Global

Highlights Overall Duration: The factors that have driven global bond yields lower over the past month are not sustainable. Maintain a below-benchmark duration exposure, with current yield levels looking attractive to add to underweight/short positions as we did last week. French Election: We got the market-friendly outcome in the French election that we were expecting. We are closing our recommended long 10-year France vs 10-year Germany Tactical Overlay trade after the post-election spread tightening, at a profit of 1.3%. Feature Investors breathed a sigh of relief yesterday, after the French presidential election produced the most market-friendly result - a Macron-Le Pen matchup in the May 7 run-off. Pre-election polling showed that the pro-Europe reformer Macron and his En Marche ("On The Move") party would easily trounce the anti-Europe populist Le Pen in a head-to-head showdown. That outcome would eliminate the possibility of a confidence-shattering "Frexit" along the lines of last year's U.K. vote that could stall the current global economic expansion. Elevated political risks in Europe, and geopolitical risks in Syria and North Korea, have been a factor driving volatility higher, and bond yields lower, in recent weeks. There have also been some data disappointments in the U.S. that have occurred at the same time (Chart of the Week). It is difficult to tell which factor has been more important for government bond markets. The fact that yields jumped worldwide yesterday after the French election result and, more importantly, the lack of any serious repricing in global equity and credit markets alongside the recent pop in volatility, suggests that bond markets are likely not sniffing out a sustained growth slowdown. Government bond yields remain too low relative to underlying economic and inflation trends, and we continue to recommend below-benchmark duration exposure and above-benchmark allocations to corporate credit versus government bonds (especially in the U.S.). Falling Bond Yields: Some Shifting Expectations, But Not A Change In Trend The recent decline in global bond yields began in mid-March. The move in most of the major markets was largely driven by falling inflation expectations, with real yields staying relatively stable, although in the U.S. the split was more 50/50. Importantly, both the nominal 10-year U.S. Treasury and German Bund yield are bouncing off the bottom of their upward sloping trend channels that started in early 2016 (Chart 2). Chart of the WeekA Series Of Unfortunate Events A Series Of Unfortunate Events A Series Of Unfortunate Events Chart 2Upward Trend In Yields Still Intact Upward Trend In Yields Still Intact Upward Trend In Yields Still Intact We see those upward trending channels as being the primary medium-term trend for bond yields. The recent pullback in yields has been the result of several individual factors that have occurred at the same time that are likely to reverse in the months ahead: Slower U.S. growth & inflation: The latest soft readings on U.S. retail sales and core CPI inflation are not consistent with the robust readings on business confidence and manufacturing activity, as well as the accelerating trend in U.S. corporate profit growth that our models expect will continue in the coming quarters (Chart 3). The latter is being driven by significant improvements in corporate pricing power that are helping boost profit margins, according to our equity strategists (bottom panel).1 We find it hard to believe that there can be a prolonged slowdown in the U.S. economy if earnings growth is accelerating and firms are not forced to cut back on hiring and investment to preserve profitability. The U.S. Overnight Index Swap (OIS) curve is now only discounting 38bps of rate increases over the next year, Treasuries look expensive as the Fed is likely to deliver at least 50bps worth of hikes by year-end and the large short positions in the Treasury market have been unwound (Chart 4). Chart 3The U.S. Economy Is Not Rolling Over The U.S. Economy Is Not Rolling Over The U.S. Economy Is Not Rolling Over Chart 4Treasuries Are Expensive & Positioning Is Now Long Treasuries Are Expensive & Positioning Is Now Long Treasuries Are Expensive & Positioning Is Now Long Softer U.S. wage inflation: Some of that boost to U.S. profit margins is also due to the recent slower pace of wage growth, which we do not expect to continue given the tightness in the U.S. labor market and the continued robust readings on labor demand indicators (Chart 5). We expect wage growth to begin ticking higher in the months ahead, as will overall U.S. inflation expectations which still appear too low. The Cleveland Fed Median CPI has been steady around 2.5%, which is where we expect headline CPI inflation to be if the Fed's inflation target of 2% on the PCE deflator is met.2 We see TIPS breakevens gravitating towards those levels in the coming months, driving longer-term U.S. Treasury yields higher. Setbacks on the Trump economic agenda: President Trump's failure to get health care reform passed in Congress was interpreted as a sign that the more pro-growth parts of his agenda, like tax reform and infrastructure spending, would also have difficulties getting implemented. We are not strong believers in the idea of a significant "Trump trade" impact on growth and bond yields, as the U.S. economy was already showing improvement before Trump won the presidency. Nonetheless, any delay in the fiscal easing that Trump promised during the campaign would act to dampen expectations for U.S. growth and Fed rate hikes on the margin, to the benefit of U.S. Treasuries. Trump announced that he will unveil his tax reform proposals this week, with Congressional hearings on the subject also set to begin. Our colleagues at BCA Geopolitical Strategy expect Trump to try and move quickly to get a deal done, especially after the initial failure on health care reform. The political risks for the Republicans are very real in next year's mid-term elections, with current polling pointing to large losses of seats that could return the House of Representatives to Democrat control. If the Republicans want to push through their reform agenda and try and boost growth heading into the 2018 midterms to try and avert a loss of the House, they cannot delay on tax reform this year. While the U.S. political situation is always a wild card, we do not think that "Trump trade" disappointment will be a factor weighing on Treasury yields over the rest of 2017. Lower oil prices: Some of the decline in the inflation expectations component of global bond yields can be attributed to the pullback in oil prices since late February. Our colleagues at BCA Commodity & Energy Strategy continue to have a bullish outlook on global oil prices, however, and view the recent dip as a buying opportunity.3 They expect Russia and Saudi Arabia to honor their agreement to remove 1.8mm barrels/day of production from the global oil market our by mid-2017, as visible inventory levels remain too high. Combined with stronger expected demand, our strategists expect oil prices to move toward the $60/bbl level by year-end (Chart 6). That move would boost help to raise inflation expectations, and bond yields, in the months ahead. Chart 5U.S. Inflation Expectations Still Too Low U.S. Inflation Expectations Still Too Low U.S. Inflation Expectations Still Too Low Chart 6Oil Prices Set To Move Higher Oil Prices Set To Move Higher Visible Inventories Barely Budge In 2017Q1, As Supply Surge And Lower Demand Collide Oil Prices Set To Move Higher Visible Inventories Barely Budge In 2017Q1, As Supply Surge And Lower Demand Collide Slower Euro Area inflation: Just like in the U.S., there was a pullback in Euro Area inflation expectations after the dip in realized inflation readings in March. While some cooling was expected simply from base effects related to swings in oil prices and the Euro, our headline CPI diffusion index indicates that an increasing majority of sectors are seeing accelerating price growth (Chart 7). If our commodity strategists are correct on the call for higher oil prices, we would expect to see some re-acceleration of Euro Area inflation, and more bear-steepening of Euro Area government bond yield curves, in the coming months. Especially if the European Central Bank (ECB) begins to send a signal about a tapering of its asset purchases - an outcome that is more likely if the polling data proves correct and Macron wins the French Presidency in two weeks, thus reducing the near-term political uncertainty in Europe. The ECB meets this week, and while we still think any shift in the ECB's tone is more likely at the June meeting (when a new set of economic projections will be produced), this will be the first opportunity for comments after the French election result. French Election Uncertainty: The pre-election rise in French risk premia fully unwound yesterday in a matter of hours (Chart 8). Implied volatilities on Euro Area equities and the EUR/USD exchange rate plunged, as did France sovereign CDS spreads. France-Germany government bond spreads tightened sharply as well, with the benchmark 10-year OAT-Bund spread declining -19bps from last Friday's closing levels. With Macron having a 20 point lead on Le Pen in a two-way race according to the latest opinion polls - which proved to be very accurate in the first round of voting - we think that current spread levels are consistent with a Macron victory on May 7. Chart 7Only A Brief Setback##br## In Euro Area Inflation Only A Brief Setback In Euro Area Inflation Only A Brief Setback In Euro Area Inflation Chart 8Taking Profit On Our Long France/Short ##br##Germany Spread Trade Taking Profit On Our Long France/Short Germany Spread Trade Taking Profit On Our Long France/Short Germany Spread Trade We do not expect much additional spread tightening if Macron does indeed win, especially if the ECB does begin to signal a tapering of bond purchases in 2018. That would result in wider risk premia across all European bond markets as valuations start to return to levels more in line with fundamentals. Given France's high sovereign debt levels and low productivity growth vis-à-vis Germany, we do not see the OAT-Bund spread returning to the pre-election lows if the ECB slows its bond buying. Thus, we are taking profits on the long France/Short Germany 10-year bond trade in our Tactical Overlay Portfolio, which we established back in early February when the spread was 76bps; 26bps higher than yesterday's close.4 Bottom Line: The factors that have driven global bond yields lower over the past month are not sustainable. Maintain a below-benchmark duration exposure, with current yield levels looking attractive to add to underweight/short positions as we did last week. We got the market-friendly outcome in the French election that we were expecting. We are closing our recommended long 10-year France vs 10-year Germany Tactical Overlay trade after the post-election spread tightening, at a profit of 1.3%. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Pricing Power Comeback," dated April 24 2017, available at uses.bcaresearch.com 2 That assumes a difference between headline CPI and PCE deflator inflation in line with its historical average of around 50bps. 3 Please see BCA Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Cuts Will Be Extended Into 2017/H2; Fade The Skew And Get Long Calls Vs. Short Puts," dated April 20 2017, available at ces.bcaresearch.com 4 Please see BCA Global Fixed Income Strategy Special Report, "Our Views On French Government Bonds," dated February 7 2017, available at gfis.bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Bond Yields On The Move, Higher Global Bond Yields On The Move, Higher Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Safe-haven assets do not simply outperform equities on a relative basis during bear markets. In fact, the average return of nine safe-haven assets has been positive in every bear market since 1972. A safe haven should serve two purposes. First, it should have a negative correlation with equities during bear markets, not necessarily in all markets. Second, it should have an insurance-like payoff, surging during systemic crashes. Low intra-correlations between safe-haven assets, and substantial absolute differences between individual returns and the overall group average suggest that selection adds significant alpha. In the next bear market, we recommend positions in CHF over USD and JPY, due to its greater consistency as a safe-haven asset and more attractive valuations. Favor gold over farmland and TIPS, as gold offers a better hedge against political risks while still protecting against rising inflation. Overweight Treasuries relative to Bunds given a more appealing return distribution and high spreads. Feature Feature ChartSafe Haven Performance Safe Haven Performance Safe Haven Performance As the economic expansion approaches its 100th month, far longer than 38.7 month average1 of cycles starting from 1854, concerns continue to mount over the next recession and equity market crash. Memories of over 50% losses in stocks during the subprime crisis are still ingrained in investors' minds and the importance of capital preservation and safe-haven assets cannot be stressed enough. Safe-haven assets do not simply outperform equities on a relative basis during bear markets. In fact, during the subprime crisis, an equal-weighted portfolio of nine safe-haven assets actually increased in absolute value by 12% (Feature Chart)! This has held consistent through every bear market since 1972 and we expect the next crisis to be the same. While we do not expect a bear market in the next 12 months, we do stress the importance of being prepared and tactically flexible given the substantial relative and absolute performance of safe-haven assets. In this Special Report, we analyze behaviors of safe havens during past bear markets in order to recommend tilts to outperform during the next major equity selloff. Historical Perspective For our analysis, we used monthly return data to more accurately compare across asset classes. We used the following nine safe-haven assets: U.S. Dollar - As the world's reserve currency, the U.S. dollar benefits from massive trade volumes. Japanese Yen - Japan is still the world's 3rd largest economy and runs a current account surplus. Investors' perceptions of safety are intact and the currency benefits from unwinding of carry trades during risk-off environments. Swiss Franc - Switzerland has built a reputation for its international banking prowess, political neutrality and economic stability. U.S. Farmland - Farmland differs from the others in that it is a tangible, hard asset. With finite supply and an increasing population leading to higher needs for farming and food, demand will remain robust. U.S. Treasuries - Treasuries have essentially no default risk. Since its formation in 1776, the U.S. has never failed to pay back its debt. German Bunds - Germany benefits from being economically and politically stable. Bunds are extremely liquid and could receive capital inflows in the event of euro area disintegration. Gold - Gold has a longstanding history as a safe-haven asset, protecting against inflation, currency debasement and geopolitical risks. U.S. TIPS - TIPS are the purest inflation hedge; their historical performance has held a very tight correlation with realized changes in consumer prices. Hedge Funds - Hedge funds are attractive given their lack of restrictions and ability to short. We classified an equity bear market as a decline in the S&P 500, from peak to trough, larger than 19%.2 Using this definition, we recorded eight separate instances since 1972 (See Appendix). On average, these episodes lasted about 14 months and equity prices experienced declines of 34%. We examined returns, correlations and recession characteristics in order to draw conclusions about potential future behavior. Key Findings: During bear markets, the value of these nine safe havens increased on average by 9.2% (Table 1). This certainly does not offset the 34% average decline in equities, but it does provide a considerable buffer, particularly if allocators tilt asset class weightings. However, there is concern that safe havens as a whole will not provide as much protection in the next downturn as they have in the past, given weak equity inflows and still-considerable cash on the sidelines (Chart 2). The average absolute spread between the returns of the nine safe havens and their overall average return was 12.3%. While the correlations between financial assets tend to spike upwards during bear markets, they actually remain very low between safe-haven assets. This indicates a significant opportunity for alpha generation during equity downturns. The region from which a crisis stems has little impact on which safe haven outperforms. For example, U.S. Treasuries and the U.S. dollar both increased in value during the past two recessions, despite the tech bubble and subprime crisis originating from the U.S. (Chart 3). Capital inflows into those assets remained robust given their reputation for safety and quality. U.S. Treasuries and the Swiss franc always had positive absolute returns during the eight bear markets, and therefore have always had a negative correlation with equities (Table 2). These two assets have very stable reputations for safety. Nevertheless, other safe havens, such as gold, USD, JPY and Bunds, still maintained negative correlations with equities during most bear markets. U.S. farmland and U.S. TIPS also had positive returns in the three bear markets since their starting dates. Hedge funds, while known to outperform equities during bear markets, did not provide positive absolute returns in any of the four equity downturns since the index began. Table 1Bear Market Performance Safe Havens: Where To Hide Next Time? Safe Havens: Where To Hide Next Time? Chart 2Safe Havens: Less Protection Next Time? Safe Havens: Less Protection Next Time? Safe Havens: Less Protection Next Time? Chart 3Location Doesn't Matter Safe Havens: Where To Hide Next Time? Safe Havens: Where To Hide Next Time? Table 2Correlation With Equities Safe Havens: Where To Hide Next Time? Safe Havens: Where To Hide Next Time? Investment Implications Chart 4A Near-term Bear Market Is Unlikely A Near-term Bear Market Is Unlikely A Near-term Bear Market Is Unlikely It is crucial to understand the purpose of a safe-haven asset as it pertains to portfolio management. First, a safe-haven asset should have a negative correlation with equities during bear markets, not necessarily in all environments. Secondly, and more importantly, a safe-haven asset should have an insurance-like payoff, surging during systemic crashes. As safe havens naturally receive a smaller allocation in typical portfolios due to their underperformance versus equities in most years, it is imperative that relatively smaller weightings and minor tilts offset large declines in equity prices. It is important, however to note that we view the probability of a bear market as highly unlikely over the next twelve months (Chart 4). First, substantial stock price declines are not very common outside of recessions. As our colleague Martin Barnes points out, the yield curve is not inverted, there are no serious financial imbalances, and the leading economic indicator remains in an uptrend.3 Monetary conditions are still stimulative, and it generally requires Fed tightening to surpass equilibrium before recessions occur. Massive average absolute deviations for each individual safe haven from the overall group average and low intra-correlations suggest that selection adds significant alpha (Chart 5). Unlike most financial assets, intra-correlations between safe havens actually decline during bear markets. In order to best compare and contrast safe havens, we divided the assets into three buckets: currencies, inflation hedges and fixed income. Below, we recommend tilts within these buckets and will revisit these recommendations closer to the next bear market. Chart 5Intra-correlations Remain Low In Bear Markets Intra-correlations Remain Low In Bear Markets Intra-correlations Remain Low In Bear Markets Currencies: Overweight CHF relative to USD and JPY. As a zero-sum game, currency selection offers a critical avenue for alpha generation. As global growth continues to improve and capital flows to more cyclical currencies, or to the USD where policymakers are tightening, the Swiss franc should become even more attractively valued. The franc's considerable excess kurtosis, indicating higher likelihood of outsized returns, best fits the insurance-like payoff quality (Chart 6). It is the only currency to have outperformed, and therefore held a negative correlation with equities, during each of the eight recessions, indicating high reliability as a safe-haven asset. Going forward, we see no reason for Switzerland's reputation for economic stability or political neutrality to be compromised. The biggest risk to this view would be if the Swiss National Bank were to stick stubbornly to its peg of the CHF to the EUR during the next recession, thereby dampening the franc's risk-off properties. The USD has historically been able to outperform even when the crisis originated in the U.S. Historical bear market performance was greatest, however, following sharp Fed tightening such as the Volker crash, when the Fed increased rates in response to high inflation, or in the subprime crisis, when the Fed increased rates to slow growth (Chart 7). While we expect inflation and growth to grind upward over the cyclical horizon, our base case is not for a surge in consumer prices or for economic growth to expand significantly above trend. Chart 6Return Distributions Safe Havens: Where To Hide Next Time? Safe Havens: Where To Hide Next Time? Chart 7Fed Tightening = USD Outperformance Fed Tightening = USD Outperformance Fed Tightening = USD Outperformance In the next bear market, the JPY will likely benefit from cheap starting valuations as the BoJ is currently aggressively easing, and its current account surplus raises its fair value. Nevertheless, the yen's returns during equity downturns have not always been consistent with its safe haven reputation. Of the three currencies, since 1970, it has had the lowest probability for large returns. Inflation Hedges: Overweight Gold relative to TIPS and Farmland. Over most of the time frames we tested, gold had the highest correlation with both headline and core inflation (Tables 3 & 4). Table 3Correlation With Core Inflation Safe Havens: Where To Hide Next Time? Safe Havens: Where To Hide Next Time? Table 4Correlation With Headline Inflation Safe Havens: Where To Hide Next Time? Safe Havens: Where To Hide Next Time? The main differentiating factor with gold is its ability to hedge against political risk. Our geopolitical strategists found that of all of the safe-haven assets, gold offered the best protection against political shocks4 (Chart 8). As mentioned in one of our recent Special Reports,5 we believe that stagnation in median wages and wealth inequality will continue to fuel the rise in populism and social unrest. Chart 8Gold Is Best At Hedging Political Risk Safe Havens: Where To Hide Next Time? Safe Havens: Where To Hide Next Time? Farmland has historically offered decent inflation protection, but its history is limited, supply is scarce and the massive runup in prices is a cause for concern. While we currently favor TIPS over nominal bonds, their negative skew and excess kurtosis suggest that they are vulnerable to large negative returns, making them a less-than-ideal safe-haven asset. Fixed Income: Overweight Treasuries relative to Bunds. Concerns that, because government yields are starting at very low levels, bonds will not provide safety in the next bear market, are overblown. Recent history proves that yields can reach negative territory, and historical performance for government fixed income has been robust in almost every significant equity decline. Additionally, the end of the 35-year decline in interest rates should not negatively affect the protection capabilities of Treasuries. Yields actually rose leading up to, and during, the 1972 and 1980 bear markets, and Treasuries still provided positive absolute returns (Chart 9). One caveat is that starting yields are much lower today. If yields were to rise during the next recession, they may not achieve positive absolute returns, though government bonds would still certainly outperform equities by a wide margin. Overall, Treasuries have held a more negative correlation with equities during bear markets, spreads over Bunds will likely continue to rise given diverging monetary policy, and they have historically been more prone to outsized positive returns during crisis periods (Chart 10). Bunds are currently benefitting from flight-to-quality flows resulting from political and policy issues originating in the periphery. However, at some point, concerns that the euro crisis will spread to Germany may eliminate this advantage. Chart 9Rising Yields Were Not A Problem Rising Yields Were Not A Problem Rising Yields Were Not A Problem Chart 10Relative Treasury Valuations Will Become More Attractive Relative Treasury Valuations Will Become More Attractive Relative Treasury Valuations Will Become More Attractive Patrick Trinh, Associate Editor patrick@bcaresearch.com 1 http://www.nber.org/cycles.html. 2 While a 20% decline may be a more widely-used measure for bear markets, there have been three instances of 19% declines since 1972, one of which was a recession. We decided to include these in our analysis to increase the number of observations and improve the reliability of our analysis. 3 Please see The Bank Credit Analyst Special Report, "Beware The 2019 Trump Recession," dated 7 March 2017, available at bca.bcaresearch.com. 4 Please see Geopolitical Strategy Special Report, "Geopolitics and Safe Havens" dated November 11, 2015, available at gps.bcaresearch.com. 5 Please see Global Asset Allocation Special Report, "Refreshing Our Long-Term Themes," dated 5 December 2016, available at gaa.bcaresearch.com.

Highlights Commercial oil inventories finished the first quarter with a minimal draw. This was largely due to a surge in production and sales by Gulf producers and Russia at the end of 2016 and earlier this year, as well as slightly lower demand. Despite reports floating storage and more opaque inventories - e.g., Caribbean storage - drew significantly, OPEC 2.0 remains well short of its goal to get visible oil stocks down to five-year-average levels by year-end. If drawing storage down to more normal levels remains OPEC 2.0's goal, then the production-cutting deal negotiated by Saudi Arabia and Russia will have to be extended when OPEC meets next month. We expect this to happen. Even so, risk-reversals in options markets indicate investors and hedgers are willing to pay more for downside put protection than upside call exposure. We recommend fading this bias, and buying out-of-the-money calls and selling out-of-the-money puts using Dec/17 options. Energy: Overweight. We closed our long Dec/17 WTI vs. short Dec/18 WTI position last Thursday with a 583.3% gain. We remain long Dec/17 Brent vs. short Dec/18 Brent, which is up 242.1%. Our long GSCI position is down 1.3%. We are recommending a long Dec/17 Brent $65/bbl call vs. a short Dec/17 Brent $45/bbl put, which we will put on at tonight's close. This is driven by our analysis of the need to extend OPEC 2.0's production-cutting deal into the end of the year to reduce OECD commercial oil inventories. We continue to expect Brent and WTI prices to trade on either side of $60/bbl by year-end. Base Metals: Neutral. Copper traded lower this week, on the back of news Freeport McMoRan is poised to resume exports from its Indonesian facilities. Precious Metals: Neutral. Gold traded higher, but remains range-bound. Our long volatility gold options play is up 2.9%. We will leave this trade on as a hedge, going into the French elections. Ags/Softs: Underweight: Despite heavy rains, grains (excluding rice) and beans were well offered this past week. Feature The surge in oil production and sales by Gulf producers and Russia at the end of last year and earlier this year, along with a reported slowing of demand - down ~ 100k b/d from our March estimates - combined to leave estimated supply and demand roughly balanced for 2017Q1 (Chart of the Week). These dynamics left visible OECD inventories above year-end 2016 levels (Chart 2). Chart of the WeekVisible Inventories Barely Budge In 2017Q1, ##br##As Supply Surge And Lower Demand Collide Visible Inventories Barely Budge In 2017Q1, As Supply Surge And Lower Demand Collide Visible Inventories Barely Budge In 2017Q1, As Supply Surge And Lower Demand Collide Chart 2Visible Inventories Will Reach 5-year Average##br## If OPEC 2.0 Production Cuts Are Extended Visible Inventories Will Reach 5-year Average If OPEC 2.0 Production Cuts Are Extended Visible Inventories Will Reach 5-year Average If OPEC 2.0 Production Cuts Are Extended Less-visible floating storage, along with oil stockpiles in China and Japan, drew more than 70mm barrels (bbls), according to Morgan Stanley, while Caribbean storage fell by some 10 - 20mm bbls during the last quarter.1 In addition, major trading companies are actively looking for buyers to take unwanted physical storage capacity off their hands. Nonetheless, OPEC 2.0 - the states banded together under the leadership of the Kingdom of Saudi Arabia (KSA) and Russia to remove some 1.8mm b/d of oil production from the market in 2017H1 - remains well short of its goal to get visible inventories down to five-year-average levels. Failure to reduce inventories almost surely requires producers allied in the production-cutting deal to extend their pact into 2017H2. We think they will, given the oft-stated desire of the Saudi and Russian energy ministers, Khalid Al-Falih and Alexander Novak, to see inventories continue to draw. Their desire was re-stated recently at a hastily called news conference in Houston last month.2 This message has remained constant from other OPEC leaders as well. The Logic Of Extending OPEC 2.0's Deal To 2017H2 Reducing the global storage overhang is imperative for the OPEC 2.0 coalition. It is the driving force behind the unlikely alliance KSA and Russia forged at the end of last year. Without pulling storage down to more normal levels, inventories remain too close to topping out, which puts markets at higher risk of the sort of price collapse seen in 2015 - 16. At the beginning of 2016, global oil markets were close to pricing in the approach of a full-storage event. In such an event, as global inventories approach capacity, prices trade below the cash-operating costs of the most expensive producers, until enough supply is forcibly knocked off line to drain excess stocks. This is an extremely high-risk scenario for states like KSA, Russia and their allies, which are heavily dependent on oil-export revenues to fund government budgets and much of the private sector.3 After the last such event at the beginning of 2016, these states were left reeling, as fiscal spending was slashed, projects were canceled and governments burned through foreign reserves in an effort to make up for lost revenue. Entering the second quarter of this year, KSA and its allies continue to over-deliver on their pledges to cut ~ 1.2mm b/d of production. Markets are expecting Russian cuts to increase to ~ 300k b/d, in line with their pledges under the OPEC 2.0 production-cutting Agreement negotiated last year (Chart 3 and Chart 4). Chart 3KSA Continues To Over-Deliver; ##br##Russian Cuts Expected to Increase KSA Continues To Over-Deliver; Russian Cuts Expected to Increase KSA Continues To Over-Deliver; Russian Cuts Expected to Increase Chart 4KSA Allies Continue to Deliver;##br## Iran And Iraq Continue To Under-Deliver KSA Allies Continue to Deliver; Iran And Iraq Continue To Under-Deliver KSA Allies Continue to Deliver; Iran And Iraq Continue To Under-Deliver However, if the OPEC 2.0 production deal to remove ~ 1.8mm b/d of production is not extended beyond its end-June deadline, storage levels will remain uncomfortably high for the KSA - Russia alliance. By our reckoning, allowing the deal to expire without extending it would only reduce visible OECD inventories by a little over 170mm barrels by year-end. This can be inferred from our assessment of balances (Chart of the Week). Not extending OPEC 2.0's deal leaves OECD commercial oil inventories close to 130mm barrels above the targeted 300mm-barrel drawdown required to return OECD inventories to more normal (i.e., five-year average) levels. With U.S. shale production coming on strong, this could be precarious for OPEC 2.0 next year. Extending the OPEC 2.0 production-cutting deal to the end of 2017H2 will reduce visible commercial inventories in the OECD by slightly more than the 300mm barrels being targeted (Chart 5). This should put storage levels back at more normal, five-year average levels, and give OPEC 2.0 some breathing room to craft a strategy to contain U.S. shale production going forward.4 For this reason, extending the 1.8mm b/d production cuts to end-2017 is almost a foregone conclusion for us, particularly as KSA needs to clean up the market, so to speak, ahead of the IPO of Saudi Aramco next year. Among other potential investors with a keen interest in the potential $100 billion floatation is a state-led consortium of Chinese banks and oil companies.5 We Think Upside Risks Dominate Oil Markets The logic of extending the OPEC 2.0 deal is compelling. But the market does not share this view. Oil speculators have significantly reduced their net long position as a percent of total open interest in the dominant crude-oil futures markets, WTI and Brent (Chart 6). This, after the specs were chastened following their huge increase in upside exposure earlier this year. Chart 5Extending OPEC 2.0'S Production Deal Reduces ##br##OECD Oil Stocks By 300mm+ Barrels By End-2017 Extending OPEC 2.0'S Production Deal Reduces OECD Oil Stocks By 300mm+ Barrels By End-2017 Extending OPEC 2.0'S Production Deal Reduces OECD Oil Stocks By 300mm+ Barrels By End-2017 Chart 6Specs Are Retreating From Oil Specs Are Retreating From Oil Specs Are Retreating From Oil We can also see a lack of conviction in oil options markets. Option markets provide a useful gauge of fear and greed called "skew," which is nothing more than the difference between implied option volatilities (IOV) for puts and calls.6 When the skew favors puts - shown by a negative number in the risk-reversal shown in Chart 7 - markets are signaling they value downside protection more than upside exposure, and vice versa when call IOVs exceed put IOVs. Chart 7Option Skew Favors Downside Puts ##br##Over Upside Call Exposure Option Skew Favors Downside Puts Over Upside Call Exposure Option Skew Favors Downside Puts Over Upside Call Exposure Given the logic we laid out above, we are recommending investors fade the put skew in the options markets. Specifically, we are getting long out-of-the-money Dec/17 $65/bbl Brent calls and selling out-of-the-money Dec/17 $45/bbl Brent puts against them, to express our view. We will be doing so at the close of trading today, and will report our strikes and net premium in next week's publication.7 Bottom Line: We expect the OPEC 2.0 production deal to be extended when OPEC meets on May 25 in Vienna. This will significantly raise the odds OECD commercial oil stocks will be drawn down to more normal levels, giving the OPEC 2.0 petro-states more breathing room to develop a strategy to regain a modicum of control over prices. This is critical for KSA, which still is on track to IPO Saudi Aramco next year. Given our expectation, we are recommending investors buy out-of-the-money Dec/17 $65/bbl Brent calls and sell out-of-the-money Dec/17 $45/bbl Brent puts. This allows investors to fade what appears to be a consensus - given put skews and spec positioning - and capitalize on what we believe is an all-but-certain extension of the OPEC 2.0 production deal. We expect WTI and Brent to trade on either side of $60/bbl by December, and to average $55/bbl to 2020. As has been mentioned often, our level of conviction in that forecast is low beyond 2018, given the large capex cuts for projects that would have been funded between 2015 and 2020 absent the 2014 - 2016 oil-price collapse. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see "OPEC's Barkindo Sees Progress in Oil Cuts as Stockpiles Drop," and "Oil Traders Drain Hidden Caribbean Hoards as OPEC Cuts Bite," published by Bloomberg.com on April 2 and 3, 2017, respectively. 2 Please see "Saudi Arabia, Russia Offer United Front on Oil Supply Cuts," published by Bloomberg.com on March 7, 2017, and "Saudi energy minister says oil market fundamentals improving," published by reuters.com on the same day. 3 BCA Research's Commodity & Energy Strategy examined this in our feature article published on September 8, 2016, entitled "Ignore The KSA - Russia Production Pact, Focus Instead On Their Need For Cash." It is available at ces.bcaresearch.com. 4 We discuss this at length in "KSA's, Russia's End Game: Contain U.S. Shale Oil," and "The Game's Afoot In Oil, But Which One," published by BCA Research's Commodity & Energy Strategy Weekly Report April 6 and March 30, 2017, Both are available at ces.bcaresearch.com. 5 Please see "Exclusive: China gathers state-led consortium for Aramco IPO - sources," published by Reuters.com on April 19, 2017. We speculated on just such an event in "Desperate Times, Desperate Measures: Aramco And The Saudi Security Dilemma," published by BCA Research's Commodity & Energy Strategy and its Geopolitical Strategy January 14, 2016. We noted, "While inviting Western investors and energy firms to take a stake in Aramco would make obvious sense for Saudi Arabia, we would speculate that the real target for the IPO will be Chinese state-owned enterprises (SOEs). China has overtaken the U.S. as the main importer of crude from Saudi Arabia ... but it continues to free-ride on Washington's security guarantees and commitments in the region. By giving China a stake in Saudi Arabia's energy infrastructure, Riyadh would force Beijing to start caring about what happens in the region." 6 "Implied option volatility" is market jargon for the standard deviation of expected returns. It is used as an input for option-pricing models. The "implied," as it's known colloquially in markets, solves an option-pricing model like Fischer Black's, once the option's premium is discovered via trading. Market participants can determine whether puts (i.e., the right, but not the obligation, to sell) are more highly valued than calls (the right to buy) in relative terms by differencing the implied volatilities of puts and calls that are equidistant from at-the-money options. This is referred to as the options' "skew." We use the IOVs for puts and calls that both change by $0.25/bbl for every $1.00/bbl move in oil futures (i.e., 25-delta puts and calls) to calculate skew. Please see Fischer Black's seminal article, "The Pricing of Commodity Contracts," in the Journal of Financial Economics, Vol. 3, (1976), pp. 167-79. 7 We employed a similar strategy in March 2016 - getting long Dec/16 Brent $50/bbl calls vs. selling $25/bbl puts, which registered a 103.5% gain between March 3 and April 14, following a rally in Brent prices. 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 OPEC 2.0 Cuts Will Be Extended Into 2017H2; Fade The Skew And Get Long Calls Vs. Short Puts OPEC 2.0 Cuts Will Be Extended Into 2017H2; Fade The Skew And Get Long Calls Vs. Short Puts

Highlights GFIS Portfolio: Our GFIS model fixed income portfolio has essentially matched the benchmark in the six months since inception. Our strategic below-benchmark duration stance has given up much of the strong Q4/2016 excess return performance over the past couple of months as bond yields have drifted lower. Corporate bonds contributed positively to performance, particularly after our upgrade of U.S. Investment Grade and High-Yield in late January. Upsizing Positions: The weightings in our model portfolio appear to have been too small versus our benchmark index to generate any meaningful outperformance. This week, we increase our positions for our highest conviction views: staying below-benchmark portfolio duration, underweighting U.S. Treasuries, overweighting U.S. corporate debt and underweighting Italian government debt. Tactical Overlay: Our current Tactical Overlay trades have been very successful over the life of the model bond portfolio, with 9 of 12 positions currently in the money with an average return of 0.45%. We are maintaining these positions for now, even as we alter the model portfolio. Feature Last September, we introduced a new element into our global bond strategy framework - a model portfolio that allows us to track the combined performance of our individual recommendations. The first piece of this process was the introduction of our custom benchmark index that defined our investment universe, which is similar to the Barclays Global Aggregate but with a dedicated allocation to global high-yield corporate debt.1 The next component is presented in this Special Report, where we take an initial look at measuring the performance of our model portfolio. The final element (to be presented in another upcoming report) will be introducing a formal risk management system into our process to help guide the relative sizes of our suggested portfolio tilts. We intend to show the portfolio returns on a quarterly basis going forward, in line with the types of reporting mandates that a typical bond manager might face. However, our recommendations are meant to play out over a more strategic investment horizon of one full year, in line with our proven strength in analyzing medium-term macroeconomic and investment trends. Each individual quarterly report should be interpreted in that context as only a partial reflection of the full expected return from our portfolio if our market calls come to fruition. Overall Portfolio Performance Attribution: Winners & Losers Chart 1GFIS Model Portfolio Performance GFIS Model Portfolio Performance GFIS Model Portfolio Performance Our model portfolio has delivered a total return of -0.41% (hedged into U.S. dollars) since inception on September 20, 2016. This slightly underperformed our Global Fixed Income Strategy (GFIS) custom benchmark index by -2bps, but did outperform the Barclays Global Aggregate index that returned -0.85%. In terms of the main drivers of our returns, the government bond portion of our portfolio added +3bps of excess return versus our GFIS benchmark, while the spread product component subtracted -5bps (Chart 1). These are admittedly small numbers, essentially delivering a benchmark return in six months. In terms of our major asset allocation decisions, our below-benchmark overall duration stance served us well in the final quarter of 2016, adding +20bps of excess return during the run-up in global bond yields following the election victory of President Trump in November. After shifting to a neutral posture in early December, however, our decision to cut duration again in late January has hurt the performance of our model portfolio, as global bond yields have since fallen and eliminated much of our gains from duration positioning from Q4/2016. On the other hand, that same choice to lower duration exposure in late January coincided with our decision to raise exposure to U.S. corporate bonds (both investment grade and high-yield) and cut the allocations to U.S. Treasuries and Euro Area investment grade corporates. U.S. corporates have performed relatively well since then, helping pull the excess return from our overall spread product exposure, excluding U.S. Mortgage Backed Securities (MBS), into positive territory (Chart 1, bottom panel). Unfortunately, our underweight tilt on U.S. MBS - a sector that represents a hefty 14% of our benchmark index - has acted as a drag on our overall returns from spread product. However, MBS performance has started to lag both U.S. Treasuries and corporates of late, justifying our underweight stance. A more detailed performance attribution is presented in Table 1, which shows the excess returns broken down by the same government bond duration buckets and credit sectors that we regularly present in the model portfolio table in our Weekly Reports. We also show the average deviation from our GFIS benchmark index weightings (our "active" positions) over the period in question to give a sense of the bias of our tilts. Table 1A Detailed Breakdown Of The GFIS Model Performance An Initial Look At The Performance Of Our Model Bond Portfolio An Initial Look At The Performance Of Our Model Bond Portfolio Within the government bond portion of our model portfolio, there were positive excess return contributions from the U.S. and Japan (Chart 2), largely coming from underweights at the very long end of the yield curves that reflect our bias for curve steepening in those markets. The 10+ year duration buckets in the U.S. and Japan added +8bps and +7bps of excess return, respectively. Also, our underweight position in Italy helped generate a small positive excess return of +3bps. Chart 2GFIS Model Portfolio Performance Attribution By Country Within Government An Initial Look At The Performance Of Our Model Bond Portfolio An Initial Look At The Performance Of Our Model Bond Portfolio At the same time, our exposures in Europe proved to be an almost equivalent drag on returns, as we maintained an underweight in U.K. Gilts, and overweights in German and French sovereign debt, for a bit too long before the trends in those markets turned late last year (more bullishly for the U.K. and bearishly for core Europe). Within the spread product segment of the portfolio (Chart 3), our steady overweight to U.S. Investment Grade Financials and our large underweight to U.S. Investment Grade industrials late last year (which we reduced substantially in December) helped those segments deliver excess returns of +5bps and +2bps, respectively. Our decision to upgrade High-Yield in late January also added positively to our performance within the Ba-rated and B-rated credit tiers. Emerging market debt, where we have maintained only a neutral weighting, was the largest contributor to absolute returns within our portfolio and our benchmark, adding +30bps to both. Chart 3GFIS Model Portfolio Performance Attribution By Sector Within Spread Product An Initial Look At The Performance Of Our Model Bond Portfolio An Initial Look At The Performance Of Our Model Bond Portfolio Detailed charts showing the total returns, yields, portfolio weights and excess returns for some of our best and worst performing sectors are presented in the Appendix on page 11. Bottom Line: Our GFIS model fixed income portfolio has essentially matched the benchmark in the six months since inception. Our strategic below-benchmark duration stance has given up much of the strong Q4/2016 excess return performance over the past couple of months as bond yields have drifted lower. Corporate bonds contributed positively to performance, particularly after our upgrade of U.S. Investment Grade and High-Yield in late January. Increasing The Sizes Of Our Highest Conviction Portfolio Recommendations Delivering only a benchmark-like return is hardly the goal we are aiming to achieve with our model portfolio. However, given how much our weightings have, in aggregate, mirrored those of our benchmark index so far, the results should not be a surprise. The average (mean) allocations to government debt and spread product over the six-month life our model portfolio are shown in Chart 4, alongside the average (mean) benchmark weightings. It is clear from that chart that our overall exposures have been far too similar to those of our GFIS benchmark index. In the parlance of portfolio management, we have been taking far too little tracking error versus our benchmark, so far, to generate any meaningful alpha. Or, more simply put, our recommended positions have been too small and, in many cases, have been offsetting each other. Chart 4Bigger Tilts Are Needed In The Model Portfolio An Initial Look At The Performance Of Our Model Bond Portfolio An Initial Look At The Performance Of Our Model Bond Portfolio The absence of a true risk management system, incorporating sector correlations and volatilities, has clearly been an issue so far. Our initial (and, admittedly, simple) attempt at sizing our recommendations was based on translating our "1 to 5" rankings from our traditional portfolio allocation tables into a factor that would scale up/down the individual country or sector weightings versus our benchmark.2 Clearly, this approach has not created portfolio weightings large enough to move the needle on performance. We will look to complete that final piece of our GFIS model portfolio framework - appropriate trade sizing and risk management - in the next couple of months. This will allow us to more properly size our relative positions going forward while maintaining enough overall deviation from the GFIS benchmark index (i.e. tracking error) to have a chance to generate meaningful outperformance. For now, however, we feel that we can comfortably increase the sizes of our current recommended tilts for our highest conviction views, which we discussed in our most recent Weekly Report.3 We are reducing our overall portfolio duration from the current 6.34 years (-0.64 years versus our GFIS benchmark index duration) to 5.75 years. After the recent decline in bond yields on the back of rising global geopolitical tensions and a modest soft patch of "hard" U.S. economic data, the entry point for reducing duration exposure even further is attractive. We are cutting our allocation to U.S. Treasuries from the current 14.6% (-3% versus the benchmark) to 10%, and placing the proceeds equally into U.S. Investment Grade and High-Yield corporate debt. This is to capitalize on the cyclical uptrend in U.S. growth and corporate profits, and additional Fed rate hikes, which we still see unfolding this year. We are cutting our allocation to Italian government debt from the current 3.5% (-0.8% versus the benchmark) to 1%, and placing the proceeds equally into Germany and Spain. This is to reduce exposure to the weakest link in the Euro Area, particularly as political risks will remain elevated in Italy leading up to the parliamentary elections that are due in 2018. We are maintaining the current sizes of the medium conviction views that we discussed last week - specifically, the overweight stance on Japanese government bonds (a low-beta market in a rising yield environment) and an underweight tilt on U.S. MBS (where valuations are stretched). The new weightings within our portfolio are shown in the model portfolio table on page 10. Bottom Line: The weightings in our model portfolio appear to have been too small versus our benchmark index to generate any meaningful outperformance. This week, we increase our positions for our highest conviction views: staying below-benchmark portfolio duration, underweight U.S. Treasuries, overweight U.S. corporate debt and underweight Italian government debt. Don't Forget About Our Tactical Overlays Our model portfolio is intended to be a reflection of the more medium-term, strategic fixed income investment views that stem from our regular analysis of trends in the global economy, inflation, monetary policy, etc. In other words, the positions in the portfolio are not intended to be changed too frequently. We also have chosen to stick with what we believe are more liquid markets in the portfolio, and without any use of derivatives of leverage to amplify returns beyond what the "fundamentals" suggest. Our recommendations that are shorter-term in nature (i.e. 0-3 months), or that may be in less liquid markets (i.e. New Zealand government bonds or U.S. TIPS), or that involve derivatives (i.e. Japanese CPI swaps or Sweden Overnight Index Swaps) are placed in our "Tactical Overlay Trades" list that appears in every Weekly Report. These recommendations have been performing extremely well since the inception of our model portfolio, as shown in Table 2.4 Table 2GFIS Tactical Overlay Trades Are Doing Well An Initial Look At The Performance Of Our Model Bond Portfolio An Initial Look At The Performance Of Our Model Bond Portfolio 9 of the current 12 trades are making money, with an average total return of 0.45%. The most successful are the long U.S. TIPS/short U.S. Treasuries trade (+3.4%) and the short 10-year Portugal government bond versus German Bunds trade (+1.0%). While we have not made any attempt to put any position sizes on those trade ideas, in contrast to our model portfolio, it is clear that even a modest allocation to each of these trades would have generated a meaningful positive return "overlay" on top of what was generated by our model portfolio. Bottom Line: Our current Tactical Overlay trades have been very successful over the life of the model bond portfolio, with 9 of 12 positions currently in the money with an average return of 0.45%. We are maintaining these positions for now, even as we alter the model portfolio. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Special Report, "Introducing Our Recommended Global Fixed Income Portfolio", dated September 20, 2016, available at gfis.bcaresearch.com 2 For example, a "5 of 5" ranking would generate a portfolio allocation that was 1.75x the benchmark index weight, while a "1 of 5" ranking would apply a 0.5x factor to the index weight. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "The Song Remains The Same", dated April 11, 2017, available at gfis.bcaresearch.com 4 Please note that in Table 2, the returns on the trades that were initiated before the inception of our model portfolio on September 20th, 2016 are shown from that date and not from the date that the trade was initiated. This is to allow an "apples-to-apples" comparison to our model portfolio performance. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index An Initial Look At The Performance Of Our Model Bond Portfolio An Initial Look At The Performance Of Our Model Bond Portfolio Appendix - Selected Sectors From The GFIS Model Portfolio Appendix 1 Appendix 1 Appendix 2 Appendix 2 Appendix 3 Appendix 3 Appendix 4 Appendix 4 Appendix 5 Appendix 5 Appendix 6 Appendix 6 Appendix 7 Appendix 7 Appendix 8 Appendix 8

Highlights Small caps have not consistently outperformed large caps. However, the cyclical nature of small-cap relative performance may provide tactical timing opportunities. Index methodology plays a very important role in the behavior of small-cap performance. Currently, we recommend being neutral on size in a balanced global equity portfolio because risk/reward between small and large caps is balanced, and because GAA is overweight cyclicals versus defensives, a similar play but with a better risk/reward profile. Feature The Academic Evidence On Size Premium In academic research, the size premium, or the outperformance of small-cap common stocks relative to large-cap common stocks, has been calculated mostly based on the difference between the return of the smallest cap portfolio and that of the largest cap portfolio. Since the first academic paper that "discovered" the "size premium" in 1981, by Rolf Banz of the University of Chicago,1 a great deal of research has been devoted to this subject, both for and against the validity of the size premium.2 Table 1 comes from Asness et al.3 It summarizes the statistics of monthly size premium over time using the two most widely used zero-cost portfolio approaches to capture the returns to size. 1) The "small minus big" (SMB) stock factor return of Fama and French:4 the average return of three small portfolios minus the average return of three large portfolios obtained from Ken French's website;5 and 2) the return spread between size-sorted and market cap-weighted decile portfolios. The universe is all the stocks listed on the NYSE, AMEX and NASDAQ, including delisted securities from the CRSP (Center for Research in Security Prices) database. Table 1Size Premium Over Time* Small Cap Outperformance: Fact Or Myth? Small Cap Outperformance: Fact Or Myth? The size premium is statistically significant at the 5% level with a t-stat of 2.27 for SMB and 2.32 for D1-D10 for the full sample period from 19266 to 2012;7 However, most of the size premium comes from January, while in the rest of the year the size return is economically and statistically not different from zero; The size premium was not always positive over time, as evidenced during the period 1980-1999 when small cap suffered a 20-year underperformance right after the size premium was "discovered" in 1981. Compared to SMB, the more extreme approach, Decile 1 minus Decile 10, has produced a larger positive size premium (as well as a larger negative size premium in periods of underperformance), suggesting that micro caps, the most volatile segment of the market, may have a significant impact on the overall size premium. However, for non-quant practitioners, especially asset allocators, the portfolio approaches used in academic research may not be practical. In this report, we will study a series of small cap and large cap benchmark indexes in the U.S. and globally that are commonly used by practitioners to shed some light on the size premium and how it can be harvested, if it indeed exists. Not All Small-Cap Indexes Are Created Equal, Even In The U.S. There is no definitive definition of small cap. The general consensus is that it refers to companies with market value between US$300 and US$2 billion in the U.S., while in other markets this may vary. In the U.S., the first small-cap index, the Russell 2000 (R2K), was created in 1984, after the size premium was discovered in 1981 by Rolf Banz. While Banz was not sure if size per se was responsible for the effect or if size was just a proxy for one or more true unknown factors correlated with size, Fama and French published their ground breaking work in 19926 and 19934 confirming the existence of size and value factors. Then in 1994 the S&P launched its own small-cap index, the S&P 600. Chart 1U.S. Small Cap Performance Divergence U.S. Small Cap Performance Divergence U.S. Small Cap Performance Divergence Chart 1 shows that the performance of these two indexes has been quite different even though they have been highly correlated. Since December 1994, the S&P 600 has outperformed the R2K by about 50%-about 2% per year on a compound basis. From 1980 to 1994, however, the back-calculated8 S&P 600 significantly underperformed the R2K. So what has contributed to such significant performance difference between these two U.S. small-cap indexes? The answer may lie in the different methodologies used in constructing them. Different Universe And Size Distribution: FTSE Russell9 and S&P Dow Jones10 use different eligibilitFy conditions to define their respective universes for the U.S. equity market. Russell 3000 (R3K) contains the 3000 largest publicly traded companies in the U.S. by market cap. The smallest 2000 names go into the R2K, which currently accounts for about 8% of the R3K by market cap weight.11 The S&P 1500 contains the 1500 largest names, also by market cap, with the S&P 600 being the smallest 600 of these names, which account for less than 3.5% of the S&P 1500. Even though the stated target market-cap range is US$30 million to US$2 billion for the R2K, and US$450 million to US$2.1 billion for the S&P 600, respectively, currently about 50% and 40% of the companies in the R2K and the S&P 600 respectively have a market cap over US$2 billion, as shown in Chart 2. The R2K even has 25% over US$3 billion, about 15% more than the S&P 600. Different Sector Compositions: Both indexes' sector composition has evolved over the years due to changes in the economy and financial markets. Their current sector compositions are shown in Table 2. Most notably, the S&P 600 has higher weights in industrials and consumer discretionary, while R2K has higher weights in technology, financials, real estate and utilities. Chart 2U.S. Small-Cap Index Market Cap Distribution Small Cap Outperformance: Fact Or Myth? Small Cap Outperformance: Fact Or Myth? Table 2Canadian Small-Cap Index Sector Composition Small Cap Outperformance: Fact Or Myth? Small Cap Outperformance: Fact Or Myth? Global Small Caps Have Not Consistently Outperformed Large Caps MSCI also produces small-cap indexes for each country. According to the MSCI Global Investable Markets Index methodology,12 the size cut-off for each size segment needs to be a balance between the minimum size requirement and the target coverage range, in addition to other requirements such as liquidity and free float. As shown in Table 3, large caps comprise the top 70% of the investable universe, mid caps the next 15%, and small caps a further 14%. As of October 2016, the market-cap range for the DM small-cap index is from US$527 million to US$5 billion, and about half that for the EM small-cap index. Table 3MSCI Size Cut-Offs* Small Cap Outperformance: Fact Or Myth? Small Cap Outperformance: Fact Or Myth? MSCI indexes apply the same rules to all markets, which aids the global comparison analysis. Unfortunately, MSCI indexes have very short histories. Chart 3 shows the relative performance of small caps vs. large caps based on the MSCI indexes, and also local exchange indexes (where available). All panels are rebased to 1 as of March 2009 when the S&P 500 reached its low during the most recent financial crisis. The shaded areas are U.S. recession periods as defined by NBER. Several observations from Chart 3: U.S., U.K. and Japan have relatively long histories for the small-cap indexes. Based on the three countries' local indexes, small caps have barely outperformed large caps over the full history available; From the index inceptions until 1999, small-cap indexes broadly underperformed large caps in the U.S., U.K. and Japan, in line with the findings of the academic research shown in Table 1; Since 2000, however, small caps have outperformed large caps in most countries (in line with the academic findings shown in Table 1) with the exception of Canada and Australia, which both have extremely skewed sector composition. As shown in Table 4, a bet on Canadian small caps vs. large caps is essentially a bet on materials, real estate and industrials versus financials and telecoms; In the most recent cycle from March 2009, small-cap outperformance has been most prominent outside the U.S., especially in the U.K. and euro area. This might be due to the fact that the U.S. is the most academically researched market and that most small-cap funds are U.S. oriented. In the U.S., the MSCI and the S&P small-cap indexes have performed better than the Russell indexes, which is likely due to the fact that Russell does not have a midcap segment, with both the R2K and R1K including stocks that would elsewhere be classified as mid caps. Table 4Canadian Small-Cap Index Sector Composition Small Cap Outperformance: Fact Or Myth? Small Cap Outperformance: Fact Or Myth? Drivers Of Small/Large Cap Performance Even though small-cap stocks have not consistently outperformed large-cap stocks over the long run, Chart 3 indicates that the relative performance does have cycles, which may provide tactical opportunities for investors. In line with our investment approach across all asset classes, we try to identify the key factors that drive the relative performance of small caps versus large caps based on economic fundamentals, valuation metrics, and technical conditions. Economic Conditions: Compared to large-cap companies, small-cap firms are usually smaller-scale enterprises with a more domestic focus and less tried-and-tested business models. On average, they have less predictable cash flows, lower profit margins and lower credit ratings. As such, their ability to withstand hard times is lower, while their likelihood to prosper in good times is higher. Chart 4 (panel 1) shows that the rate of change in the small/large cap performance ratio has a good correlation with the PMI, indicating that stronger economic growth is indeed better for the more cyclically-oriented small-cap firms. Other factors such as credit spreads and small enterprise confidence also have good correlations with small/large cap performance in the most recent cycle, but historical correlations were much looser (panels 2 and 3). Chart 3Small Vs. Large Cap Performance Small Vs. Large Cap Performance Small Vs. Large Cap Performance Chart 4What Drives Size Performance? What Drives Size Performance? What Drives Size Performance? Valuation Metrics: Asness et al4 labelled 2000-2012 as the "resurrection" period for small-cap outperformance. Chart 4 (panel 4), shows that the first uninterrupted outperformance from 2000 to 2006 started at an extremely cheap valuation in 2000 when small caps were trading at a 36% discount to large caps, two standard deviations below the five-year average discount of 8%. The six-year uninterrupted outperformance was largely driven by relative valuation expansion such that by 2006, when the outperformance peaked, small caps were trading at a 20% premium, two standard deviations above the five-year average, which was a discount of 4%. The unwinding of the excessive valuation over the next two years brought the valuation metrics back to an extremely cheap level again in 2008, which kick-started another strong period of outperformance for small caps. However, since 2012 valuation has failed to expand even though small caps continued to outperform, albeit at a slower pace. This might be due to the fact that, on an absolute basis, small caps have been trading at a premium to large caps, and because valuation expansion became more difficult given how low small-cap profit margins have been (panel 5). Technically, based on our factor studies on momentum, a simple 12-month rate of change has generated positive alpha in a statistically significant way. We use the standardized 12-month rate of change of the relative performance ratio to gauge the relative momentum (panel 6) Portfolio Recommendation: Neutral On Size Over The Next 9-12 Months Chart 5There Is A Better Alternative There Is A Better Alternative There Is A Better Alternative The top panel of Chart 5 shows that the relative performance of global small caps versus large caps had a close correlation with cyclicals/defensives from 1995 to 2011, but that the two have diverged over the past five years, during which time small caps have outperformed large caps by 7%, but cyclicals have underperformed defensives by 4%, despite a strong reversal in 2016. This divergence could be explained by relative earnings growth, as shown in panel 2: small-cap earnings outpaced large-cap over the past five years, while cyclicals' earnings growth lagged defensives' until 2016 when a reversal occurred. Given our view on global growth and the historical correlation shown in panel 3, it's likely that cyclical earnings growth will further outpace the defensive earnings growth over the next 12 months. GAA's portfolio approach is to take risk where risk is most likely to be rewarded. We already have overweights on equities versus bonds at the asset class level, and on cyclicals versus defensives in our global equity sector positioning, on a 12-month investment horizon. As such, we do not feel comfortable adding a similar, but less rewarding, risk into our recommended global equity portfolio. In addition, current readings on the key performance drivers also support a neutral rating: as shown in Chart 4, both valuation and technical indicators are at the neutral level. The Global PMI is strong, but credit spreads are tight and small enterprise surveys in the U.S. and Japan are already at extremely optimistic levels. Xiaoli Tang, Associate Vice President xiaolit@bcaresearch.com 1 Banz, Rolf (1981), "The relationship between Return and Market Value of Common Stocks," Journal of Financial Economics, vol.6, 103-126 2 Van Dijk, Mathijs A, (2011), "Is size dead? A review of the size effect in equity returns," Journal of Banking and Finance, 35, 3263-3274. 3 Asness, Clifford S., Andrea Frazzini, Ronen Israel, Tobias Moskowitz and Lasse H. Pedersen, "Size Matters, If You Control Your Junk", AQR Working Paper, 2015. 4 Fama, Eugene F. and Kenneth R. French (1993), "Common Risk Factors in the Returns to Stocks and Bonds", The Journal of Financial Economics, vol 33, pp.3-56. 5 Kenneth R. French website: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/Data_Library/f-f_bench_factor.html 6 Fama, Eugene F. and Kenneth R. French (1992), "The Cross Section of Expected Stock Returns," Journal of Finance 47, 427-465 7 Fama, Eugene F. and Kenneth R. French (1993), "Common Risk Factors in the Returns to Stocks and Bonds," The Journal of Financial Economics, vol 33, pp.3-56. 8 S&P600 history before October 1994 was back calculated by Datastream, Russell 2000 history before 1984 was back calculated by FTSE Russell. 9 Please see "Construction and Methodology : Russell U.S. Equity Indexes, v.2.4," FTSE Russell, March 2017. 10 Please see "S&P U.S. Indices Methodology," S&P Dow Jones, March 2017. 11 https://en.wikipedia.org/wiki/Russell_2000_Index 12 Please see "MSCI Global Investable Market Indexes Methodology," MSCI, Feb 2017.

Highlights The rally in risk assets appears to have stalled, raising fears that the misnamed "Trump Trade" has ended. Investors are attaching too much importance to the reality show in Washington and not enough to the fundamentals underpinning the acceleration in global growth and corporate earnings. For now, these fundamentals are strong, and should remain so for the next 12 months. Beyond then, the impulse from easier financial conditions will dissipate and policy will turn less friendly, setting the stage for a major slowdown - and possibly a recession - in 2019. Stay overweight global equities and high-yield credit, but be prepared to reduce exposure next spring. Feature Risk Assets Hit The Pause Button After rallying nearly non-stop following the U.S. presidential election, risk assets have stalled since early March (Chart 1). The S&P 500 has fallen by 1.8% after hitting a record high on March 1st. Treasury yields have also backed off their highs and credit spreads have widened modestly. Globally, the picture has been much the same (Chart 2). The yen - a traditionally "risk off" currency - has strengthened, while "risk on" currencies such as the AUD and NZD have faltered. EM currencies have dipped, as have most commodity prices. Only gold has found a bid. Chart 1A Pause In Risk Assets In The U.S.... A Pause In Risk Assets In The U.S.... A Pause In Risk Assets In The U.S.... Chart 2...And Globally ...And Globally ...And Globally The key question for investors is whether all this merely represents a correction in a cyclical bull market for global risk assets, or the start of a more sinister trend. We think it is the former. Global Growth Still Solid For one thing, it would be a mistake to attach too much significance to the unfolding reality show in Washington. As we discussed in last week's Q2 Strategy Outlook,1 the recovery in global growth and corporate earnings began a few months before last year's election and would have likely continued regardless of who won the White House (Chart 3). For now, the global growth picture still looks reasonably bright. Our global Leading Economic Indicator remains in a solid uptrend. Burgeoning animal spirits are powering a recovery in business spending, as evidenced by the jump in factory orders and capex intentions (Chart 4). Consumer confidence is also soaring. If history is any guide, this will translate into stronger consumption growth in the months ahead (Chart 5). Chart 3Recovery Predates President Trump Recovery Predates President Trump Recovery Predates President Trump Chart 4Global Growth Backdrop Remains Solid Global Growth Backdrop Remains Solid Global Growth Backdrop Remains Solid Chart 5Rising Consumer Confidence Will Provide A Boost To Consumption Rising Consumer Confidence Will Provide A Boost To Consumption Rising Consumer Confidence Will Provide A Boost To Consumption The lagged effects from the easing in financial conditions over the past 12 months should help support activity. Chart 6 shows that the 12-month change in our U.S. Financial Conditions Index leads the business cycle by 6-to-9 months. The current message from the index is that U.S. growth will stay sturdy for the remainder of 2017. Stronger global growth should continue to power an acceleration in corporate earnings over the remainder of the year. Global EPS is expected to expand by 12.5% over the next 12 months. Analysts are usually too bullish when it comes to making earnings forecasts. This time around they may be too bearish. Chart 7 shows that the global earnings revisions ratio has turned positive for the first time in six years, implying that analysts have been behind the curve in revising up profit projections. Chart 6Easing Financial Conditions Will Support Activity In 2017 Easing Financial Conditions Will Support Activity In 2017 Easing Financial Conditions Will Support Activity In 2017 Chart 7Global Earnings Picture Looking Brighter Global Earnings Picture Looking Brighter Global Earnings Picture Looking Brighter Gridlock In Washington? As far as developments in Washington are concerned, it is certainly true that the failure to repeal and replace the Affordable Care Act has cast doubt on the ability of Congress to implement other parts of President Trump's agenda. Despite reassurances from Trump that a new health care bill will pass, we doubt that the GOP can cobble together any legislation that jointly satisfies the hardline views of the Freedom Caucus and the more moderate views of the Republicans in the Senate. Ironically, the failure to jettison Obamacare may turn out to be a blessing in disguise for Trump and the Republican Party. Opinion polls suggest that the GOP would have gone down in flames if the American Health Care Act had been signed into law (Table 1). According to the Congressional Budget Office, the proposed legislation would have caused 24 million fewer Americans to have health insurance in 2026 compared with the status quo. The bill would have also reduced federal government spending on health care by $1.2 trillion over ten years. Sixty-four year-olds with incomes of $26,500 would have seen their annual premiums soar from $1,700 to $14,600. Even if one includes the tax cuts in the proposed bill, the net effect would have been a major tightening in fiscal policy. Now, that would have warranted lower bond yields and a weaker dollar. Table 1Passing The American Health Care Act Could Have Cost The Republicans Dearly The Trump Trade Will Fizzle Out, But Not Yet The Trump Trade Will Fizzle Out, But Not Yet Granted, the political fireworks over the past month serve as a reminder that comprehensive tax reform will be more difficult to achieve than many had hoped. However, even if Republicans are unable to overhaul the tax code, this will not prevent them from simply cutting corporate and personal taxes. Worries that tax cuts will lead to larger budget deficits will be brushed aside on the grounds that they will "pay for themselves" through faster growth (dynamic scoring!). Throw some infrastructure spending into the mix, and it will not take much for the "Trump Trade" to return with a vengeance. Trump's Fiscal Fantasy This is not to say that the "Trump Trade" won't fizzle out. It will. But that will be a story for 2018 rather than this year. This is because the disappointment for investors will stem not from the failure to cut taxes, but from the underwhelming effect that tax cuts end up having on the economy. The highly profitable companies that will benefit the most from lower corporate taxes are the ones who least need them. In many cases, these companies have plenty of cash and easy access to external financing. As a consequence, much of the tax cuts will simply be hoarded or used to finance equity buybacks or dividend payments. A large share of personal tax cuts will also be saved, given that they will mostly accrue to higher income earners. Chart 8From Unrealistic To Even More Unrealistic From Unrealistic To Even More Unrealistic From Unrealistic To Even More Unrealistic The amount of infrastructure spending that actually takes place will likely be a tiny fraction of the headline amount. This is not just because of the dearth of "shovel ready" projects. It is also because the public-private partnership structure the GOP is touting will severely limit the universe of projects that can be considered. Most of America's infrastructure needs consist of basic maintenance, rather than the sort of marquee projects that the private sector would be keen to invest in. Indeed, the bill could turn out to be little more than a boondoggle for privatizing existing public infrastructure projects, rather than investing in new ones. Meanwhile, the Trump administration is proposing large cuts to nondefense discretionary expenditures that go above and beyond the draconian ones that are already enshrined into current law (Chart 8). In his Special Report on U.S. fiscal policy, my colleague Martin Barnes argues that "it is a FALLACY to describe overall non-defense discretionary spending as massively bloated and out-of-control."2 As such, the risk to the economy beyond the next 12 months is that markets push up the dollar and long-term interest rates in anticipation of continued strong growth and major fiscal stimulus but end up getting neither. Investment Conclusions Risk assets have enjoyed a strong rally since late last year, and a modest correction is long overdue. Still, as long as the global economy continues to grow at a robust pace, the cyclical outlook for risk assets will remain bullish. As such, investors should stay overweight global equities and high-yield credit at the expense of government bonds and cash. We prefer European and Japanese equities over the U.S., currency-hedged (See Appendix). As we discussed in detail last week, global growth is likely to slow in the second half of 2018, with the deceleration intensifying into 2019, possibly culminating in a recession in a number of countries. To what extent markets "sniff out" an economic slowdown before it happens is a matter of debate. U.S. equities did not peak until October 2007, only slightly before the Great Recession began. Commodity prices did not top out until the summer of 2008. Thus, the market's track record for predicting recessions is far from an envious one. Nevertheless, investors should err on the side of safety and start scaling back risk exposure next spring. The 2019 recession will last 6-to-12 months. By historic standards, it will probably be a mild one. However, with memories of the Great Recession still fresh in most people's minds and President Trump up for re-election in 2020, the response could be dramatic. This will set the stage for a period of stagflation in the 2020s. Chart 9 presents a visual representation of how the main asset markets are likely to evolve over the next seven years. Chart 9Market Outlook For Major Asset Classes The Trump Trade Will Fizzle Out, But Not Yet The Trump Trade Will Fizzle Out, But Not Yet Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Outlook, "Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com 2 Please see BCA Special Report, "U.S. Fiscal Policy: Facts, Fallacies And Fantasies," dated April 5, 2017, available at bca.bcaresearch.com. Appendix Tactical Global Asset Allocation Monthly Update We announced last week that we are making major upgrades to our Tactical Asset Allocation Model. In the meantime, we will send you a concise update of our recommendations every month based on a combination of BCA's proprietary indicators as well as our own seasoned judgement (Appendix Table 1). Appendix Table 2Global Asset Allocation Recommendations (Percent) The Trump Trade Will Fizzle Out, But Not Yet The Trump Trade Will Fizzle Out, But Not Yet In a Special Report published last year, we laid out the quantitative factors that have historically predicted stock market returns. Appendix Chart 1 updates the output of that model for the U.S. It currently shows a slightly above-average return profile for the S&P 500 over the next three months. Appendix Chart 1S&P 500: Above Average Returns Over The Next 3 Months The Trump Trade Will Fizzle Out, But Not Yet The Trump Trade Will Fizzle Out, But Not Yet Applying this model to the rest of the world yields a somewhat more positive picture for Europe and Japan, given more favorable valuations and easier monetary conditions in those regions. The technical picture has also improved in Europe and Japan. This is especially true with respect to price momentum: After a long period of underperformance, euro area equities have outpaced the U.S. by 11.5% in local-currency terms since last summer’s lows. Japanese stocks have suffered over the past few months, but are still up 12.5% against the U.S. over the same period (Appendix Chart 2). Turning to government bonds, the extreme bearish sentiment and positioning that prevailed in February and early March has been largely reversed, suggesting that the most recent rally in bonds could run out of steam (Appendix Chart 3). Looking ahead, yields are likely to rise anew on the back of strong economic growth and rising inflation. Thus, an underweight allocation to government bonds is warranted, particularly in the U.S. Appendix Chart 2Relative Performance Of Euro Area ##br##And Japanese Equities Troughed Last Summer Relative Performance Of Euro Area And Japanese Equities Troughed Last Summer Relative Performance Of Euro Area And Japanese Equities Troughed Last Summer Appendix Chart 3Rally In Bonds Could Soon Peter Out Rally In Bonds Could Soon Peter Out Rally In Bonds Could Soon Peter Out Clients should consult our Q2 Strategy Outlook for a more detailed discussion of the global investment outlook. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Recommended Allocation Quarterly - April 2017 Quarterly - April 2017 The sweet spot of non-inflationary accelerating growth is likely to continue. European politics will fade as a risk, and Trump should still be able to get tax cuts through. We continue to be positive on risk assets on a one-year horizon, though returns are unlikely to be as good as in the past 12 months and there is a risk of the next recession arriving in 2019. Our portfolio tilts are generally pro-risk and pro-cyclical. We are overweight equities versus fixed income. We move overweight euro area equities, which should benefit from inexpensive valuations, higher beta and a falling political risk premium. Within fixed income, we prefer credit over government bonds, and raise high-yield debt to overweight on improved valuations. We expect the dollar to appreciate further, which makes us cautious on emerging market assets and industrial commodities. Feature Overview No Reasons To Turn Cautious Markets have paused for breath following the reflation trade that began a year ago and that was given an extra boost by the election of Donald Trump in November. Since the turn of the year, the dollar, U.S. 10-year Treasury yields, credit spreads and (to a degree) equities have all eased back a little (Chart 1). We don't think the risk-on rally is over, but the going will undoubtedly get tougher from here. The momentum of global growth cannot continue to rise at the same pace, with the Global PMI already at its highest level since 2011 (Chart 2). Global equities, therefore, are unlikely to return the 16% over the next 12 months, that they have over the past 12. Chart 1A Pause For Breath A Pause For Breath A Pause For Breath Chart 2Growth Momentum Must Slow From Here Growth Momentum Must Slow From Here Growth Momentum Must Slow From Here Nonetheless, we see nothing that is likely to stop risk assets continuing to outperform over the one-year horizon: Growth is likely to rise further. While the initial pick-up was in "soft" data such as consumer sentiment and business confidence, signs are emerging that "hard" data such as household spending and production are now also improving (Chart 3). Models developed by our colleagues on The Bank Credit Analyst indicate that real GDP growth in the U.S. this year will come in above 3% and in the euro area above 2% (Chart 4),1 compared to consensus forecasts of 2.2% and 1.6% respectively. Chart 3Hard Data Also Not Picking Up Hard Data Also Not Picking Up Hard Data Also Not Picking Up Chart 4GDP Growth Could Beat Consensus GDP Growth Could Beat Consensus GDP Growth Could Beat Consensus For now, this growth is unlikely to prove inflationary. In the U.S. the diffusion index for PCE inflation shows more prices in the basket falling than rising; in the eurozone, the rise to 2% in headline inflation in January was temporary, mainly because of higher oil prices, and core inflation remains at only 0.7%. The U.S. output gap will close soon, but the eurozone's is still deeply negative (Chart 5). We see the Fed raising rates twice more this year, in line with its dots, though it may have to accelerate the pace next year if the Trump administration succeeds in passing fiscal stimulus. The ECB, however, is unlikely to raise rates until 2019 and will taper asset purchases only slowly.2 Misplaced worries that it will tighten more quickly than this have recently dragged on European equities and strengthened the euro. We think the market is wrong to price out the probability of a tax cut in the U.S. just because of the Trump administration's failure to reform healthcare. Our Geopolitical strategists argue that Republicans in Congress (even the Freedom Caucus) are united behind the idea of cutting taxes, even if these are not funded by tax reforms or spending cuts (they can be justified on the grounds of "dynamic scoring").3 We see a cut in corporate and personal taxes passing before year-end to take effect in 2018. And Trump has not abandoned the idea of infrastructure spending. The market no longer expects any of this: the prices of stocks that would most benefit from lower corporate taxes or from government spending have reverted to their pre-election levels. European political risk is likely to wane. The market continues to worry about the possibility of Marine Le Pen winning the French Presidential election, as shown in the spread of OATs over Bunds (which has widened to 60-80 bp from 20 bp last summer). We think this very unlikely: polls show her consistently at least 20 points behind Emmanuel Macron in the second round of voting (Chart 6). While Italian politics remain a risk, the parliamentary election there is unlikely to take place until March 2018. Brexit is a threat to the U.K., but should have minimal impact on the eurozone. We retain, therefore, our pro-cyclical and pro-risk tilts on a 12-month time horizon. We have even added a little more beta to our recommended portfolio by raising high-yield bonds to overweight (since their valuations now look more attractive after a recent sell-off) and by going overweight eurozone stocks (paid for by notching down our double-overweight in U.S. stocks). The eurozone has consistently been a higher beta (Chart 7), more cyclical equity market than the U.S. and, once the political risks (at least temporarily) subside, should be able to outperform for a while. Chart 5Eurozone Output Gap Still Very Negative Eurozone Output Gap Still Very Negative Eurozone Output Gap Still Very Negative Chart 6Can Le Pen Really Win From Here? Can Le Pen Really Win From Here? Can Le Pen Really Win From Here? Chart 7Eurozone Is A High Beta Stock Market Eurozone Is A High Beta Stock Market Eurozone Is A High Beta Stock Market But we warn that the good times may not last for long. Tax cuts in the U.S. would add stimulus to an economy already at full capacity. The Fed might have to raise rates sharply next year (although the timing might depend on how President Trump tries to affect monetary policy, for example whom he appoints as Fed chair to replace Janet Yellen next February). U.S. recessions have typically come two or three years after the output gap turns positive (Chart 5). As Martin Barnes, BCA's chief economist, recently wrote,4 that may point to next recession arriving as soon as 2019. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com What Our Clients Are Asking Chart 8Expensive, But Not At An Extreme Expensive, But Not At An Extreme Expensive, But Not At An Extreme Aren't You Worried About U.S. Equity Valuations? Valuation is a poor timing tool in the short term but, when it reaches extremes, it has historically added value. The valuation metrics we watch show that U.S. equities are expensive, but not at the extreme levels that have historically warranted an outright sell or underweight. First, according to MSCI, U.S. equities are currently trading at 24.4 times 12-month trailing earnings, and 25.7 times 10-year cyclically-adjusted earnings; both measures are about one standard deviation from their 10-year averages. Second, U.S. equities are trading at a premium to global equities, but the premium to the developed markets is in line with the 10-year average (Chart 8, panel 1), while the premium to emerging markets is about 1.5 standard deviations from the 10-year average (panel 2). Third, equities are cheap compared to fixed income: the earnings yield is still higher than the yields on both 10-year government bonds and investment grade corporate bonds, and the yield gaps are currently only slightly lower (more expensive) than their respective 10-year averages (panels 3 and 4). In the long run, the 10-year cyclically-adjusted PE (CAPE) has had relatively good forecasting power for 10 year forward returns. Currently, the regression indicates 143% (9.3% annualized) total returns over the next 10 years. This could be on the optimistic side given that we are no longer in an environment of declining bond yields and margins are elevated compared to the 1990s. That said, we have cut our U.S. equity overweight by half, partly due to valuation concerns. Is EM Debt Attractive? Chart 9Avoid EM Debt Avoid EM Debt Avoid EM Debt Emerging market debt has continued its run from last year, with sovereign and local currency debt providing YTD returns of 3% and 2% respectively. Over long periods, EM debt has displayed the ability to provide substantial returns while also providing robust diversification benefits to a 50/50 DM equity/bond portfolio, even more so than EM equities.5 However, over the cyclical horizon, we remain bearish on EM debt both in absolute terms and relative to global equities. EM fixed income markets have been able to defy deteriorating fundamentals for some time, but this is unsustainable. After years of leveraging, credit excesses will need to be unwound. Decelerating credit growth will be enough to dampen economic growth and damage emerging markets' ability to service their debt. Risks in EM sovereign debt markets are high. Historical returns have shown negative skewness and fat tails, suggesting high vulnerability to large downswings. This is particularly concerning given that yields are one standard deviation lower than their long-term average (Chart 9). While EM local currency debt is more fairly priced and has a more favorable risk/return profile than its sovereign debt counterpart, local currency debt returns are even more heavily influenced by their currencies. Above-trend growth in the U.S. leading to additional rate hikes, as well as rising U.S. bond yields and softer commodity prices will add further downward pressure to EM currencies. For EM dedicated investors, we suggest overweight positions in low beta/defensive markets. Regions that are less susceptible to currency weakness with high yields and low foreign funding requirements include Russia, India and Indonesia. How Will The Fed Shrink Its Balance Sheet, And Does It Matter? After the Fed's third rate hike, attention is turning to when it will begin to reduce its balance sheet. This has grown to $4.5 trillion, up from $900 billion before the Global Financial Crisis. Assets currently include $2.5 trillion of Treasury securities and $1.8 trillion of mortgage-related securities. Since asset purchases ended in October 2014, the Fed has rolled over maturing bonds to maintain the size of the balance sheet. The FOMC statement last December committed to maintaining this policy "until normalization of the level of the federal funds rate is well under way". The market takes this to mean 1-1.5%, a level likely to be reached by year-end. The view of BCA's fixed income team6 is that the Fed will start by ceasing reinvestment of Agency bonds and mortgage-backed securities (MBS) in 2018, at the same time reducing excess bank reserves on the liability side of the balance sheet (Chart 10). This will worry markets to a degree and the Fed will need to be careful how it communicates the policy: for example what size it thinks its balance sheet should ultimately be. It may also need to skip a rate hike or two in the first months of the shrinkage. The MBS market is likely to suffer from the increased supply. But the only historical precedent - the BoJ's unwinding of its 2000-3 QE - is reassuring: this had no discernible effect on rates or the yen (Chart 11). Chart 10Fed Will Cut MBSs First Fed Will Cut MBSs First Fed Will Cut MBSs First Chart 11Nobody Noticed The BoJ Taper Nobody Noticed The BoJ Taper Nobody Noticed The BoJ Taper When Will ECB Taper? Chart 12Recovery Not Permanent Recovery Not Permanent Recovery Not Permanent Euro area growth is recovering and headline inflation has hit the ECB's 2% target (Chart 12). Investors are wondering how rapidly the ECB will taper its asset purchases and when it will raise rates. Our view is that the ECB will move only slowly. The pickup in inflation is mostly driven by the base effect and by the rise in energy prices. The failure of core inflation, which remains below 1%, to pick up appreciably suggests that underlying price pressures are weak. The current program has the ECB purchasing EUR 60 Bn of assets each month until December 2017. Markets have recently become more hawkish with regards to the likely path of policy: currently futures are pricing in the first hike only 19 months away versus an expectations in January of 44 months. We expect the ECB to remain more dovish than that, given weak underlying inflation, political uncertainty, and banking system troubles. We think the ECB will announce around September this year a taper of its asset purchases in 2018. However, it is not clear whether it will cut them to, say EUR 30 Bn a month, or whether it will reduce the amount steadily each month or quarter. But we don't see an interest rate hike soon, since the euro area economy is not expected to reach full employment until 2019. Ewald Novotny, president of the Austrian central bank, spooked markets by suggesting a hike before complete withdrawal of asset purchases but, in our view, that would will send a confusing signal to investors. Nowotny has long been hawkish and we think his view is untypical of ECB council members. If our analysis is correct, ECB policy should be positive for euro area equities and bearish for the euro over the next 12 months. Will REIT Underperformance Continue? Chart 13Underweight REITs Underweight REITs Underweight REITs Relative REIT performance has continued its downtrend, underperforming the broad index by 5% YTD. While valuations have become more attractive and rental income is still robust, we expect the decline to continue given unsupportive macro factors. We previously argued that real estate is in a sweet spot, where economic growth was sufficient to generate sustainable tenant demand without triggering a new supply cycle.7 This is no longer the case. Office completions increased substantially over the past quarter and apartment completions remain in an uptrend. As we expect growth to remain robust in the U.S., the likelihood is that these two trends remain in place. REIT relative performance peaked at the beginning of August, shortly after long-term interest rates bottomed. REITs have historically outperformed when yields are falling and inflation is low (Chart 13). However, long-term rates should continue to rise over the cyclical horizon, primarily due to higher inflation expectations. Additionally, REITs typically benefit from increasing central bank asset purchases, as increased liquidity and lower interest rates boost real estate values. With the Fed clearly in tightening mode and the strong likelihood of ECB tapering next year, slowing asset purchases will be a considerable headwind to REIT performance. Within REITs, we maintain our sector tilts. Continue to favor Industrials, which will benefit in a rising USD environment and provide considerable income. Maintain underweight position in Apartments, due to rising completions and a low absorption ratio. Additionally, we continue to favor trophy over non-trophy markets given more stable rent growth as well as geopolitical risks in Europe and potential Washington disappointments. Global Economy Overview: The global economy has continued to recover from its intra-cycle slowdown in late 2015 and early 2016. Economic surprise indexes have everywhere surprised significantly on the upside since mid-2016 (Chart 14, panel 1). Although "hard" data (consumption, production etc.) have lagged "soft" data (consumer sentiment, business confidence), the former also have begun to recover recently. Although there are few negative indicators, it will get harder to beat expectations. U.S.: Lead indicators continue to improve, with the manufacturing ISM at 57.7 and new orders at 65.1. Sentiment quickly turned bullish after the presidential election, and hard data has now started to follow, with personal consumption expenditure rising 4.7% year on year and capital goods orders (+2.7% YoY in February) growing for the first time since 2014. With steady wage growth, continuing employment improvements, and a likely pick-up in capex, we expect 2017 GDP growth to beat the current consensus expectations of 2.2%. For now inflation remains quiescent, with core PCE inflation stuck at around 1.8%, below the Fed's 2% target. Euro Area: Leading indicators, such as PMIs, have rebounded in Europe too (Chart 15), suggesting that the consensus 2017 GDP forecast of 1.6% is achievable. Inflation has picked up, with the headline CPI 2.0% for the Eurozone in January, but core inflation remains low at 0.7% and headline fell back to 1.5% in February. However, the recent slowdown in bank loan growth (new credit creation is 36% below the level six months ago) suggests that continuing weakness in the banking sector is likely to keep growth sluggish. Chart 14How Long Can Growth Continue To Surprise? How Long Can Growth Continue To Surprise? How Long Can Growth Continue To Surprise? Chart 15A Synchronized Global Growth Rebound A Synchronized Global Growth Rebound A Synchronized Global Growth Rebound Japan is a tale of two segments. International-oriented data have recovered, with IP up 3.7% (Chart 15, panel 2) and exports +5.4% year on year. But domestic demand remains weak: wages are rising only 0.5% YoY (despite a tight labor market), which is holding back household spending (-1.2% YoY in January). Core inflation has shown the first signs of picking up, but remains very low at 0.1% YoY. Emerging Markets: The effects of China's reflationary policies from early 2016 continue to boost activity (Chart 15, panel 3). But the excess liquidity they triggered worries the authorities, who have clamped down on real estate purchases and capital outflows, slowed fiscal spending, and tightened monetary policy. China will prioritize stability until the Party Congress in the fall, but the impact of reflation on commodity prices and on other emerging markets will fade. Interest rates: The Fed is likely to hike twice more this year in line with its "dot plot", unless inflation surprises significantly to the upside. This, plus an acceleration of nominal GDP growth to 4.5-5%, should push the 10-year bond yield above 3% by year end. The ECB will not be as hawkish as the market expects (futures markets indicate a rate hike by end-2018), since Mario Draghi expects headline inflation to fall back once the oil price stabilizes and is concerned about political risk especially in Italy. Consequently, rates are unlikely to rise as quickly as in the U.S. The Bank of Japan will keep its 0% yield target for 10-year JGB for the foreseeable future. Global Equities Global equities continued to make impressive gains in Q1 2017, after a strong 2016. The price appreciation since the low in February 2016 has been driven by both multiple expansion and earnings growth, roughly in equal proportion, as shown in Chart 16, panel 1. Chart 16Earnings Improving But Valuation Stretched Earnings Improving But Valuation Stretched Earnings Improving But Valuation Stretched Equity valuation is expensive by historical standards but, as an asset class, equities are still attractively valued compared to bonds (see the "What Our Clients Are Asking" section on page 6). In this "TINA" (There Is No Alternative) world, we remain overweight equities versus bonds. Within equities, we maintain our call of favoring DM equities versus EM equities despite of the 6% EM outperformance in Q1, which was supported by attractive valuations. About half of that outperformance came from the appreciation of EM currencies versus the USD. Our house view is that the USD will strengthen further versus the EM currencies. Within EM, we have been more positive on China and remain so on a 6-9 month horizon. The only adjustment we make now is to upgrade euro area equities to overweight by reducing half of our large overweight in the U.S. so that now we are equally overweight the U.S. and euro area (see details on the next page). In terms of global sector positioning, we maintain a pro-cyclical tilt. Our largest overweight in Healthcare panned out very well in Q1 but the overweight in Energy did not, due to the drop in oil prices. Our Energy strategists believe this was caused by one-off technical factors on the supply side, and argue that the oil price will soon revert to $55 a barrel. Euro Area Equities: A Cheaper Alternative To The U.S. Political risks related to elections in some eurozone countries are receding. The ECB is likely to maintain its easy monetary policies, while the Fed is on track to normalize interest rates in the U.S. We have had a large overweight of 6 percentage points (ppts) on U.S. equities while being neutral on the euro area. We upgrade the eurozone to overweight by 3 ppts, so that we are now equally overweight the U.S. and the euro area. The following are the reasons: First, the relative performance of total returns between eurozone and the U.S. equities is at its lowest since 1987. Since April 2015, when the most recent brief period of eurozone outperformance ended, eurozone equities have underperformed the U.S. by over 16% in common currency terms (Chart 17, panel 1), while the euro lost only about 4% versus the USD over the same period. Second, eurozone equities are trading at a 22% discount to the U.S., compared to the five-year average discount of 17% (panel 3). Third, eurozone equities have lower margins than the U.S., but the profit margin in the eurozone has been improving (panel 2). Lastly, the PMIs in the euro area have been improving (panel 4) and this improvement is faster than the global aggregate PMI (panel 5), which implies - based on the close correlation between PMIs and earnings growth - that profitability in the eurozone should improve at a faster pace than the global average. Sector Allocation: We have had a relatively pro-cyclical tilt in our global sector positioning, overweight three cyclical sectors (Energy, Industrials and Info Tech) plus Healthcare, while underweight three defensive sectors (Consumer Staples, Telecoms and Utilities) as well as Consumer Discretionary. We have been neutral on Financials and Materials. After very strong performance in 2016, cyclical sectors underperformed in Q1 2017 (Chart 18, panel 1). The underperformance of cyclicals versus defensives can be largely attributed to the polar-opposite performance of Energy and Healthcare (Chart 19). Going forward, we maintain our current sector positioning for the following reasons: Chart 17Earnings Growth At Lower Valuation Earnings Growth At Lower Valuation Earnings Growth At Lower Valuation Chart 18Maintain The Cyclical Tilt Maintain The Cyclical Tilt Maintain The Cyclical Tilt Chart 19Global Sector Performance Quarterly - April 2017 Quarterly - April 2017 First, Energy was the only sector which fell in Q1, largely due to the decline in oil prices. BCA's Energy and Commodity Strategy attributes the oil price weakness to inventory buildup related to the production rush before the OPEC agreement to cut production, and therefore expects the WTI oil price to return to the $50-55 range. Energy stocks should benefit once oil prices turn back up. Chart 20Relative Factor Performance Relative Factor Performance Relative Factor Performance Second, the relative profitability between cyclicals and defensives is underpinned by global economic conditions, as represented by the global PMI. The PMI is on track to recover further, which bodes well for the profit outlook for cyclicals versus defensives. Third, our pro-cyclical tilt in sector positioning is hedged by an overweight in Healthcare (a defensive sector) and underweight in Consumer Discretionary (a cyclical). Smart Beta Update: No Style Bet Q1 2017 saw some significant performance reversals in the five most enduring factors: quality, minimum volatility, momentum, value, and size (Chart 20, panels 2-6). Quality and Momentum performed the best, outperforming the global benchmark by over 200 bps in Q1. The star performer in 2016, the Value factor, performed the worst, underperforming by 190 bps. According to the findings in our Special Report,8 recent factor performance seems to be pricing in a "Goldilocks" environment in which growth is rising and inflation falling. We have shown that it is very difficult to time the shift in factor performance cycles and so have advocated an equal weight in the five factors (Chart 20, panel 1) for long-term investors. We reiterate this view. Government Bonds Maintain slight underweight duration. Our 2-factor model made up of global PMI and U.S. dollar sentiment indicates the current fair value of the 10-year Treasury yield is 2.4% (Chart 21). While this suggests bonds are currently correctly priced, we still expect that long-term yields will rise over a cyclical horizon. The long end should grind higher given improving growth, rising equity prices and renewed "animal spirits." Additionally, large net short positions have been unwound, allowing for another leg higher in yields. Overweight TIPS vs. Treasuries. Diffusion indexes for both PCE and CPI inflation shifted into negative territory, suggesting realized inflation will soften in the near term. Nevertheless, with headline and core CPI readings of 2.7% and 2.2% respectively, U.S. inflation has clearly bottomed for the cycle (Chart 22). This trend should continue as a result of cost-push inflation driven by faster wage growth. Very gradual Fed hikes will not be enough to derail the upward momentum in consumer prices. Euro area growth is stable, but expectations of a rate hike from the ECB are premature (Chart 23). While the central bank opened the door slightly to a less-accommodative policy stance, it is unlikely that the ECB will hike until full employment is reached. Our expectation is for a tapering of asset purchases to occur in 2018. Once tapering is complete, rate hikes will follow by approximately 6-12 months. The implication is upward pressure on European bond yields and wider spreads for peripheral government debt. Chart 2110-Year Treasury Fair Value Model 10-Year Treasury Fair Value Model 10-Year Treasury Fair Value Model Chart 22Inflation Has Bottomed Inflation Has Bottomed Inflation Has Bottomed Chart 23Will the ECB Hike Soon? Will the ECB Hike Soon? Will the ECB Hike Soon? Corporate Bonds The BCA Corporate Health Monitor remains deeply in "Deteriorating Health" territory, indicating weakness within corporate balance sheets (Chart 24). Over the last quarter, the indicator worsened, as profit margins, return-on-capital and liquidity declined. However, leverage did improve slightly. The trend toward weaker corporate health has been firmly established over the past 12 quarters. This is consistent with the very late stages of past credit cycles. Maintain overweight to Investment Grade debt. The U.S. is in a self-reinforcing, low-inflation recovery. Economic growth should accelerate throughout 2017, with strong consumer spending, rising capex intentions, and still accommodative monetary policy. The potential sell-off from rate hikes this year should be fairly mild given that the market is already close to pricing in three. Additionally, credit has historically outperformed in the early stages of the Fed tightening cycle. Expect low but positive excess returns (Chart 25). Shift to overweight in high-yield debt. Our default model is showing improvement due to elevated interest coverage, a robust PMI reading, declining job cut announcements, softening lending standards and a rising sales/inventory ratio. The recent backup in yields has made junk bond valuations more attractive. The default adjusted spread, calculated by subtracting an ex-ante estimate of default losses from the average spread, is now approximately 220bps (Chart 26). Chart 24Balance Sheets Deteriorating Balance Sheets Deteriorating Balance Sheets Deteriorating Chart 25A Supportive Backdrop A Supportive Backdrop A Supportive Backdrop Chart 26High Yield: Valuations Becoming More Attractive High Yield: Valuations Becoming More Attractive High Yield: Valuations Becoming More Attractive Commodities Chart 27Upside To Resource Prices Limited Upside To Resource Prices Limited Upside To Resource Prices Limited Secular Perspective: Bearish A slowdown in Chinese activity, led by its transition to a services economy, coupled with unfavorable global demographics, will continue to constrain demand for commodities. This slack in demand coupled with excess capacity will continue to limit the upside in resource prices and prolong the commodities bear market which began in 2012 (Chart 27). Cyclical Perspective: Neutral Energy markets have moved from excess supply to excess demand, and so we remain positive on oil. But, with the impact of Chinese fiscal stimulus waning, excess supply in the metals market will persist, putting downward pressure on prices. Our divergent outlook for energy vs metals gives us an overall neutral view for commodities over the cyclical horizon. Energy: With a synchronized upturn in global growth and inflation, both OECD and non-OECD demand will remain strong. Following Saudi Arabia's production cuts, we expect the OPEC agreement to be honored by all members, including Russia. With strengthening demand and falling production, storage should draw through the year. We expect the oil-USD divergence to persist as improving fundamentals override the stronger dollar. Base Metals: With Chinese government spending slowing from 24% growth year on year in January 2016 to only 4%, the country's fiscal impulse has ended. Tightening in Chinese liquidity conditions have led to higher borrowing rates for the real estate sector, which is dampening its demand for materials. At the same time, inventories for key metals such as copper and steel have risen. We expect metals prices to correct over the coming months. Precious Metals: Gold has rallied 10% from last December, and another 4% following the Fed's March rate hike. These were responses to the dovish nature of the hike and continuing political risk. We expect the Fed to turn more hawkish in coming weeks, sending the dollar and real yields higher, thereby holding back the gold price from rising much further. Currencies Chart 28Return Of The Dollar Return Of The Dollar Return Of The Dollar USD: The last Fed meeting resulted in a dovish hike, as evidenced by the subsequent fall in the dollar. However, as the U.S. economy nears full employment, we expect a more hawkish tone from FOMC members in the coming weeks which will push the dollar up (Chart 28). The Fed continues to be data dependent, and sees the recent synchronized global upturn as an opportunity to deliver hikes in line with market expectations. Euro: As the economy stabilizes, as evidenced by rising headline inflation, stronger retail sales and improving PMI numbers, the ECB has opened the window for reducing monetary accommodation. However, since the economy is expected to reach full employment only in 2019, we expect rates to be kept low even after the tapering of ECB asset purchases starts next year. This will add further downward pressure on the euro. Yen: The Bank of Japan will continue its highly accommodative monetary policy, centered on its 0% yield target for 10-year government bonds, because Japanese growth and inflation is lagging the global upturn. Japan is benefitting from global growth, as seen in the improvement in its manufacturing PMI, but domestic demand remains weak as consumer confidence and retail sales stagnate. Continued downward pressure on relative interest rates will drive the only reliable source of inflation: a weaker yen. EM: A more hawkish Fed and rising bond yields will tighten global liquidity conditions, making it difficult for emerging nations that run current account deficits. The rising threat of protectionism could affect EM exports and create a new wave of deflationary pressure, forcing central banks to engineer currency devaluation. The fact that commodity prices have risen, yet EM currencies have remained weak, is a clear indications that EM fundamentals are weak. Alternatives Overweight private equity / underweight hedge funds. Leading indicators suggest that global growth continues to improve. In the absence of a recession, private equity typically outperforms as the illiquidity premium should provide a boost to returns. Additionally, surveys suggest that managers are planning on increasing their allocation percentage toward private equity over the rest of the year. Hedge funds, on the other hand, have displayed a negative correlation with global growth. Historically, they have outperformed private equity only during recessions or periods of high credit market stress (Chart 29). Overweight direct real estate / underweight commodity futures. Demand for commercial real estate (CRE) assets remains robust but the increase in completions is worrying. Favor Industrials for its income potential and Retail given resilient consumer spending. Overweight trophy markets, as demand remains robust given multiple macro risks. Commodities have bounced, but remain in a secular bear market caused by a supply glut and exacerbated by a market-share war (Chart 30). Overweight farmland & timberland / underweight structured products. The potential for trade wars, geopolitical risk in Europe and concerns over an equity market correction have increased the importance of volatility reduction. Favor farmland & timberland. Substantial portfolio diversification benefits, resulting from low correlations with traditional assets, coupled with a positive skew, make these assets highly attractive. As the most bond-like alternative, the end of the 35-year bull market in bonds presents a substantial headwind. Structured products also tend to outperform during recessions, which is not our base case (Chart 31). Chart 29PE: Tied To Real Growth PE: Tied To Real Growth PE: Tied To Real Growth Chart 30Commodities: A Secular Bear Market Commodities: A Secular Bear Market Commodities: A Secular Bear Market Chart 31Structured Products Outperform In Recessions Structured Products Outperform In Recessions Structured Products Outperform In Recessions Risks To Our View Our pro-cyclical pro-risk tilts are based on the premise that global growth will remain strong over the next 12 months. We do not see many risks to this view: leading indicators suggest that consumption and capex are likely to continue to rebound. The one major indicator that suggests downside risk is loan growth. In the U.S., loans to firms have slowed to 5.4% from over 10% last summer, and in the euro area the meager pickup in corporate loan growth seems to have faltered (Chart 32). There may be some special factors: oil companies that borrowed in early 2016 when in difficulty no longer need to tap credit lines, and U.S. companies may be holding back to see details of tax cuts. But loan growth needs to be watched closely. More granularly, our country and sector preferences - in particular, our cautious views on Emerging Markets and industrial commodities - are based partly on the expectation that the U.S. dollar will appreciate further. If the global expansion remains highly synchronized (Chart 33) this might instigate all G7 central banks to tighten, allowing the Fed to raise rates without appreciating the dollar. However, we expect continuing divergences in growth and monetary policy to push the dollar up further. Finally, some indicators suggest that investors have become too positive on the outlook for stocks (Chart 34). Sentiment has in the past not been a reliable indicator of stock market peaks, but excess euphoria could trigger a short-term correction. Chart 32Why Is Bank Loan Growth Slowing? Why Is Bank Loan Growth Slowing? Why Is Bank Loan Growth Slowing? Chart 33Could Synchronized Growth Push Down USD? Could Synchronized Growth Push Down USD? Could Synchronized Growth Push Down USD? Chart 34Are Investors Too Euphoric? Are Investors Too Euphoric? Are Investors Too Euphoric? 1 Please see The Bank Credit Analyst, March 2017, page 33, available at bca.bcaresearch.com 2 Please see What Our Clients Are Asking: When Will The ECB Taper? on page 9 of this report for a full explanation of why we think this. 3 Please see Geopolitical Strategy Weekly Report, "Donald Trump Is Who We Thought He Was", dated March 8, 2017, available at gps.bcaresearch.com 4 Please see BCA Special Report titled "Beware The 2019 Trump Recession", dated March 7, 2017, available at bca.bcaresearch.com 5 Please see Global Asset Allocation Strategy Special Report, "EM Asset Allocation: Is There Any Reason To Own Stocks?," dated November 27, 2012, available at gaa.bcaresearch.com. 6 Please see Global Fixed Income Strategy Special Report, "The Way Forward For The Fed's Balance Sheet," dated February 28, 2017, available at gfis.bcaresearch.com. 7 Please see Global Asset Allocation Strategy Special Report, "REITs Vs. Direct: How To Get Exposure To Real Estate," dated September 15, 2016, available at gaa.bcaresearch.com. 8 Please see Global Asset Allocation Strategy Special Report, "Is Smart Beta A Useful Tool In Global Asset Allocation?," dated July 8, 2016, available at gaa.bcaresearch.com. Recommended Asset Allocation Model Portfolio (USD Terms)

Highlights The locomotive of the U.S. economy, the consumer, remains supported by powerful tailwinds. The Fed will be able to tighten monetary policy relative to other central banks by a higher degree than the market appreciates. The dollar will rise further. Use this dip to buy more dollars. Being tactically long the yen is a hedge against growth disappointments. Set a stop-sell for AUD/NZD. Feature In June of last year, we wrote a piece titled "What Could Go Right?" arguing key changes in the global economy may have justified a more pro-risk stance for investors.1 The core of the argument was that markets were pricing in a lot of negatives, as the annual return of the global stock-to-bond ratio was deeply negative and could only fall further if a recession were to emerge. Moreover, as commodity prices were improving, we foresaw a waning of deflationary forces that had engulfed the world. This easing deflation would cause real rates to fall and economic activity in EM to rebound. Chart I-1Global Asset Prices: From Gloom To Glee Global Asset Prices: From Gloom To Glee Global Asset Prices: From Gloom To Glee Over the subsequent nine months, this scenario moved from the world of theories to being the reality for the global economy. Today, the annual return of the global stock-to-bond ratio is now the mirror image of last June (Chart I-1). Thus, for the stock-to-bond ratio to move higher, we need to explore where growth may come from. Moreover, we need to consider whether this growth is likely to help the dollar or help other currencies. The U.S. Is In Charge The U.S. economy continues to show the most promise. It is true that some signs do point to a weak Q1. Much noise has been made about the decline in commercial and industrial loans. We are more sanguine. To begin with, the Conference Board includes C&I loans in its list of lagging indicators, not leading ones. Additionally, C&I loans lag banks' lending standards, and, in fact, the weakness in this subsection of credit aggregates is the natural consequence of the 2015-2016 tightening in lending standards. Their recent easing points toward a rebound in C&I loans, as do core durable goods new orders (Chart I-2). What is more concerning is the slowdown in credit to households (Chart I-3). The U.S. economy is driven by household dynamics and the Conference Board does include consumer credit in its list of leading indicators. Moreover, the amount of MBS and ABS on primary dealers' balance sheets remains in a downtrend. This is worrisome because it suggests that the slowing accumulation of consumer debt on banks' balance sheet is genuine, and not a reflection of securitization (Chart I-4). Chart I-2C&I Loans##br## Will Pick Up C&I Loans Will Pick Up C&I Loans Will Pick Up Chart I-3However, Household Credit ##br##Dynamics Are A Worry However, Household Credit Dynamics Are A Worry However, Household Credit Dynamics Are A Worry Chart I-4Securitization Unlikely ##br##To Be The Culprit Securitization Unlikely To Be The Culprit Securitization Unlikely To Be The Culprit However, there are causes to minimize these concerns. Mainly, the drivers of household income and spending are still healthy. First, U.S. financial conditions remain easy, a phenomenon that tends to boost GDP growth in the following quarters, suggesting that national income will remain strong. Second, the outlook for employment in the U.S. remains robust. As Chart I-5 illustrates, the employment components of the ISM and the Philly Fed surveys both point to a pick-up in job creation. This further supports the notion that nominal household income will strengthen Third, our real disposable income indicator, based on various components of the NFIB survey, is showing that households should enjoy strong income growth in the coming months (Chart I-6). Moreover, despite the failure of the AHCA, Marko Papic, the head of BCA's Geopolitical Strategy service argues that it will be much easier for the GOP to implement tax cuts, especially geared toward the middle class, than it was to repudiate the much-maligned Obamacare.2 This could further help household disposable income. Chart I-5Job Growth Will Rebound Job Growth Will Rebound Job Growth Will Rebound Chart I-6Household Income: Highway Star Household Income: Highway Star Household Income: Highway Star Fourth, household liquid assets represent 270% of disposable income, the highest level in decades. Moreover, household debt-servicing costs are still near multi-generational lows, suggesting that households are in the best financial shape they have been in decades. And fifth, household confidence has surged to its highest levels since 2000, reflecting both the large increase in net worth created by surging asset values as well as the very low level of unemployment in the U.S. (Chart I-7). Thus, the decline in the savings rate from 6.2% in 2015 to 5.5% at present could deepen further, adding more impetus to transform income gains into consumption gains. At the worst, this development suggests that the household savings rate will not rise much. These factors all imply that household consumption will remain robust and may in fact accelerate in the coming quarters. Consequently, that capex too has upside. We have highlighted how capex intentions have risen substantially, and this has historically been a powerful leading indicator of capex itself.3 However, the financial press is replete with commentators reminding us that the positive global economic surprises have mostly been a reflection of "soft data" and that "hard data" has not followed through. Not only do we philosophically disagree with this statement - historically soft data does indeed lead hard data - but as Chart I-8 illustrates, core capital goods orders have risen quite sharply, mimicking the developments in retail sales. A combination of strong retail sales and strong orders tend to portend to a rise in capex. Chart I-7Happy Shiny People Happy Shiny People Happy Shiny People Chart I-8Capex Will Rebound Capex Will Rebound Capex Will Rebound These developments raise the likelihood that U.S. growth will power the global economy and that the Fed will be in a good position to make good on its intent to increase interest rates two more times this year. In fact, there is even a growing probability that the Fed will add another tool to its tightening arsenal: letting MBS run off, resulting in a contraction of its balance sheet. The combined tightening of two more hikes and a shrinking balance sheet will be much greater than any tightening emanating from an ECB taper. As we argued last week: Europe's inflation and wage backdrop remains icy cold, limiting how far the ECB can tighten monetary policy.4 While an environment of globally rising rates is normally negative for the yen, with the BoJ displaying and even easier bias than in the past, any increase in rates in the U.S. is likely to supercharge weaknesses in the yen, as the BoJ will put a lead on JGB yields and force them to remain subdued.5 As a result of these views, we remain very committed dollar bulls on a 12-18 months basis and recommend using the current dip in the dollar as a buying opportunity, especially on a trade-weighted basis. Bottom Line: While consumer loan growth has slowed - which could result in a poor Q1 U.S. growth number - the outlook for U.S. household income and consumption remains promising. This will also feed through to higher investment growth, clearing the Fed's path toward higher rates. This dip in the dollar should be used as an occasion to buy the greenback. But Why Still Long The Yen Tactically? This position has two purposes. First, we have been worried about dynamics in China that could cause a correction in EM markets.6 More recently, the decline in Chinese house-price appreciation has deepened, representing an ominous sign for the iron ore market (Chart I-9). Poor metal prices tend to represent a negative terms of trade shock and therefore an economic handicap for many large EM nations. Moreover, back in June, the improvement in Taiwanese IP was one of the factors that prompted us to highlight a potential improvement in the global economy. So was the uptrend in our boom/bust indicator. Today, not only is the boom/bust indicator losing steam, but Taiwanese IP has sharply rolled over (Chart I-10). While this is not a reason to worry about our bullish view on the U.S. economy, this could suggest that the global manufacturing upswing has seen its heyday, a development that is likely to weigh more heavily on EM economies than on the U.S. Any EM stress is likely to boost the yen's appeal, temporarily countering the BoJ's aggressive stance. Chart I-9Problems For Iron Ore Problems For Iron Ore Problems For Iron Ore Chart I-10Two Clouds For Global Growth Two Clouds For Global Growth Two Clouds For Global Growth Second, we do not want to be dogmatic on our U.S. growth view. As the top panel of Chart I-11 illustrates, increases in 2-year Treasury yields have tended to lead to decreases in U.S. inflation expectations. While we would argue that the U.S. economy is on a stronger footing to withstand higher rates than at any point since 2010, a policy mistake is not out of the scope of probabilities. If rising rates is indeed a policy mistake, a large risk-off event would be a very likely outcome, one that boosts the yen. Finally, as the middle and bottom panels of Chart I-11 shows, a fall in U.S. inflation expectations would also extract its toll on EM and cyclical plays, further reinforcing any disappointment out of China, and further adding shine to the yen. Our original target on USD/JPY was 110, we are moving it to 108. At this point, we will become sellers of the yen, unless we see signs that the global economy is entering a more dangerous path than originally anticipated. Additionally, investors looking to express a bearish view on EM may want to go short MXN/JPY (Chart I-12). The peso has massively rallied and is now at a crucial technical spot against the JPY. Moreover, while being short USD/JPY may be a dangerous move - after all, we are playing what amounts in our view to a countertrend bounce in the yen - if EM are at risk, these risks could be exacerbated by the tightening in financial conditions created by a higher dollar. Mexico, with its high external debt, representing nearly 70% of GDP, is particularly exposed to this problem. Also, MXN, with its high liquidity for an EM currency, is often a vehicle for investors to play EM weaknesses. Thus, shorting MXN/JPY could be a great hedge for investors with long EM exposures. Chart I-11Are We Out Of The Woods Yet? Are We Out Of The Woods Yet? Are We Out Of The Woods Yet? Chart I-12A Gauge And A Play A Gauge And A Play A Gauge And A Play Bottom Line: Being tactically long the yen in a portfolio offers two advantages. First, it is a direct play on any disappointment of investors in the EM space, and, second, it is also a hedge against the risks to our strong U.S. growth view. AUD/NZD: Not A Bargain It is often argued that AUD/NZD is a bargain as it trade 6% below its purchasing power parity rate. This may be a valid reason to buy this cross, but only for investors with extremely long investment horizons, as PPP deviations can take seven years to correct. In fact, following the recent rebound in AUD/NZD, we would be inclined to short this pair once again. On the international front, AUD/USD seems to be driven by the dynamic in Chinese nominal GDP growth. We doubt Chinese nominal GDP growth will accelerate much beyond Q1. As Chart I-13 illustrates, AUD/USD seems to have moved ahead of Chinese GDP, putting this currency at risk. We also can also interpret AUD/NZD as a vehicle to play the growth rebalancing in China. The AUD (iron ore, other metals, and coal) is a bet on industrial and investment growth while the NZD (dairy, meat, and wool) is a wager on the Chinese households. As China moves away from an investment-led growth model toward a more consumption-led growth model, AUD/NZD should underperform. A simple fair value model for this cross designed to capture these dynamics as well as the USD dynamics indicates that AUD/NZD is 8% overvalued (Chart I-14). Chart I-13AUD Prices In Chinese Optimism AUD Prices In Chinese Optimism AUD Prices In Chinese Optimism Chart I-14AUD/NZD Is Expensive AUD/NZD Is Expensive AUD/NZD Is Expensive Moreover, still with an eye firmly planted on China, AUD/NZD has tended to perform poorly when Chinese monetary conditions tighten. The recent upward move in the Chinese 7-day repo rate could be a harbinger of bad things to come for this cross. Relative domestic factors also temper any bullishness on AUD/NZD. Kiwi house prices are outperforming Aussie prices and New Zealand inflation is catching up to that of Australia's. Moreover, the RBA has been paying more attention to the poor state of the Australian labor market, while that of New Zealand remains very strong. These dynamics suggest that kiwi rates could rise relative to that of Australia (Chart I-15). More technically, investors are massively long the AUD relative to the NZD (Chart I-16). This usually is a good signal to bet against this pair. Chart I-15Domestic Conditions Favor##br## Higher NZ Rates Vs. Australia Domestic Conditions Favor Higher NZ Rates Vs. Australia Domestic Conditions Favor Higher NZ Rates Vs. Australia Chart I-16Speculators ##br##Are Bullish Speculators Are Bullish Speculators Are Bullish Bottom Line: Shorting AUD/NZD at current levels makes sense. Not only is it a way to take advantage of the desire by Chinese authorities to rebalance growth away from the Chinese industrial sector, the Kiwi economy is outperforming that of Australia, and too much negativity has been priced in for the RBNZ relative to the RBA. Finally investors are overly long the AUD relative to the NZD. Set up a stop-sell of AUD/NZD at 1.1100, with a target of 1.000 and a stop at 1.1330. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "What Could Go Right?", dated June 24, 2016 available at fes.bcaresearch.com 2 Please see Geopolitical Strategy Weekly Report, "Five Questions On Europe", dated March 22, 2017 available at gps.bcaresearch.com 3 Please see Foreign Exchange Strategy Special Report, "Outlook: 2017's Greatest Hits", dated December 16, 2016 available at fes.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report, "Healthcare Or Not, Risks Remain", dated March 24, 2017 available at fes.bcaresearch.com 5 Please see Foreign Exchange Strategy Weekly Report, "JPY: Climbing To The Springboard Before The Dive", dated February 24, 2017 available at fes.bcaresearch.com 6 Please see Foreign Exchange Strategy Weekly Report, "Healthcare Or Not, Risks Remain", dated March 24, 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 DXY displayed resilience this week: the third estimate for U.S. GDP in 2016Q4 outperformed expectations at 2.1%, after being revised up from 1.9%; consumer confidence increased to 125.6, the highest level since 2000; yet Initial jobless claims ticked in at 258,000, underperforming expectations of 248,000 but beating previous figures of 261,000. Another factor lifting the dollar were recent comments by Secretary of Transportation, Elaine Chao, who stated that Trump's $1 trillion infrastructure plan will be unveiled later this year. This could be considerably positive for U.S. economic growth as it will cover a large part of the economy: "transportation infrastructure, energy, water and potentially broadband and veterans hospitals as well." Although specifics were not disclosed, such stimulus in the face of tightening labor market could fan inflation. Under the assumption of a proactive Fed, this could translate into a strong dollar. Report Links: USD, Oil Divergences Will Continue As Storage Draws - March 17, 2017 Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 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 Last week's hawkish comments by ECB board member Ewald Nowotny drove the euro higher, while recent comments by Peter Praet confirmed that "a very substantial degree of monetary accommodation is still needed", which pushed the euro down. Promoting the euro's downside were Italian industrial sales and orders, which contracted at a monthly pace of 3.5% and 2.9% respectively, although annual rates remain positive. Article 50's invocation was another factor which contributed to volatility. How Brexit negotiations evolve will dictate movements in EUR/GBP for the foreseeable future. President Tusk's demeanor was also quite negative in his speech, focusing on minimizing "the costs for EU citizens, businesses and Member States". In other news, Portugal's Finance Minister Mario Centeno hinted at a possible upgrade to the growth forecast to around 2% from 1.5% as exports grew by 19% in January. As exports continue to be a key driver of growth for this country, this suggests a weaker euro is still needed to support growth in the periphery. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 The French Revolution - February 3, 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 data has been mixed for Japan: Corporate services prices rose by 0.8% year-over-year, outperforming expectations. However, retail trade yearly growth deteriorated to 0.1% from 1% the previous month, underperforming expectations. Furthermore, manufacturing PMI fell to 52.6 from 53.3 the previous month. We are changing our tactical target for USD/JPY from 110 to 108. The decline in Chinese property prices as well as slowing inflation expectations in the U.S. might create a risk off environment that will affect carry currencies and will benefit the safe havens like the yen. On a cyclical basis, we remain yen bears, as recent sluggishness will only embolden BoJ policy makers to maintain their radical monetary stance. Report Links: Et Tu, Janet? - March 3, 2017 JPY: Climbing To The Springboard Before The Dive - February 24, 2017 Updating Our Long-Term FX Value Models - February 17, 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 It's official: Theresa May has triggered Article 50. The pound reacted relatively positive to the event as both parties in the negotiations chose to start with the carrot rather than the stick: In her letter to the EU Theresa May stated that she hoped to enjoy a "deep and special" relationship with the European Union once Brexit is finalized. On the other side of the channel, Donald Tusk also pledged to work "closely" with their counterparts in London, and that he hoped that the U.K. will stay a close partner after Brexit. These developments are encouraging, as it shows that cooler heads might prevail at the end of the day. This rosier outlook in an environment where expectations for the Britain are still too pessimistic makes the pound a very attractive buy, particularly against the euro, despite the potential for short-term volatility as the stick will ineluctably come out. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 In an attempt to curb housing market euphoria, all four major banks - ANZ, CBA, NAB and Westpac - increased lending rates on investor and interest-only mortgages this month. Fitch Ratings reports that the tightening was done "ahead of probable regulatory tightening", as hinted frequently by the RBA. Rising wholesale funding costs due to tighter U.S. policy is also a motivating factor behind this. For the time being, the housing market risk will continue to be restricted through macroprudential policies rather than actual tightening by the central bank. Eventually risks related to record-high household debt will limit the capacity of the RBA to increase rates. On the brighter side, banks are well positioned with strong capital buffers and pre-impairment to profitability, with Fitch rating them 'Stable'. This means that risks may not lie with the banking sector, but that the consumer sector will be the key drag on growth. Report Links: AUD And CAD: Risky Business - March 10, 2017 Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 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 In the current environment, although we like to continue to be short the NZD against the yen, we are also shorting AUD/NZD once again. Beyond its uncorrelated nature, there are many reasons why this is an attractive cross to short: AUD/NZD tends to perform poorly when Chinese monetary conditions tighten. Therefore, the spike in Chinese repo rates could weigh on this cross. Furthermore, investors are very long the AUD relative to the NZD. This gives us confidence that this cross might be in overbought territory and that the 5.5% rally in AUD/NZD over the last 2 months may be exhausting itself. Finally, as we have mentioned before, domestic factors still favor the NZD, as kiwi house prices are rising at a faster pace than Aussie ones, which should put pressure on rate differentials. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 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 is displaying some strength on the back of stronger oil prices, outweighing the pressure from a stronger USD. As mentioned last week, the trend for USD/CAD is still negative in the short term, as corroborated by a negative MACD trend. The greenback's seasonal behavior is also generally negative in April, which could buoy the CAD in the next month. Nevertheless, at the Bank of Canada's meeting in two weeks, Poloz is likely to continue displaying a dovish rhetoric, limiting the CAD's resilience. Similar to Australia, risks lie with the consumer sector, which is burdened by a huge debt load. This gives another reason for Poloz to stay off hikes for the time being and concentrate instead on promoting the implementation of macroprudential policies to regulate lending standards and mitigate housing market risks. Report Links: AUD And CAD: Risky Business - March 10, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 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 now hovers around 1.07, clearing the implied floor by the Swiss National Bank. Recent data have been positive: The Zew survey for economic expectations reached 29.6, up from 19.4 in February. It is now at the highest level in 3 years. The KOF leading indicator came at 107.6, above expectations. Although it does seem that the Swiss economy is still improving, the SNB will stay resolute in its intervention for the time being. Indeed, this was the message of SNB Governing Board Member Andrea Maechler, who asserted that there was no limit on their expansion of FX reserves, and that the Swiss franc was "strongly overvalued". We will continue to observe how the Swiss economy develops. However, for the time being the SNB is likely to keep its floor in place. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 USD/NOK has been relatively flat this week, even in the face of a rally in oil prices. This has been in part due to a phenomenon that should continue in the next months: an appreciation of the U.S. dollar against EM and commodity currencies. Furthermore, domestic factors should continue to weigh on the krone, as employment continues to contract and inflation is receding due to the stabilization of the krone. Indeed, Governor Olsen signaled that the Norges bank will likely leave rates unchanged for "a good while" due to these developments. Furthermore, oil could be at risk as well, as the market is starting to doubt the Russian commitment to its deal with OPEC. This, coupled with a slowdown in EM, could prompt a down leg in oil, hurting the NOK in the process. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 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 came out strong: Retail sales annual growth remains unchanged at 2.7%; The producer price index grew at 7.5%; Consumer confidence for March was at 102.6, down from the previous 104.3. Interesting technical developments for the krona are pointing to further weakness. USD/SEK has rebounded from oversold levels and the MACD line is beginning to overtake the signal line. More importantly, the Coppock curve is rebounding, signifying a bullish trend. EUR/SEK is showing similar signs with the MACD pointing up and the Coppock curve rebounding. Interestingly, Swedish inflation expectations have substantially decreased this week which might give the Riksbank cover to remain dovish. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

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

Highlights Animal spirits have soared, according to soft data from surveys. But 6-month credit impulses have slumped in the euro area, U.S. and China, according to hard data from the ECB, Federal Reserve and PBOC. The negative 6-month credit impulse - rather than soaring animal spirits - is more important for the cyclical direction of the global economy. A growth-pause would blindside financial markets. Lean against any rise in high-quality bond yields and equity prices until the conflict between soaring animal spirits and slumping credit impulses is resolved. Feature Animal spirits have soared since the surprise election of President Trump on November 8. For many investors, the heightened animal spirits - shown in surging sentiment and survey data (Chart I-2) - are a strong signal that the global economy is about to accelerate. Unfortunately, these investors could end up very disappointed. Chart of the Week6-Month Credit Impulses Have Slumped 6-Month Credit Impulses Have Slumped 6-Month Credit Impulses Have Slumped Chart I-2Animal Spirits Have Soared... Animal Spirits Have Soared... Animal Spirits Have Soared... The problem is that the hard data on bank credit are giving the exact opposite signal. Over the past few months, global credit flows have slumped (Chart of the Week, Chart I-3 and Chart I-4). Chart I-3...But Credit Impulses Have Slumped ...But Credit Impulses Have Slumped ...But Credit Impulses Have Slumped Chart I-4The Global 6-Month Credit Impulse Has Turned Negative Despite Heightened Animal Spirits The Global 6-Month Credit Impulse Has Turned Negative Despite Heightened Animal Spirits The Global 6-Month Credit Impulse Has Turned Negative Despite Heightened Animal Spirits The ECB's latest Monetary Developments in the Euro Area shows that the euro area 6-month credit flow has shrunk by €26 billion. The most recent 6-month credit flow fell to €321 billion from €347 billion in the previous period. The U.S. Federal Reserve's latest weekly H8 release paints an even starker picture. The U.S. 6-month credit flow has shrunk by $271 billion, equivalent to 3% of U.S. GDP (at an annualised rate). The most recent 6-month credit flow plunged to just $152 billion from $423 billion in the previous period. For completeness, look at the world's other major economy, China. Given the lower credibility of official bank credit data in China we prefer to focus on the broad money supply numbers. The People's Bank of China does not seasonally adjust this data, but it is straightforward to do ourselves using standard seasonal adjustment functions. The seasonally-adjusted data shows that the most recent 6-month flow, at 8.1 trillion yuan, was slightly higher than the preceding 7.7 trillion yuan. Nevertheless, the resulting marginally positive China 6-month impulse is sharply down from previous months. Why Optimism Is Up, But Borrowing Is Down Let's explain why sentiment data and credit flows have headed in polar opposite directions since the shock electoral success of Donald Trump. Imagine that firms (or households) are willing to borrow $1 billion for investment projects at a long-term borrowing cost of 1.5%. Then, an unexpected event causes animal spirits to surge. Suddenly, firms will become more optimistic about the expected profits from the investment projects. At this higher net1 profitability, firms might be willing to borrow and invest more than $1 billion, let's say $1.5 billion. In which case, the sentiment data will be higher and so will the credit flow, resulting in a credit impulse of +$0.5 billion. Chart I-5A Sharp Rise In Borrowing Costs Has##br## Countered Heightened Animal Spirits A Sharp Rise In Borrowing Costs Has Countered Heightened Animal Spirits A Sharp Rise In Borrowing Costs Has Countered Heightened Animal Spirits Now imagine that in response to this improved economic outlook, the financial markets expect the central bank to hike interest rates quicker and further. So the markets push up the bond yield to 2.0%. For firms, this higher cost of long-term borrowing might now exactly neutralise the expected profit boost from the investment projects. At this unchanged net profitability, firms will continue to borrow and invest $1 billion. In which case, the sentiment data will be higher but the credit flow will be unchanged, resulting in a credit impulse of zero. Finally imagine that in response to the improved economic outlook, the financial markets get carried away. They push up the bond yield to 2.5%. Now, the much higher cost of long-term borrowing will more than neutralise the expected profit boost from the investment projects. At a sharply lower net profitability, firms will borrow and invest less than $1 billion, let's say $0.5 billion. In which case, the sentiment data will be higher but the credit flow will fall, resulting in a credit impulse of -$0.5 billion. Note that in all three cases, animal spirits are up sharply. For credit flows, these heightened animal spirits in isolation are a tailwind. But any associated rise in the cost of long-term borrowing is a headwind. It follows that the net impact on credit flows depends on the relative strengths of the tailwind from heightened animal spirits and the headwind from higher long-term borrowing costs. Today, we would suggest that for global credit flows, the tailwind from heightened animal spirits is weaker than the headwind from the sharpest rise in bond yields in a decade (Chart I-5). The result is a negative 6-month global credit impulse. And it is this negative 6-month credit impulse - rather than heightened animal spirits per se - that is more important for the cyclical direction of the global economy. The History Of "Animal Spirits" In the early nineteenth century, the 'British Currency School', led by David Ricardo, postulated that expansions and contractions of bank credit and the broad money supply are the main cause of the economic cycle. We are very strong advocates of Ricardo's Currency School thesis. In opposition to the Currency School, the 'British Banking School' believed that expansions and contractions of bank credit are merely the passive effects of the economic cycle. The true cause of the economic cycle is fluctuations in business speculation and expectations of profit, which ultimately come from psychological mood swings. A century later in 1936, John Maynard Keynes wrote The General Theory of Employment, Interest and Money. In it, Keynes reiterated the Banking School's psychological mood swing explanation of the cycle. To describe these mood swings, he came up with the now very familiar phrase "animal spirits". Keynes blamed the Great Depression on the collapse of these animal spirits, and a consequent collapse in investment and consumption. But Keynes was only partly right. Animal spirits in isolation do not cause the cycle. As discussed in the previous section, borrowing costs lean against mood swings in both directions. Optimism results in higher borrowing costs, countering the desire to borrow. Pessimism results in lower borrowing costs, countering the reluctance to borrow. And it is the net impact on credit flows that drives the cycle. The specific problem in the Depression was a slump in asset prices. This depressed the value of households' and firms' balance sheet assets to below the value of the liabilities - an extreme event which economist Richard Koo calls a 'balance sheet recession'. Crucially, in a balance sheet recession, no amount of borrowing cost reduction can counter the reluctance to borrow, because households' and firms' single-minded objective is to regain solvency. Hence for us, the Ricardian bank credit cycle - rather than Keynesian animal spirits - is the better explanation for the Great Depression, as well as for Japan's post-1990 bust and for the 2008-09 Great Recession. The Ricardian bank credit cycle also explains the more common and garden variety of economic fluctuations (Box I-1). Readers should review our February 2 report Slowdown: How And When? for the compelling theoretical and empirical evidence. Right now, the important message is that the global bank credit cycle is weakening. Box I-1The Mathematics Of Mini-Cycles Credit Slumps While Animal Spirits Soar. Why? Credit Slumps While Animal Spirits Soar. Why? Credit Slumps While Animal Spirits Soar: What Should Investors Do? Many commentators and investors look at sentiment and survey data and note that animal spirits have soared. On this basis, they expect global growth to accelerate. But to reiterate, animal spirits in isolation do not cause the economic cycle. Heightened animal spirits do generate a tailwind for credit creation, but any associated rise in the cost of long-term borrowing generates a headwind (Chart I-6). And it is the net effect on the 6-month credit impulse - rather than heightened animal spirits per se - that determines the cyclical direction of the economy (Chart I-7). Chart I-6Higher Borrowing Costs Weaken Credit Flows... Higher Borrowing Costs Weaken Credit Flows... Higher Borrowing Costs Weaken Credit Flows... Chart I-7...And Weaker Credit Flows Slow The Economy ...And Weaker Credit Flows Slow The Economy ...And Weaker Credit Flows Slow The Economy Today, the hard data on bank credit in the euro area, the U.S. and China show that 6-month impulses have slumped. The risk is that this could generate an unwelcome surprise. Rather than accelerate in the coming months, global growth may level off or even decelerate. Even if it were a short-lived pause, major financial markets - including all of those in Europe - would be blindsided. The risk-on mode so far in 2017 would turn out to be incongruous. At the very least, until the conflict between soaring animal spirits and weakening credit impulses is resolved, we will lean against any rise in high-quality bond yields and equity prices. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Profitability net of borrowing cost. Fractal Trading Model* Excessive optimism in global equity prices reinforces our near-term caution towards stocks. We are expressing this through a short position in the AEX. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-8 Fractal Trading Model Fractal Trading Model * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. 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