Global Growth Passing Its Zenith Meanwhile, purely domestic economic conditions have been buoyant in the euro area and quite morose in the U.S., though the picture seems to be reversing. To make this judgment, we begin by evaluating a global growth factor, a global economic force that lifts or pulls down all boats, similar to a tide. Such a global growth factor should not just affect various countries through trade, but it should also impact their economies through financial linkages. In order to evaluate this phenomenon, we conducted a Principal Component Analysis (PCA) of the LEIs of 21 countries. We found that the combined factor 1 and factor 2 explains nearly 50% of global growth dynamics (Chart I-3). Once we estimated this global growth factor, we then proceeded to estimate how much it contributes to LEI gyrations in the U.S. and euro area, using the factor loadings of both relative to the two main components revealed by the PCA. With that information in hand, we then simply subtracted the European and U.S. impact from their respective LEIs. What is left reflects purely endogenous changes in the LEIs for the euro area and the U.S. This same procedure can be applied to any country. Through this exercise, we can see very well that European domestic conditions have been rebounding sharply since 2012. However, the pure domestic element of the U.S. LEIs has been falling steadily since late 2014, shortly after the U.S. dollar began its 27% rally (Chart I-4). Chart I-3The Tide That##br## Lifts All Boats The Tide That Lifts All Boats The Tide That Lifts All Boats Chart I-4A Look At Purely Domestic##br## Growth Dynamics A Look At Purely Domestic Growth Dynamics A Look At Purely Domestic Growth Dynamics To a large degree, these differentiated dynamics make sense. 2012 marked the apex of the euro area crisis. The improvement in the domestic component of the European LEIs coincided with Mario Draghi's "whatever it takes" speech. This moment was crucial as it resulted in the normalization of private sector borrowing costs across the Eurozone. Thanks to the ensuing compression in break-up risk premia, Italian and Spanish private lending rates collapsed by 110 and 240 basis points over the following 24 months, respectively. Easy money was finally being transmitted to the private sector. Chart I-5Massive Tightening In 2014 Massive Tightening In 2014 Massive Tightening In 2014 In the U.S., the deterioration began after the dollar perked up massively, but also, after the Fed began tapering its purchases of securities, events associated with a 300 basis-point increase in the Wu-Xia shadow fed funds rate (Chart I-5). The combined effect of this monetary tightening resulted in a significant brake on economic activity, one made most evident by the deceleration in the domestic component of the LEIs. These forces seems to be reversing. Today, the dollar is trading in line with its March 2015 level, and while the fed funds rate has increased by 75 basis points, this still pales in comparison to the large increase in the shadow fed funds rates recorded between May 2014 and November 2015. Meanwhile in Europe, the lagged effects of the massive 15% decline in the trade-weighted euro between June 2014 and March 2015 is dissipating. These monetary dynamics partially explain why the domestic element of the European LEIs is rolling over while the U.S. one is improving. However, we think financial conditions play a larger role. U.S. financial conditions have greatly eased in recent months, while financial conditions in Europe have been deteriorating, suggesting domestic growth conditions will follow a similar path (Chart I-6). These crosscurrents are especially evident when looking at the relative European and U.S. domestic growth impulses vis-a-vis their relative financial conditions. Currently, the purely endogenous elements of growth in the euro area look set to roll over against those of the U.S. So if the international and domestic elements of growth in Europe are set to slow relative to the U.S., when should these dynamics begin to affect market pricing? Historically, the German Ifo survey has been one of the most reliable bellwethers of European economic activity. The same can be said of the ISM in the U.S. While the ISM rolled over three months ago, the Ifo is still at all-time highs. However, historically, one of the most reliable leading indicators of the Ifo has been none other than the ISM itself. Hence, the likelihood that the Ifo rolls over sharply by September is high, especially in the context of the observations made above (Chart I-7). With expectations that European growth will remain strong but that the U.S. is incapable of generating inflation, a weak ISM is well known, but a weak Ifo would be a surprise. Chart I-6Follow The Financial Conditions Follow The Financial Conditions Follow The Financial Conditions Chart I-7Where The ISM Goes, The IFO Follows Where The ISM Goes, The IFO Follows Where The ISM Goes, The IFO Follows When the Ifo underperforms the ISM, the euro tends to suffer (Chart I-8). This was not true in 2001, but back then the euro was trading 15% below its long-term fair value, and the U.S. was entering a recession. Today, the euro is trading at a more modest 5% discount to its long-term fair value, and BCA believes the U.S. is not on the verge of a recession. Moreover, on a short-term basis, the euro is already trading 6% above its interest rate and risk-aversion implied tactical fair value. Chart I-8If No U.S. Recession Emerges, A Falling IFO Equals A Falling Euro If No U.S. Recession Emerges, A Falling IFO Equals A Falling Euro If No U.S. Recession Emerges, A Falling IFO Equals A Falling Euro These dynamics also imply that the massive positive skew in economic surprises between the euro area and the U.S. should soon end, which is likely to prompt a re-think of the relative monetary policy stance between the ECB and the Fed, and therefore put an end to the recent sharp rally in the euro. Bottom Line: The ECB did not surprise markets this week. Yet, Mario Draghi made it very clear that despite an upgrade to forward guidance, the path toward achieving the central bank's inflation target continues to require very easy policy. How easy? Our view is that based on global dynamics and financial conditions, European growth could slow in the coming months, delaying the point in time when the euro area output gap closes. Meanwhile, investors are too conservative regarding the U.S.'s growth and inflation prospects, and therefore are not anticipating enough rate hikes from the Fed. What To Do With Momentum? The key issue for now is that the euro's momentum is extremely powerful and hard to fight. Indeed, the euro seems to have dissociated from fundamentals. While aggregate real rate differentials continue to move in favor of the U.S. dollar, the euro is ignoring these dynamics and instead has become overtaken by powerful flows into the euro area (Chart I-9). These dynamics may be stretched, but they could still have additional room to run. Non-commercial traders have fully purged their short bets on EUR/USD, and they have accumulated the most long-euro positions in three years. Additionally, our composite sentiment indicator, based on the positioning, sentiment, and 13-week rate-of-change in the currency, is now at elevated levels relative to the past three years (Chart I-10). The violence of these shifts highlights an improving risk-reward ratio to shorting the euro, but this could be of little solace: historically, both the composite sentiment measure and positioning in the euro have hit much higher levels. Technical indicators point to similar dilemmas. Both the EUR/USD intermediate-term technical indicator and its 13-week rate of change have hit levels congruent with a reversal (Chart I-11). However, these indicators have also displayed inertia in the past, with occasions such as in 2013, where their elevated readings did not preclude a higher EUR/USD. Chart I-9EUR/USD Is A Lone Wolf EUR/USD Is A Lone Wolf EUR/USD Is A Lone Wolf Chart I-10EUR/USD Is Overbought But...(1) EUR/USD Is Overbought But...(1) EUR/USD Is Overbought But...(1) Chart I-11EUR/USD Is Overbought But...(2) EUR/USD Is Overbought But...(2) EUR/USD Is Overbought But...(2) As a result, we are highly cognizant of the risks to our positive bet on the DXY (which due to its near 60% weighting in the euro is equivalent to a short euro bet). But the good news in the euro seems well priced in. In line with the 8% surge in the euro this year, the average analyst forecast for the euro for Q4 2017 moved from EUR/USD 1.05 to EUR/USD 1.12 (Chart I-12, top panel). Recent peaks in the euro have materialized when these forecasts hit 1.13, which we are very close to. At these levels, the optimism toward Europe seems fully discounted. Chart I-12When To Be Contrarian In FX When To Be Contrarian In FX When To Be Contrarian In FX In fact, the gap between the euro itself and the forecast is now decreasing (Chart I-12, bottom panel). This suggests that each new forecast upgrade is lifting the euro less and less, implying that buyers have already internalized these increasing forecasts and need ever better news, especially on the wage and inflation front, to lift the euro higher. Hence, while worried that the EUR/USD could move to 1.15 in a blink of an eye before reversing, we remain cautiously optimistic on our negative EUR/USD and our positive DXY stances. Bottom Line: At this point, the key problem with our view is that momentum is clearly in the euro's favor, a dangerous position for euro bears. While most indicators highlight that EUR/USD is overbought, these same metrics could in fact remain overbought for longer. However, investors have already massively upgraded their EUR/USD forecasts suggesting that much news is in the price, especially as each successive upgrade is showing diminishing returns in their capacity to lift EUR/USD spot rates. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled "Capacity Explosion = Inflation Implosion", dated June 2, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The soft patch in the U.S. economy continues: Unit labor costs growth has softened to 2.2%, a less-than-expected pace of 2.5%; Non-Manufacturing/Services sectors are looking weak with both PMI and ISM measures underperforming; Consumer credit also grew by USD 8.2 bn, underperforming the expected USD 15.5 bn. As a result, the dollar remains weak. While the data is worrying, we stand with the Fed's view. The Fed will hike in June, and when this soft patch proves temporary, it is likely that a September hike will materialize. With the ECB constrained in its capacity to move to a hawkish stance, it is possible for the USD to see some upside sooner rather than later. Report Links: Capacity Explosion = Inflation Implosion - June 2, 2017 Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 The euro has witnessed a particularly strong two months due to positive surprises in data, but momentum somewhat slowed this week due to mixed data: Services PMI in Spain, Italy and France underperformed expectations, while Germany and the overall euro area outperformed; Retail sales increased at a 2.5% annual rate; German factory orders increased by 3.5% annually, which was less than expected. Even worse they contracted by 2.1% on a monthly basis; Overall GDP growth in the euro area outperformed expectations, being revised to 1.9%. Furthermore, Draghi reiterated the need for extremely easy conditions in order to stay on the path to reach the target inflation rate, especially as inflation forecasts were downgraded. If the European data cannot keep up with its current blistering pace, investors should again begin to wonder about the ECB's capacity to move away from what remain a dovish stance. Report Links: Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent economic data has been mixed in Japan: Consumer confidence came in at 43.6, increasing from last month. Bank lending annual growth came in at 3.2%, beating expectations. However, GDP annualized growth was greatly revised downward to 1%. Although we continue to be bullish on the yen on a short term basis, it would be preferable to play yen strength by shorting NZD/JPY rather than USD/JPY, as we believe that the correction in the U.S. dollar has run its course. Thus, we are looking to exit our short USD/JPY trade once it reaches 108. On a cyclical basis, the yield curve target implemented by the BoJ, along with a hawkish fed will weigh on Japanese real rates vis-à-vis U.S ones and consequently push the yen downward. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data has been mixed in the U.K.: Construction PMI came in at 56, blowing past expectations. Halifax house price annual growth came in at 3.3%, also outperforming expectations. However, Markit Services PMI came below expectations at 53.8. The results of the elections happening as of the date of this writing will create some volatility in the pound. A greater majority government by the conservatives would likely be a boost to the pound, as it will give Prime Minister May more leeway when negotiating the exit of the U.K. from the European Union. On the other hand, if labor wins enough seats to create a hung parliament, the pound could suffer as political uncertainty will once again reign supreme. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 The Aussie experienced an upbeat week, appreciating almost 2.5%. A few positive data was recorded: TD Securities Inflation increased at a 2.8% annual rate, more than the previous 2.6% reading; GDP growth increased 1.7% annually, beating both yearly and quarterly expectations. Chinese imports were very strong, coming in at 22% growth on an annual pace, suggesting continued intake by the Middle Kingdom of what Australia exports. The GDP was a key driver in this week's rally. However, while the headline number was great, the details were more worrisome. Inventories led GDP growth, while exports subtracted most from it. This is peculiar considering that terms of trade increased at a 24.8% annual rate. This also predates the near 40% decline in iron ore futures. The trade balance for April also missed expectations greatly, coming in at 555 million, compared to the expected 1.95 million, setting up a poor start for Australia's second quarter. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 The kiwi economy continues to improve: Headline and core inflation have both surpassed the 2% threshold, reaching 2.2% and 2.3% respectively in the first quarter of 2017. Meanwhile, nominal retail sales are growing at a healthy 7.5%. Considering the continued strength in the kiwi economy, the NZD should continue to outperform the AUD on a cyclical basis, given that Australia is much more sensitive to a slowdown in Chinese economic activity, which is beginning to suffer in response to the tightening campaign by the PBoC. On the other hand the upside for the NZD against the U.S. dollar remains limited. Not only is NZD/USD overbought on a short term basis, but the tight correlation between the kiwi and commodity prices should eventually weigh on this currency. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 The CAD went through a rough patch this week: The seasonally-adjusted measure of PMIs delivered a disappointing 53.8 reading compared to the expected 62; Building permits are contracting at a 0.2% monthly pace; Housing starts increased at 194,700, which was less than expected; On the plus side, house price growth was at 3.9% yoy, beating expectations of 3.3%. Oil was also a big player in the loonie's weakness. Crude oil inventories were higher than expectations by roughly 6 million barrels: a 3.464 million barrels decline in inventories was expected, while inventories increased at a 3.295 million barrels. The CAD remains oversold, but we remain bullish on it in the G10 space as investors have rarely been so short the Canadian currency as they currently are. Report Links: Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent economic data in Switzerland has been very positive: The unemployment rate came in at 3.2%, beating expectations. Headline inflation came in at 0.5%, higher than last month and beating expectations. Yesterday, the ECB underwehlmed bulls, as ECB president Mario Draghi stated that asset purchases will "run until the end of December 2017, or beyond, if necessary". We expect the ECB to ultimately find it very difficult to switch to a hawkish bias, especially relative to relative to other central banks, as pricing power in the euro area remains muted. On the other hand, Switzerland is slowly recovering, and a removal of the implied floor by the SNB on EUR/CHF could happen as early as the end of the year. Thus, we are already shorting this cross to take advantage of such an event. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 On Wednesday, oil inventories rose by 3.3 million against expectations of a 3.5 million draw. This caused oil prices to plunge by almost 4%. Nevertheless, the response of USD/NOK has been somewhat muted. This is in part due to the fact that real rate differentials matter more than oil for USD/NOK. Indeed, while oil is down almost 15% on the year, the NOK has actually appreciated slightly in the year against the dollar, given that rates in the U.S. have decreased substantially during the year. Thus, given that we expect a more hawkish Fed than the market anticipates, we are USD/NOK bulls. Additionally, we are also bullish on CAD/NOK, as the Norges Bank is likely to have a much more dovish bias than the BoC going forward. Report Links: Exploring Risks To Our DXY View - May 26, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 The SEK has been depreciating this week on the back of disappointing industrial production figures, with the yearly measure increasing at a meagre 0.8% pace, much less than the anticipated 4.2%. Moreover, IP experienced a monthly contraction of 2.4%. Additionally, the recent Financial Stability Report also highlighted that "further measures need to be introduced to increase the resilience of the household sector and reduce risks", as well as vulnerabilities in the Swedish banking system. While we think USD/SEK's weakness is nearing its end, EUR/SEK will likely see some weakness in the near future, given its expensive level. Report Links: Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The global economy remains awash in massive amounts of oversupply, reflecting extraordinary levels of capex in emerging markets. This will weigh on global inflation. Thanks to a tighter labor market, the U.S. is likely to suffer less from this force than the euro area or commodity producers. In this context, the tightening in Chinese and U.S. policy could represent a severe blow to the recent improvement in global trade. Continue to hold some yen and some dollars but stay short commodity and European currencies. Feature The U.S. is in its eighth year of recovery, yet core PCE is clocking in at a paltry 1.5% despite the headline unemployment rate standing 0.3% below its long-term equilibrium and despite incredibly low interest rates. The phenomenon is not unique to the U.S., euro area core CPI remains a meager 1% and even Germany, despite experiencing an unemployment at 26 year lows, is incapable of generating core inflation beyond 1.6%. Let us not even broach the topic of Japan... So what lies behind this low inflation environment? Not Enough Capex Or Too Much Capex? Capex in advanced economies has averaged 21% of GDP since 2008, compared to an average of 24% of GDP between 1980 and 2007, suggesting that the supply side of the economy is not expanding as fast as before (Chart I-1). Historically, countries plagued by low investment rates have tended to experience higher inflation. Simply put, these low investment rates mean these economies do not enjoy high labor productivity growth rates, causing severe bottlenecks. When these capacity constraints are hit, inflation emerges. This time around, the low investment rate in advanced economies is not yielding this development. Why? One reason is that demand has been hampered by the rise in savings preferences that emerged following the financial crisis (Chart I-2). But another phenomenon is also at play. Global capex has remained very elevated. Chart I-1Low Investment In DM ##br##Should Create Bottlenecks Low Investment In DM Should Create Bottlenecks Low Investment In DM Should Create Bottlenecks Chart I-2Post 2008: ##br##Marked Preference For Savings Post 2008: Marked Preference For Savings Post 2008: Marked Preference For Savings As Chart I-3 illustrates, global capex has averaged 25.2% of world GDP since 2010, well above the international average from 1980 to 2009. This is simply a reflection of the massive amount of capacity expansion that continues to materialize in the EM space, where investment has equaled more than 30% of GDP for eight years in a row. This matters because since the 1990s, the world has experienced a massive outward shift in the aggregate supply curve, resulting in an extended period of falling inflation and then, low inflation, independent of the state of growth or of long-term inflation expectations (Chart I-4). Chart I-3Global Capex Is High Global Capex Is High Global Capex Is High Chart I-437 Years Of Inflation History At A Glance 37 Years Of Inflation History At A Glance 37 Years Of Inflation History At A Glance In the 1990s, this expansion of global production capacity reflected the addition of billions of potential workers to the international capitalist system, but this phenomenon slowed massively in the 2000s and is now over (Chart I-5). Instead, the driver of the expansion of the global supply curve has since become the rampant investment taking place in developing economies, which has resulted in a massive increase in the capital-to-GDP ratio for the entire planet (Chart I-6). Chart I-5 Chart I-62000s To Present: Capital Drives##br## The Supply Expansion 2000s To Present: Capital Drives The Supply Expansion 2000s To Present: Capital Drives The Supply Expansion In the first decade of the millennium, this massive increase in the level of global capacity was still manageable. Global real GDP growth expressed in purchasing-power parity terms averaged 7% from 2000 to 2008 and was able to absorb some of the productive capacity being added to the world economy. As a result, core inflation average 2% in the OECD while short-term and long-term interest rates averaged 2.9% and 4.1%, respectively. However, since 2009, global GDP growth expressed in purchasing-power parity terms has only averaged 4.6%, despite a continued robust pace of investment globally, suggesting that now, supply growth is outstripping demand growth by a greater margin than in the previous cycle. This means that to achieve an average core inflation rate of 1.8% in the OECD, short-term and long-term interest rates have needed to average 0.7% and 2.4%, respectively. Going forward, the problem is that global excess capacity has not been expunged. With credit growth still limited in the G10 and in a downtrend in China (Chart I-7), deflationary tendencies are likely to remain a prevalent feature of the global economy for the rest of the business cycle. Thus, central banks the world over will find it very difficult to tighten monetary policy by much without re-invigorating downward spirals in inflation. While this problem applies to the Fed - a case cogently described by Lael Brainard this week - this is even truer for many other economies. The global trend in inflation is a function of this global expansion in supply, but domestic dynamics can still affect the dispersion of national inflation rates around this depressed global level. As Chart I-8 shows, countries with an unemployment rate substantially below equilibrium - a negative unemployment gap - do experience higher levels of inflation. Today, this puts the U.S. on a path toward higher inflation relative to the euro area. This suggests that there remains a valid case to expect a tightening of monetary conditions in the U.S. vis-à-vis the euro area. Chart I-7Low Credit Growth Harms Demand Growth Low Credit Growth Harms Demand Growth Low Credit Growth Harms Demand Growth Chart I-8 In this vein, Japan is an interesting case. Japan does have one of the most negative unemployment gaps among major economies, yet it experiences one of the lowest inflation rates. Japan is such an outlier that if it were excluded from the chart above, the explanatory power of the employment gap on inflation would double. This is because Japan has to grapple with another, even more pernicious problem: chronically depressed inflation expectations. Hence, the BoJ has to commit to an "irresponsibly easy" monetary policy and keep the economy growing above its potential for an extended period of time to genuinely shock inflation expectations upwards if it ever wants to remotely approach its 2% inflation target. Thus, we should remain negative the yen on a cyclical basis, only buying the JPY when asset markets are at risk. Bottom Line: The global economy remains awash in excessive supply. In the 1980s and 1990s, much of the supply expansion reflected an increase in the global labor force; since the turn of the millennium, the global supply expansion has been a function of high investment rates in developing economies. Without credit growth, the global economy will be hostage to deflationary pressures, at least for the rest of this cycle. Despite this picture, among major economies, the U.S. needs the smallest amount of monetary accommodation, supporting a bullish dollar stance. Policy Mistake In The Making? In this context of global overcapacity, low growth and underlying deflationary pressures, deflationary policy mistakes are easy to come by, and the world economy may be facing two such shocks. In and of itself, the U.S. economy may be able to handle higher rates. Even if inflation is likely to remain low by historical standards, a rebound toward 2% could happen later this year. At the very least, our diffusion index of industrial sector activity suggests that the recent inflation deceleration in the U.S. may be over (Chart I-9). However, it remains to be seen if EM economies, which is where the true excess capacity still lies, can actually handle higher global real rates. The rollover in our global leading indicator diffusion index is perplexing and points to a deceleration in global growth, a potential warning sign about the frailty of the global economy (Chart I-10). Additionally, it is true that 1% CPI inflation in China does not necessitate much of a strong policy response by the PBoC. But the vast swathe of cumulative capital investment in China implies that this country could suffer from the greatest amount of excess capacity (Chart I-11). China required a massive amount of stimulus in 2015 and early 2016 to generate a small rebound in growth. Thus, the current tightening in Chinese monetary conditions, as small as it may be, could be enough to prompt another wave of weakness in that country. The recent softness in PMIs - with the Caixin gauge falling below 50 - could be a symptom of this problem. Chart I-9U.S. CPI Deceleration Is Ending... U.S. CPI Deceleration Is Ending... U.S. CPI Deceleration Is Ending... Chart I-10...But Global Growth Is Deteriorating ...But Global Growth Is Deteriorating ...But Global Growth Is Deteriorating Chart I-11China Is Oversupplied China Is Oversupplied China Is Oversupplied Making the situation even more precarious is that China stands at the apex of the overcapacity problem, which makes it prone to develop virtuous and vicious cycles. Chinese corporate debt stands at 180% of GDP, heavily concentrated in state-owned enterprises and heavy industries. This means that swings in producer prices can have a deep impact on real rates. Based on a 10 percentage points swing in PPI, Chinese real rates were able to collapse from 10% to -1% in the matter of 12 months last year. The problem is that for this PPI rebound to happen, Chinese monetary conditions had to ease greatly (Chart I-12). Now that Chinese monetary conditions are tightening and now that commodity prices are weakening anew, PPI could once again fall toward 0%, lifting real rates to 4.4% in the process (Chart I-13). Chart I-12Chinese MCI: From Friend To Foe Chinese MCI: From Friend To Foe Chinese MCI: From Friend To Foe Chart I-13Real Rates Are Likely To Go Up Real Rates Are Likely To Go Up Real Rates Are Likely To Go Up This means that the already emerging contraction in manufacturing and the recent deceleration in new capex projects could gather further momentum (Chart I-14). As credit flows dry up because of the increasing price of credit in a weakening and over-supplied economy, so will Chinese imports, which are so sensitive to the investment cycle and credit impulse (Chart I-15). This is a problem because the recent bright patch in the global economy was based on this rebound in Chinese demand. In the wake of the Chinese growth acceleration last year, global exports and export prices rebounded sharply (Chart I-16). However, now that China is facing a renewed slowdown, this improvement is likely to dissipate. Chart I-14Problems With Chinese Growth Problems With Chinese Growth Problems With Chinese Growth Chart I-15Slowing Chinese Credit Will Hurt Chinese Imports... bca.fes_wr_2017_06_02_s1_c15 bca.fes_wr_2017_06_02_s1_c15 Chart I-16...Which Will Weigh On Global Trade ...Which Will Weigh On Global Trade ...Which Will Weigh On Global Trade This is obviously negative for the commodity currency complex. Not only does this mean that the negative terms of trade shock that is affecting many commodity producers could deepen - for example iron ore futures continue to fall and are now down 39% since mid-march - but also, monetary policy could be eased relative to the U.S. Actually, our monetary stance gauge, based on real short rates and the slope of the yield curve, already highlights potential weaknesses for AUD/USD (Chart I-17). This development is also a problem for Europe. As we have highlighted before, European growth is three times more levered to EM dynamics than the U.S. economy is. Also, employment in the manufacturing sector in the euro area is still five percentage points above that of the U.S., underscoring the euro area's greater exposure to global manufacturing and global trade. This means that if Chinese troubles deepen, the closing of the European unemployment gap might slow, at least relative to the U.S. where the unemployment rate is already below equilibrium. Therefore, the high-time to bet on a tightening of European policy relative to the U.S. could be passing. Already, before the European economy has even been hit by a negative shock from EM, the euro looks vulnerable. Investors are very long the euro, but also EUR/USD has dissociated enough from interest rate fundamentals that it is now expensive on a short-term basis. The relative monetary stance gauge between the euro area and the U.S. is pointing toward trouble ahead (Chart I-18). This trend may be magnified if, as we expect, global goods prices weaken anew. Another problem for the euro is that now that the world has embraced president Macron with a firm handshake, political risk may be once again rearing its ugly head in Europe. The Italicum electoral reform in Italy is progressing and there may be a new prime minister sitting in the Palazzo Chigi in Rome this fall. The problem is that the Italian public remains much more euroskeptic than France and the euro is supported by barely more than 50% of the population (Chart I-19, top panel). With euroskeptic and pro-euro parties standing neck-and-neck in the polls, the risk of a referendum on the euro in the area's third largest economy is becoming increasingly real (Chart I-19, bottom panel). Chart I-17Relative Monetary Conditions ##br##Point To A Lower AUD Relative Monetary Conditions Point To A Lower AUD Relative Monetary Conditions Point To A Lower AUD Chart I-18Euro At ##br##Risk Euro At Risk Euro At Risk Chart I-19Italy Is Not ##br##France Italy Is Not France Italy Is Not France The yen could benefit if the combined impact of higher U.S. rates and tighter Chinese policy proves to be a mistake. Our composite indicator of global asset market volatility - based on implied volatility in bonds, global stocks, global commodities, and various exchange rates - is near record lows (Chart I-20). Hence, global risk assets - commodity and EM plays in particular - could suffer some damage in the face of a deeper than anticipated global growth slowdown led by China. The recent improvement in Japanese industrial production, which mirrors the improvement in EM trade, may be short-lived. This would depress Japanese inflation expectations and boost Japanese real rates, helping the yen in the process (Chart I-21). Shorting GBP/JPY may be one of the best ways to take advantages of these dynamics (Chart I-22). Chart I-20Global Cross-Asset ##br##Volatility Is Too Low Global Cross-Asset Volatility Is Too Low Global Cross-Asset Volatility Is Too Low Chart I-21If China And EM Slow, Japanese ##br##CPI Expectations Will Plunge If China And EM Slow, Japanese CPI Expectations Will Plunge If China And EM Slow, Japanese CPI Expectations Will Plunge Chart I-22New Downleg In ##br##GBP/JPY? New Downleg In GBP/JPY? New Downleg In GBP/JPY? Bottom Line: An oversupplied global economy could find it difficult to withstand the combined tightening emanating from China and the U.S. The improvement in global trade and global good prices is likely to dissipate in the coming month. The euro and commodity currencies could suffer from this development and the yen could benefit. Concluding Thoughts Global policy makers will ultimately not stand pat in the face of this problem. This may in fact deepen their well-entrenched dovish biases. As a result, while the scenario above sounds dire, it is likely to be transitory. The Chinese authorities will not let growth crater; European and Japanese policymakers will fight deflation; and even the Fed may be forced to leave policy easier than it would like. We will explore this topic in more detail in future publications. A Few Words On The RMB Chart I-23China Has Regained Control ##br##Of Its Capital Account China Has Regained Control Of Its Capital Account China Has Regained Control Of Its Capital Account This week, the RMB has been well bid as the PBoC announced that the currency will increasingly be used as a countercyclical tool. The market has interpreted this move as an attack on speculators betting on a falling RMB. The conditions had become very propitious for this kind of announcement to lift the CNY. On the back of a weaker dollar the trade-weighted RMB had in fact weakened for most of 2017 (Chart I-23, top panel), implying that the RMB has continued to help the Chinese economy. Additionally, capital flight out of China has slowed in response to the enforcement of capital controls, something made clear by the collapse in import over-invoicing (Chart I-23, bottom panel). Going forward, it is not clear whether this announcement is necessarily bullish or bearish. It all depends on the Chinese economy and its deflationary pressures. If we are correct that Chinese deflationary pressures are set to increase in the coming quarters, this could imply that Chinese authorities put downward pressure on the CNY later this year. That being said, we remain reluctant to short the yuan to play Chinese deflationary forces. The capital account is well controlled and the PBoC will continue to aggressively manage the exchange rate. This implies that currencies like the AUD or BRL, which exhibit strong correlations with Chinese imports, could remain the main vehicles to play a Chinese slowdown in the forex space. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The greenback displayed further weakness as FOMC member Brainard shared her opinions questioning the future path of U.S. policy. We consider these remarks as temporary hurdles for the dollar, as fundamentals are still in favor of a stronger dollar, which is something the Fed recognizes. This week, some minor deflationary worries resurfaced as the ISM Prices Paid declined to 60.5 from the previous 68.5. While this is true, the labor market continues to tighten as the ADP survey come in very strong. Additionally, ISM Manufacturing PMI also paints a brighter picture for manufacturing, coming in at 54.9. We believe the Fed will hike this month, and will continue to highlight its tightening path going forward, which will provide a fillip for the dollar. Report Links: Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Europe delivered a more negative outlook this week with softer data: Services sentiment, economic sentiment indicator, industrial confidence and business climate all came in less than expected; German CPI disappointed with CPI increasing at a 1.5% rate, less than the expected 2% rate, and the harmonized index also underperformed at 1.4%; European CPI also disappointed at 1.4%, while core CPI also slowed; However, Italian unemployment improved to 11.1% from 11.5%. President Draghi also reiterated his dovish stance in a speech on Monday. While the euro is up this week, elevated short-term valuations warrant a lower euro in coming months. Furthermore, following Draghi's reiteration, rate differentials may continue to move in favor of the dollar. Report Links: Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Upbeat data from Japan has lifted the yen this week: Job/applicants ratio is at 1.48, a level last seen in 1974; Retail trade increased at a 3.2% annual pace, much more than the expected 2.3% rate; Industrial production increased at a 5.7% pace; Housing starts increased at 1 .9%. While data surprises to the upside in Japan, low inflation still remains entrenched in the economy. We believe the BoJ will remain dovish until inflation emerges, which will keep JPY's upside limited. That being said, risk-averse behavior can provide a temporary tailwind for the yen in the upcoming months. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 The U.K.'s consumer sector remains mixed, showing a ray of sunshine after batches of poor numbers: Gfk Consumer Confidence came in at -5, better than the expected -8; Consumer credit came in at GBP 1.525 bn,; M4 Money Supply also increased at 8.2% yoy. Mortgage approvals, however, clicked in below estimates, while net lending to individuals was GBP 4.3 billion, less than expected and previously reported. Nevertheless, cable has been relatively strong this week, lifted by the euro. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 There was some negative data out of Australia this week: Building permits are still contracting, now at a 17.2% pace, less than the 19.9% pace last month; Private sector credit is expanding at a slower pace of 4.9%; AiG Performance of Manufacturing Index decreased to 54.8 from 59.2; AUD has been considerably softened recently, as commodity prices weakened. While the Chinese NBS manufacturing PMI marginally beat expectations, the Caixin Manufacturing PMI actually weakened from 50.3 to 49.6, and is now in contraction territory. As China continues to face structural issues, which are now front and center thanks to their most recent debt rating downgrade, AUD could suffer even more. In the G10 space, it is likely it will be one of the worst performing currencies this year. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 The NZD has seen a broad-based appreciation across the G10 space in the past 2 weeks due to stronger than expected trade balance and visitor arrivals. Dairy prices annual growth rate also remain robust at 56% this week. Further buoying the NZD was the release of the RNBZ Financial Stability Report, which was upbeat and states that financial risks have subsided in the past 6 months. The RBNZ also highlighted the slowdown in house price growth due to macroprudential measures. Most recently, NZD has been weak against European currencies, as upbeat data and a higher euro drove up these currencies. EUR/NZD is likely to trend downwards as growth differentials could further bifurcate central bank policies, and weigh on this cross. NZD/USD, itself, is unlikely to see much upside if the dollar bull market resumes and EM cracks deepen. However, AUD/NZD should weaken some more. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 The CAD has seen downside recently as oil's gains receded after markets seemed disappointed by the OPEC deal. Data further corroborated this negative view, as both industrial and raw material prices increased by less than expected at 0.6% and 1.6% respectively. Additionally, the first quarter current account also faltered into a further deficit of CAD 14.05 bn. However, GDP growth was strong and could improve further. Investors are currently highly bearish on the CAD, with net speculative positions at the lowest level in 10 years, suggesting the bad news is well priced in. Going forward, the BoC continues to argue that the output gap is closing quicker than expected which will warrant higher rates, and help the CAD. While the CAD may not appreciate much against the USD, it will be one nonetheless one of the best performing currencies in the G10 space. Report Links: Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 EUR/CHF continues to drift lower as lofty short-term valuations are hurting the euro. As the ECB is likely to remain accommodative, as per Draghi's recent remarks, the recent weakness may only be the beginning of a new trend. Recent data shows that there might be a slight deceleration in the Swiss economy as the KOF leading indicator has slowed down to 101.6. However, with Italian political risks growing faster than anticipated, the CHF could find additional support. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 As oil prices falter after the OPEC deal, the NOK displayed substantial downside against the USD, the EUR, and the CAD. Despite our Commodity and Energy team seeing additional upside for oil prices, the NOK will continue to be pulled down by low rates as the Norges Bank battles against deflationary prices, falling wages, and a weak labor market. Real rate differentials will prompt upside in USD/NOK, as well as CAD/NOK, as both the U.S. and Canada have adopted a hawkish and neutral bias, respectively. Regarding data, retail sales picked up from a meager 0.1% growth rate to a still unimpressive rate of 0.2%. At 5.1%, Norway's credit Indicator also grew less than expected and continues to slowdown. Report Links: Exploring Risks To Our DXY View - May 26, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Swedish data this week showed that last quarter, the economy did not perform as well as anticipated, with GDP increasing by 2.2%, lower than the expected 2.9%. However, more recent data shows a pickup in activity, with retail sales increasing at a 4.5% rate. USD/SEK has been weak recently due to the dollar's weakness, which we think is at its tail end. EUR/SEK's recent appreciation is likely to alleviate the Riksbank's deflationary worries. However, downside is possible as the euro may retract some of its gains. Report Links: Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades