Gov Sovereigns/Treasurys

Highlights The 50bps spike in the JPM global government bond yield since August constitutes one of the most aggressive tightenings since the Great Recession. Higher bond yields weaken credit growth, and weaker credit growth almost always depresses subsequent GDP growth. Maintain at most a neutral weighting to equities. Lean against the aggressive sell-offs in Healthcare, Consumer Goods, Telecoms and government bonds. Lean against the aggressive rally in Financials. Feature November 9 is an important date in the annals of history. November 9, 1989 was the day that the Berlin Wall came down. Chart of the WeekGlobalization Has Been Good For Profits, Bad For Wages Globalization Has Been Good For Profits, Bad For Wages Globalization Has Been Good For Profits, Bad For Wages Through 1961-89, the Berlin Wall divided a city. More significantly, it symbolized a divided world. So when the wall came down on November 9, 1989, it marked a new era of globalization. Goods, services, capital and people started to move around the world much more freely, resulting in greater efficiencies and lower costs. In developed economies, profits surged. Using the United States as an example, in the 27 years since the Berlin Wall came down, stock market real earnings per share have gone up 200% (Chart I-2). Chart I-2The Backdrop For Populism bca.eis_wr_2016_11_17_s1_c2 bca.eis_wr_2016_11_17_s1_c2 But globalization has exacted a heavy price: the pressure on wages means that in the 27 years since the Berlin Wall came down, U.S. median household real income has gone up just 10%. By comparison, in the 28 years that the Berlin Wall stood, the median household real income went up 60% (Chart of the Week). November 9 is also the date that Donald Trump won the presidency of the United States. So exactly 27 years after one symbolic wall fell, is another one about to go up? Will Mr. Trump's promised wall with Mexico symbolize a new era of anti-globalization, and a reversal of the economic and financial trends since the Berlin Wall came down? Flaws In The Trump Plan Economists are almost unanimous that protectionism, trade barriers and tariffs - in other words, "building walls" - depresses long-term global growth. It is conceivable that protectionism could help some parts of the U.S. economy, though other parts might lose out as trading partners retaliated. It is inconceivable that protectionism would be good for the world economy as a whole. Chart I-3One Of The Most Aggressive Tightenings ##br##Since The Great Recession bca.eis_wr_2016_11_17_s1_c3 bca.eis_wr_2016_11_17_s1_c3 But what about Trump's noise about fiscal stimulus, and specifically infrastructure spending - why would anybody not get excited about that? The two word answer is: crowding out. If a dollar that is borrowed and spent by the government (or even forecast to be borrowed and spent by the government) pushes up the bond yield (Chart I-3), it makes it more expensive for the private sector to borrow and spend. If, as a result, the private sector scales back its borrowing by a dollar, the dollar of government spending would have no impact on GDP. This is because the dollar of government spending has crowded out a dollar of private sector spending. The fiscal multiplier would be zero. But doesn't the euro area debt crisis provide compelling evidence of the power of fiscal thrust and a very high fiscal multiplier? No, not exactly. The fiscal multiplier was high through the debt crisis because euro area austerity - a fiscal tightening - very unusually coincided with sharply rising bond yields - which killed private sector borrowing. In other words, fiscal tightening and private sector tightening were reinforcing each other. Through 2009-12, when the euro area debt crisis escalated, the relationship between fiscal tightening and growth in GDP per capita in 13 sampled economies had a near-perfect explanatory power (r-squared of 0.9); and its slope of 1.5 indicated an extremely high average fiscal multiplier (Chart I-4). But through 2012-15, after Mario Draghi "did whatever it takes" the unusual combination of fiscal tightening and higher bond yields no longer existed, and both the explanatory power of the relationship and fiscal multiplier collapsed (Chart I-5). Chart I-4A Very Strong Connection Between Fiscal Policy And Growth Through 2009-12... From Berlin Wall To Mexican Wall From Berlin Wall To Mexican Wall Chart I-5...But No Connection Between Fiscal Policy And Growth Through 2012-15 From Berlin Wall To Mexican Wall From Berlin Wall To Mexican Wall The lesson is that the efficacy of fiscal stimulus and infrastructure spending crucially depends on its impact on the bond yield - and thereby on private sector borrowing. Now note that the 6-month increase in the U.S. (and global) 10-year bond yield constitutes one of the sharpest tightenings since the Great Recession. Higher borrowing costs depress credit growth as captured in the 6-month credit impulse (Chart I-6). A weaker 6-month credit impulse then almost always depresses subsequent 6-month GDP growth (Chart I-7). Chart I-6Higher Borrowing Costs Depress##br## Credit Growth... bca.eis_wr_2016_11_17_s1_c6 bca.eis_wr_2016_11_17_s1_c6 Chart I-7...And Weaker Credit Growth Depresses ##br##Subsequent GDP Growth bca.eis_wr_2016_11_17_s1_c7 bca.eis_wr_2016_11_17_s1_c7 So yes, fiscal stimulus and infrastructure spending could be effective as long as the bond yield is anchored, as it is in Japan. But if the bond yield goes up sharply, the consequent drag from the private sector will partly or entirely negate any putative boost from the government. Explaining Market Shocks And Electoral Shocks In his seminal book Thinking, Fast And Slow psychologist and Nobel Laureate Daniel Kahneman1 proposed that the human brain has evolved two separate and independent systems for decision making: a fast, rapid-response, associative way of thinking which he calls "System 1" and a slow, analytical, measured way of thinking which he calls "System 2". The two ways of thinking, fast and slow, have evolved to protect us from two types of threat to our survival: immediate, and long-term. Thousands of years ago, the immediate threat to survival might have been a sudden noise in the bushes suggesting that a predator was stalking. Today, for a bond investor, the immediate threat might be a sudden noise about aggressive U.S. fiscal stimulus, suggesting that the end of deflationary pressures is nigh. Faced with this immediate but uncertain threat, using the slow and measured thinking of System 2 could be fatal. So we obey the fast-thinking, associative, emotional System 1 and run for cover - or sell bonds. Thousands of years ago, a long-term threat might have been a war of attrition against an enemy tribe. Today, for the bond investor, the long-term threat might be the end of the debt super cycle, suggesting that deflationary pressures will persist. Faced with this long war of attrition, an over-reliance on the impulsive decisions of System 1 could also be fatal. We must use the measured analysis and strategies of slow-thinking System 2. Kahneman's System 1 and 2 is also an excellent framework to help explain how the simple messages of the Brexiteers and Donald Trump led to stunning success at the ballot box. Faced with job destruction and stagnant real wages, many people intuitively believe that less globalization, less competition and less immigration must mean more jobs and a better standard of living. Associative and emotional System 1 immediately identifies with simple messages such as "take back control" or "build a wall". The success of the Brexiteers and Donald Trump was to acknowledge the deep malaise that many people are feeling and offer simple and intuitive cures. To be absolutely clear, this is neither an endorsement nor a criticism of the Brexiteers or Donald Trump, but simply an explanation of why their message hit home. Still, as we have argued, the more analytical and measured System 2 will find that the simple and intuitive cures that the Brexiteers and Donald Trump offer are not the panaceas that they might first seem. The Immediate Investment Decision Short-term traders generally use the rapid-response, associative, emotional System 1 for their decision making. Long-term investors generally use the slow, analytical, measured System 2. But after a shock, disoriented long-term investors may also switch from System 2 to System 1 and just follow the herd. Eventually though, System 2 switches back on, and the excessive herding and trend-following reverses. At the moment, several sector trends are at or near such a point of reversal according to our excessive groupthink indicator (Chart I-8, Chart I-9, Chart I-10, Chart I-11, Chart I-12). Chart I-8Healthcare Reversals After Excessive Trend-Following Healthcare Reversals After Excessive Trend-Following Healthcare Reversals After Excessive Trend-Following Chart I-9Consumer Goods Reversals After Excessive Trend-Following bca.eis_wr_2016_11_17_s1_c9 bca.eis_wr_2016_11_17_s1_c9 Chart I-10Telecoms Reversals After Excessive Trend-Following Telecoms Reversals After Excessive Trend-Following Telecoms Reversals After Excessive Trend-Following Chart I-11Financials Reversals After Excessive Trend-Following Financials Reversals After Excessive Trend-Following Financials Reversals After Excessive Trend-Following Chart I-12Government Bond Reversals After Excessive Trend-Following Government Bond Reversals After Excessive Trend-Following Government Bond Reversals After Excessive Trend-Following Specifically, on a 3-month trading view, we would lean against the aggressive sell-offs in Healthcare, Consumer Goods, Telecoms and government bonds; and we would lean against the aggressive rally in Financials. More generally, what does the Trump victory mean for European equities? In today's highly-connected financial markets, mainstream investments in Europe overwhelmingly depend on global developments, and not on parochial issues. The dominant components of the Eurostoxx600, FTSE100, DAX30, CAC40, AEX, SMI, and other major indices, are multinationals with a truly global footprint. So the answer rests on two subsidiary questions: What does the Trump victory mean for global monetary conditions? What does the Trump victory mean for global growth? As already mentioned, global monetary conditions have tightened significantly in recent months, and in accelerated fashion after the Trump victory. The 50bps tightening in the JPM global government bond yield since August constitutes one of the sharpest 3-month spikes since the Great Recession. But as in previous cases, the spike may be self-limiting given its squeeze on credit sensitive sectors and emerging markets. Since August, the dividend yield on equities is little changed - meaning that equities have become more expensive relative to bonds. But this is hard to justify as short-term growth prospects have, if anything, worsened. To repeat the powerful messages from Chart 6 and Chart 7, higher bond yields weaken credit growth; and weaker credit growth almost always depresses subsequent GDP growth. Putting all this together, asset allocators should maintain at most a neutral weighting to equities. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Daniel Kahneman won the Nobel Prize in economics in 2002 for his work on decision making. Fractal Trading Model* There are no new trades this week. After the big recent moves in markets, four open positions were closed at their trading-rule limits, two at profit targets, two at stop-losses. 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 1-13 Copper Vs. Tin Copper Vs. Tin * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields bca.eis_wr_2016_11_17_s2_c1 bca.eis_wr_2016_11_17_s2_c1 Chart II-2Indicators To Watch - Bond Yields bca.eis_wr_2016_11_17_s2_c2 bca.eis_wr_2016_11_17_s2_c2 Chart II-3Indicators To Watch - Bond Yields bca.eis_wr_2016_11_17_s2_c3 bca.eis_wr_2016_11_17_s2_c3 Chart II-4Indicators To Watch - Bond Yields bca.eis_wr_2016_11_17_s2_c4 bca.eis_wr_2016_11_17_s2_c4 Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_11_17_s2_c5 bca.eis_wr_2016_11_17_s2_c5 Chart II-6Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_11_17_s2_c6 bca.eis_wr_2016_11_17_s2_c6 Chart II-7Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_11_17_s2_c7 bca.eis_wr_2016_11_17_s2_c7 Chart II-8Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_11_17_s2_c8 bca.eis_wr_2016_11_17_s2_c8

Highlights Trump's Win: The Republican sweep of both the White House and Congress in the U.S. elections will allow President-elect Donald Trump to implement much of his planned policies, including a major fiscal stimulus package. Trump Stimulus & The Yield Curve: Trump's proposed aggressive fiscal stimulus package will continue to put bear-steepening pressure on the U.S. Treasury curve. However, the future direction of global bond yields will be more influenced by the upcoming monetary policy decisions in the U.S. & Europe. Maintain a below-benchmark overall duration stance, while exiting curve flattening positions in the U.S. U.S. High-Yield: U.S. junk bond valuations have improved slightly in recent weeks, especially in light of an improving U.S. nominal growth outlook for 2017 that will reduce default risk to some degree. Upgrade U.S. high-yield allocations to below-benchmark (2 of 5) from maximum underweight. Feature Chart of the WeekTrump Turmoil For Bonds Trump Turmoil For Bonds Trump Turmoil For Bonds America has been treated to a pair of major shocking events over the past couple of weeks. The Chicago Cubs won baseball's World Series for the first time in 108 years. And now, Donald Trump - real estate tycoon, reality TV star, Twitter addict - has become the 45th President of the United States. In the aftermath of that stunning election victory, investors are being treated to one more shocker that seemed impossible even just a few months ago - rapidly rising bond yields. Trump's victory has not only changed the political power structure in the U.S., but has seemingly altered many of the familiar financial market narratives as well. The idea of "deficit spending" by the government to boost growth has not been heard for many years in Washington, but Trump has made it clear that a big fiscal stimulus is coming soon to America. He has laid out a combination of large tax cuts and infrastructure spending that could result in both a surge in U.S. Treasury issuance in the coming years and a more structural rise in inflation - again, developments that have not been seen in the U.S. in quite a while. The prospect of fiscal easing amid still-accommodative monetary conditions in the U.S., with the economy running at full employment, has sent Treasury yields surging back to pre-Brexit levels, wiping out six months of positive bond returns in the process (Chart of the Week). While many details are still to be worked out with regards to Trump's proposed fiscal policy shift, the markets have taken its pro-business tilt as a bullish sign for growth and a bearish sign for bonds. There is more scope for yields to rise in the near term, in the U.S. and elsewhere, with the Fed likely to deliver another rate hike next month and the global economy now in a cyclical upswing. Duration risk remains the biggest immediate threat for bond investors, and we continue to recommend a below-benchmark portfolio duration stance. A New Sheriff In Washington Chart 2Markets Cheer Trump 'Bigly' Markets Cheer Trump 'Bigly' Markets Cheer Trump 'Bigly' The consensus opinion among investors going into the U.S. election was that a Trump victory would result in considerable market turmoil. This was a reasonable argument, as Trump ran a disruptive, anti-status-quo campaign that, by definition, would be expected to generate far more changes and uncertainty than a victory by Hillary Clinton. Yet outside of a few shaky moments in the wee hours of Election Night as markets began to realize that Trump would win, the big bond-bullish/equity-bearish risk-off moment never arrived. Perhaps Trump's more conciliatory tone in his victory speech helped to calm investors' fears that his caustic campaign demeanor would continue in the White House. More likely, investors saw the results in the U.S. Congressional elections and realized that the Republican Party had won a clean sweep in D.C. that would allow Trump to implement many of his campaign promises. Markets have been rapidly pricing the potential implications of a Trump presidency into many financial assets (Chart 2), from bank stocks (which would gain from Trump's proposed rollback of the Dodd-Frank regulations on bank activities and, more importantly, from the impact of higher bond yields and a steeper yield curve on profitability) to the U.S. dollar (which would benefit from Trump's protectionist trade agenda through narrower U.S. trade deficits and stronger U.S. growth that would raise the future trajectory of U.S. interest rates). Higher-quality USD-denominated credit spreads have been surprisingly well behaved, given the moves higher in U.S. yields and the USD itself. This may reflect an optimistic belief that Trump's pro-business, pro-growth policies can offset the negative impact on corporate profits from higher yields and a stronger USD. Markets are right to assume that Trump can actually deliver on his economic agenda. A detailed analysis of the implications of the Trump victory was laid in a Special Report sent last week to all BCA clients by our colleagues at BCA Geopolitical Strategy.1 One of their main conclusions was that Trump's ability to enact his plans will not be hindered much by the U.S. Congress. Republicans now control both the House of Representatives and Senate after last week's elections and Trump has been strongly supported even by the small government fiscal conservatives in Congress. After delivering such a stunning victory for the Republicans, Trump shouldn't face much serious resistance to his economic initiatives. Investors are starting to price in the potential inflationary implications of a President Trump, with the 5-year inflation breakeven, 5-years forward from the U.S. TIPS market now sitting at 1.84%. This is still well below the Fed's 2% inflation target (after adjusting for the usual historical difference between the CPI used to price TIPS and the Fed's preferred inflation gauge, the PCE deflator, which is around 0.4-0.5%). This measure can keep moving higher over the medium-term, given the timing of Trump's proposed fiscal stimulus. Bottom Line: The Republican sweep of both the White House and Congress in the U.S. elections will allow President-elect Donald Trump to implement much of his planned policies, including a major fiscal stimulus package. The 1980s Called - They Want Their Economic Policy Back The U.S. economy is now showing few internal imbalances that would require wider government deficits as a counter-cyclical policy measure. The private sector savings/investment balance is close to zero, as the post-crisis household deleveraging phase has ended and corporate sector borrowing has skyrocketed in recent years (Chart 3, top panel). Also, measures of spare capacity in the U.S. economy like the output gap or the unemployment gap are also near zero (bottom panel), suggesting that any pickup in aggregate demand from current levels could trigger a rise in wage inflation and domestically-focused core inflation. Chart 3Deficit Spending At Full Employment: Back To The Future? Deficit Spending At Full Employment: Back To The Future? Deficit Spending At Full Employment: Back To The Future? The last time that such a combination of fiscal stimulus and full employment occurred was in the mid-1980s during the presidency of Ronald Reagan. Trump's plans for aggressive tax cuts and sharp increases in discretionary government spending do echo the policies of Reagan, who presided over one of the nation's largest peacetime run-ups in discretionary government budget deficits and debt (Chart 4). Perhaps there was a kernel of truth in the Trump/Reagan comparisons made during the election campaign! Chart 4Less Fiscal Space Than In The 1980s Less Fiscal Space Than In The 1980s Less Fiscal Space Than In The 1980s Clearly, a sharp run-up in federal budget deficits could have a much greater impact on longer-term interest rates and the shape of the yield curve, given the much higher starting point for federal debt/GDP now (74%) compared to the beginning of the Reagan presidency (26%). Especially given the potentially large budget deficits implied by Trump's campaign promises. Back in June, Moody's undertook an economic analysis of Trump's economic policies based on publically available information (i.e. Trump's campaign website) and their own assumptions based on Trump's campaign speeches.2 Moody's ran policies through its own U.S. economic model, which is similar to the forecasting and policy analysis models used by the Fed and the U.S. Congressional Budget Office. This model allows feedback from fiscal policy changes to the expected swings in growth and inflation and the likely shifts in monetary policy. The Moody's analysts used a variety of scenarios, ranging from full implementation of Trump's proposals3 to a heavily watered-down version if he faced a hostile Congress (which is clearly not the case now). We show the Moody's model forecasts for the U.S. Federal budget deficit as a percentage of GDP in Chart 5, along with the slope of the very long end of the U.S. Treasury curve. We also show the 10-year/30-year slope versus a measure of the Fed's policy stance, the real fed funds rate. According to Moody's, a full implementation of the Trump platform would push the U.S. budget deficit to double-digit levels by 2020, and would add nearly $7 trillion in debt over that time, pushing the federal debt/GDP ratio to 100%. The less extreme scenarios show smaller increases in deficits and debt, but the main point is that even if Trump implements only some fraction of his policies, the U.S. budget deficit will go up significantly during his first term in office. Looking at the historic relationship between the deficit and the slope of the Treasury yield curve, this implies that Trump's policies should put steepening pressures on the long-end of the curve as the bond market prices in greater Treasury issuance and higher future inflation rates. Of course, the bottom panel of Chart 5 shows that Fed policy also matters for the shape of the curve, and this is where the current debate over the Fed's next moves comes into play. Chart 5Trump's Deficits Will Steepen The Curve (Fed Permitting) Trump's Deficits Will Steepen The Curve (Fed Permitting) Trump's Deficits Will Steepen The Curve (Fed Permitting) The market is currently discounting a 70% probability that the Fed will hike at the December FOMC meeting, which has been our call for the past few months. The Fed has been projecting an increase next month and another 50bps of hikes in 2017, but these were forecasts made in the BT (Before Trump) era. The pricing from the Overnight Index Swap (OIS) curve shows that the market's expectations have started to shift upward towards the Fed's forecasts, in contrast to the BT dynamic where the Fed was having to cut its forecasts down towards the lower levels implied by the market (Chart 6). Will the Fed now look at the fiscal stimulus proposed by Trump as a reason to hike rates higher, or faster, than their latest set of projections? A big fiscal stimulus at full employment would certainly give the FOMC cover to raise its forecasts for growth and inflation, which would require a shift upwards in its interest rate projections. We do not expect that outcome at next month's FOMC meeting, as the Fed would likely want to see more specific budget details from the Trump administration in the New Year. More importantly, the Fed will want to avoid any additional strength in the U.S. dollar by moving to a more hawkish stance too soon, which would turn the dollar once again into a drag on U.S. growth, inflation and corporate profits, potentially disrupting financial markets. With the Fed unlikely to become more hawkish in the near term, the Treasury market will remain focused on the fiscal implications of Trump, placing bear-steepening pressures on the Treasury curve. For that reason, we are exiting our current Treasury curve flattener positions (2-year vs 10-year, 10-year vs 30-year) this week and moving to a neutral curve posture. We continue to maintain a below-benchmark stance on overall portfolio duration, as well as an underweight bias toward U.S. Treasuries within the developed market bond universe (on a currency-hedged basis). Treasuries are still not cheap, despite the recent run-up in yields, according to our global PMI model which incorporates variables for growth, U.S. dollar sentiment and policy uncertainty (Chart 7). Fair value has risen to 2.25% on the back of improving global growth and reduced uncertainty post-Brexit, with rising dollar bullishness providing a downward offset. Chart 6Markets Moving UP To The Fed Forecasts bca.gfis_wr_2016_11_15_c6 bca.gfis_wr_2016_11_15_c6 Chart 7USTs Not Yet Cheap USTs Not Yet Cheap USTs Not Yet Cheap If the Fed were to move too quickly to a more hawkish stance, dollar bullishness would increase and limit the cyclical rise in yields. At the same time, greater policy uncertainty under a new President could also limit yield increases although, as we have laid out above, the nature of the Trump uncertainty is not bond-bullish if it results in rising levels of government debt. For now, it is best to maintain a cautious investment stance until there is greater clarity on the U.S. policy front, while being aware that Treasuries are no longer as sharply undervalued as they were just a week ago. Looking ahead, this bond bear phase could end if the ECB announces an extension of its bond-buying program beyond the March 2017 deadline. As we discussed in a recent Weekly Report, the ECB will not be able to credibly declare that European inflation will soon return to the 2% target.4 This will force the ECB to extend the bond buying for at least another six months, with some changes to the rules of the program to allow for smoother implementation of future purchases. If, however, the ECB does indeed announce a tapering of bond purchases starting in March, bond yields will reprice higher within the main developed bond markets, led by rising term premiums (Chart 8). Given the global bond market's current worries about the inflationary implications of a switch away from extremely accommodative monetary policy to greater fiscal stimulus, a spike in yields related to a less-accommodative ECB could turn nasty fairly quickly. Chart 8A Dovish ECB Will Prevent A Deeper Global Bond Rout A Dovish ECB Will Prevent A Deeper Global Bond Rout A Dovish ECB Will Prevent A Deeper Global Bond Rout Bottom Line: Trump's proposed aggressive fiscal stimulus package will continue to put bear-steepening pressure on the U.S. Treasury curve. However, the future direction of global bond yields will be more influenced by the upcoming monetary policy decisions in the U.S. & Europe. Maintain a below-benchmark overall duration stance, while exiting curve flattening positions in the U.S. U.S. High-Yield: More Growth, Fewer Defaults In recent discussions with clients, many have asked whether the implications of Trump's pro-growth policies, coming at a time of a cyclical upturn in the U.S. economy and inflation, should provide a boost to corporate profits that will, by extension, reduce the default risk in U.S. high-yield bonds. Chart 9Higher Nominal Growth Is Good For Junk (During Expansions) Is The Trump Bump To Bond Yields Sustainable? Is The Trump Bump To Bond Yields Sustainable? Chart 10High-Yield Valuations Have Improved Slightly High-Yield Valuations Have Improved Slightly High-Yield Valuations Have Improved Slightly It is a valid question to ask, as the excess returns on U.S. junk bonds have been historically been higher during expansions when nominal GDP growth (currently 2.8%) has been 4% or greater (Chart 9).5 With real U.S. GDP growth likely to expand by at least 2.5% in 2017, with moderately higher inflation, nominal growth should accelerate to a pace that has historically been friendlier for junk returns. Chart 11Corporate Balance Sheets Are Still A Problem Corporate Balance Sheets Are Still A Problem Corporate Balance Sheets Are Still A Problem Of course, the state of the corporate leverage cycle matters too, and that remains the biggest problem for high-yield. We have been maintaining an extremely cautious stance on U.S. junk bonds over the past few months, as a combination of highly-levered balance sheets and unattractive valuations led us to expect an underwhelming return performance from junk, especially with a volatility-inducing Fed rate hike likely to occur by year-end. That has not been case, however, as junk spreads declined steadily as the summer turned to autumn and have been relatively stable during the U.S. election uncertainty. Our colleagues at our sister publication, BCA U.S. Bond Strategy, recently introduced a simple model to predict junk bond excess returns as a function of lagged junk spreads and realized default losses.6 That model had been predicting excess returns over the next year of close to zero, but at today's spread levels the expected excess return over duration-matched U.S. Treasuries during the next year is closer to 157bps (Chart 10). While this is not the usual return that investors expect from an allocation to high-yield, it is better than the previous model prediction. Given this slightly more attractive level of spreads, a bond market now more prepared for a Fed rate hike, and with the default risks potentially narrowing somewhat on the back of a better nominal growth outlook for 2017, we no longer see the case for a maximum underweight position in high-yield. We still have our concerns about the state of the corporate credit cycle, and the valuations have not improved enough to justify a move back to neutral (Chart 11). Thus, we are only moving our U.S. high-yield allocation to below-benchmark (2 of 5) from maximum underweight (1 of 5). We are maintaining our below-benchmark stance on Euro Area and Emerging Market high-yield within our model portfolio, in line with our stance on U.S. junk. Bottom Line: U.S. junk bond valuations have improved slightly in recent weeks, especially in light of an improving U.S. nominal growth outlook for 2017 that will reduce default risk to some degree. Upgrade U.S. high-yield allocations to below-benchmark (2 of 5) from maximum underweight. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes & Investment Implications", dated November 9, 2016, available at gps.bcaresearch.com. 2 https://www.economy.com/mark-zandi/documents/2016-06-17-Trumps-Economic-Policies.pdf 3 Aggressive income tax cuts, no changes to entitlement spending, increased defense outlays, and even the more controversial protectionist promises such as a 46% tariff on Chinese imports and the deportation of 11 million undocumented immigrant workers. 4 Please see BCA Global Fixed Income Strategy Weekly Report, "The ECB's Next Move: Extend & Pretend", dated October 25, 2016, available at gfis.bcaresearch.com. 5 Excess returns are the highest during low growth or recession periods, as this is when credit spreads are at their widest and companies are deleveraging and actively acting to reduce default risks. That is not the case at the moment. 6 Please see BCA U.S. Bond Strategy Special Report, "Don't Chase The Rally In Junk", dated November 1, 2016, available at usbs.bcaresearch.com. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Is The Trump Bump To Bond Yields Sustainable? Is The Trump Bump To Bond Yields Sustainable? Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Trump's election victory means that there is potential for policy settings to flip from "easy money, tight fiscal" to "tight money, easy fiscal" The market implications of that shift are dollar bullish, bond bearish and equity mixed. The major risk is that violent currency and bond market moves rekindle emerging market stress and/or choke off the recovery before fiscal spending kicks in. Trump's trade reform risks being a tax on growth. Businesses may opt to automate instead of hire. A variety of factors now make small caps appealing relative to large caps. Feature Contrary to the pre-election consensus, Donald Trump's election victory has prompted a risk-on rally, based on the notion that Trump's vision of fiscal largesse will be realized (Chart 1). Ultimately, it will only become clear what policy changes are on the table once Trump takes office in January. The consensus at BCA is that Trump will be "unbound" in his first two years as President. Thus, if Trump lives up to his campaign promises, fiscal stimulus and trade restriction will be tabled early in 2017. Chart 1Trump Moves Trump Moves Trump Moves As we argue below, trade restrictions should be viewed as a tax on growth. We have doubts about the link between job creation and tariffs. If anything, imposing tariffs on imports could incite a more intense wave of automation. After all, the cost of capital is still attractive relative to labor costs. Meanwhile, fiscal spending - if delivered even close to the size and scope that Trump has hinted at in his pre-election speeches - will boost GDP growth well above trend in 2017. If that occurs, the dynamic that has existed since 2010, i.e. "tight fiscal, exceptionally easy money policy" will rapidly flip to "easy fiscal, tight money". For the bond market and the U.S. dollar, the investment implications are clear: Treasuries are likely to head higher, and the pressure will be for the U.S. dollar to rise. Implications for equities are less certain. If the U.S. dollar rises, it might rekindle emerging world financial stress and undermine U.S. corporate profits. The rapid rise in yields may not easily be digested by the equity market and it is notable that corporate spreads have not rallied along with other risk assets in recent days. We are comfortable maintaining a defensive stance. Donald Trump said a lot of things to a lot of people during the campaign process. He can't possibly deliver on all of his promises, but earlier this week, BCA sent out a Special Report to all clients, outlining the implications of the election results and what we expect he can accomplish.1 We believe there are three that are especially important for investors to monitor: the potential for trade restrictions, gauging fiscal stimulus and monetary policy settings in this possibly new environment. Stagflation? Trump has repeatedly signaled his intention to restrict American openness to international trade and the U.S. president can revoke international treaties solely on their own authority. Trump can also impose tariffs. All of this is of course inflationary, and it's the nasty kind. We have repeatedly written in this publication that, historically, the U.S. economy only falls into recessions for two reasons. The first is growth-restrictive monetary policy and the second is an adverse supply shock that acts like a tax on growth, e.g. an oil price spike. Tariffs are akin to the latter. Chart 2 shows that as import penetration rose over the past 30 years, tradeable goods price inflation steadily fell. A simple read of the chart suggests that with barriers in place and as import penetration recedes, the process of the past 30 years will reverse and consumer goods prices will rise. This can easily be absorbed if it is accompanied by rising wages via the "onshoring" of jobs. But that is not a foregone conclusion. Instead of bringing manufacturing jobs back to the U.S., a more logical decision might be for businesses to further automate production. After all, earlier studies have already concluded that nearly half of all existing jobs are at high risk of being automated over the next decade or so.2 As Chart 3 shows, with the price of capital equipment and software still falling and the cost of capital so low relative to the cost of labor, the incentive to automate instead of hire is high. Chart 2Trade And Inflation Trade And Inflation Trade And Inflation Chart 3Tariffs May Lead To Robots, Not Jobs Tariffs May Lead To Robots, Not Jobs Tariffs May Lead To Robots, Not Jobs The bottom line is that increased tariffs will increase prices in the near term. But it is hardly clear that this will improve the lives of voters or create a more virtuous economic recovery. Opening The Fiscal Taps... In last week's report, we explored the potential for fiscal spending to turbocharge the U.S. economy. We warned that fiscal multipliers are probably not overly high in the current environment and the effectiveness of fiscal spending is highly dependent on the type of fiscal stimulus. Trump has called for significantly lowering both income and corporate taxes, although his main pitch has been infrastructure spending. The latter tends to have the highest multiplier effects, but can often take a long time to get underway. However, one important point is that Trump will face little political restraint, at least in his first two years in office. Gridlock will not be a problem given that all three Houses are now in GOP hands. And it will be difficult politically for Republicans in the Senate and House to stand in Trump's way given that he has just been elected on a populist platform; it would be seen as thwarting the will of the people. Over the past 28 years, each new president has generally succeeded in passing their signature items. Moreover, the GOP has historically not been that fiscally conservative. Overall, a Trump government will more than make up for the drag from weak state and local spending that we wrote about last week. Exactly how big of an impulse will only become clear once Trump takes office. ...And Tightening The Money Supply? Forecasts about the impact of fiscal spending on 2017 GDP growth are premature, since it is impossible to decipher an action plan from campaign rhetoric. And the severity of stagflation due to trade restrictions will be highly dependent on the form and scope of trade reform. Ergo, it is too early to make bold new assumptions about the path of Fed rate hikes. An aggressive fiscal plan that boosts GDP well above trend growth would force policymakers to revise their expected path of rate hikes higher. That would be a sea change from the past four years, when policymakers have consistently revised the neutral rate down. We are not worried about central bank independence or Janet Yellen's future. Donald Trump has, at various times, both praised and attacked Janet Yellen and current monetary policy settings. A review of the Fed may happen at some point, but we assert that investigating the Fed will not be a priority early in Trump's mandate. Market Action The bond market has already priced in more inflation and more growth for 2017 since Trump's victory. 10-year Treasury yields have surged to 2.15% and momentum selling could lift the 10-year Treasury yield even further into oversold territory. But that is not a case to become aggressively underweight duration. Dollar strength and rising bond yields have already tightened financial conditions significantly over the past several weeks. The risk is that these trends go too far in the near term, inflicting economic damage before fiscal spending kicks in. Given the easy monetary stance of central banks around the world, lack of significant fiscal stimulus elsewhere, economic growth outperformance in the U.S. and rising interest rates, the dollar should rise in the medium term. We remain dollar bulls. We have been surprised by the equity market action since November 8. Although we repeatedly wrote that a Trump victory was unlikely to have meaningful negative consequences for risk asset prices, we did not anticipate a rally. As for equities, our cautiousness toward risk assets in 2016 has been primarily focused on the ongoing headwinds for profits in a demand-deficient economy, especially while margins are falling and valuations are elevated (Chart 4). Greater fiscal spending would surely help to alleviate our concern, although that conclusion seems premature given the lack of contour to Trump's plans so far. Perhaps the greatest downside risk is a reaction from China. After all, Trump's anti-trade rhetoric has been pointed (mostly) at China and Asia. Recall that in August, 2015, the RMB was devalued just weeks ahead of an expected rate hike from the Fed. That devaluation sent shock waves through financial markets and ultimately delayed the Fed rate hike until the end of the year (Chart 5). A similar proactive policy move from Chinese policymakers should be on investors' radars. Overall, we remain comfortable with our cautious equity stance, albeit recent market action has created an entry point in favor of small relative to large cap stocks. Chart 4Equity Fundamentals Still Poor Equity Fundamentals Still Poor Equity Fundamentals Still Poor Chart 5China: Global Stability Risk? China: Global Stability Risk? China: Global Stability Risk? Enter Small Cap Bias We upgraded small caps relative to large caps to neutral in August. We now recommend investors make the full switch to a small cap bias relative to large caps. Small cap stocks were hit harder than large caps in the weeks leading up to the election, as investors shed riskier assets; we believe this provides a good entry point to a cyclical uptrend in small cap performance (Chart 6). True, at first glance, advocating for small cap exposure appears inconsistent with our overall defensive equity strategy. After all, small cap outperformance tends to be associated with risk-on phases. However, small cap stocks have a variety of other characteristics that currently make them appealing relative to larger caps. Chart 6(Part I) Favor Small/Large Caps (Part I) Favor Small/Large Caps (Part I) Favor Small/Large Caps Chart 7(Part II) Favor Small/Large Caps (Part II) Favor Small/Large Caps (Part II) Favor Small/Large Caps Small cap companies tend to be more domestically focused. We expect that U.S. growth will continue to outpace growth overseas. And particularly important, small cap companies, with their domestic focus, are better insulated from dollar strength (Chart 7). Small cap weightings are no longer geared toward cyclical sectors. As part of our cautious strategy, we remain focused on defensive vs. cyclical sectors. There are no major differences between large and small cap defensive and cyclical sector weightings (Table 1). Trump corporate tax reform, if implemented, will favor small, domestic firms. Because major corporations already have low effective tax rates, any lowering of the marginal rate will benefit small and medium enterprises (SMEs) and the domestic oriented S&P 500 corporations. If corporate tax reform also includes closing loopholes that benefit the major multi-national corporations (MNCs), then this would diminish their current tax advantage vis-à-vis smaller companies. Table 1Similar Weightings For Small And Large Cap Cyclicals And Defensives Easier Fiscal, Tighter Money? Easier Fiscal, Tighter Money? Bottom Line: Small cap outperformance is typically associated with risk-on equity phases. However, valuations now favor small caps. Importantly, small caps are better insulated from dollar strength and are one way to play the domestic vs. global theme. Additionally, smaller firms will be the relative winners from corporate tax reform. Small caps are set to outperform large caps. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 Please see Geopolitical Strategy Special Report "U.S. Election: Outcomes & Investment Implications," dated November 9, 2016, available at gps.bcaresearch.com 2 "The Future Of Employment: How Susceptible Are Jobs To Computerisation?" Carl Frey and Michael Osborne, September 2013. Appendix Monthly Asset Allocation Model Update Our Asset Allocation (AA) model provides an objective assessment of the outlook for relative returns across equities, Treasuries and cash. It combines valuation, cyclical, monetary and technical indicators. The model was constructed as a capital preservation tool, and has historically outperformed the benchmark in large part by avoiding major equity bear markets. Please note that our official cyclical asset allocation recommendations deviate at times from the model's recommendation. The model is just one input to our decision process Chart 8. The model's recommended weightings for the major asset classes remained unchanged this month: neutral equity exposure at 60% (benchmark 60%), slightly overweight Treasury allocation at 40% (benchmark 30%) and underweight cash at 0% (benchmark 10%). The neutral portfolio recommendation for equities is in line with our qualitative defensive stance, in place since August 2015. Although the technical component of the equity model still has a "buy" signal, the breadth indicator has moved into less favorable territory relative to the momentum indicator. The monetary component has also slightly weakened but retains its positive bias for equities. The earnings-driven component continues to warrant caution as expectations for the outlook of corporate profits would need to be bolstered through stronger economic stronger growth over the medium term. Our qualitative stance for the allocation of Treasuries in balanced portfolios is neutral (since November 7, 2016) in contrast to the slightly overweight recommendation from our quantitative model. Even so, despite that the "buy signals" of the cyclical and technical components of the bond model still persist, the preference for Treasuries has diminished to some extent. Nevertheless, the valuation component continues trending towards expensive territory and a "buy signal" remains in place Chart 9. Chart 8Portfolio Total Returns Portfolio Total Returns Portfolio Total Returns Chart 9Current Model Recommendations Current Model Recommendations Current Model Recommendations Note: The asset allocation model is not necessarily consistent with the weighting recommendations of the Cyclical Investment Stance. For further information, please see our Special Report "Presenting Our U.S. Asset Allocation Model", February 6, 2009.

Highlights Today, we are sending out a previously scheduled Special Report, highlighting our thoughts on the how to assess the impact of China on global bond markets. This is an important topic that we hope you will find of great interest. We will not be offended, however, if that report sits in your inboxes for a day or two while the world awaits the results of today's U.S. Presidential election. Feature Global financial markets have been subject to extraordinary volatility over the past couple of weeks as the election campaign has drawn to a close. Investors have had to deal with the steady inflow of shifting poll results, overbearing media punditry, surprising FBI letters and wild conspiracy theories, all while trying to price the risks associated with two of the most polarizing presidential candidates in U.S. history. The recent narrowing of Hillary Clinton's lead in the polls has forced investors to seriously consider the possibility of a President Donald J. Trump, with all the change from the status quo that he represents. Given how markets have reacted to Trump closing the gap with Clinton - falling equity prices, higher volatility, lower bond yields and a weaker U.S. dollar - a Trump win could trigger a true risk-off market rout, with global investors wanting to avoid been burned by another political surprise after Brexit. Our colleagues at BCA Geopolitical Strategy still view a narrow Clinton victory as the most likely outcome, with admittedly lower conviction levels than usual for such an important election. Such is the problem of making predictions when polls are within margins of error. However, given the well-understood realities of the U.S. Electoral College map and the still-uphill climb needed for Trump to win, the result that would catch investors most off-guard would be The Donald pulling off the upset. From our perspective at BCA Global Fixed Income Strategy, a Clinton victory would keep the global economy on its current positive growth track in the near-term. This would shift bond investors' focus back over to the Fed and a likely December rate hike. However, a risk-off market move after a Trump win would represent the biggest risk to our current portfolio recommendations: We are positioned for rising global bond yields via an overall below-benchmark duration stance, given our view that we are in a cyclical growth upturn that is also pushing global inflation higher (more details on China's contribution to that can be found in the Special Report sent out today). In terms of regional bond allocation, we are favoring the areas with the lowest inflation rates and most credible dovish central banks, via an above-benchmark tilt in core Europe and a neutral stance on Japan and Canada. We are underweight the countries where central bankers are either in the process of raising rates (the U.S.) or will soon face a decision to tighten policy in the face of strong growth and rising inflation pressures (the U.K., Australia). We are also underweight Peripheral European debt (Italy, Spain, Portugal) versus Germany due to our concerns over decelerating growth in the Periphery combined with the ongoing stresses on Euro Area banks. We are overweight inflation protection (via linkers and CPI swaps) in the U.S. and U.K. where we see the greatest potential for rising inflation expectations. Within global credit markets, we are maintaining a defensive stance via underweights in U.S., Euro Area and Emerging Markets High-Yield (which are all overvalued and overlevered). Within Investment Grade corporates, we are only maintaining a neutral stance in the U.S. and above-benchmark tilts in the Euro Area and U.K. We are also neutral on Emerging Market hard currency debt, both sovereigns and corporates. In the event that Trump pulls out the win tonight, we would expect our overall below-benchmark duration call to suffer if bond yields declines in a risk-off move. However, our "break-even" level on that call allows some cushion to stick with the underweight, as we initiated the recommendation back in July when the 10-year U.S. Treasury yield was just below 1.60%. A return to those levels would be a 25bp decline from yesterday's closing level of 1.83%, which would be a massive move if it happened in a short period of time immediately after Trump was declared the winner. Yet if such large move in yields were to occur, it would almost certainly be in the context of a rout in global equity markets. Our underweight stance on high-yield corporates and Peripheral Europe would perform very well there. Our generally cautious stance on higher-quality corporates and Emerging Markets would likely cause minor hits only via our overweights in Europe, but with those markets supported by the ongoing central bank buying by the ECB and Bank of England, the losses should be relatively well-contained. There is also a risk that our overweights in inflation protection in the U.S. and U.K. would underperform, especially if the market rout turns into a lasting shock to global growth and inflation expectations. That will be difficult to determine in the immediate aftermath of a Trump win. Summing it all up, there are enough offsetting positions within our recommended portfolio to not suggest any changes into tonight's election. Let us hope that the election result is decisive enough that a winner can be declared tonight and this period of U.S. political uncertainty can end, whoever wins. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Recommendations Duration Regional Allocation Spread Product

Highlights There is an eternal duality between bulls and bears on the Chinese economy. We prefer to stay away from the debate, and simply monitor the situation while adjusting our portfolio recommendations as the situation evolves. From the perspective of BCA Global Fixed Income Strategy (GFIS), and in the short term, five key questions on China influence our duration stance and our core bond portfolio allocation recommendations. To answer these questions, we are following specific indicators, laid out in this Special Report. Together, those form the "GFIS China Checklist". Several of our financial stress indicators reveal the possibility that China's macro stability could be starting to fray a bit at the edges. These trends could become worrisome if they linger or re-appear. China's cyclical growth impulses are positive, suggesting a tailwind for the global economy, and upward pressure on inflation and bond yields in the near-term. At the moment, the "China Factor" reinforces our below-benchmark portfolio duration stance and our bias towards underweighting bond markets that are most exposed to Chinese demand and higher commodity prices (i.e. Australian government debt), while also favoring inflation-linked bonds over nominals across the developed world. Table 1The GFIS China Checklist How To Assess The "China Factor" For Global Bonds How To Assess The "China Factor" For Global Bonds Feature Chart 1Getting China Right Is Crucial Getting China Right Is Crucial Getting China Right Is Crucial At the macro level, several factors have a disproportionate impact on the direction of global bond yields. The evolution of monetary policies in the developed economies, globalization, new technologies, demographic changes and productivity trends are among the themes that top our list. A positive or negative shift in these factors could significantly alter the path of global growth and inflation and, by the same token, bond yields. In this Special Report, we will address the "China factor". Through its massive aggregate demand, this huge country can tip the global macro landscape into equilibrium or disequilibrium (Chart 1).1 As such, closely monitoring its developments is crucial for investors to correctly position for/against the cyclical drivers of bond markets. Unfortunately, understanding China's dynamics and seeing through the opacity of its policy-setting process is extremely challenging. Experts on the matter often disagree (even here at BCA!) on the complex issues, and sometimes even the most basic assumptions, underlying a view on China. In this Special Report, our goal is not to try to untangle the ultimate truth about China. Instead, we will cut through the fog and offer a simple framework to monitor its economy and associated risks. From an investment perspective, getting China right comes down to answering five keys questions: Is China's macro stability starting to deteriorate? Are China's growth impulses positive? Is Chinese economic momentum accelerating? Are China's business fundamentals evolving positively? Is the outlook for Chinese household consumption improving? To answer those, we follow simple indicators, laid out in this Report. Together, they form the BCA Global Fixed Income Strategy (GFIS) "China Checklist" (Table 1). The Eternal Duality In Chinese philosophy, the Yin - the dark swirl - represents shadows, the moon and the trough of a wave. In the investment world, members of the Yin camp view China's great accomplishments of the last 30 years with a doubtful eye. In its economic miracle, they see fragility and unsustainability. Those doubters are quick to raise the multiple structural problems such as regional disparities, income inequality, pollution, workers' dissatisfaction, and the unfair hukou2 system, among others. China' high debt levels and widespread, institutionalized misallocation of capital usually anchor their gloomy view. On the other end of the spectrum, the Yang - the light swirl - represents the sun and growth. For members of the Yang camp, China's policymakers have a grand master plan that will lead China to dominate economically and geopolitically for decades to come. Discarding the potential credit addiction problem, they believe that China should continue to invest at a record pace, arguing that investments will eventually lead to faster productivity, which will lift potential growth and overall prosperity. They posit that leveraging is simply a natural process for a fast-growing country with massive excess savings. To their despondency, China bears fail to recognize the merits of the country's un-paralleled meritocratic political system and the communal dynamic that makes it unique. Where does GFIS stand in this debate? Both camps have legitimate arguments and could be right in the end. The key thing about the Yin/Yang symbol is that both the black and white contain a little bit of each other. In the end, this duality might just be a healthy dynamic where one cannot exist without its opposite. For us, it leaves an important dilemma. On one hand, betting on a Chinese hard landing that never materializes could turn out to be a widow-maker trade.3 On the other hand, ignoring China's structural issues and assuming that everything will be all right is a strategy that can be prone to devastating disappointments. Instead of trying to predict the end game, we will focus our efforts on assessing how the economic momentum and the risks are evolving at each particular moment. This will inform our overall views on global growth and inflation and, in the end, the direction of bond yields and credit spreads. Bottom Line: There is eternal debate between the Yin and Yang camp in regards to China's future. We prefer to stay away from the debate, and will monitor the situation through specific indicators and adjust our investment recommendations accordingly. Is China's Macro Stability Starting To Deteriorate? Maybe Nobody knows for sure when or if China will go through an acute period of turbulence related to stresses in its financial system. Nonetheless, to properly calibrate our duration call and the pro-cyclical bets in our recommended fixed income portfolio, we need to assess if the stress points are flashing red, and to what degree. Below, we propose a set of indicators that could eventually signal a bubbling credit-related event (Chart 2 & Chart 3). Chart 2Is China's Macro Stability Deteriorating? Part I bca.gfis_sr_2016_11_08_c2 bca.gfis_sr_2016_11_08_c2 Chart 3Is China's Macro Stability Deteriorating? Part II Is China's Macro Stability Deteriorating? Part II Is China's Macro Stability Deteriorating? Part II In aggregate, they warn that China has been experiencing some instability lately. This should be taken seriously and temper any China optimism. The Renminbi If China goes through a period of instability, its currency, the Renminbi (RMB), would deteriorate as money tries to escape through any cracks in the financial system or real economy. The RMB has had several episodes of rapid depreciation (by China's standards) over the past 18 months which could be a bad omen. That said, since China's policymakers still largely have the capacity to control the evolution of its currency, the RMB could end up reflecting a serious capital outflow problem only far after the fact. Nonetheless, it is still something to follow closely. Hibor/Shibor rates When a financial system goes through episodes of turbulence, lenders tend to freeze operations until the cause is clear. Banks stop lending to each other and overnight interest rates tend to spike. It is possible that the RMB-based Hong Kong Interbank Offered rate (Hibor) or the Shanghai Interbank Offered Rate (Shibor) can offer such a signal. Since mid-2015, the Hibor has experienced three such episodes. In each case, they proved to be temporary - rates came down shortly after each spike - but we still view this with a wary eye. Since China has a closed capital account and maintains a stable currency through several interlinked instruments, it is possible that the overnight lending market might not be as relevant a signal as it would be for countries with open capital accounts. Our colleagues at the BCA China Investment Strategy have recently been sanguine about the significance of those spikes.4 Regardless, we will keep this indicator on our list of possible China stress points. Equity prices of global banks with heavy links to China & Emerging Markets Capital market data are often the first to hint that financial stress is rising. In China's case, the stock prices of major global banks that are highly exposed to China and, more broadly, emerging markets might play that role. Two such banks are Standard Chartered and HSBC. If China's internal dynamic eventually becomes shaky, the relative equity performance of those banks could quickly erode.5 For now, this does not seem to be the case, as their stocks are performing well; the stress appears to be contained. Capital outflows If China's economy is about to crumble under a pile of debt, money will leak through the cracks. Part of the money flowing out will eventually trickle through to safe assets in the rest of the world, like U.S. Treasuries and non-Chinese property markets. Since mid-2014, China capital flight has been large and clearly represents a potential source of worry. Official Holdings of U.S. Treasuries If the Chinese economy were to deteriorate meaningfully, or if there were potential undercapitalization issues stemming from any buildup of bad loans within the Chinese banking system, the authorities might be driven to sell some of China's enormous stock of U.S. Treasuries and "invest" the money domestically. Lately, China has been a net seller of U.S. Treasuries, which could be a potential sign of trouble but could also simply be the result of China having less of a need to accumulate U.S. dollar assets to fight inherent appreciation pressures on the RMB. Policy Uncertainty Capital flight out of China could be related to many factors. Pessimism towards the future or lack of domestic investment opportunities could force savings outward. Another possibility is increasing policy uncertainty and/or brewing political instability among China's leadership. Lately, China's Policy Uncertainty Index has skyrocketed.6 Before pushing the panic button, however, one has to consider mitigating factors. It is possible, considering the after-effects of the shocking U.K. Brexit referendum and the increased odds of a Donald Trump U.S. Presidency, that this jump in the China uncertainty index has been more externally than domestically driven. Bottom Line: Several of our financial stress indicators reveal the possibility that China's macro stability could be starting to fray a bit at the edges. These trends could become worrisome if they linger or re-appear. Are China's Growth Impulses Positive? Yes Economic momentum can develop as a result of several growth impulses. Below, we propose five of them (Chart 4 & Chart 5). Currently, they are trending favorably, for the most part, and suggest that China is in the expansionary phase of its economic cycle. If sustained, this tendency should have a considerable impact on global growth, inflation and bond yields. Chart 4Are The Growth Impulses Positive? Part I bca.gfis_sr_2016_11_08_c4 bca.gfis_sr_2016_11_08_c4 Chart 5Are The Growth Impulses Positive? Part II Are The Growth Impulses Positive? Part II Are The Growth Impulses Positive? Part II The monetary conditions index Both the movement in policy interest rates and the currency can influence a country's monetary conditions, which in turn impact the backdrop for growth. Since the beginning of 2015, China's policy interest rate and the reserve requirement ratio for banks have been cut several times. The Renminbi has also depreciated during the same period. Combined, these factors have eased monetary conditions, which has been a positive development for the Chinese economy. Money supply growth In most countries, a more rapidly growing money supply usually leads to greater credit expansion, which eventually leads to faster economic growth. Again, since the beginning of 2015, Chinese money supply growth has shot up markedly. This should sustain credit/growth expansion in the coming months. Corporate bond yields An abundance of money can be of little help to an economy if corporations cannot finance themselves at a reasonable yield. Historically, the average Chinese corporate bond yield has been a leading indicator of industrial output growth. As the corporate yield decreases, financing becomes more attractive and a credit boom could follow, resulting in increased economic activity. Since 2015, Chinese corporate bond yields have literally collapsed, seemingly following the trend in non-Chinese corporate bond yields. If history is any guide, this should be setting the stage for accelerating output growth. One caveat: China's private sector debt servicing ratio might have reached too high a level, such that it has reduced the ability for companies to benefit from lower corporate bond yields moving forward. This could explain why industrial output growth has not gained ground as corporate bond yields have fallen. The credit impulse Credit origination has been a vital part of China's economic success since 2000 and even more so since the 2008 global financial crisis. Our Emerging Markets Strategy team has created the credit impulse indicator - which is the second derivative of credit growth - to assess the condition of the credit impulse.7 This simple indicator has proven to be one of our more reliable leading indicators of economic growth (for China and for many other countries) Of late, this indicator has moved into positive territory. Possibly, easy monetary conditions, stronger money supply growth and lower corporate bond yields have helped push the impulse upward. We interpret that as a very powerful signal for future Chinese growth. Again, a cautionary note is warranted. For a while now, Chinese credit growth has been faster than nominal GDP growth, potentially representing an unsustainable dynamic. Hence, it is likely that the latest surge proves to be only temporary, as credit growth slows to a more desirable pace.8 So, we won't get too excited just yet. Fiscal thrust Outside the credit channel, the Chinese government embodies another major contributor to the growth impulse. Considering its relatively low debt levels, the government has the means to sustain the economy via increased fiscal expenditures, especially via infrastructure investments. Lately, to alleviate the pain from the reforms and restructuring of certain parts of the economy,9 the government has engineered a decent fiscal thrust. Many infrastructure projects have been laid out, growing at a rate up of 15% in the last four years. As long as China continues along a long-term restructuring path, reducing that rapid pace of government spending will prove to be difficult. Bottom Line: Chinese growth impulses are currently positive. Is Chinese Economic Momentum Accelerating? Yes An open liquidity tap and a positive fiscal thrust should lead to increased Chinese demand. Below, we provide six indicators showing that this occurred lately (Chart 6 and Chart 7). The synchronicity of their upward acceleration reinforces our optimism about the Chinese cyclical outlook. Chart 6Is Chinese Economic Momentum Accelerating? Part I Is Chinese Economic Momentum Accelerating? Part I Is Chinese Economic Momentum Accelerating? Part I Chart 7Is Chinese Economic Momentum Accelerating? Part II Is Chinese Economic Momentum Accelerating? Part II Is Chinese Economic Momentum Accelerating? Part II Keqiang index Since Chinese economic growth data could be described as "man-made" and potentially unreliable, an index of Premier Li Keqiang's favorite economic indicators has been used, since it was leaked to the press several years ago, to appraise the true state of the economy. Cargo volumes, electricity consumption and loans disbursed by banks comprise this indicator. In the last twelve months, the Keqiang index has hooked decisively higher. The index has a flaw - the declining role of banks loans in overall new credit - but it is still useful, and it corroborates the positive signal sent by the growth impulses mentioned previously in this report. Excavator sales Traditionally, the construction sector has been at the core of China's growth miracle. To gauge the evolution of this sector, the growth rate of excavator sales has been very reliable. After being negative since mid-2011, it has surged in 2016. With a lift off of such magnitude, one could doubt the validity of this data. However, it has followed a similar spurt seen in money supply and a burst in the "projects started" capital spending growth rate. Residential floor space sold The state of the construction sector can also be assessed through the time series of residential floor space sold, which tends to lead new housing starts by several months. Again, since the beginning of the year, this indicator has been trending higher, echoing the message sent by excavator sales growth. Import volume growth No other time series better expresses the state of China's demand than its import volume growth. If the global growth and inflation outlook were to get a boost, Chinese imports would need to gain positive momentum. Lately, they have accelerated; this constitutes a very positive sign. CRB Raw Industrials prices Since China is by far the biggest consumer of commodities globally (see Chart 1, on page 2), China's demand indicators should be correlated with global commodity prices. In theory, both should move in a similar fashion to validate one another. This year, the CRB Raw Industrials price index has indeed stabilized and confirmed the positive growth dynamic observed through other indicators. The Chinese yield curve The yield curve has traditionally been recognized as an excellent leading indicator for most economies. It usually signals slowing growth when it flattens and steepens when growth gains momentum. China's yield curve has been especially well correlated with the Chinese PMI data, for example. Lately, China's yield curve has flattened a bit, which is not a good sign. However, until it inverts, like in 2011, 2013 and 2015, we will treat its message as neutral. Bottom Line: Chinese economic momentum is accelerating. A flattening yield curve tempers our optimism to some degree, however. Chart 8Are The Business Fundamentals Evolving Positively? Are The Business Fundamentals Evolving Positively? Are The Business Fundamentals Evolving Positively? Are The Business Fundamentals Evolving Positively? Yes If Chinese economic momentum truly accelerates, domestic businesses should reap the benefits and their internal dynamics should improve. As per the business indicators presented below, this is currently the case (Chart 8). Final goods producer prices Producer pricing power is crucial and it has been lacking over the last few years on a global scale. Without pricing power, capital investment and employment growth tend to stay depressed, and vice versa. Since 2012, China's final goods producer prices have been contracting. This started before the beginning of the commodities collapse in 2014 and has been hugely deflationary for the rest of the world. But this might be a story of the past; final goods producer prices have turned positive lately. This could prove a major development, if it lasts. The risk here is that the U.S. dollar appreciates - due to a Fed hike and/or a more hawkish tone going forward - pushing global commodity prices lower, which has historically depressed global producer prices. However, if the Fed treads carefully after the December rate hike that we expect, waiting for the rest of the global economy to catch up to a U.S. acceleration, the dollar could end up trending sideways. Commodity prices could then continue on the current upward trend, preventing producer price growth from relapsing back into negative territory. Cash flow ratio Leveraging during the 2009-2011 period has left many Chinese firms highly indebted, especially in the industrials, materials and real estate sectors. As debts increased, debt servicing cash flows substantially shrank during the 2011-2014 period. Fortunately, since mid-2015, this situation has reversed, with the cash flow/total liabilities ratio having increased steadily. Net earnings revisions In the end, strong profits are necessary for a healthy economy. This has been lacking globally, but even more so in China; most China MSCI equity index sectors suffer from contracting earnings per share, except consumer staples. Nonetheless, the jump higher in net earnings revisions seen this year is encouraging. Bottom Line: China's business fundamentals are evolving positively. Chart 9 Is Chinese Consumption Outlook Improving? Is Chinese Consumption Outlook Improving? Is Chinese Consumption Outlook Improving? Is the Outlook For Chinese Household Consumption Improving? Yes Ultimately, improved business conditions should lead to better job creation, strong workers' income and more robust final consumer spending. Lately, the virtuous cycles in credit, demand and the business sector have indeed trickled down to the consumers. Employment and consumption are synchronously accelerating (Chart 9). PMI Employment Index Despite the questionable quality of China's employment data - making it difficult to assess the true picture of the labor market - the employment sub-index of the overall China Purchasing Managers Index (PMI) gives a relatively reasonable reading. Since 2012, it has been trending downward. However, the fact that the latest data point rose sharply above the 12-month moving average is a good sign, perhaps indicating the cyclical downtrend in Chinese employment growth truly bottomed in 2015. Auto sales If employment growth and wages are indeed in a cyclical upturn, Chinese retail consumption growth should be thriving. This has been the case in 2016, with auto sales growth shooting up sharply. Bottom Line: The outlook for Chinese household consumption is improving. Investment Implications Chart 10Investment Implications Investment Implications Investment Implications In the analysis above, we concluded that: The possibility of eroding Chinese macro stability cannot be discarded, as financial stress points are rising. This needs close monitoring. Chinese growth impulses are, for the most part, positive. Chinese economic momentum is accelerating, but a flattening yield curve tempers our optimism. China's business fundamentals are evolving positively. The outlook for Chinese household consumption is improving. In sum, despite the reigning policy uncertainty and persistent capital outflows, the current short-term dynamics are surprisingly positive. Accordingly, and taking the overall "China factor" in isolation, the following fixed income investment recommendations should be implemented (Chart 10): Maintain a below-benchmark duration bias. There is a meaningful positive contribution to global growth and inflation from China. If the Chinese economy gathers more steam, global bond yields and inflation will also move higher. Maintain low exposure to bond markets most negatively exposed to faster Chinese growth & rising commodity prices. Our positive cyclical view on China has an impact on our core recommended bond portfolio allocation. We have been underweight Australian government bonds versus global hedged benchmarks since the summer, and China's improving demand constitutes a definite plus to this view, as it is Australia's largest export destination. We have also maintained a bias to favor inflation-linked bonds versus nominals in the major developed markets. A faster pace of Chinese goods inflation should translate into an acceleration in global traded goods prices (and inflation rates) in the coming months, to the benefit of the relative performance of linkers. Maintain a neutral stance on Emerging Market hard currency bonds. Due to a very unappealing structural backdrop, we have a negative longer-term bias towards Emerging Markets sovereign and corporate bonds. However, in July, we turned neutral, from underweight, due to the improving global cyclical outlook, especially based on what was happening in China. This move has paid off so far and the position should be maintained, even if there is some upward pressure on the U.S. dollar from a Fed rate hike next month.10 Overweight Australian Semis. Since March 2016, we have had a positive bias towards Australian Semi-government debt.11 Semis outperform Australia federal government debt during global expansionary phases, and China will continue to support the current cyclical growth upturn. Finally, the biggest risk to our view is that China's structural fragilities won't allow the current cyclical recovery to be sustained beyond the next year. Our GFIS China Checklist will help us to detect any downturn if and when it becomes apparent. Jean-Laurent Gagnon, Editor/Strategist jeang@bcaresearch.com 1 Furceri, Jalles, and Zdzienicka (2016) perform time-varying coefficient analysis using local projection methods on a sample of 148 countries over 1990-2014, and show that spillovers from a 1 percentage point shock to China's final demand growth now have a cumulative impact on global GDP of about 0.25 percent, after one year. Source: http://www.imf.org/external/pubs/ft/weo/2016/02/pdf/c4.pdf 2 The hukou system was originally introduced to register China's households as part of an effort to gather population statistics. It has morphed into a government tool to control rural-urban migration flows that has made it more difficult for migrant workers to access health care or education services in China's cities. For more information, please see: http://thediplomat.com/2016/02 chinas-plan-for-orderly-hukou-reform/ 3 Here we have a thought for all those who have bet on the demise of the Japanese bond market over the years without glory. 4 For details on this issue, please see BCA China Investment Strategy Weekly Report, "HIBOR, Liquidity And Chinese Stocks", dated September 22, 2016, available at cis.bcaresearch.com 5 For details on this issue, please see http://www.imf.org/~/media/files/publications/spillovernotes/spillovernote5 6 This is part of a global suite of indicators produced by researchers Baker, Bloom and Davis, designed to measure economic policy uncertainty for the major economies. For more information, please go to www.policyuncertainty.com. 7 Please see BCA Emerging Markets Strategy Special Report, "Gauging EM/China Credit Impulses", dated August 31, 2016, available at ems.bcaresearch.com 8 For more perspective on this idea, please see BCA Emerging Market Strategy Special Report "Misconceptions About China's Credit Excesses", dated October 26, 2016, available at ems.bcaresearch.com 9 Massively decreased output and increased employee layoffs in the steel industry, for example. 10 Please see BCA Global Fixed Income Strategy Special Report, "Emerging Markets Hard Currency Debt: Time For More Optimism?", dated July 12, 2016, available at gfis.bcaresearch.com 11 Please see BCA Global Fixed Income Strategy Special Report, "Australian Credit: Time To Test The Waters", dated March 29, 2016, available at gfis.bcaresearch.com

Highlights Chart 1Targeting 2% bca.usbs_pas_2016_11_08_c1 bca.usbs_pas_2016_11_08_c1 The Fed did its best to avoid roiling markets so close to today's election, but still managed to hint at a December rate hike. The post-meeting statement was tweaked so that now only "some further evidence" rather than "further evidence" is required in order to lift the funds rate. We remain below benchmark duration in anticipation of a December rate hike. Before the end of the year we expect our 12-month discounter to reach at least 40-50bps (meaning the market will expect a further 1-2 hikes in 2017) from its current level of 28bps, and for the 10-year Treasury yield to reach 1.95-2%. While our global PMI model pegs fair value for the 10-year Treasury yield at 2.27%, the uptrend in the 10-year yield will face severe technical resistance as it approaches 2% (Chart 1). Positioning has already moved to net short duration, signaling that the bond sell-off is becoming stretched. While a Clinton victory would all but ensure a December rate hike, a Trump victory could cause a large enough market riot that the Fed delays until 2017. This would only be a brief hiccup in the return of the 10-year yield to the 1.95-2% range, and would not signal a long-lasting trend reversal. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview bca.usbs_pas_2016_11_08_c2 bca.usbs_pas_2016_11_08_c2 Investment grade corporate bonds outperformed the duration-equivalent Treasury index by +56bps in October, but have already given back -26bps of those gains so far this month (Chart 2). The index option-adjusted spread is -2bps tighter than at the end of September and, at 136bps, it remains very close to its historical average. Corporate credit performance faces two immediate risks. The first is today's election and the second is the prospect of a Fed rate hike in December. A Clinton victory would likely prompt a knee-jerk rally in risk assets and virtually ensure a rate hike next month. In that case we would be inclined to further trim exposure to credit risk in the coming weeks as the rate hike approaches. Already, we recommend investors avoid the Baa credit tier within a neutral allocation to investment grade corporates. In a recent report we pointed out that highly-rated credit (A-rated and above) performed well in the initial stages of last year's run-up in rate hike expectations, but then started to suffer once market-implied rate hike probabilities approached 100%.1 Conversely, a Trump victory would likely prompt a flight-to-safety event in markets which, depending on its severity, could also cause the Fed to delay the next rate hike into 2017. In that event, the prospect of delayed Fed tightening would make us more likely to increase credit exposure in the near term, especially if any knee-jerk sell-off in risk assets creates better value in corporates. Table 3Corporate Sector Relative Valuation And Recommended Allocation* (Continued) "Some"thing To Talk About "Some"thing To Talk About Table 3BCorporate Sector Risk Vs. Reward* "Some"thing To Talk About "Some"thing To Talk About High-Yield: Maximum Underweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by +92bps in October, but has already underperformed the Treasury benchmark by -108bps so far in November. The index option-adjusted spread is +25bps wider since the end of September and, at 505bps, it is 16bps below its historical average. In a Special Report2 published last week we noted that while the default rate will not re-visit its previous lows (at least until after the next recession), it should decline from 5.4% to close to 4% during the next 12 months (Chart 3). However, even a slightly brighter default outlook will not be enough for junk bonds to sustain their current pace of outperformance. A simple model of lagged junk spreads and default losses explains more than 50% of the variation in 12-month high-yield excess returns. This model suggests that even with lower default losses, excess junk returns will be +264bps during the next 12 months (panel 3). The reason is that lower default losses are more than offset by the lower starting point for spreads. Junk spreads should also come under widening pressure in the very near term, as a December Fed rate hike spurs an increase in implied volatility. Maintain a maximum underweight allocation to high-yield and await a better entry point for spreads in the New Year. MBS: Overweight Chart 4MBS Market Overview bca.usbs_pas_2016_11_08_c4 bca.usbs_pas_2016_11_08_c4 Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by +2bps in October, but are underperforming the benchmark by -7bps so far in November. Year-to-date, MBS have outperformed the duration-equivalent Treasury index by a mere +22bps. Since the end of September, the conventional 30-year MBS yield has risen +23bps, driven by a +21bps increase in the rate component. The option-adjusted spread has widened +2bps, while the compensation for prepayment risk (option cost) has remained flat. Unattractive option-adjusted spreads and the prospect of further increases in issuance make for bleak long-run return prospects in MBS. However, the likelihood that Treasury yields will continue to rise in the near-term means that MBS could outperform due to a decline in the option cost component of spreads (Chart 4). We will likely reduce exposure to MBS once a December rate hike has been fully digested by the market, and the uptrend in Treasury yields starts to taper off. The Fed's Senior Loan Officer Survey for the third quarter, released yesterday, showed that banks continue to ease standards on GSE-eligible mortgage loans, while demand for these same loans continues to increase. The combination of easing lending standards and strengthening demand means that issuance is likely to continue its march higher, as does the persistent uptrend in existing home sales (bottom panel). Government Related: Overweight Chart 5Government Related Market Overview bca.usbs_pas_2016_11_08_c5 bca.usbs_pas_2016_11_08_c5 The government-related index outperformed the duration-equivalent Treasury index by +5bps in October, but has already underperformed the Treasury benchmark by -9bps so far in November. The Foreign Agency and Local Authority sub-sectors drove October's outperformance, returning +24bps and +14bps in excess of Treasuries respectively. Domestic Agency debt outperformed the Treasury benchmark by +3bps, while Supranationals (-7bps) and Sovereigns (-10bps) both underperformed. After adjusting for differences in credit rating and duration, Foreign Agency and Local Authority bonds still appear attractive relative to investment grade U.S. corporate debt. Sovereigns, on the other hand, appear modestly expensive. We continue to recommend avoiding Sovereign issues while remaining overweight the other sub-sectors of the government related index. In a recent report,3 we observed that the performance of sovereign debt relative to equivalently-rated and duration-matched U.S. corporate credit tends to track movements in the U.S. dollar. As such, a continued bull market in the U.S. dollar will remain a significant headwind for sovereigns. At the country level, the only nations whose USD-denominated debt offers a spread advantage over Baa-rated U.S. corporate debt are Hungary, South Africa, Colombia and Uruguay. Unusually, bullet agency debt outperformed callable agency debt last month even though Treasury yields moved higher (Chart 5). Within Domestic Agency bonds, we continue to favor callable over bullet issues on the expectation that this divergence will not persist. Municipal Bonds: Overweight Chart 6Municipal Market Overview bca.usbs_pas_2016_11_08_c6 bca.usbs_pas_2016_11_08_c6 Municipal bonds underperformed the duration-equivalent Treasury index by -12bps in October, dragging year-to-date excess returns down to -152bps (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio is largely unchanged since the end of September, and remains close to its post-crisis average. In recent months, trends in M/T yield ratios have fluctuated alongside the betting market odds for today's Presidential election. A Trump victory would cause yield ratios to widen sharply, as President Trump's promised tax cuts would substantially de-value the tax advantage in municipal bonds. We expect yield ratios to tighten in the event that Clinton prevails, as any expectation of a Trump victory works its way out of the price. Due to attractive yield ratios relative to recent history, we are inclined to remain overweight municipal bonds in the near-term. However, we will likely downgrade the sector if yield ratios move back to previous lows. As we detailed in a recent Special Report,4 historical lags between the corporate and municipal credit cycles suggest that municipal bond downgrades will start to increase in the second half of next year, alongside a deterioration in state & local government balance sheets. Further, state & local government investment spending is poised to move higher next year, regardless of the election result, leading to even greater muni issuance (Chart 6). Elevated fund flows have offset the impact of strong issuance this year, the risk is that they will not keep pace going forward. Treasury Curve: Stay In Flatteners Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve has bear-steepened significantly since the end of September. The 2/10 Treasury slope has steepened +16bps and the 5/30 slope has steepened +14bps. As a result, our two curve flattener trades have struggled. Our 2/10 Treasury curve flattener has returned -41bps since initiation on September 6. Our 10/30 Treasury curve flattener has returned -25bps since initiation on September 20. Our other tactical trade - short December 2017 Eurodollar - has returned +16bps since initiation on July 12. All three of the above tactical trades are premised on the view that the Fed will deliver a rate hike in December, and that such a rate hike has not yet been fully discounted by the market. At present, we calculate that the market-implied probability of a December rate hike is 62%, as discounted in fed funds futures. The historical pattern suggests the yield curve should bear flatten as the rate hike probability approaches 100%. Unusually, the correlations between both the 2/10 and 10/30 Treasury slopes and the level of Treasury yields have moved into positive (bear-steepening) territory (Chart 7). This is especially unusual for the 10/30 slope, where the correlation has been firmly in negative (bear-flattening) territory since 2013. We continue to recommend holding curve flatteners, and expect both correlations to revert into negative (bear-flattening) territory in advance of a December rate hike, as they did last year. Any surge in bullish dollar sentiment between now and December would only increase the flattening pressure on the curve (bottom panel). So far bullish dollar sentiment has remained relatively flat, but we cannot discount a large increase in the run-up to the next rate hike, as occurred last year. TIPS: Overweight Chart 8TIPS Market Overview bca.usbs_pas_2016_11_08_c8 bca.usbs_pas_2016_11_08_c8 TIPS outperformed the duration-equivalent nominal Treasury index by +112bps in October. The 10-year breakeven rate has increased +8bps since the end of September, and currently sits at 1.68%. The 10-year TIPS breakeven rate has increased substantially during the past couple months, and has now converged with the fair value reading from our TIPS Financial model (Chart 8). Rising expectations of a Fed rate hike and a flatter Treasury curve will weigh on TIPS during the next month, and we would not be surprised to see breakevens temporarily cease their uptrend as attention turns to Fed hawkishness following today's election. But we also expect that TIPS breakevens will resume their uptrend heading into next year. As we flagged in a recent report,5 the sensitivity of TIPS breakevens to core inflation has increased since the financial crisis. We posit that the reason for this increased sensitivity is that the Fed's ability to control long-dated inflation expectations has been impaired by the zero-lower bound on rates. As a result, the trend in breakevens is increasingly taking its cue from the realized inflation data. Realized inflation continues to trend steadily higher (bottom two panels), and diffusion indexes suggest that further gains are ahead (panel 4). Given that breakevens remain well below pre-crisis levels, we intend to remain overweight TIPS relative to nominal Treasuries and ride out any near-term volatility related to a Fed rate hike. ABS: Maximum Overweight Chart 9ABS Market Overview bca.usbs_pas_2016_11_08_c9 bca.usbs_pas_2016_11_08_c9 Asset-Backed Securities outperformed the duration-equivalent Treasury index by +10bps in October, bringing year-to-date excess returns up to +101bps. Aaa-rated ABS outperformed the Treasury benchmark by +8bps on the month, while non-Aaa issues outperformed by +24bps. The index option-adjusted spread for Aaa-rated ABS has tightened -3bps since the end of September and, at 45bps, is considerably below its pre-crisis average (Chart 9). According to our days-to-breakeven measure, there still exists a valuation advantage in Aaa-rated auto ABS relative to Aaa-rated credit card ABS, but that advantage is rapidly evaporating (panel 3). We calculate that it will take 12 days of average spread widening for Aaa-rated auto ABS to underperform Treasuries on a 6-month horizon and 10 days of average spread widening for Aaa-rated credit card ABS to underperform. Moreover, credit card ABS exhibit superior collateral credit quality relative to autos. Credit card charge-offs remain near all-time lows, while the auto net loss rate appears to have bottomed (bottom panel). Further, the Fed's senior loan officer survey shows that auto lending standards have tightened for two consecutive quarters, while credit card lending standards were unchanged in Q3 following 25 consecutive quarters of net easing (panel 4). We recommend investors favor Aaa-rated credit cards over Aaa-rated auto loans within a maximum overweight allocation to consumer ABS. CMBS: Underweight Chart 10CMBS Market Overview bca.usbs_pas_2016_11_08_c10 bca.usbs_pas_2016_11_08_c10 Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by +4bps in October, bringing year-to-date outperformance up to +194bps. The index option-adjusted spread for non-agency Aaa-rated CMBS has tightened -3bps since the end of September, and remains very close to its pre-crisis average (Chart 10). The Fed's Senior Loan Officer Survey for the third quarter, released yesterday, showed that banks continue to tighten standards on all classes of commercial real estate (CRE) loans (panel 3). The survey also shows that CRE loan demand continues to increase, though at a less rapid pace than in prior quarters. While CRE prices continue to march higher (bottom panel), tightening lending standards and a rising delinquency rate (panel 4) make us cautious on non-agency CMBS. Agency CMBS outperformed the duration-equivalent Treasury index by +4bps in October, bringing year-to-date excess returns up to +105bps. Agency CMBS still offer 56bps of option-adjusted spread. This is greater than what is offered by Aaa-rated consumer ABS (45bps) and conventional 30-year MBS (19bps) for a similar amount of spread volatility. We continue to recommend overweight positions in Agency CMBS. Treasury Valuation Chart 11Global PMI Model Global PMI Model Global PMI Model The current reading from our Global PMI Treasury model places fair value for the 10-year Treasury yield at 2.27% (Chart 11). This model is based on a linear regression of the 10-year Treasury yield on three factors, using a post-financial crisis time interval.6 The three factors are: Global Growth: Measured using the Global Manufacturing PMI (sourced from JP Morgan and Markit) Global Growth Divergences: Proxied by bullish sentiment toward the U.S. dollar (sourced from Marketvane.net) Economic Uncertainty: Measured using the Global Economic Policy Uncertainty Index (sourced from policyuncertainty.com) The correlation between the global PMI and the 10-year Treasury yield is strongly positive (panel 3). However, improving global growth is offset by any increase in bullish sentiment toward the U.S. dollar. For a given level of global growth any increase in bullish sentiment toward the dollar represents a drag on interest rate expectations. As such, bullish dollar sentiment enters our model with a negative sign (panel 4). The final component of our model - global economic policy uncertainty - captures changes in Treasury yields related to headline risk and "flights to quality". This factor enters our model with a negative sign - more uncertainty correlates with lower bond yields (bottom panel). Monetary Conditions And Rate Expectations The BCA Monetary Conditions Index (MCI) combines changes in the fed funds rate with changes in the trade-weighted dollar using a 10:1 ratio. Historically, economic downturns have been preceded by a break in this index above its equilibrium level - calculated using the Congressional Budget Office's estimate of potential GDP growth (Chart 12). Using assumptions for the time until the MCI converges with equilibrium and the annual appreciation of the trade-weighted dollar, it is possible to calculate the expected change in the fed funds rate for the cycle. The shaded region in Chart 13 shows the expected path for the federal funds rate assuming that the MCI reaches equilibrium at the end of 2019. The upper-end of the region corresponds to a scenario where the trade-weighted dollar depreciates by 2% per year and the lower-end of the region corresponds to a scenario where the dollar appreciates by 2% per year. The thick line through the middle of the region corresponds to a flat dollar. Chart 12Monetary Conditions Vs. Equilibrium bca.usbs_pas_2016_11_08_c12 bca.usbs_pas_2016_11_08_c12 Chart 13Fed Funds Rate Scenarios bca.usbs_pas_2016_11_08_c13 bca.usbs_pas_2016_11_08_c13 Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching", dated September 13, 2016, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Special Report, "Don't Chase The Rally In Junk", dated November 1, 2016, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching: An Update", dated October 25, 2016, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Special Report, "Trading The Municipal Credit Cycle", dated October 18, 2016, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching: An Update", dated October 25, 2016, available at usbs.bcaresearch.com 6 For additional details on the model please see U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Model", dated October 11, 2016, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights Bond yields have room to move higher in the near run, but a move above 2% would represent a buying opportunity. U.S. elections are too close to call. Even if Trump wins, we caution that federal fiscal spending programs will have to work hard to offset the ongoing drag from sluggish state and local spending. Economic and inflation data will not stand in the way of a Fed rate hike in December. But heightened market volatility associated with the elections could still derail their plans. Feature October was a tough month for Treasuries, as the 10-year climbed 25 basis points since October 1. The sell-off puts Treasury yields closely in line with our bond strategists' estimate of fair value. This week, we review the factors that argue for or against a further rise in bond yields. Our conclusion is that the Treasury sell-off is likely to continue in the near run. Yields above 2% would represent a buying opportunity. The primary bearish driver for Treasuries in the next two months is the Fed. As we discuss below, recent economic data has been decent enough to meet the Fed's threshold for a rate hike and inflation indicators are moving towards the Fed's 2% target. Indeed, the FOMC statement released last Wednesday sent a mildly hawkish signal by highlighting that growth has improved, while both inflation expectations and realized inflation are tracking higher. The statement very much keeps a December rate hike in play, but it does not elevate the odds. In the FOMC meeting just prior to last year's rate hike, the Fed specifically mentioned the "next meeting" as a possibility for a rate increase. The Fed did not go as far this time around1 as policymakers are no doubt wary of spooking the markets when uncertainty is running high ahead of the U.S. election. Whether the Fed actually pulls the trigger in December will continue to hinge on the incoming economic data and the behavior of the markets following the election, but our base case remains that the Fed will follow through with a rate hike. The market is currently priced for a 65% chance of a rate move before the end of the year. This is roughly the same as the probability of a 2015 rate hike at this time last year (Chart 1). As long as the economic data remain reasonably firm, as we expect, then rate hike probabilities should follow last year's path and move to 100% by the December 13-14 FOMC meeting. Last year, the revision in the rate hike probability from November-December corresponded with a 35 bps rise in the 10-year Treasury. Chart 1Room For Expectations To Move Higher Room For Expectations To Move Higher Room For Expectations To Move Higher Since last year, the Fed has drastically downgraded its long-term rate projections. Recall that ahead of the December 2015 FOMC meeting, the Fed projected that the Fed funds rate would reach 1.4% in 2016. Since then, the Fed has revised downward its interest rate forecast to two rate hikes in 2017. Assuming the Fed does not revise these forecasts, it is unlikely that Treasuries respond as negatively as they did in 2015. Moreover, as we noted above, at 1.8% today, Treasuries are already roughly at fair value. During last year's sell-off, bond yields were starting from a substantially overbought level. This argues for a somewhat more muted reaction to a Fed rate hike, although we still expect yields could move higher. Beyond December, i.e. once the rate hike is priced in, our base case is that yields trend sideways for a time. The Fed's forecast for growth in 2017 is 2.0%, which would represent an increase of 0.5% from the first three quarters of 2016. If economic growth meets the Fed's expectation of 2%, then it is reasonable to expect that policymakers would increase twice next year, i.e. in line with their current forecasts. As shown in Chart 1, the Treasury market is not yet priced for this outcome: market participants currently assign only 80% odds to one rate hike by the end of 2017. The message is that the Fed, even with a reasonable (for the first time in years!) forecast for growth, will end up being a source of upward pressure on bond yields beyond 2017. There is nonetheless an important mitigating factor for bond yields: the U.S. dollar. A stronger currency represents a tightening of financial conditions that acts to depress expectations of future economic growth. This can spell trouble for risk assets and also lower the market-implied odds of future rate hikes. Indeed, a central bank can tighten monetary conditions, but does not have control over how much of the tightening comes via interest rates and how much through currency appreciation. In the current environment, the Fed knows that the process of normalizing interest rates will trigger bouts of volatility, because its actions will be exaggerated by movements in the currency. The bottom line is that we expect the Fed to tighten in December, followed by two more quarter-point hikes in 2017. Given that the bond market is not yet priced for this, the recent sell-off in bond yields will continue, perhaps to as high as 2%. Thereafter, we would expect Treasuries to trade in a fairly narrow range, with 2% representing the higher end of the band. A Coin Toss Election In the very near term, the U.S. elections pose an important risk to the view expressed above. For the past several months, market odds of a Trump Presidency have been positively correlated with the uncertainty index and negatively correlated with Treasury yields (Chart 2 and Chart 3). On the eve of the election, the race is once again too close to call. Our expectation has been that any flight-to-quality related to a Trump victory will be short-lived. However, with equity market multiples stretched and the earnings outlook still leaving much to be desired, equity markets are ripe for a correction. Chart 2Bond Market Tracks Uncertainty Bond Market Tracks Uncertainty Bond Market Tracks Uncertainty Chart 3Trump And Uncertainty bca.usis_wr_2016_11_07_c3 bca.usis_wr_2016_11_07_c3 In our September 26 Weekly Report, we warned that investors may be assigning too low odds of a Trump Presidential win. We posited that if the polls remained tight, the potential for further volatility was high. We followed up in mid-October, advising clients how to implement portfolio insurance against downside market risks, and specifically against a Trump election win. One recommended vehicle for insurance that we highlighted was the U.S. dollar, which is part of our Protector Portfolio (Chart 4 and Chart 5). We believe the currency will rally due to the combination of coming fiscal expansion and risk aversion flows on the back of a Trump win. True, this strategy has not held up in recent days, as the U.S. dollar has softened while Trump improves in the polls and risk assets have corrected. Still, the dollar's reputation as a safe-haven currency is well-deserved. It has consistently outperformed during times of crisis - even when the U.S. itself was the source, as most recently demonstrated during the summer 2011 budget impasse. Chart 4Protector Portfolio Components bca.usis_wr_2016_11_07_c4 bca.usis_wr_2016_11_07_c4 Chart 5Protector Portfolio Returns bca.usis_wr_2016_11_07_c5 bca.usis_wr_2016_11_07_c5 In a recent report,2 our geopolitical strategists outline several things to watch for on November 8, the day of the election, and in its immediate aftermath. The immediate developments most relevant for investors are anything that prolongs the period of uncertainty regarding voting. For example, the 2000 election is a reminder that the results may not be clear immediately. Although the 2000 election was held on November 7, the official result was not declared until November 26; Al Gore did not concede until December 12. This time, any number of things could delay declaring a winner, including a tie in the electoral college, or a "faithless elector," i.e. an electoral college member that does not cast his/her ballot for the candidate chosen by popular vote, and therefore causes the Supreme Court to intervene. A delay in declaring the election result would increase uncertainty and therefore be negative for risk assets. Longer term, the margin of victory has become important for policy. It is now clear that a Clinton win, if it were to happen, will be a narrow one. According to our Geopolitical Strategy team, it is almost guaranteed at this point that the chances of a Democratic sweep in the House of Representatives are zero. This is a positive development for the market as a Democratic sweep would mean a slew of anti-business regulation out of Congress. Nonetheless, a narrow win - with sub-50% of the vote - would give Hillary Clinton an extremely weak mandate. The probability of a compromise between the White House and GOP in Congress is therefore declining and puts in jeopardy any possibility of modest fiscal stimulus under a Clinton White House, or of corporate tax reforms. The likelihood of more fiscal spending in 2017 has become common lore among investors. Thus, a disappointment on that front would be negative for risk assets. Post-Election Government Spending Throughout the twists and turns of the U.S. election campaign, one higher conviction view that has endured at BCA is that popular sentiment is shifting away from fiscal austerity and that 2017 would feature more ambitious spending programs. That would be quite welcome, given that real government consumption and investment - at all levels of government - has been a drag on growth during most of the recovery since the Great Recession. Ongoing weakness at the Federal level is due to restraint in defense expenditure, while state and local spending has been weak due to a significant downtrend in tax revenues. It is notable that the decline in state tax revenues is not confined to oil-producing states. A recent report by the Rockefeller Institute compiled state tax revenue forecasts for 2017 and concludes that the decline in tax revenues from all sources (sales, income and corporate) will be slow to recover next year.3 Remember that states can only spend what they take in outside of infrastructure spending. If state and local governments can manage to cut the drag on real GDP to 0%, that would still leave a major onus for government spending on the federal government. Assuming the contribution to real GDP from state and local spending is zero, it would require a 6% annual growth in federal spending to return total government spending as a contribution to GDP back to its historic average of 0.4% (Chart 6). As Chart 7 shows, fiscal spending of that magnitude rarely occurs outside of recession. Chart 6(Part 1) How Much Fiscal Spending? (Part 1) How Much Fiscal Spending? (Part 1) How Much Fiscal Spending? Chart 7(Part 2) How Much Fiscal Spending? bca.usis_wr_2016_11_07_c7 bca.usis_wr_2016_11_07_c7 Importantly, how much long-term effect a fiscal boost will deliver depends on how well fiscal multipliers - which measure how much a dollar of increased government spending or reduced taxes raises output - are working. Indeed, the magnitude of fiscal multipliers continues to be a massive source of disagreement in policy circles. Recent work by the IMF suggests that the multiplier, in some economies and under certain interest rate settings, could be as high as four: for each dollar the U.S. government spends, it will generate another $4 dollars of GDP!4 Other academics put the fiscal multiplier at less than 0.5. The wide range of forecasts is due to several factors, but there are nonetheless some generally held principles: Fiscal stimulus tends to be more effective when the output gap is large: when output is well below its potential, the monetary policy response to an increase in spending is likely to be limited. In other words, fiscal multipliers are larger in recessions than in expansions.5 The type of fiscal stimulus matters, a lot. Table 1 shows a range of CBO estimates for different types of government activity. For example, income tax cuts on high income earners tend to have a low multiplier effect (well below 1), while direct spending by government, e.g. infrastructure outlays, tends to have a much higher multiplier (above 1). Multiplier effects tend to last no more than eight quarters when output is close to potential. Fiscal stimulus tends to have a more impressive impact, although short-lived (four quarters) when the output gap is large. Table 2 shows the CBO-estimated effect of an increase in demand over eight quarters under two different economic scenarios. The first is when monetary policy is constrained, and the second is when monetary policy responds to the increase in demand from government stimulus. Our guess is that we are currently somewhere in between the two economic scenarios presented: there is still an output gap and monetary policy is already off the zero bound. Thus, the fiscal multiplier is likely a little above than one, meaning that government spending does not "crowd out" private spending. Table 1Ranges For U.S. Fiscal Multipliers Policy, Polls, Probability Policy, Polls, Probability Table 2The Effect Of A $1 Increase In Aggregate Demand Over Eight Quarters Policy, Polls, Probability Policy, Polls, Probability Overall, government expenditures will contribute positively to GDP next year, though the amount of fiscal expansion is dependent on the political configuration in Washington after the elections. Similarly, the impact of any spending will depend on what form new fiscal measures takes. CBO research suggests that the fiscal multiplier will be slightly above 1. Business Sentiment: Neither Euphoria Nor Misery Without further participation from the government sector, the economy is likely to achieve above 2% real GDP growth. A more optimistic scenario could unfold if capex improves substantially and/or a Trump win significantly opens the fiscal taps. Recent private sector data shows that businesses are continuing on a mild expansion path. The ISM surveys of business confidence were little changed in October - sentiment among manufacturers is broadly unchanged, while respondents from the service sector were slightly less optimistic than the previous month (Chart 8). Still, the major indices remain above their boom/bust lines and respondents' comments suggest neither euphoria nor misery. Meanwhile, payrolls increased by 161,000 in October. Although this was slightly below the consensus forecast of 175,000, there was a cumulative 44,000 in upward revisions to the prior two months. Elsewhere, wages accelerated more than expected and average hourly earnings rose 0.4% m/m, pushing the annual growth rate to a new cyclical high of 2.8% (Chart 9). Chart 8ISM Surveys Are Steady bca.usis_wr_2016_11_07_c8 bca.usis_wr_2016_11_07_c8 Chart 9Wage Growth Is Perking Up bca.usis_wr_2016_11_07_c9 bca.usis_wr_2016_11_07_c9 To paraphrase from this week's FOMC statement, the employment report provides some further evidence that the U.S. economy is progressing towards the Fed's dual mandate. In itself, it reinforces the case for the Fed raise interest rates in December. It seems now that the only thing that could derail the Fed is an election surprise and related heightened market volatility. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 https://www.federalreserve.gov/newsevents/press/monetary/20151028a.htm 2 Please see Geopolitical Strategy Special Report "It Ain't Over 'Till The Fat Man Sings," dated November 1, 2016, available at gps.bcaresearch.com 3 http://www.rockinst.org/pdf/government_finance/state_revenue_report/2016-09-21-SRR_104_final.pdf 4 https://www.imf.org/external/pubs/ft/wp/2014/wp1493.pdf 5 "How Powerful Are Fiscal Multipliers In Recessions? Alan Auerbach and Yuriy Gorodnichenko, NBER Reporter 2015, http://www.nber.org/reporter/2015number2/auerbach.html

Highlights Lesson 1: Don't fear the end of the debt super cycle. Lesson 2: The ECB will ultimately target the long-term bond yield. Lesson 3: Financials will structurally underperform. Lesson 4: Personal Products (Beauty) will structurally outperform. Feature Striking similarities exist between the post debt super cycle economies in the euro area and Japan. Feature ChartPersonal Products Will Outperform Structurally... Financials Will Not bca.eis_sr_2016_11_03_s1_c1 bca.eis_sr_2016_11_03_s1_c1 In many regards, the euro area looks remarkably like Japan with a 17 year lag. Line up the 2007 peak in the euro area credit boom with the 1990 peak in the Japan credit boom - and the subsequent evolutions of many economic and financial metrics also line up almost perfectly: for example, the policy interest rate; the 10-year bond yield; inflation; and nominal GDP (Chart I-2, Chart I-3, Chart I-4, Chart I-5). Chart 2Striking Similarities Between The Euro Area... bca.eis_sr_2016_11_03_s1_c2 bca.eis_sr_2016_11_03_s1_c2 Chart 3...And Japan, Advanced By 17 Years ...And Japan, Advanced By 17 Years ...And Japan, Advanced By 17 Years Chart I-4Striking Similarities Between The Euro Area... Striking Similarities Between The Euro Area... Striking Similarities Between The Euro Area... Chart I-5...And Japan, Advanced By 17 Years bca.eis_sr_2016_11_03_s1_c5 bca.eis_sr_2016_11_03_s1_c5 This is very useful because if the euro area continues in Japan's footsteps, Japan's experience can teach us several important lessons about the euro area economy and financial markets out to the year 2034. Lesson 1: Don't Fear The End Of The Debt Super Cycle Does the euro area economy have "lost decades" ahead of it? Not exactly. Japan's so-called lost decades describe its stagnant nominal GDP since the mid-1990s. But this emphasis on nominal income is misleading (Chart I-6). The average citizen's standard of living does not depend on nominal GDP or even on real GDP. What truly matters is real GDP per head combined with the absence of extreme income inequality. Real incomes must grow and the growth must be reasonably distributed across society. On both counts, the euro area can be encouraged by Japan's experience. Since the late 1990s, Japan's real GDP per head has averaged close to 1% growth a year, broadly in line with the expected real productivity growth in a developed economy. This is exactly the real growth rate to be expected when there is no artificial and unsustainable tailwind from credit expansion. It is an economy's natural state of growth when the debt super cycle comes to an end, as it did in Japan more than 20 years ago.1 And it is good growth because it comes entirely from productivity improvements. Mankind's persistent ability to learn, experiment, and innovate produces more and/or better output from a fixed set of inputs. Furthermore, unlike other major economies, income inequality in Japan has not increased through the past 20 years and remains amongst the lowest in the developed world (Chart I-7). Again, this is not surprising. It is credit expansions that inflate bubbles in financial assets and exacerbate income and wealth inequalities. Therefore, unlike bad growth fuelled by credit booms, real growth that comes from productivity improvements is sustainable and unpolarising. The first lesson from Japan is that the euro area can expect structural growth in real GDP per head of around 1% a year. Chart I-6What ##br##"Lost Decades"? bca.eis_sr_2016_11_03_s1_c6 bca.eis_sr_2016_11_03_s1_c6 Chart I-7Income Inequality In Japan ##br##Has Not Increased bca.eis_sr_2016_11_03_s1_c7 bca.eis_sr_2016_11_03_s1_c7 Lesson 2: The ECB Will Ultimately Target The Long-Term Bond Yield One objection to Lesson 1 is that in a highly indebted economy, nominal GDP growth does matter. As debt is a nominal amount, it is nominal incomes that determine the ability to service and repay the high level of debt. So given a free choice, policymakers would prefer to have inflation at 2% or 4% rather than at -1%; and nominal GDP growth at 3% or 5% rather than zero. Unfortunately, policymakers do not have this free choice. Contrary to what central bankers promise, inflation and nominal GDP growth cannot be dialled up or down at will to hit a point-target. As we explained in The Case Against Helicopters,2 inflation is a notoriously non-linear phenomenon which is extremely difficult, if not impossible, to control. As a reminder, look at the standard identity of monetary economics: MV = PT M is the broad money supply, V is its velocity of circulation, P is the price level and T is the volume of transactions. PT is effectively nominal GDP. The big problem is that both the broad money supply M and its velocity V - whose product determines nominal GDP - are highly non-linear. M is non-linear because the commercial banking system money multiplier - the ratio of loans to reserves - is non-linear (Chart I-8). At a tipping point of inflation, the onus suddenly flips from lending as little as possible to lending as much as possible. Chart I-8The Money Multiplier Is Non-Linear bca.eis_sr_2016_11_03_s1_c8 bca.eis_sr_2016_11_03_s1_c8 Admittedly, the central bank (in cahoots with the government) could by-pass the commercial banking system to control the money supply M directly. But it can do nothing to change the extreme non-linearity of the other driver of nominal GDP, the velocity of money V. Again, at a tipping point of inflation, the onus suddenly flips to spending money - both newly created and pre-existing balances - as fast as possible. At which point, nominal GDP growth and inflation suddenly and uncontrollably phase-shift from ice to fire with little in between. Therefore in the highly indebted euro area economy with near-zero inflation, the prudent course of action is not to risk uncontrolled inflation with so-called "helicopter money". Instead, the second lesson from Japan is to expect the ECB ultimately to emulate the BoJ and target the long-term bond yield. But which bond yield? Most likely, it would be the euro area synthetic 10-year yield, which the ECB already calculates and publishes, or a close proxy. In combination with the ECB's (as yet unused) OMT program - whose mere presence limits individual sovereign yield spreads - expect euro area government bond yields to remain structurally well anchored. Lesson 3: Financials Will Structurally Underperform Japanese financial sector profits today stand at less than half their level in 1990. For euro area financial sector profits, the concerning thing is that their evolution is tracking the Japanese experience with a 17 year lag. If euro area financial profits continue to follow in Japan's footsteps, expect no sustained growth over the next 17 years (Chart I-9). Chart I-9Euro Area Financial Profits May Experience No Sustained Growth bca.eis_sr_2016_11_03_s1_c9 bca.eis_sr_2016_11_03_s1_c9 In a post debt super cycle world, banks lose the lifeblood of their business: credit creation. And this becomes a multi-decade headwind to financial sector profit growth and share price performance. Euro area financials face two other headwinds similar to those in post debt super cycle Japan. As explained in Lesson 2, high indebtedness makes the economy hyper-sensitive to rising bond yields. The upshot is that the interest rate term-structure, which drives banks' net lending margins, cannot sustainably steepen. Also, just like Japan's 'zombie' banks, many European banks will take a long time to fully recognise the extent of their non-performing loans. The consequent squeeze on new lending combined with a requirement for additional capital further weighs down banks' return on equity. So the third lesson from Japan is that euro area financials is not a sector to buy and hold for the long term. Rather, it is a sector to play for periodic strong countertrend rallies. Now is not the time for such a play. Lesson 4: Personal Products (Beauty) Will Structurally Outperform Over the past 20 years, Japan's nominal GDP has gone sideways. But over this same period, the sales of skin cosmetics and beauty products have almost tripled (Chart I-10). This has helped the personal products sector to outperform very strongly. While Japanese financial profits have halved since 1990, Japanese personal products profits have quintupled (Feature Chart). Once again, the useful thing is that euro area personal product profits are uncannily tracking the Japanese experience with a 17 year lag. If euro area personal product profits continue to follow in Japan's footsteps, expect them to almost triple over the next 17 years (Chart I-11). Chart I-10Beauty Sales Have Boomed In Japan bca.eis_sr_2016_11_03_s1_c10 bca.eis_sr_2016_11_03_s1_c10 Chart I-11Euro Area Personal Products Profits Might Triple bca.eis_sr_2016_11_03_s1_c11 bca.eis_sr_2016_11_03_s1_c11 The very strong growth in beauty sales and profits in Japan is an extended example of the phenomenon known as the lipstick effect. Our Special Report Buy Beauty: The Lipstick Effect Stays Put3 provides the detail. But in a nutshell, the demand for beauty products and cosmetics - epitomised by lipstick - experiences a surge when the economic environment feels harsh. For many people, the post debt super cycle world of 1% real income growth with high indebtedness and no more bingeing on credit does feel like an extended hangover - at least compared to the spendthrift era that preceded it. Hence, it creates the ideal backdrop for an extended play of the lipstick effect, as witnessed in Japan. The fourth lesson from Japan is that euro area personal products is a sector to buy and hold for the long term. Expect profits to trend up at around 6% a year, and the sector to strongly outperform the broader market. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Admittedly, after the debt super cycle ended in Japan, government levering was needed to counter the impact of aggressive de-levering in the private sector. But in the euro area, this will not be needed to the same extent as the de-levering in the private sector is not as aggressive. 2 Please see the European Investment Strategy Weekly Report 'The Case Against Helicopters' published on May 5, 2016, available at eis.bcaresearch.com 3 Please see the European Investment Strategy Special Report 'Buy Beauty: The Lipstick Effect Stays Put' published on April 14, 2016, available at eis.bcaresearch.com Fractal Trading Model This week's recommended trade is to go short French banks versus the CAC40. 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. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields bca.eis_sr_2016_11_03_s2_c1 bca.eis_sr_2016_11_03_s2_c1 Chart II-2Indicators To Watch - Bond Yields bca.eis_sr_2016_11_03_s2_c2 bca.eis_sr_2016_11_03_s2_c2 Chart II-3Indicators To Watch - Bond Yields bca.eis_sr_2016_11_03_s2_c3 bca.eis_sr_2016_11_03_s2_c3 Chart II-4Indicators To Watch - Bond Yields bca.eis_sr_2016_11_03_s2_c4 bca.eis_sr_2016_11_03_s2_c4 Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations bca.eis_sr_2016_11_03_s2_c5 bca.eis_sr_2016_11_03_s2_c5 Chart II-6Indicators To Watch - Interest Rate Expectations bca.eis_sr_2016_11_03_s2_c6 bca.eis_sr_2016_11_03_s2_c6 Chart II-7Indicators To Watch - Interest Rate Expectations bca.eis_sr_2016_11_03_s2_c7 bca.eis_sr_2016_11_03_s2_c7 Chart II-8Indicators To Watch - Interest Rate Expectations bca.eis_sr_2016_11_03_s2_c8 bca.eis_sr_2016_11_03_s2_c8

The Tactical Asset Allocation model can provide investment recommendations which diverge from those outlined in our regular weekly publications. The model has a much shorter investment horizon - namely, one month - and thus attempts to capture very tactical opportunities. Meanwhile, our regular recommendations have a longer expected life, anywhere from 3-months to a year (or longer). This difference explains why the recommendations between the two publications can deviate from each other from time to time. Highlights Chart 1Model Weights bca.gis_taami_2016_10_28_c1 bca.gis_taami_2016_10_28_c1 In October, the model outperformed global equities in USD and local-currency terms; it also outperformed the S&P 500 in local-currency terms, while performing in line with the S&P in USD terms. For November, the model trimmed its allocation to cash and stocks and boosted its weighting in bonds (Chart 1). The model increased its weighting in French, Dutch, and Swedish stocks at the expense of the U.S., Japan, Germany, Switzerland, New Zealand, and Emerging Asia. Within the bond portfolio, allocation to New Zealand and the U.K. was increased, while the allocation to U.S., Australian and Spanish paper was reduced. The risk index for stocks deteriorated in October, while the bond risk index improved noticeably. Feature Performance In October, the recommended balanced portfolio gained 0.6% in local-currency terms, and was down 1% in U.S. dollar terms (Chart 2). This compares with a loss of 1.4% for the global equity benchmark, and a 1% loss for the S&P 500 index. Given that the underlying model is structured in local-currency terms, we generally recommend that investors hedge their positions, though we do provide recommendations from time to time. The higher allocation to EM stocks in October was timely, but the boost to bonds was a drag on the model's performance. Weights The model cut its allocation to stocks from 67% to 66% and increased its bond weighting from 21% to 26%. The allocation to cash was decreased from 12% to 8%, while commodities remain excluded from the portfolio (Table 1). The model reduced its allocation to New Zealand equities by 3 points, Emerging Asia by 2 points and U.S., Japan, Germany and Switzerland by 1 point each. Meanwhile, it increased allocation to Dutch, French and Swedish stocks by 4 points, 3 points and 1 point, respectively. In the fixed-income space, the allocation to U.K. and New Zealand paper was increased by 6 points and 5 points respectively, while allocation to Australia, Spain and the U.S. was cut by 3 points, 2 points and 1 point, respectively. Chart 2Portfolio Total Returns bca.gis_taami_2016_10_28_c2 bca.gis_taami_2016_10_28_c2 Table 1Model Weights (As Of October 27, 2016) Tactical Asset Allocation And Market Indicators Tactical Asset Allocation And Market Indicators Currency Allocation Local currency-based indicators drive the construction of our model. As such, the performance of the model's portfolio should be compared with the local-currency global equity benchmark. The decision to hedge currency exposure should be made at the client's discretion, though from time to time, we do provide our recommendations. The dollar appreciated in October and investors should position for additional dollar strength. Our Dollar Capitulation Index seems to be breaking out to the upside following a pattern of lower highs. Since 2008, such breakouts have been followed by a significant rally in the broad trade-weighted dollar (Chart 3). Chart 3U.S. Trade-Weighted Dollar* And Capitulation bca.gis_taami_2016_10_28_c3 bca.gis_taami_2016_10_28_c3 Capital Market Indicators Our model continues to exclude commodities from the portfolio. The risk index for this asset class remains at the highest level in over two years (Chart 4). For the first time since June 2014, the risk index for global equities is above the neutral line (Chart 5). The higher overall risk reflects deteriorating liquidity and momentum readings. Our model cut its weighting in equities for the third month in a row. Chart 4Commodity Index And Risk Commodity Index And Risk Commodity Index And Risk Chart 5Global Stock Market And Risk bca.gis_taami_2016_10_28_c5 bca.gis_taami_2016_10_28_c5 The value component of the risk index for U.S. stocks improved in October, but this was overshadowed by worsening liquidity and momentum readings. The model slightly trimmed its allocation to U.S. equities (Chart 6). Even after the latest small uptick in the risk index for Dutch equities, it remains one of the lowest among the model's universe. The allocation to this bourse was increased. (Chart 7). Chart 6U.S. Stock Market And Risk bca.gis_taami_2016_10_28_c6 bca.gis_taami_2016_10_28_c6 Chart 7Netherlands Stock Market And Risk bca.gis_taami_2016_10_28_c7 bca.gis_taami_2016_10_28_c7 The risk index for U.K. stocks declined slightly in October, but remains firmly in high-risk territory both compared to its own history and its global peers. This asset class remains excluded from the portfolio (Chart 8). The model slightly upgraded Swedish equities, despite a worsening risk index. The continued favorable liquidity backdrop remains a boon for Swedish stocks (Chart 9). Chart 8U.K. Stock Market And Risk U.K. Stock Market And Risk U.K. Stock Market And Risk Chart 9Swedish Stock Market And Risk bca.gis_taami_2016_10_28_c9 bca.gis_taami_2016_10_28_c9 After declining for four consecutive months, the overall risk index for bonds is not at extreme high-risk levels anymore. The increase in yields has helped completely unwind overbought conditions, as per our momentum indicator. The model used the latest selloff to increase its allocation to bonds (Chart 10). The risk index for U.S. Treasurys declined markedly in October, but a few other markets also feature improved risk readings. As a result, the model downgraded U.S. Treasurys (Chart 11). Chart 10Global Bond Yields And Risk bca.gis_taami_2016_10_28_c10 bca.gis_taami_2016_10_28_c10 Chart 11U.S. Bond Yields And Risk bca.gis_taami_2016_10_28_c11 bca.gis_taami_2016_10_28_c11 The selloff in New Zealand bonds has pushed the momentum indicator into oversold territory, boosting the allocation to this asset class (Chart 12). The risk index for euro area bonds remains firmly in the high-risk zone even after a notable decline. However, there are select bond markets in the common-currency area that have relatively more favorable risk readings (Chart 13). Chart 12New Zealand Bond Yields And Risk bca.gis_taami_2016_10_28_c12 bca.gis_taami_2016_10_28_c12 Chart 13Euro Area Bond Yields And Risk bca.gis_taami_2016_10_28_c13 bca.gis_taami_2016_10_28_c13 Within the euro area, Italian bonds feature a risk reading that has fallen below the neutral line. While the cyclical indicator continues to move into more bond-negative territory, it is currently being offset by the oversold reading on the momentum indicator (Chart 14). U.K. gilt yields moved up as the post-Brexit inflation backdrop became gilt-unfriendly and growth surprised on the upside. Now, with momentum moving from overbought to oversold over just a couple of months, any negative economic surprises could potentially weigh on gilt yields. The model has added this asset class to the portfolio (Chart 15). Chart 14Italian Bond Yields and Risk bca.gis_taami_2016_10_28_c14 bca.gis_taami_2016_10_28_c14 Chart 15U.K. Bond Yields And Risk bca.gis_taami_2016_10_28_c15 bca.gis_taami_2016_10_28_c15 A more hawkish Fed could push the dollar higher. The 13-week momentum measure for the USD remains above, but close to the neutral line. The recovery of the 40-week rate of change from mildly negative levels which have represented a floor since 2012 would suggest that a new leg in the dollar bull market is in the offing (Chart 16). Both the 13-week and 40-week momentum measures for the euro are below the neutral line (Chart 17). Growing monetary divergences could continue weighing on EUR/USD before the technical indicators are pushed into more oversold territory. Fears of hard Brexit knocked down the pound. The 13-week rate of change is now close to its post-Brexit lows, while the 40-week rate of change measure is at the most oversold level since 2000 (excluding the great recession). At these technical levels the pound seems overdue to find a temporary bottom (Chart 18). Chart 16U.S. Trade-Weighted Dollar* bca.gis_taami_2016_10_28_c16 bca.gis_taami_2016_10_28_c16 Chart 17Euro Euro Euro Chart 18Sterling Sterling Sterling Miroslav Aradski, Senior Analyst miroslava@bcaresearch.com

Highlights ECB Monetary Policy: Euro Area inflation will likely remain below the European Central Bank (ECB) 2% target for the next few years due to persistent excess capacity in Europe. The ECB will signal this at the December monetary policy meeting, providing the justification to extend their quantitative easing (QE) asset purchase program beyond the current March 2017 expiration date. ECB QE Changes: The constraints imposed on the ECB's bond purchases are self-imposed, and can be easily altered in the event of potential "shortages" of available debt for the QE program. Fears of a potential taper of ECB buying because of those constraints, which have bearish implications for Euro Area bond yields, are overstated. Country Allocation: Move to an above-benchmark stance on core European government debt, which are a low-beta safe haven in the current environment of a cyclical rise in global bond yields. Feature After spending the past couple of months fretting over the next move by the U.S. Federal Reserve or the Bank of Japan, investors' attention shifted to Europe last week. With the current European Central Bank (ECB) government bond quantitative easing (QE) program set to expire in March of next year, the markets were seeking any sort of guidance on whether the ECB will end the program as scheduled, or extend the program beyond March - perhaps with a reduction ("taper") in the size of the bond buying. ECB President Mario Draghi provided no new information at the post-meeting press conference last Thursday, leaving bond investors in limbo until the December meeting when the results of the ECB's assessment of their QE program will be published. Some alterations of the program will likely be announced, but it is too soon for the ECB to consider ending their QE program. With regards to the title of this Weekly Report - the most likely outcome is that the ECB will extend the QE program past March 2017, but will tinker with the rules of QE in an effort to pretend that the central bank is still following a prudent logic for its purchases. Fears of an early taper are overstated, and this makes core European government debt a potential oasis of safety while global bond yields remain in a bear phase. Plenty Of Reasons For The ECB Not To Taper This talk of a tapering of ECB asset purchases following the scheduled end of the current QE program seems premature. After all, neither the ECB's own economic forecasts, nor those of its Survey of Professional Forecasters, are calling for inflation to get close to the 2% target until at least 2018 (Chart of the Week). The ECB staff will prepare a new set of forecasts for the December policy meeting that will include projections for 2019 - perhaps these new estimates will have inflation finally reaching the 2% goal. But in the absence of a credible forecast of inflation returning to target, the ECB will be hard pressed to signal any move to a less-accommodative monetary policy. Headline Euro Area inflation is currently only 0.4%, despite a recent increase in the oil price denominated in Euros, which has been a reliable directional indicator for Euro Area inflation (Chart 2). Chart of the WeekNo Need For An ECB Taper bca.gfis_wr_2016_10_25_c1 bca.gfis_wr_2016_10_25_c1 Chart 2European Inflation Is Stubbornly Low bca.gfis_wr_2016_10_25_c2 bca.gfis_wr_2016_10_25_c2 The steady decline in the Euro Area unemployment rate over the past three years has coincided with a move higher in overall labor compensation, but this has been purely a "volume" effect resulting from steadily increasing employment growth. With the entire region not yet at full employment, there has been minimal upward pressure on wages or inflation in domestically focused sectors like services (bottom panel). In other words, the lack of Euro Area inflation is a direct function of the excess capacity in Euro Area product and labor markets. According to the IMF, the Euro Area output gap will not close until 2020, which will limit any rise in inflation over the rest of the decade (Chart 3). It will take a more prolonged period of above-trend economic growth to close the output gap, reducing the Euro Area unemployment rate below the full employment NAIRU level, before any recovery in wages or core inflation can take place (bottom panel). This lack of realized inflation is weighing on Euro Area inflation expectations and creating some potential credibility problems for the ECB. As we have discussed in earlier Weekly Reports, inflation expectations in much of the developed economies seem to follow an "adaptive" process, where expectations are formed in lagged response to actual inflation.1 If central banks are fully credible in their ability to use monetary policy to fight inflation (and demand) shortfalls, then those forward-looking expectations should eventually gravitate towards the central bank inflation target. However, if there is a large and persistent shock to realized inflation, then inflation expectations can deviate from the central bank target for an extended period. Using a 5-year moving average of realized headline CPI inflation as a proxy for inflation expectations is a reasonably good (albeit simple) approximation of this adaptive process (Chart 4). The current 60-month moving average for Euro Area headline inflation is 0.6%, not far from the 5-year Euro Area CPI swap rate of 0.9%. However, if the ECB's inflation forecasts for the next two years come to fruition (1.2% in 2017, 1.6% in 2018), then the 5-year moving average will continue to decline, as those higher inflation figures would not offset the sharp fall in inflation witnessed over the past few years. Chart 3Excess Capacity Holding Inflation Down bca.gfis_wr_2016_10_25_c3 bca.gfis_wr_2016_10_25_c3 Chart 4Inflation Expectations Will Stay Low bca.gfis_wr_2016_10_25_c4 bca.gfis_wr_2016_10_25_c4 Simply put, the ECB's current projections are not consistent with inflation expectations hitting the 2% target by 2018, and likely even beyond that. The ECB will be presenting new projections in December, but it would take a significant upgrade of their growth and inflation forecasts to "move the needle" on longer-term inflation expectations. Perhaps a move away from fiscal austerity across the Euro Area could trigger an upgrade on growth expectations, as that would imply a faster pace of growth and a more rapidly narrowing output gap. However, while the topic of greater fiscal spending has been heating up in the halls of governments in Washington, London and Tokyo, there has been little sign that Euro Area governments are about to open the fiscal spigots anytime soon (and certainly not before elections in Germany and France in 2017). Chart 5European Banks Getting More Cautious? European Banks Getting More Cautious? European Banks Getting More Cautious? ECB Still Needs To Support Loan Growth The state of Euro Area banks, and what it means for future lending activity, is another factor for the ECB to consider before contemplating any move to a less-accommodative monetary policy. The current growth rates of money and credit are showing no signs of significant deceleration (Chart 5). The latest ECB Euro Area bank lending survey, released last week, did show a modest decline in the net number of banks reporting easier lending standards to businesses, as well as a reduction in the number of banks reporting increasing loan demand from firms. The ongoing hit to European bank profitability from the current negative interest rate environment could be playing a role in the banks moving to a less easy environment for lending. As can be seen in the bottom panel of Chart 5, there is a reliable leading relationship between Euro Area bank equity prices and the growth in bank lending to businesses. The downturn in Euro Area bank stocks in 2016, which has been driven by declining profit expectations, could pose a risk to credit growth in the months ahead. According to a special question asked within the ECB's bank lending survey, a net 82% of respondents reported that the ECB's negative deposit rate has damaged banks' net interest income over the past six months.2 In that same survey, a net 12% of banks reported a boost to loan demand from the ECB's negative interest rate policy, and a net 15% of banks reported that the additional liquidity provided by the ECB bond purchases went towards extending loans to businesses. So while negative interest rates may be hurting bank profit margins, the impact of the ECB's QE is helping offset that to some degree by providing banks with capital gains on their bond portfolios that can be used to finance lending. So without any sign that inflation will soon approach the ECB's target, thus requiring a potential tapering of QE or even a move away from negative interest rates, the prudent course for the ECB to take to support Euro Area credit demand, and economic growth, is to continue with the QE program beyond the March 2017 expiration date. That will require some changes to the ECB's rules of the program, but, in the end, these are only self-imposed constraints. Bottom Line: Euro Area inflation will likely remain below the ECB 2% target over the next few years due to persistent excess capacity in Europe. The ECB will signal this at the December monetary policy meeting, providing the justification to extend their quantitative easing asset purchase program beyond the current March 2017 expiration date. The ECB Has Some Policy Options To Avoid A Taper Tantrum Core European bond yields have been depressed by the ECB's QE program, which have acted to push down both the future expected path of interest rates and the term premium (Chart 6). This has helped anchor real bond yields in negative territory, even with inflation expectations at such low levels. But any signs of potential slowing of the pace of QE buying could quickly unwind this effect, which makes the ECB's next steps so critical for the path of global bond yields. In Chart 7, we show the level and growth rate for the ECB's monetary base, along with five potential future scenarios: The ECB ends their QE program in March 2017, as currently planned; The ECB extends QE for six months to September 2017, at the current pace of €80bn in bond buying per month; The ECB extends QE program for twelve months to March 2018, at a pace of €80bn per month; The ECB extends QE to September 2017, but reduces the pace of purchases to €60bn per month; The ECB extends QE to March 2018, but cuts to €60bn per month. Chart 6ECB QE Still Holding Down Yields bca.gfis_wr_2016_10_25_c6 bca.gfis_wr_2016_10_25_c6 Chart 7ECB Needs To Keep The Monetary Base Growing bca.gfis_wr_2016_10_25_c7 bca.gfis_wr_2016_10_25_c7 As can be seen in the bottom panel of Chart 7, the growth rate of the ECB's monetary base (and the asset side of their balance sheet) will decelerate sharply in 2017 & 2018 if the ECB does end the QE program as scheduled next March. Extending the program, however, does push out the rapid deceleration phase for monetary base into 2018. This is of critical importance for the Euro Area bond market, as both the outright level and term premium component of German Bund yields have been broadly correlated with the growth rate of the monetary base (Chart 8). In other words, extending the ECB QE program into the future is most important to prevent a "taper tantrum" in European bonds, by signalling to the markets that the ECB wishes to maintain low interest rates for longer. The ECB could even announce a reduction in the pace of purchases, along with an extension, and bond yields should remain well-behaved. This will also help prevent an unwanted appreciation of the Euro, the value of which currently reflects the far easier monetary stance in Europe (Chart 9). Chart 8An ECB Taper Would Be Bad For Bunds An ECB Taper Would Be Bad For Bunds An ECB Taper Would Be Bad For Bunds Chart 9An Easy-For-Longer ECB Will Weigh On The Euro bca.gfis_wr_2016_10_25_c9 bca.gfis_wr_2016_10_25_c9 Given the persistent debates within the ECB (and between the ECB and some Euro Area governments) about the long-run merits of QE, the combination of both an extension and reduction in QE purchases could be the compromise option that satisfies all parties. Alternatively, the ECB could choose to maintain the pace of bond purchases but alter the selection rules governing the program. Given the recent concerns in bond markets that the ECB is "running out of bonds to buy", changing the rules of the QE program is a sensible way for the central bank to free itself from the self-imposed shackles on its bond purchases. There are three options that the ECB can consider: Moving away from strictly allocating the bond purchases according to the ECB "capital key", which essentially weights the bond purchases by the size of each economy; Raising the issuer limits on QE, which limits the ECB to holding no more than 33% of any single issuer or individual bond issue; Reducing the current yield floor on QE, which prevents the ECB from buying any bonds with yields below the ECB deposit rate, which is currently -0.4%; We think option 1 is the least likely to occur, as this would imply buying a greater share of countries with more problematic debt profiles, like Italy or Portugal. There is little chance of such a strategy being well received by the governments in Berlin and Brussels, and the ECB would likely wish to avoid a major political confrontation by allowing larger deviations from the capital key Option 2 is an easier solution to implement. The 33% issuer constraint was always an arbitrary level that was aimed more at bonds with so-called "collective action clauses", where a majority of bondholders can force a decision on all bondholders in the event of a debt restructuring. It is understandable why the ECB would not want to become to decision-making counterparty in the event of a future messy bond restructuring in Europe. However, the ECB's ownership percentages within each Euro Area country are nowhere near the 33% limit at the moment (Chart 10) and, at the current pace and composition of buying, that 33% limit will not even be reached for Germany anytime soon.3 There is room for the ECB to raise the issuer limits, as it has already done for some other parts of its asset purchase programs, like bonds issued by European Union supranationals.4 Chart 10ECB Holdings Are Far From The 33% Issuer Limit The ECB's Next Move: Extend & Pretend The ECB's Next Move: Extend & Pretend Chart 11Lowering The Yield Floor For QE Makes Sense The ECB's Next Move: Extend & Pretend The ECB's Next Move: Extend & Pretend Option 3 is the most binding constraint of all on the ECB purchases, as very large shares of the European government bond market are now trading below the ECB's -0.4% deposit rate (Chart 11). In the case of Germany, nearly 70% of all QE-eligible debt is trading below the ECB's yield floor, which has raised investor concerns that the ECB will soon be unable to buy enough German debt at the current pace of purchases. However, that yield floor constraint is completely arbitrary - there is nothing stopping the ECB from buying bonds trading at a yield below the deposit rate, other than (we suspect) a desire to impose some sort of price discipline on the QE buying to make the ECB appear more credible with its purchases. Chart 12The QE Yield Floor Can Be Changed The ECB's Next Move: Extend & Pretend The ECB's Next Move: Extend & Pretend If the ECB decided to lower the yield floor below the current -0.4% deposit rate, this would open up a greater share of the core European bond markets to QE buying (Chart 12). This would also change the current market narrative that the ECB will soon run out of German bonds to buy. In the end, the most likely path the ECB will take following its December re-assessment of its QE program is a combination of lowering the yield floor on QE bond purchases below -0.4% and raising the issuer limits above 33%. There appears to be plenty of leeway for the ECB to alter their purchases, but without necessarily reducing the monthly pace of buying. Combined with an extension of the end-date of the QE program beyond March, this should alleviate any concerns that the ECB will soon hit a wall with its asset purchases. Bottom Line: The constraints imposed on the ECB's bond purchases are self-imposed, and can be easily altered in the event of potential "shortages" of available debt for the QE program. Fears of a potential taper of ECB buying because of those constraints are overstated. Investment Implications: Move To An Above-Benchmark Stance On Core European Bonds With the ECB having no need to end its QE program early, the case for moving to an overweight stance on core Europe is a strong one. As we noted in our last Weekly Report, favoring bond markets of countries with the lowest inflation rates is a logical investment strategy in the current environment of a modest cyclical upturn in global growth and inflation.5 That justifies our current below-benchmark recommendation on U.S. and U.K. government debt, as both realized inflation and expected inflation are rising in both countries. That leaves the Euro Area and Japan as possible candidates to move to above-benchmark weightings, given their defensive properties as low-beta bond markets. Although with the Bank of Japan now pegging the Japanese government bond (JGB) yield curve with a 10-year yield at 0%, we do not see a compelling investment case for overweighting JGBs as a defensive trade. If an investor wants safety at a 0% yield - with no chance of a capital gain from a decline in yields - than owning T-bills, or even gold, is just as viable as owning JGBs. We recently upgraded Japan to neutral in our recommended portfolio allocation, and we see no reason to move from that. Thus, core European bonds stand out as the candidate to upgrade as a defensive trade during the current bond bear phase, which we expect will continue until at least December when the Fed is expected to deliver another rate hike in the U.S. We see a case for moving to above-benchmark for both Germany and France, but especially so in the latter. The beta of bond returns between France and both the U.S. (Chart 13) & U.S.(Chart 14) is very low, making French bonds a good market to favor at the expense of U.S. Treasuries and U.K. Gilts in currency-hedged bond portfolios. Chart 13French Bonds Are Low Beta To USTs... French Bonds Are Low Beta To USTs... French Bonds Are Low Beta To USTs... Chart 14...And To U.K. Gilts bca.gfis_wr_2016_10_25_c14 bca.gfis_wr_2016_10_25_c14 Bottom Line: Move to an above-benchmark stance on core European government debt, which are a low-beta safe haven in the current environment of a cyclical rise in global bond yields. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "Why Are Global Inflation Expectations Still So Low", dated March 1, 2016, available at gfis.bcaresearch.com. 2 The Q4 2016 ECB Euro Area Bank Lending Survey can be found at https://www.ecb.europa.eu/stats/pdf/blssurvey_201610.pdf. 3 Please note that the denominator in the percentages shown in Chart 10 include only bonds with maturities that are eligible for ECB QE purchases, omitting bonds that will mature in less than 2 year and more than 30 years. 4 For more details on that change to the supranational issuer limits, please see https://www.ecb.europa.eu/mopo/implement/omt/html/pspp-qa.en.html. 5 Please see BCA Global Fixed Income Strategy Weekly Report, "Return Of The Bond Vigilantes", dated October 18, 2016, available at gfis.bcaresearch.com. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index The ECB's Next Move: Extend & Pretend The ECB's Next Move: Extend & Pretend Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns