Inflation/Deflation

Highlights Duration: Investor optimism about U.S. growth and inflation will return in the coming months. Remain at below-benchmark duration and enter a short position in the July fed funds futures contract. Close short positions in the January contract for a small gain. Credit Spreads: Spreads are at risk of widening as Fed rate hike expectations ramp up in the second half of the year, though we would be inclined to view a Fed-driven back-up in spreads as a buying opportunity. Bank Bonds: Banks continue to shore up their balance sheets and are likely to see rising profits in the coming months. Bank bonds also offer a spread advantage compared to other similarly risky sectors. Feature Chart 1Synchronized Global Selloff Synchronized Global Selloff Synchronized Global Selloff The bond selloff is now two weeks old. What began as a reaction to perceived hawkish policy shifts from central banks outside of the U.S. - the European Central Bank in particular - is now morphing into a selloff built on optimism about U.S. growth. Needless to say, we think the recent bearish price action has further to run. Global participation makes it more likely that the weakness in U.S. Treasuries will persist because it prevents the dollar from strengthening as yields move higher (Chart 1). In recent years, most U.S. bond selloffs have been met with an appreciating exchange rate. The stronger dollar then caused investors to lower their U.S. growth expectations, and capped the upside in yields. We view the dollar's current stability as a bearish signal for U.S. bonds. But it has not just been non-U.S. factors driving the uptrend in yields. Last week's positive ISM and employment figures are ushering in renewed optimism about U.S. growth. We also think that U.S. growth is poised to bounce back in the second half of the year, and the Fed is inclined to agree. The Fed's median projection calls for one more 25 basis point rate hike before the end of the year, and we also expect the committee to announce the run-off of the balance sheet in September. With the market still only priced for 15 bps of hikes between now and year-end, there remains scope for further upside surprises. Of course, this forecast for balance sheet run-off in September and another rate hike in December hinges on a second-half snapback in growth, continued strength in labor markets and a rebound in core inflation. Growth Is On The Way Although GDP growth averaged just 1.75% during past two quarters, all signs suggest that the next two quarters will be much stronger. As was mentioned above, both the manufacturing and non-manufacturing ISM surveys delivered strong readings in June. The manufacturing ISM came in at 57.8 and the non-manufacturing survey came in at 57.4, both signal stronger GDP growth in the coming months (Chart 2). The crucial new orders-to-inventories figure calculated from the manufacturing survey is also displaying remarkable strength (Chart 2, bottom panel). We can also infer the current trend in growth from the employment and productivity data. In fact, aggregate hours worked - a combination of total employment and average weekly hours - plus labor productivity growth is more or less equivalent to GDP (Chart 3). After last week's payrolls report, aggregate hours worked are now growing at 1.99% year-over-year. If we combine that growth rate with quarterly productivity growth of 0.7%, the average since 2012, we get a tracking estimate of just below 2.7% for GDP growth. The Atlanta Fed's GDPNow model also currently expects that second quarter growth will be 2.7%. Chart 2PMIs Point To Stronger Growth... PMIs Point To Stronger Growth... PMIs Point To Stronger Growth... Chart 3...As Does The Labor Market ...As Does The Labor Market ...As Does The Labor Market Labor Markets: Watching The Participation Rate Last week's jobs report showed that the economy added 222k jobs in June, and that the prior two months were also revised higher. This pushed the 3-month moving average up to +180k jobs per month, right in line with the +187k jobs per month averaged in 2016. However, despite robust payroll gains, the unemployment rate actually ticked higher in June. This is because many previously sidelined workers re-entered the labor force, pushing the labor force participation rate up to 62.8%. Going forward, for the Fed to have confidence that wage growth and inflation will continue to rise, the unemployment rate will have to remain under downward pressure (Chart 4). As long as the labor force participation rate remains flat (or declines) this should be relatively easy to achieve. We calculate that the economy needs to add just above 117k jobs per month for the unemployment rate to continue falling. However, if we assume a higher labor force participation rate of 63.2%, we would need to add 195k jobs per month, a much higher hurdle.1 We detailed the main drivers of the labor force participation rate in a recent report,2 and while we do not see much potential for a significant increase in the participation rate, its trend is critical for the monetary policy outlook and should be monitored closely going forward. Inflation: Is The Fed Too Sanguine? The most important question for policymakers is whether inflation will rebound in the second half of the year. While the Fed will probably start winding down its balance sheet in September no matter what, another rate hike in December is likely contingent on core inflation showing some signs of strength in the next few months. We have previously written3 that if the Fed were to proceed with a December rate hike in the face of low and falling inflation, the market would start to price in a "policy mistake" scenario. The yield curve would flatten, credit spreads would widen, TIPS breakevens would narrow and long-dated Treasury yields could even decline. However, we do expect that core inflation will trend higher in the coming months, mostly driven by strength in the core services (excluding shelter and medical care) component. That component is historically the most sensitive to tight labor markets and rising wage growth (Chart 5). Chart 4Falling Unemployment Rate = ##br##Rising Inflation Falling Unemployment Rate = Rising Inflation Falling Unemployment Rate = Rising Inflation Chart 5A Boost From Import##br## Prices Is Coming A Boost From Import Prices Is Coming A Boost From Import Prices Is Coming Although it is unlikely to be a long-run driver of inflation, the core goods component also has some upside in the coming months in response to recent dollar weakness and rising non-oil import prices (Chart 5, bottom 2 panels). Investment Strategy Chart 6Too Few Hikes In The Price Too Few Hikes In The Price Too Few Hikes In The Price We think U.S. growth and inflation are poised to snap back during the second half of the year, probably by enough for the Fed to deliver another hike before year-end. We therefore continue to recommend that investors maintain below-benchmark portfolio duration. We have also been advising clients to hold short positions in the January 2018 fed funds futures contract since March 21.4 That contract is now priced for the fed funds rate to increase 15 bps between now and the end of the year. Given that even an optimistic economic scenario would likely only result in a 25 bps increase in the funds rate, there is not much potential for further gains in this trade. We close this position, booking a small profit of +1 bp. Looking further out, we now see an attractive opportunity to short the July 2018 fed funds futures contract. That contract is currently priced for 32 bps of rate hikes between now and next June (Chart 6), and would therefore turn a profit in the event of two or more rate hikes during that timeframe. Bottom Line: Investor optimism about U.S. growth and inflation will return in the coming months. Remain at below-benchmark duration and enter a short position in the July fed funds futures contract. Close short positions in the January contract for a small gain. Credit Spreads: When Good News Is Bad News Chart 7High Risk Of A Near-Term Selloff High Risk Of A Near-Term Selloff High Risk Of A Near-Term Selloff Renewed optimism on U.S. growth and inflation could ironically pose a problem for credit spreads, at least in the very short term. As we have often discussed in the context of our Fed Policy Loop,5 hawkish shifts in Fed policy tend to result in wider credit spreads and tighter financial conditions more broadly. Fortunately, these periods are usually short lived. Once financial conditions tighten, the Fed backs away from its hawkish stance, allowing financial conditions to ease once again. An extreme example of this dynamic is the 2014/15 selloff in credit markets. Of course, the plunge in oil prices and related stress in the energy sector was the chief catalyst, but what is often overlooked is that Fed rate hike expectations were also quite elevated during that period (Chart 7). It is the combination of stress in the energy sector and unsupportive Fed policy that resulted in the prolonged rise in spreads. A more benign example is the price action from this past March. Junk spreads widened from 344 bps on March 2 to 406 bps on March 22, as rate hike expectations ramped up heading into the March FOMC meeting. Ultimately, this period of spread widening represented a buying opportunity in credit markets. It is a March 2017 style selloff that we see as quite likely in the coming months as growth recovers by just enough to give the Fed cover for another rate increase. Bottom Line: Credit spreads are at risk of widening as Fed rate hike expectations ramp up in the second half of the year. But with inflation and inflation expectations still well below target, the Fed will ultimately be forced to remain supportive. We would therefore view any period of Fed-driven weakness in credit markets as a buying opportunity. Bank Bonds: Still A Strong Buy The Federal Reserve released the results of its annual bank stress tests last month and for once it did not object to the capital plans of any of the 34 participating bank holding companies, a recognition of the fact that banks have dramatically boosted their capital ratios since the first round of stress tests in 2009 (Chart 8). For the most part bank profit growth has also outpaced debt growth during this period, with the exception of last year when profit growth turned negative and debt growth surged (Chart 8, panel 2). A large portion of last year's increase in debt growth was likely a response to the new Total Loss Absorbing Capital (TLAC) regulations which require banks to issue a specified minimum amount of securities that can be easily written off in case of bankruptcy. This includes capital and long-term unsecured debt. Regardless, bank debt growth has already fallen back close to zero and we see upside for bank profits in the next 6-12 months. Meanwhile, non-financial corporate profits have had a much more difficult time outpacing debt growth in recent years (Chart 8, bottom panel). Bank Profits On The Rise A number of forward looking loan growth indicators suggest that credit and capital formation are on an upward trajectory (Chart 9). Our U.S. Equity Strategy service's proprietary Capex Indicator,6 consumer and business confidence, manufacturing new orders and our own C&I loan growth model all point to accelerating loan growth in the coming months. Net interest margins also have scope to widen. A recent blog post from the Federal Reserve Bank of New York7 showed that net interest margins are sensitive to both the level of interest rates and the slope of the yield curve (Chart 10). Lower rates and a flatter curve have both compressed margins in recent years. In addition, net interest margins tend to narrow when banks take less risk on the asset side of their balance sheets, we proxy this by showing banks' risk-weighted assets as a percent of total assets (Chart 10, bottom panel). Chart 8Bank Health Still Improving Bank Health Still Improving Bank Health Still Improving Chart 9Loan Growth Will Accelerate Loan Growth Will Accelerate Loan Growth Will Accelerate Chart 10A Higher, Steeper Curve Will Help NIMs A Higher, Steeper Curve Will Help NIMs A Higher, Steeper Curve Will Help NIMs Going forward, higher rates and a steeper yield curve8 will apply widening pressure to net interest margins. Similarly, risk-weighted assets have already risen considerably as a fraction of total assets and will increase further as the Fed starts to drain reserves from the banking system. Bank Bonds Are Still Cheap The truly remarkable thing is that even though banks have been raising capital while the non-financial sector has been taking on leverage, bank spreads still look attractive compared to most non-financial sectors after adjusting for credit rating and duration (Chart 11). This is true for both senior and subordinated bank debt. As can be seen in Chart 11, senior bank debt has a low duration-times-spread (DTS) compared to the overall index. This means that it acts as a "low-beta" sector, underperforming the investment grade benchmark during rallies and outperforming during selloffs. Conversely, subordinate bank bonds are a high-DTS sector. They tend to outperform during rallies and underperform during selloffs (Chart 12). Chart 11Corporate Sector Risk Vs. Reward* Summer Snapback Summer Snapback LegendCorporate Sector Abbreviations Summer Snapback Summer Snapback Chart 12Add "Beta" With Subordinate Bank Debt Add "Beta" With Subordinate Bank Debt Add "Beta" With Subordinate Bank Debt While we strongly recommend grabbing the extra spread available in both senior and subordinate bank debt relative to other similarly risky alternatives, subordinate bank bonds look particularly attractive in the current environment. This is because they both add some pro-cyclical risk ("beta") to a corporate bond portfolio and offer a spread advantage compared to other similarly risky bonds. Bottom Line: Banks continue to shore up their balance sheets and are also likely to see rising profits in the coming months. Meanwhile, bank bonds still offer a spread advantage compared to other similarly risky sectors. Remain overweight both senior and subordinate bank debt. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 These calculations assume population growth of 0.08% per month, or 1% per year. 2 Please see U.S. Bond Strategy Weekly Report, "Three Scenarios For Treasury Yields In 2017", dated June 20, 2017, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Three Scenarios For Treasury Yields In 2017", dated June 20, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Equity Strategy Weekly Report, "Unfazed", dated June 12, 2017, available at uses.bcaresearch.com 7 http://libertystreeteconomics.newyorkfed.org/2017/06/low-interest-rates-and-bank-profits.html 8 For further details on the case for a bear-steepening yield curve please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Near record high levels for stocks are not an impediment to gains in the stock-to-bond ratio in the next 12 months. Minutes from June's FOMC meeting confirmed that policymakers agree that monetary policy should continue to normalize in the coming quarters. None of the main indicators that have provided some leading information in the past are warning of an equity bear market. Solid ISM and industrial production readings herald bullish profit growth in the second half the year. Treasury yields are headed higher in 2017, supporting our stocks over bond view. Within the U.S. bond market, we prefer short over long duration and investment-grade and high-yield bonds over high-quality debt; MBS will be hurt more than Treasuries as the Fed pares its balance sheet. Feature U.S. stocks will continue to reach all-time highs if inflation remains low, the economic backdrop fosters EPS growth and the Fed only gradually raises rates. We expect these conditions to stay in place in the second half of 2017 and into 2018, allowing stocks to outrun bonds. We note below that neither valuations nor technicals are flashing a red warning sign. Chart 1 shows that most of the time, even when equities are at record highs, valuations are above average (but not extreme) and the Fed is slowly removing accommodation, stocks can still rise. Moreover, none of the indicators that provided leading information in the past now warn of an equity bear market. Chart 1Macro Conditions Favorable For More Gains In Equities Macro Conditions Favorable For More Gains In Equities Macro Conditions Favorable For More Gains In Equities Chart 2Labor Market Strong But Wages Still Stagnant Labor Market Strong But Wages Still Stagnant Labor Market Strong But Wages Still Stagnant The June jobs report suggests that the environment of solid economic growth and still muted wage pressures remains in place, a positive backdrop for equity markets. The report showed that the economy added 222,000 jobs in June, well above the consensus forecast of 178,000. Prior months were also revised higher by 47,000 pushing the 3-month moving average up to 180,000 jobs per month. This is right in line with the 187,000 jobs per month averaged in 2016. Despite robust payroll gains, the unemployment rate actually ticked higher in June, from 4.3% to 4.4%, as previously sidelined workers were drawn back into the labor force. Meanwhile, wage growth continues to underwhelm, rising only 0.2% in June with the year-over-year growth rate holding steady at 2.5%. The deceleration in the 3 month change in average hourly earnings from 2.7% in December 2016 to 1.9% in June challenges the Fed's view on inflation (Chart 2). The recent moderation in wage growth is not yet severe enough to prevent the Fed from delivering one more rate hike before year-end. However, if the labor force participation rate continues to increase, and especially if this increase occurs alongside a rising unemployment rate, then the Fed's forecast of gradually accelerating wages will come into question. Fed Minutes: No Change To Our Base Case Minutes from June's FOMC meeting show that the debate among policymakers over monetary policy centers on the timing and pace of normalization in the coming quarters. The minutes did not provide any new insight about the Fed's plans to shrink its balance sheet. This will be done using caps on the monthly amount of principal repayments from the Fed's security holdings that will not be rolled over. These caps will rise over time on a pre-set path. The FOMC is still debating the timing of the start of this process. The FOMC was reasonably pleased with the tone of recent economic data, which support the view that GDP has bounced back from a soft patch in the first quarter. The June manufacturing and services ISM surveys, released since the FOMC meeting, undoubtedly reinforced policymakers' confidence in the underlying growth trajectory (see below for more details). The FOMC participants discussed at length the recent pullback in core measures of consumer price inflation. Most policymakers are willing for the time being to believe that inflation is driven primarily by temporary one-off factors. Others are worried that it will be more enduring. The moderation in three-month rates of change of prices this year was widespread across sectors of the CPI (i.e. it is not merely the result of one-offs). Inflation according to the Fed's favored measure, the core PCE price index, has also moderated this year although the disinflation has not been as broadly based as in the CPI (Chart 3). Much of the FOMC's debate focused on the relationship between labor market tightness and inflation. The doves want to see inflation rise closer to the 2% target before tightening even more. The hawks worry that the relationship could be non-linear, which means that a further undershoot of unemployment below estimates of full employment could suddenly generate a surge in inflation. At a minimum, an undershoot could boost risks to financial stability by promoting excess risk-taking in the financial markets. The minutes reveal that the worries about the impact of easing financial conditions on financial stability have intensified since the start of the year. Inflation forecasting has been particularly tricky since the Great Recession for both the Fed and other economic prognosticators. Admittedly, it is difficult to explain the sudden and broadly-based inflation deceleration, even in sectors that have nothing to do with oil prices, shifts in the currency or wage growth. That said, the model shown in the top panel of Chart 4 suggests that core CPI inflation will edge higher in the coming months. This reflects the acceleration in ECI wage growth (feeding into higher core services inflation) and in core goods inflation (reflecting rising import prices), which more than offset the slight moderation in our projection for shelter inflation. Chart 3Inflation Readings Must##BR##Improve In Next Few Months Inflation Readings Must Improve In Next Few Months Inflation Readings Must Improve In Next Few Months Chart 4Core CPI Should Edge Higher##BR##In Coming Months Core CPI Should Edge Higher In Coming Months Core CPI Should Edge Higher In Coming Months Bottom Line: The minutes did not change our base case outlook; the FOMC will announce in September that it will begin to shrink the Fed's balance sheet shortly thereafter. The next rate hike will occur in December. Nonetheless, this forecast hangs importantly on the assumption that core inflation edges higher in the coming months. We think it will, but uncertainty is high. Monitoring The Bear Market Barometer The FOMC's seeming determination to stick with the current tightening timetable raises question marks over the equity market, especially given elevated valuations. Chart 5Equity Bear Market Indicators Equity Bear Market Indicators Equity Bear Market Indicators BCA's Chief Economist, Martin Barnes, highlighted the best "equity bear market" indicators to watch in a 2014 Special Report1. He noted that no two bear markets are the same and that there are no indicators that have reliably heralded bear phases. Nonetheless, there are some common elements. The safest time to invest in the market is when monetary conditions are favorable, there are no signs of a looming economic downturn, extreme overvaluation is not present and technical indicators are not flashing red. Some indicators related to each of these fundamental factors are shown in Chart 5: Monetary Conditions: The yield curve is flat by historical standards, but it is far from inverted. Moreover, real short-term interest rates are usually substantially higher than today, and above 2%, when bear markets commence. Excess liquidity, which we define as M2 growth less nominal GDP growth, is also well above the zero line, a threshold that in the past has warned of a downturn in stock prices. Valuation: Our composite valuation indicator is still shy of the +1 standard deviation level that defines over-valued. However, this is due to the components that compare equity prices to bond yields. The other three components of the equity indicator, which are unrelated to bond yields, suggest that stock valuation is stretched. Economic Outlook: Economic data, such as the leading economic indicator and ISM, have been unreliable bear market signals. We do not see anything that indicates that a recession is on the horizon. U.S. growth will remain above-trend in the second half of the year based on its relationship with financial conditions. Technical Conditions: Sentiment is elevated, which is bearish from a contrary perspective. However, breadth, the deviation from the 40- week moving average and our composite technical indicator, all are not flashing red. Earnings: Trends in earnings and margins did not provide any additional reliable signals for timing equity market downturns in the past. Still, it is a bad sign when EPS growth tops out. This is often preceded by a peak in industrial production growth. We expect EPS growth to continue to accelerate for at least a few more months, but we are closely watching industrial production. Bottom Line: The equity market is vulnerable to unforeseen shocks given stretched valuation. Nonetheless, none of the indicators that have provided leading information in the past warn of an equity bear market. ISM Above 50 Supports 2H Profit Outlook The elevated level of ISM sets the stage for EPS growth to gather speed in the second half of 2017. Industrial production is a good proxy for sales of S&P 500 companies (Chart 6). A rollover in the 12-month change in IP would challenge our view. However, strong readings on the ISM, which tracks IP, suggest that IP should accelerate in the next six months (Chart 6, panel 1). Chart 6Solid Backdrop For Earnings And Sales Solid Backdrop For Earnings And Sales Solid Backdrop For Earnings And Sales At 57.8 in June, the ISM has rebounded from the recent low of 47.9 in 2015. Investors wonder if it will roll over again or simply fluctuate at a high level. The leading components of ISM, including the new orders index and the new orders-to-inventory ratio, indicate that the ISM will remain above 50 in the months ahead (Chart 7). Moreover, the new export orders component of the ISM has also surged. The implication is that foreign demand (rather than domestic consumer or business spending) is leading the U.S. manufacturing sector. In fact, the 3- and 12-month change in the industrial production indices in advanced economies outside the U.S. have outpaced domestic growth (Chart 8). Chart 7IP Poised To Accelerate IP Poised To Accelerate IP Poised To Accelerate Chart 8U.S. IP Lagging Other Developed Markets U.S. IP Lagging Other Developed Markets U.S. IP Lagging Other Developed Markets Bottom Line: Firm readings on ISM are an indication that our bullish profit story for 2017 remains intact. Stay overweight stocks versus bonds. Inflection Point The increase in Treasury yields since late June indicates that growth expectations had become overly pessimistic. Our assessment is that U.S. growth will remain above trend for the rest of 2017. The implication for investors is that Treasury bond yields will move higher, the yield curve will bear-steepen, and that credit will outperform Treasuries in the second half of 2017. Moreover, we expect MBSs to underperform. According to our U.S. Bond Strategy service2, Treasury yields are poised to follow the economic surprise index higher in the coming months. Extreme net long positioning in the futures market supports the view. The current reading from our 2-factor Treasury model (which is based on Global PMI and dollar sentiment) places fair value for the 10-year Treasury yield at 2.52%. Our 3-factor version of the model, which also includes the Global Economic Policy Uncertainty Index, places fair value at 2.45% (Chart 9). Investors should continue to position for a steeper curve by favoring the 5-year bullet versus a duration-matched 2/10 barbell. Small positive excess returns, consistent with carry, remain the most likely scenario for investment- grade credit, where we recommend an overweight. We do not see the potential for much spread tightening from current levels. However, a large spread widening would be equally unlikely given the favorable backdrop of steady growth and muted inflation. We recommend an overweight in the high-yield market. We expect the decline in the 12-month trailing speculative default rate to continue for the rest of the year, aided by a moderation in energy sector defaults (Chart 10, bottom panel). This means that the current compensation offered by junk spreads in excess of expected default losses stands at 221 bps, in line with its historical average (Chart 10, panel 3). In last week's Weekly Report3 our U.S. Bond Strategy team showed that a default-adjusted spread of 221 bps is consistent with excess returns close to 150 bps during the next 12 months. Chart 9Treasury Fair Value Models Treasury Fair Value Models Treasury Fair Value Models Chart 10High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview Our Energy Sector Strategy team stated in a Weekly Report4 last week that our base case of $50-$60/bbl WTI crude oil prices by the end of 2017 should keep high-yield energy spreads contained. We remain underweight MBSs. Nominal MBS spreads are already very tight compared with previous levels, and they appear even tighter relative to trends in net issuance. While refinancing activity will remain depressed, we see potential for option-adjusted spreads to follow net issuance higher, even as the compensation for prepayment risk (option cost) remains low. The Fed's exit from the MBS market, which could occur as early as September, represents an additional upside risk for spreads. Bottom Line: Rates have bounced up after undershooting between March and the end of June. Loftier inflation readings are needed to sustain the bounce. Higher rates in the rest of 2017 support our stocks-over-bond stance. Within the U.S. bond market, we favor short duration over long, and credit over high-quality. MBSs will be hurt more than Treasurys as the Fed begins to shrink its balance sheet. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see BCA Special Report "Timing The Next Equity Bear Market, " dated January 24, 2014, available at bca.bcaresearch.com. 2 Please see U.S. Bond Strategy Portfolio Allocation Summary, "Inflection Point", dated July 5, 2017, available at usbs.bcaresearch.com. 3 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com. 4 Please see Energy Sector Strategy Weekly Report, "HY Debt Update: Offshore Drilling & Transportation Getting Left Behind", dated July 5, 2017, available at nrg.bcaresearch.com.

Highlights The rise in global bond yields has been largely "reflective" of stronger global growth rather than "restrictive." Stay cyclically overweight global equities. The Fed has more scope to raise rates than the ECB. Not only is labor market slack much higher in the euro area, but the neutral rate is considerably lower there too. Financial conditions have eased a lot more in the U.S. than in the euro area, which should support relative U.S. growth in the months ahead. U.S. inflation will bounce back in the second half of 2017, removing a key obstacle to further Fed rate hikes. Short-term momentum is working in the euro's favor, but we expect EUR/USD to fall to 1.05 by the end of the year. We are closing our short January 2018 fed funds futures trade for a gain of 11 basis points and rolling it into the June 2018 contract. Oil prices are heading higher. Go long the Russian ruble. Feature Bond Bulls Turned Into Steak Global bond yields continued to move up this week on the back of rising rate expectations (Chart 1). A brighter growth picture helped drive the bond selloff. The ISM manufacturing index jumped to a three-year high in June. The euro area manufacturing PMI clocked in at 57.4, the strongest level since April 2011. That solid PMI report follows on the heels of a record-high German Ifo reading last week. Central bankers are taking note of the better economic data. The FOMC minutes indicated that downside risks to growth have diminished and that the decline in core inflation is likely to be temporary. In fact, the Fed staff upgraded its inflation forecast from the May meeting to show an earlier return to 2%. On the other side of the Atlantic, the ECB minutes expressed confidence about the domestic growth outlook. The release of the minutes followed an upbeat speech by Mario Draghi in late June in which he noted that all signs point to "a strengthening and broadening recovery in the euro area" and that "the past period of low inflation is ... on the whole temporary." We expect ECB asset purchases to be scaled back at the start of next year. However, a full-fledged tightening cycle still looks to be some way off. Labor market slack in the euro area is 3.2 percentage points higher than it was in 2008 and 6.7 points higher outside of Germany (Chart 2). And even when the ECB does start hiking, it is doubtful that it will be able to raise rates all that much. This is because the neutral rate is extremely low in the euro area. Chart 1Rate Expectations Have Adjusted Higher Rate Expectations Have Adjusted Higher Rate Expectations Have Adjusted Higher Chart 2Euro Area: Labor Market Slack Still High Outside Of Germany Euro Area: Labor Market Slack Still High Outside Of Germany Euro Area: Labor Market Slack Still High Outside Of Germany The Importance Of The Neutral Rate Some commentators have alleged that the concept of a neutral rate is of little practical importance. They are wrong. At the start of 2010, 10-year German bund and U.S. Treasury yields stood at 3.4% and 4%, respectively. Much of the rally in bonds since then can be attributed to the slow realization among investors that the equilibrium interest rate in Europe and the U.S. has fallen. Those who understood this point at the outset made a lot of money. Why did the neutral rate decline? Part of the answer has to do with demographics. Slower labor force growth has reduced the incentive for companies to expand capacity. This has weighed on investment spending, leading to lower aggregate demand. Compared to the U.S., the euro area has been more afflicted by deteriorating demographics. For a while, the region was able to make up for the shortfall in population growth by expanding labor participation. But with participation rates in the euro area now higher than in the U.S., that avenue has closed (Chart 3). The end of the debt supercycle also caused the neutral rate to plummet around the world. Here again, Europe was disproportionately affected. Private-sector debt soared across the region in the years leading up to the Great Recession. This was particularly the case in the Mediterranean economies, which benefited from plunging real interest rates and a seemingly insatiable appetite for their debt among banks and foreign investors (Chart 4). When the music stopped, panic ensued. Greece was driven into default. Ireland, Spain, Italy, and Portugal survived by the skin of their teeth. Chart 3Rising Participation Boosted Euro Area Labor Force Growth Rising Participation Boosted Euro Area Labor Force Growth Rising Participation Boosted Euro Area Labor Force Growth Chart 4Private Debt Levels Soared In The Run-Up To The Great Recession Private Debt Levels Soared In The Run-Up To The Great Recession Private Debt Levels Soared In The Run-Up To The Great Recession True, financial stresses have receded since then. But all the spending that rising debt generated has not come back. This is a critical point and one that is often overlooked: If the ratio of private debt-to-GDP simply ends up being flat in the future - rather than rising by an average of 3.9 percentage points per year as it did in the euro area during the 2000s - this will still translate into significantly less demand than what the region was once used to.1 The ECB will need to offset this loss of demand by keeping interest rates lower for longer. Put differently, low rates in the euro area look to be more of a structural phenomenon than a cyclical one. The Shackles Of The Common Currency Chart 5Markets See Only A Small Gap In Neutral Rates Between The U.S. And The Euro Area Markets See Only A Small Gap In Neutral Rates Between The U.S. And The Euro Area Markets See Only A Small Gap In Neutral Rates Between The U.S. And The Euro Area The now all-too-evident drawbacks of euro area membership only amplify the need to keep rates low. As many European countries have discovered, loosening fiscal policy during a recession is nearly impossible when one loses guaranteed access to a central bank that can serve as a lender of last resort. The inability to devalue one's currency also means that competitive adjustments must occur through weak wage growth or even outright declines in nominal wages. Such outcomes can only occur in the presence of high unemployment. An economy which cannot respond effectively to adverse economic shocks with either fiscal easing or a cheaper currency is one that is likely to experience higher levels of labor market slack over the long haul. This, in turn, implies that interest rates will end up being lower than they would otherwise be. Has the market adequately discounted the fact that the neutral rate is lower in the euro area than in the U.S.? We don't think so. Chart 5 shows market estimates of the neutral real rate based on the difference between 5-year, 5-year forward interest rate index swaps and 5-year, 5-year forward CPI swap rates. The market is currently saying that the neutral rate is 26 basis points higher in the U.S. than in the euro area. We think the true gap is close to 100 basis points. A Higher Hurdle For The Euro Think about what this means for currencies. If interest rates are lower in one country than they are in another, investors will only purchase bonds in the low-yielding economy if they expect that country's currency to appreciate. What will cause them to expect a stronger currency? The answer is that the low-yielding currency has to first depreciate to a level below its long-term fair value. Consider a concrete example: German bunds and U.S. Treasurys. The latter yields 1.82% more than the former for 10-year maturities. This implies that investors expect the euro to appreciate by about 20% over the next decade. As such, whatever one thinks is the true long-term fair value for EUR/USD, the euro currently should trade at a substantial discount to that value. And, of course, the longer one thinks the neutral rate in the U.S. will exceed that of the euro area, the larger that discount should be. Thus, whenever someone tells you that it is "obvious" that the euro will strengthen over the long haul, ask them where they think the euro will be trading against the dollar in ten years' time. If their answer is less than 1.36, they will lose money by being long EUR/USD. Short-Term Momentum Favors The Euro, But The Cyclical Picture Is Still Dollar Bullish Ten years is a long time, of course. Over the next couple of months, we would not be surprised if investors extrapolate the euro area's economic recovery too far into the future, leading to higher bond yields across the region. In fact, BCA's Global Fixed Income Strategy service downgraded core European bonds this week largely for this reason. If that were to happen, EUR/USD could move to as high as 1.18 over the next few weeks. Such euro strength, however, will not last. We are confident that the Fed will deliver more tightening than the ECB over a 12-month horizon compared to what investors are currently anticipating. Despite the decline in the euro area unemployment rate over the past four years, it is still five points higher than in the U.S., greater than at virtually any point during the 2000s! (Chart 6). U.S. financial conditions have eased substantially so far this year - indeed, considerably more so than in the euro area (Chart 7). Our empirical work has shown that financial conditions lead growth by about 6-to-9 months. This suggests that U.S. growth could trump growth in the euro area over the balance of the year, even on a per capita basis. Chart 6There Is More Slack In The Euro Area There Is More Slack In The Euro Area There Is More Slack In The Euro Area Chart 7Easier Financial Conditions Will Support U.S. Growth Over The Coming Months Easier Financial Conditions Will Support U.S. Growth Over The Coming Months Easier Financial Conditions Will Support U.S. Growth Over The Coming Months U.S. Inflation Will Rise U.S. inflation should also bounce back, removing a key obstacle to further Fed rate hikes. Chart 8 presents a breakdown of U.S. core PCE inflation based on its various components. A few points stand out: About one-third of the decline in core PCE inflation between January and April can be attributed to lower wireless data prices, partly reflecting recent methodological changes undertaken by the Bureau of Labor Statistics to better measure inflation in this segment. We see this largely as statistical noise, which will wash out from the data over the next few quarters. Core goods inflation has been weighed down by the lagged effects of the dollar's appreciation in 2014-15. Given that the broad trade-weighted dollar has weakened by 4.3% this year, goods inflation should begin to move higher, as already foreshadowed by the jump in import prices (Chart 9). Health care inflation rose in the lead-up to the U.S. elections, reportedly because some health care providers feared they would not be able to jack up prices once Hillary Clinton became president. Thus, the ebbing in health care costs over the past few months is not too surprising. Going forward, health care inflation is likely to rise as insurers raise premiums, particularly for policies sold through the exchanges created under the Affordable Care Act. Service inflation has decelerated a notch. We do not expect this to last. Chart 10 shows that underlying wage growth has been accelerating on the back of a tightening labor market. Historically, wage growth has been the dominant driver of service inflation. The deceleration in rent inflation looks more durable, given rising apartment supply (Chart 11). However, one could argue that weaker rent growth could actually make the Fed more hawkish. After all, if builders are now churning out too many new apartments, keeping interest rates low would just encourage overbuilding. Chart 8U.S. Inflation Will Compel The Fed To Hike Rates U.S. Inflation Will Compel The Fed To Hike Rates U.S. Inflation Will Compel The Fed To Hike Rates Chart 9Goods Inflation Will Move Up Goods Inflation Will Move Up Goods Inflation Will Move Up Chart 10Deceleration In Service Inflation Will Not Last Deceleration In Service Inflation Will Not Last Deceleration In Service Inflation Will Not Last Chart 11Rent Inflation Has Peaked Rent Inflation Has Peaked Rent Inflation Has Peaked Investment Conclusions The jump in global bond yields in recent weeks raises the odds of a near-term pullback in stocks. Still, history suggests that equities almost always outperform bonds and cash outside of recessions. If global growth remains strong over the next 12 months, as we expect, stocks are likely to climb to new highs. Chart 12Euro Area Business Cycle Follows The U.S. Euro Area Business Cycle Follows The U.S. Euro Area Business Cycle Follows The U.S. The combination of faster U.S. growth and rising inflation should allow the Fed to raise rates at least three or four more times between now and next June. This is more than the 30 basis points of rate hikes that the market is currently pricing in over this period. We have been positioned for higher rate expectations by being short the January 2018 fed funds futures contract. We are closing this trade today for a gain of 11 basis points and rolling it into the June 2018 contract. While a somewhat more hawkish ECB will blunt the dollar's ascent to some extent, it will not fully counteract it. This is simply because the Fed wants to tighten financial conditions while the ECB does not. The ECB would be happy if the euro were to weaken. In contrast, further dollar weakness would cause the Fed to ramp up its hawkish rhetoric. This asymmetry means that it is the Fed, rather than the ECB, that is in the driver's seat when it comes to the outlook for EUR/USD. We expect the euro to weaken to 1.05 against the dollar by the end of the year, possibly reaching parity in early 2018. When will the dollar peak? The answer is when U.S. growth finally falters and the Fed stops raising rates. As we discussed last week in our Third Quarter Strategy Outlook, this could happen towards the end of 2018.2 Historically, the euro area business cycle has lagged the U.S. cycle by 6-to-12 months (Chart 12). Thus, it is reasonable to assume that euro area growth will remain resilient late next year, even if the U.S. economy begins to slip into recession. That is when the euro will finally take off. New Trade: Go Short EUR/RUB Chart 13Falling Oil Inventories Should Lead To Higher Crude Prices Falling Oil Inventories Should Lead To Higher Crude Prices Falling Oil Inventories Should Lead To Higher Crude Prices Until then, the euro will remain under pressure. In contrast, the Russian ruble is likely to strengthen over the next 12 months. Russian industrial production surprised to the upside in May, growing at the fastest pace since 2014. Retail sales also accelerated thanks to a pickup in wage growth. The growth revival should reduce the pressure on the Russian central bank to cut rates aggressively. A recovery in oil prices will also help the ruble. Our energy strategists expect global production to increase by only 0.7 MMB/d in 2017, compared to 1.5 MMB/d growth in consumption. While shale output continues to rise, this is largely being offset by falling production from conventional oil fields. Consequently, oil inventories should fall in the remainder of this year. If history is any guide, this will boost oil prices (Chart 13). With this in mind, investors should consider going short EUR/RUB. The ruble has lost 15% against the euro since April, making it ripe for a rebound. The juicy 9.4% in carry that the ruble currently offers over the euro should also benefit this trade. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 In equilibrium, aggregate demand must equal GDP. Since debt is a stock variable while GDP is a flow variable, it is the change in debt that influences GDP. Likewise, it is the change in the change in debt - the so-called "credit impulse" - which influences GDP growth. 2 Please see Global Investment Strategy, "Strategy Outlook Third Quarter 2017: Aging Bull," dated June 30, 2017, available at gis.bcaresearch.com. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

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

Highlights Fed Policy Loop: Low inflation is preventing rate hike expectations from being revised higher, prolonging the current rally in spread product. We expect rate hike expectations to move up as inflation recovers, eventually leading to a correction in spread product. Such a correction will prove fleeting as long as inflation stays below target. High-Yield: High-yield valuation is consistent with its historical average, after accounting for expected default losses. Current valuation levels should translate into excess returns of just over 200 bps during the next 12 months. Aaa Spread Product: Non-agency CMBS offer the most spread pick-up of any Aaa-rated sector. However, we prefer to focus our Aaa-rated spread product allocation in Agency CMBS and credit card backed consumer ABS. Feature Chart 1The Fed Policy Loop In Action The Fed Policy Loop In Action The Fed Policy Loop In Action One of this publication's main themes during the past few years has been the Fed Policy Loop.1 In essence, the Loop describes the feedback mechanism between monetary policy and financial markets, a relationship that results from both investors' sensitivity to the Fed's policy stance and the Fed's reliance on financial conditions as a predictor of economic growth. In practice, the Loop works as follows: Easier Fed policy causes spread product to outperform Treasuries. Tighter credit spreads lead to easier financial conditions, which the Fed interprets as a sign that economic growth will accelerate. An improved economic outlook causes the Fed to step up the pace of tightening. Tighter Fed policy causes spread product to underperform Treasuries. Wider credit spreads lead to tighter financial conditions, which the Fed interprets as a sign that economic growth will moderate. A worse economic outlook causes the Fed to slow its expected pace of tightening. Rinse, repeat. Chart 2 Chart 2 provides a graphical description of the Loop, and its most recent iteration can be seen in Chart 1 above. Chart 1 shows that corporate bonds outperformed Treasuries leading up to the March rate hike, but then rate expectations rose too far. In mid-March the market was discounting a fed funds rate of 1.86% by the end of 2018. These overly stringent rate hike expectations caused corporate bonds to underperform, and this underperformance led rate hike expectations to be revised lower. The market now expects a fed funds rate of only 1.47% by the end of 2018, and these depressed rate expectations have fueled the rally in corporate bonds that started in mid-April. Normally at this stage of the Fed Policy Loop we would expect rate hike expectations to move higher until they eventually prompt a correction in corporate spreads. However, extremely disappointing core inflation prints during the past three months have caused the market to keep its rate hike expectations depressed. This has extended the most recent rally in spread product. This is why we have consistently pointed to core inflation and the cost of inflation protection embedded in long-maturity bond yields as the main factors to watch to determine how much life is left in the corporate bond trade. As long as inflation stays below target, the Fed absolutely needs it to rise. It will therefore be quick to respond to any tightening of financial conditions/widening of credit spreads. Table 1 shows average monthly excess returns for investment grade corporate bonds relative to duration-matched Treasuries. These returns are split into buckets based on the reading from the St. Louis Fed's Price Pressures Measure (PPM). The PPM is a composite of 104 economic indicators designed to measure the probability that inflation will exceed 2.5% during the next 12 months. As can be seen, average monthly excess returns are strongest when inflation pressures are low, but they gradually decline as inflation heats up and the Fed's reaction function becomes less supportive for markets. At present, the PPM gives a reading of only 4.8%. Table 1Investment Grade Corporate Bond Excess Returns* Under Different ##br## Ranges Of Price Pressures Measure** (January 1990 To Present) Risk Rally Extended Risk Rally Extended Similarly, Table 2 shows that it is difficult to get a long-lasting correction in an environment with low inflation pressures and a responsive Fed. This table shows the results of a "buy the dips" trading strategy where if the average junk spread widens by 20 basis points we buy the junk index versus duration-matched Treasuries and hold it for a period of 1, 2 or 3 months. Just as in Table 1, this strategy works well when inflation pressures are muted, but starts to fail as inflation ramps up. Table 2High-Yield Corporate Bond Returns* Achieved By Holding The Junk Index ##br## Following A 20 BPs Widening In High-Yield Corporate OAS** Under Different Ranges Of ##br## The St. Louis Fed Price Pressures Measure*** (February 1994 To Present) Risk Rally Extended Risk Rally Extended Beatings Will Continue Until Morale Improves So when will the Fed staunch the current rally? That depends on how quickly inflation rebounds,2 and also on how much emphasis Fed policymakers place on financial conditions versus the actual inflation data. At the moment, most indexes are sending the message that financial conditions are easier than average and that the Fed should continue to tighten (Chart 3). However, as was noted above, inflation gauges are sending the opposite signal (Chart 3, panel 2). For now, the Fed is downplaying low inflation as transitory. It decided to leave its median projected rate hike path unchanged at the June FOMC meeting. But the Fed's refusal to capitulate in the face of weaker inflation has caused the yield curve to flatten, the cost of inflation protection to plummet (Chart 3, bottom panel) and investors to grow increasingly concerned about a policy mistake (Chart 4). Chart 3Financial Conditions Are Supportive Financial Conditions Are Supportive Financial Conditions Are Supportive Chart 4Should The Fed Keep Tightening? Should The Fed Keep Tightening? Should The Fed Keep Tightening? This brings up an interesting flaw in the financial conditions approach to policymaking. Most indexes of financial conditions are at least partially driven by long-maturity Treasury yields (lower yields = easier financial conditions, and vice-versa). This makes some sense. Lower yields do in fact indicate that the financing back-drop is more supportive and tend to translate into higher growth in the future (Chart 5). Chart 5Financial Conditions Lead Economic Growth Financial Conditions Lead Economic Growth Financial Conditions Lead Economic Growth However, what if lower long-maturity Treasury yields are the result of excessively tight Fed policy? This would appear to be the case at the moment. Investors are revising their long-run inflation forecasts lower on the view that the Fed is not doing enough to allow prices to rise. In such a situation it would be incorrect to interpret lower Treasury yields as a signal that policy needs to tighten further. On the contrary, tighter policy would only exacerbate the downtrend in yields. For this reason we do not include the level of yields in the financial conditions component of our Fed Monitor (Chart 3, top panel). As a result, this financial conditions indicator is not as deep in "easing territory" as most other indicators. However, it is still above the zero line, suggesting that policy should be biased tighter at the margin. Bottom Line: Low inflation is preventing rate hike expectations from being revised higher, prolonging the current rally in spread product. We expect rate hike expectations to move up as inflation recovers, eventually leading to a correction in spread product. Such a correction will prove fleeting as long as inflation remains below the Fed's target. The key risk is that inflation stays low but the Fed continues to focus exclusively on "easy" readings from financial conditions indexes, and proceeds on its current tightening path. In that scenario cries of "policy mistake" will grow louder and spread product will sell off, converging with lower rate hike expectations. We view this scenario as a low-probability tail risk. Junk Valuation Update At 378 bps, the average spread on the Bloomberg Barclays High-Yield index is only 55 bps above its post-crisis low, but still more than 100 bps above the level where it tends to settle in the late stages of the economic cycle when the Fed is tightening policy (Chart 6, top panel). Higher debt levels than are typical for this stage of the cycle suggest that somewhat wider spreads are justified,3 but the idea that junk spreads are extremely tight compared to history does not hold up to scrutiny. Chart 6High-Yield Default-Adjusted Spread High-Yield Default-Adjusted Spread High-Yield Default-Adjusted Spread Our preferred measure of junk valuation, the default-adjusted high-yield spread, paints an even rosier picture. The second panel of Chart 6 shows an ex-post measure of the default-adjusted spread (the option-adjusted spread of the high-yield index less actual default losses over the subsequent 12 months). The most recent reading from this indicator is based on our forecast of default losses for the next 12 months, and is shown as a dashed line. The message from the default-adjusted spread is that, assuming our default loss forecast is correct, junk bonds currently offer compensation for default risk that is in line with the historical average. That level of compensation would be consistent with an excess return of just over 200 bps during the next 12 months (Chart 6, panel 3), and is contingent on the speculative grade default rate falling to 2.68%, in line with Moody's baseline forecast (Chart 6, bottom panel). We expect a decline in the default rate to materialize in the coming months as commodity sector defaults continue to work their way out of the data. Moody's did not record any commodity-related defaults in May, the first month this has occurred since January 2015. The risk going forward is that defaults start to emerge in the increasingly stressed retail sector. So far, Moody's has recorded two retail defaults this year. However, more are probably on the way. This will be especially true if inflationary pressures start to mount and the Fed tightens policy, giving banks less incentive to extend credit. We will be monitoring the situation in retail closely going forward. Bottom Line: High-yield valuation is consistent with its historical average, after accounting for expected default losses. Current valuation levels should translate into excess returns of just over 200 bps during the next 12 months. Aaa Roundup As can be inferred from the previous two sections, we are still reasonably comfortable taking credit risk in U.S. bond portfolios. However, this week we also look at the compensation offered by Aaa-rated spread product. For investors who desire some Aaa-rated allocation outside of the Treasury market, Chart 7 provides a snapshot of where the most additional spread is available. Chart 7 The first thing that jumps out is that Agency bonds offer very little spread compared to other Aaa-rated instruments. Agency residential mortgage-backed securities also offer relatively little compensation, unless one is willing to extend into premium coupons (4% and above). Agency CMBS, auto ABS and credit card ABS all offer more spread than Aaa-rated corporate bonds. Non-agency CMBS offer much more attractive spreads than the other Aaa sectors, but we see potential for capital losses in that segment, as is discussed below. Agency MBS Only agency MBS carrying coupons of 4% or above offer interesting compensation relative to other Aaa-rated sectors, and even there we see potential for spread widening in the coming months. Nominal MBS spreads are already very tight compared to history (Chart 8) and appear even tighter relative to trends in net issuance (Chart 8, panel 2). While refinancing activity will likely stay depressed (Chart 8, panel 3), we see potential for option-adjusted spreads to follow net issuance higher, even as the compensation for prepayment risk (option cost) remains low. A similar scenario played out in 2007 (Chart 8, bottom panel). The Fed's exit from the MBS market, which could occur as early as September, represents an additional upside risk for spreads. Chart 8MBS Spreads Biased Wider MBS Spreads Biased Wider MBS Spreads Biased Wider Chart 9Avoid Non-Agency CMBS Avoid Non-Agency CMBS Avoid Non-Agency CMBS CMBS As noted above, non-agency CMBS look very attractive compared to other Aaa-rated spread products. But we see potential for spread widening in this sector. Commercial real estate lending standards are tightening and property prices are decelerating, both should pressure non-agency CMBS spreads wider (Chart 9). Agency CMBS offer somewhat lower spreads than their non-agency counterparts. But this sector should be more insulated from spread widening. For one thing, Agency CMBS are mostly backed by multi-family loans. Multi-family property prices have been stronger than those in the retail or office segments (Chart 9, panel 3), and multi-family properties have also experienced much lower delinquencies (Chart 9, bottom panel). Consumer ABS Chart 10Credit Cards Greater Than Autos Credit Cards > Autos Credit Cards > Autos While Chart 7 shows that Aaa-rated auto ABS offer a slight spread advantage over Aaa-rated credit card ABS, we are inclined to view credit card ABS more favorably. Rising auto loan net loss rates pose a risk for auto ABS spreads, while credit card charge-offs remain historically low (Chart 10). Auto lending standards have also moved deep into "net tightening" territory, while credit card lending standards have dipped back into "net easing" territory. The small extra compensation available in auto ABS relative to credit card ABS does not seem to be worth the extra risk. Bottom Line: Non-agency CMBS offer the most spread pick-up of any Aaa-rated sector. However, we view the risk of a further widening in non-agency CMBS spreads as substantial. We prefer to focus our Aaa-rated spread product exposure in Agency CMBS and credit card backed consumer ABS. Both sectors offer reasonably attractive spreads, and should remain insulated from capital losses going forward. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Caught In A Loop", dated September 29, 2015, available at usbs.bcaresearch.com 2 Our view is that core inflation will rebound fairly quickly. For further details please see U.S. Bond Strategy Weekly Report, "Three Scenarios For Treasury Yields In 2017", dated June 20, 2017, available at usbs.bcaresearch.com 3 For further details please see U.S. Bond Strategy Weekly Report, "Low Inflation And Rising Debt", dated June 13, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The rollover in the economic surprise index is not sending a near-term recession signal and should trough in the next month or so, as decent economic data begins to surpass now lowered expectations. Investors should be prepared for a mild recession in 2019, but odds of a recession are low in the next 12-18 months. Oil prices will move higher from the mid $40s per barrel as investors start to see the inventory drawdowns we expect in the coming months. We expect that the Fed will stick to its plan to begin shrinking its balance sheet in September and hike rates again in December. Still, a stubbornly low inflation rate in the next few months would likely see the Fed postpone any further tightening until early 2018. Small cap stocks have underperformed large caps this year, but investors should not interpret this as a sign of that start of sell-off in risk assets. Feature The Citi Economic Surprise Index (CESI) is not sending a near-term recession signal and should trough in the next month as decent economic data begin to surpass lowered economic expectations. The index is nearly two standard deviations below its mean after peaking in early March in the wake of the election and has been falling for 71 days. It typically takes 90 days for the surprise index to find a footing after readings above 40. Moreover, the mean reverting nature of the index suggests a rebound at two standard deviations, absent a recession that we do not foresee (Chart 1). Chart 1Economic Surprise Index Approaching A Turning Point Economic Surprise Index Approaching A Turning Point Economic Surprise Index Approaching A Turning Point CESI is composed of two components, whose composition and recent behavior are crucial to interpreting the weakness in the overall surprise metric. A positive reading on the "consensus change" index, which tracks economists' forecasts, means that expectations have improved relative to their one-year average. A positive reading on the "data change" component suggests that economic releases have been stronger than their one-year average. The overall surprise index combines these two elements/factors (Chart 2). Chart 2Post Election, Economic Expectations For Soft Data Hit An Eight Year High Post Election, Economic Expectations For Soft Data Hit An Eight Year High Post Election, Economic Expectations For Soft Data Hit An Eight Year High Lofty expectations, rather than poor data, account for much of CESI's weakness in the past three months. This is most pronounced in the soft economic surprise index, where outlooks moved sharply in the wake of the U.S. election when forecasters were swept up in Trump euphoria. By early March 2017, the economic consensus index for soft data was at its highest in seven years, topping out just shy of the all-time record set in late 2009. Prognosticators also ratcheted up their forecasts for the hard data, but not by nearly as much. The inevitable result of elevated expectations, combined with economic reports that signaled that overall growth remained close to 2%, was a prolonged spell of economic disappointment. This type of divergence between heightened expectations and weakness in the overall surprise index has occurred several times in the past 13 years (2004, 2010, 2011, 2012 and 2017). Each episode took place before a bottom in the economic surprise index and our view is that this time is no different (Chart 2). Despite the dismal surprise index, forecasts for U.S. and global GDP in 2017 and 2018 have held up, which is a positive sign for profits (Chart 3). The stability of these forecasts is in sharp contrast to 2012, 2013, 2015 and 2016 when global growth estimates sunk at the same time as the economic surprise index. As we stated in our recent report,1 GDP growth in 1H 2017 in the U.S. is on track to match the Fed's modest 2.1% target for the year. Moreover, in years when Q1 GDP is weak, 2H growth is faster than 1H growth 70% of the time. Chart 3U.S. & Global GDP Estimates For 2017 & 2018 Have Held Up Well U.S. & Global GDP Estimates For 2017 & 2018 Have Held Up Well U.S. & Global GDP Estimates For 2017 & 2018 Have Held Up Well Falling oil prices are another worry for investors concerned that global growth is on the wane. We take a different view and expect oil prices to increase in the coming months. In a recent report,2 our Energy Sector Strategy team noted that investors are confused about conflicting supply signals in oil markets. Traders do not see the physical shortage that the IEA/EIA/OPEC and BCA's top-down supply & demand analyses argue should prevail (Chart 4). Investors are cautious amid the uncertainty. We view the investment environment as overly pessimistic and anticipate that oil prices (and oil-focused upstream equities) will improve as inventory withdrawals escalate in the coming months. The latest 3.5% year-over-year reading on LEI for May points to low odds of a near-term recession (Chart 2, panel 3). However, BCA's Global Investment Strategy service has raised the possibility of a U.S. recession commencing in 2019. Financial markets would move ahead of a recession, thus investors should begin to adjust their portfolios3 for a recession scenario in the latter half of 2018, as economic and profit growth begins to weaken. Until then, we favor stocks over bonds, but we remain vigilant for any signs of imbalances that typically precipitate a recession. Our Global Investment Strategy service points out that in the post-war era the unemployment rate's three-month moving average has never risen by more than one-third of a percentage point without a recession. A good leading indicator of the unemployment rate is the weekly unemployment claims data, and they suggest continued tightening in the labor market (Chart 5). Chart 4We Expect The Oil Balance To Tighten Later This Year We Expect The Oil Balance To Tighten Later This Year We Expect The Oil Balance To Tighten Later This Year Chart 5Claims Not Even Close To Sending A Recession Signal Claims Not Even Close To Sending A Recession Signal Claims Not Even Close To Sending A Recession Signal A tighter labor market will lead to the familiar vicious cycle of a more aggressive Fed, a margin squeeze, slower and eventually falling profits, rising corporate defaults and layoffs. The resulting economic downturn would be mild compared with the 2007-2009 recession because the current imbalances are not as severe as those in 2007. Even so, with valuations stretched, the pain of the recession may be most felt in the financial markets, with a likelihood of a 20-30% equity bear market. Bottom Line: Despite signs to the contrary, the sweet spot that has buoyed risk assets remains in place: a beneficial combination of moderate economic growth, healthy corporate profit growth, stable margins, low inflation and a Fed prepared to only gradually hike rates. We remain overweight stocks versus bonds in the next 6-12 months. Threats to this risk-asset friendly environment include a further drop in core inflation, an over-aggressive central bank, and signs that negative economic shocks are leading to a significant markdown of global growth prospects. Is The Fed's Inflation Target Credible? The recent drop in oil prices has undermined our short-duration recommendation. But more than that, investors are questioning whether the Fed even has the ability to reach its inflation goals, following the surprising May CPI report and the softening in some of the wage data. Is it possible that the U.S. is following Japan's roadmap where even an over-heated labor market is insufficient to generate any meaningful inflation? The sharp flattening of the Treasury curve indicates that the bond market has already rendered its judgement. As we noted last week, the energy component pulled down the headline CPI rate again in May, but the softening of inflation this year is widespread in the index. This is contrary to Fed Chair Yellen's assertion that recent weak readings are due largely to special factors, such as wireless telecommunications prices. The deceleration in inflation began around the start of the year. The 3-month rate of change of the headline index fell by more than five percentage points between January and May, of which energy accounts for 3.3 percentage points. The deceleration in the core rate was a less severe, but still substantial, 2.8 percentage points. Table 1 presents the components of the CPI that made the largest contribution to the deceleration in core inflation. Motor vehicles, owners' equivalent rent, apparel, recreation, wireless telecom and medical care services accounted for 1.2 percentage points as a group. However, many other sectors contributed in a small way to the overall deceleration of core inflation in the first five months of the year. Table 1Key Drivers Of Core Inflation Deceleration In 2017 Waiting For The Turn Waiting For The Turn Some special factors were at play. The moderation in rent inflation likely reflects the bottoming of the vacancy rate. Discounting in the auto sector is not a surprise given weak sales. Wireless prices can be viewed as a special case as well. Nonetheless, the breadth and suddenness of the deceleration in core inflation across such diverse sectors, some unrelated to labor markets, commodity prices, the weak dollar or on-line shopping, is startling. The disinflation this year in the Fed's preferred measure, the PCE price index, is not as extended but the data lag the CPI by roughly a month. A diffusion index made up of the components of the PCE index is still in positive territory, unlike the CPI's diffusion index (Chart 6). Nonetheless, the CPI data suggest that core PCE inflation will edge lower when the May data are released at the end of June. There has also been a moderation in some of the wage inflation data, such as average hourly earnings (Chart 7). The slowdown has been fairly widespread across manufacturing and services. The good news is that the soft patch appears to be over; 3-month rates of change have firmed almost across the board (retail is a major exception). Chart 6CPI, PCE Diffusion##BR##Indices Are Mixed CPI, PCE Diffusion Indices Are Mixed CPI, PCE Diffusion Indices Are Mixed Chart 7Wages Have Accelerated##BR##Over Past Three Months Wages Have Accelerated Over Past Three Months Wages Have Accelerated Over Past Three Months There is no slowdown evident at all in the better-constructed Employment Cost Index (ECI) as of the first quarter (Chart 8). The related diffusion indexes also remain constructive. The ECI is adjusted to avoid compositional effects that can distort the aggregate index. We conclude from these and other wage measures that the Phillips curve is still operating. Admittedly, the curve appears to be quite flat, which means it is difficult to generate inflation even when the labor market overheats. Nonetheless, the relationship between the ECI and measures of labor market tightness, such as the quit rate, the "jobs plentiful" index and NFIB compensation plans, does not appear to have broken down (Chart 9). The percentage of U.S. states with unemployment below the Fed's estimate of full employment is above 70%. Anything over 60% in the past has been associated with wage pressure (Chart 10). The percentage jumped from 58% in March to 71% in April, blasting through the 60% threshold. Chart 8No Slowdown##BR##In ECI Data No Slowdown In ECI Data No Slowdown In ECI Data Chart 9Labor Market Tight Enough##BR##To Push Up Inflation Labor Market Tight Enough To Push Up Inflation Labor Market Tight Enough To Push Up Inflation The bottom line is that, while we are concerned about the breadth of the soft patch in the consumer price data, we are in agreement with the Fed that the labor market is tight enough to gradually push up inflation. We are willing at this point to chalk up the recent drop in core inflation partly to randomness in the data, and partly to lagged effects of the slowdown in real GDP growth in the first half of 2016 (Chart 11). The PPI for services and for core goods are not suggesting there is deflationary pressure in the pipeline (Chart 8). Chart 10Rise In State Level Diffusion Indices Consistent With Higher Compensation Costs Rise In State Level Diffusion Indices Consistent With Higher Compensation Costs Rise In State Level Diffusion Indices Consistent With Higher Compensation Costs Chart 11Inflation Lags Economic Growth By 18 Months Inflation Lags Economic Growth By 18 Months Inflation Lags Economic Growth By 18 Months What Will The Fed Do? The CPI data have rattled some on the FOMC. Federal Reserve Bank of Dallas President Kaplan, for example, believes that the Fed needs to be patient to ensure that the inflation pullback is temporary. However, the June FOMC Statement and Yellen's press conference suggested that the consensus is determined to stick with the current tightening timetable in terms of rate hikes and balance sheet adjustment. FOMC Vice Chairman Dudley echoed this view in comments he made last week to the press. The Fed has been quick to ease or back away from planned rate hikes at the first hint of trouble since the Lehman shock. However, it appears that the reaction function has changed, now that the labor market is at full employment. This is especially the case because financial conditions have eased further since the June rate hike. Unemployment will edge further below the full-employment level if the FOMC does not slow the economy. Policymakers know that the Fed has had little success in the past when it tried to nudge unemployment higher in order to relieve inflation pressure and achieve a soft landing; these attempts almost always ended in recession. Dudley added that "...pausing policy now could raise the risk of inflation surging and hurting the economy." Other FOMC members are worried that financial stability risk will rise if the low-rate environment extends much further. The bottom line is that we expect the Fed will stick with the game-plan for now. The FOMC will begin shrinking the balance sheet in September, but will wait until December for the next rate hike. That said, a stubbornly low inflation rate in the coming months would likely see the FOMC postpone the next rate increase into next year. Where Next For Bonds? Our fixed-income strategists see three possible scenarios for the bond market:4 Base Case: Weak recent inflation readings are nothing more than a lagged response to last year's deceleration in economic growth. U.S. growth accelerates in the second half, unemployment falls further and both wage growth and inflation pick up. Oil inventories begin to contract and prices head higher. The FOMC is vindicated in its inflation view and proceeds with the current rate hike and balance sheet adjustment agenda. Investors receive a "wake up call" from the Fed, bond prices get hit and recent curve-flattening trend reverses. Fed Capitulates: The U.S. labor market continues to tighten, but core PCE inflation is still close to 1½% by the September FOMC meeting. We would expect the Fed to lower its forecasted rate hike path, signaling that no further rate hikes are likely in 2017. Long-maturity real yields would fall in this scenario, although long-term inflation expectations could rise to the extent that the Fed's more dovish tilt will weaken the dollar and generate more inflation in the medium term. Nominal yields may not end up moving much in this scenario. A Policy Mistake: If core inflation remains low between now and the September FOMC meeting and the Fed continues to write-off low inflation as transitory, signaling its intention to stick to its current projected rate hike path, then the market would price-in a policy mistake scenario. The yield curve would flatten and long-maturity nominal yields would fall, led by tighter TIPS breakevens. In terms of likelihoods, we would characterize Scenario 1 as our base case scenario, Scenario 2 as unlikely and Scenario 3 as a tail risk. The bottom line is that short-duration positions have been a "pain trade" in recent weeks, but it appears to us that the rally is overdone. We remain short-duration. No Signal From Small Caps Chart 12Small Caps Are No Longer Expensive Small Caps Are No Longer Expensive Small Caps Are No Longer Expensive The underperformance of small cap stocks since December is not sending a signal about the broader equity market. In fact, small cap relative performance has a mixed track record calling the peak in large cap equities. We maintain our view from a 2014 report:5 There is no basis for concluding that small cap underperformance heralds a fragile economy, stock market weakness or heightened risk aversion. Investors should note the sector/compositional, domestic/international, cyclical/defensive, and valuation discrepancies between small and large cap stocks before drawing any conclusions about the signals from small caps. The S&P 500 small cap index has more exposure to financials, industrials and materials than its large cap cousins, and has lower weights in energy, staples and healthcare. This mix makes small caps more cyclically oriented. Moreover, small caps have less exposure to overseas economies and, therefore, less sensitivity to fluctuations in the U.S. dollar. Plus, our small cap valuation indicator has moved even further into undervalued territory since our discussion of small cap equities in this publication on April 246 (Chart 12). Chart 13Small Caps Are Not Great##BR##Market Prognosticators Small Caps Are Not Great Market Prognosticators Small Caps Are Not Great Market Prognosticators Small-cap stocks outperformed large cap by 12% from November 8 through December 8, 2016, but have lagged since, as investors unwound the Trump trade. The implication is that the recent sell-off in small caps is not a signal that the broader market is poised for a downturn. Instead, it reflects the market's view that Trump's pro-small business agenda has stalled. Moreover, history shows that the relative performance of small caps versus large caps is not a good predictor of the future performance of risk assets versus bonds. The small-to-large ratio sent plenty of mixed signals in the '80s and '90s when the economy was in a long expansion, fostered by low inflation and a gradualist Fed (Chart 13, panels 1 and 2). On the other hand, local peaks and troughs in small cap performance provided solid signals for turns in stock versus bond performance from the early '70s through the mid-80s, a period characterized by soaring inflation that is not present today (Chart 13, panel 1). Small-cap outperformance starting in late 2008 did presage an upturn in the stock-to-bond total return ratio in 2009, and captured a few of the risk on/risk off periods from 2010 through 2012, while the Fed engineered QE2, Operation Twist and QE3. More recently, the relative performance of small versus large has been range-bound and has not provided a consistent signal for turns in the overall market (Chart 13, panel 3). Bottom Line: The underperformance of small caps to large is a reaction to the market's perception that Trump's pro-small business agenda will disappoint, not a sign that U.S. growth is waning. While several planned policies of the Trump administration have been delayed, a legislative agenda that appears to be pro-business is in place. As such, our view is that it is too early to abandon a bullish bias towards small cap stocks, especially given the major improvement in relative valuation noted above. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see U.S. Investment Strategy Weekly Report "Can The Service Sector Save The Day?", June 5, 2017, available at usis.bcaresearch.com. 2 Please see Energy Sector Strategy Weekly Report, "Views From The Road", June 21, 2017, available at nrg.bcaresearch.com. 3 Please see Global Investment Strategy Weekly Report "The Timing Of The Next Recession", June 16, 2017, available at gis.bcaresearch.com. 4 Please see U.S. Bond Strategy Weekly Report "Three Scenarios For Treasury Yields In 2017", June 20, 2017, available at usbs.bcaresearch.com. 5 Please see U.S. Investment Strategy Weekly Report "On The Road Again", June 2, 2014, available at usis.bcaresearch.com. 6 Please see U.S. Investment Strategy Weekly Report "Spring Snapback", April 24, 2017, available at usis.bcaresearch.com.

Highlights Portfolio Strategy Swap consumer staples into financials in our pair trade versus the tech sector. Relative profit fundamentals signal that this relative share price ratio will soon come alive. Global growth tailwinds argue for lifting the air freight & logistics index to high-conviction overweight status. Recent Changes S&P Financials/S&P Tech - Switch the long side of the S&P Consumer Staples/S&P Tech pair trade from S&P Consumer Staples to S&P Financials. S&P Consumer Staples - Remove from the high-conviction overweight list. S&P Air Freight & Logistics - Add to the high-conviction overweight list. Table 1Sector Performance Returns (%) Disentangling Pricing Power Disentangling Pricing Power Feature Equities broke out to new highs early last week, and there are good odds that a playable rally will unfold. Investors' jitters have recently focused on the bear market in oil prices and weak core CPI, which have joined forces to push down inflation expectations (Chart 1). However, we have a more bullish interpretation. Unlike in late-2015/early-2016, oil and stock prices have decoupled. True, energy stocks are plumbing multi-decade lows relative to the broad market, but the energy sector comprises less than 6% of the S&P 500's market cap. In fact, the two largest S&P 500 constituents have a greater weight than the 34 stocks in the S&P energy index combined. In other words, the energy sector's broad market influence has been severely diluted. We think it is unlikely that the positive correlation between oil and stock prices reasserts itself. Rather, our sense is that this is likely an energy/commodity-centered deflation that will not have a serious contagion on the rest of the corporate sector. High yield energy spreads continue to widen, but the overall junk spread is flirting with cyclical lows. This stands in marked contrast with the summer of 2014 and late-2015, the last time oil prices melted (second panel, Chart 1). Chart 2 shows that the nonfarm business sector and the GDP implicit price deflators, both of which are reliable corporate sector pricing power proxies, are positively deviating from core CPI. These deflators have historically been excellent leading indicators of inflation and signal that the recent poor inflation prints will likely prove transitory. Importantly, the U.S. is a large closed economy that benefits greatly from lower oil prices, via a boost to discretionary income. Lower energy costs are adding to an already stimulative backdrop owing to the decline in the U.S. dollar and Treasury yields. At the margin, the broad corporate sector also benefits from oil price deflation: energy is a non-trivial input cost. Our more optimistic overall economic and market outlook is also borne out by survey data: economists revised higher their U.S and global GDP growth expectations both for 2017 and 2018, according to Bloomberg estimates (bottom panel, Chart 1). Finally, real yields, the bond market's gauge for economic growth expectations, have climbed close to a 2-year high, and suggest that GDP growth will soon pick up steam (Chart 1). Our view remains that this is a goldilocks scenario for equities, as it may keep the Fed at bay for a while longer and sustain easy financial conditions. This thesis also assumes that the corporate sector will maintain its pricing power gains, and likely pull consumer prices out of their lull. On that front, we have updated our corporate pricing power proxy and while it has lost some steam of late, it continues to expand at a healthy clip (Chart 3). Chart 1Decoupled Decoupled Decoupled Chart 2Implicit Price Deflators Lead Core CPI Implicit Price Deflators Lead Core CPI Implicit Price Deflators Lead Core CPI Chart 3Corporate Pricing Power Is Fine Corporate Pricing Power Is Fine Corporate Pricing Power Is Fine Table 2 shows our updated industry group pricing power gauges, which are calculated from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. The table also highlights shorter term pricing power trends and each industry's spread to overall inflation in order to identify potential profit winners and losers. Table 2Industry Group Pricing Power Disentangling Pricing Power Disentangling Pricing Power Our analysis concludes that still ¾ of the industries we cover are enjoying rising selling prices and 43% are also beating overall inflation rates. Admittedly, the inflation rates have come down since our April update, and there was a tick up in the number of deflating industries from 14 to 16, but that figure is still down from the 19 registered in January. Importantly, 27 out of 60 industries have clocked a rising pricing power trend down from 31 in April, but still up from 20 in January, 14 have a flat trend and 19 are falling. Encouragingly, corporate sector selling prices are still comfortably outpacing wage inflation, which suggests that the positive momentum in profit margins has staying power (Chart 3). One theme that stands out from our analysis is that commodity related industries have either falling or flat inflation trends, with the exception of aluminum and chemicals. We take this as confirmation that resources are at the epicenter of deflation/disinflation pressures. Similarly, the majority of tech sub-sectors are still fighting deflation and suffer from a flat or down trend in selling prices. Adding it all up, the recent mild slowdown in corporate sector selling prices is transitory, mostly commodity related and unlikely to infect the broad business sector. There are high odds that an earnings-led playable break out phase in the equity market will develop from here. This week we promote an industrials sub-sector to our high-conviction overweight list and swap a safe haven sector out, and also tweak our long/short pair trade. Pair Trade Tweak: Long Financials/Short Tech Over the past month, we have reduced the extent of our consumer staples overweight, downgrading soft drinks to underweight and hypermarkets to neutral. In contrast, in May we boosted the S&P financials index to overweight on the back of improving earnings fundamentals. As a result, swapping out consumer staples for financials in our existing pair trade versus the tech sector makes sense. This relative share price ratio is at a critical juncture and has dropped to its long term support level (top panel, Chart 4). Importantly, the relative market capitalization differential is at its widest gap since the tech bubble (Chart 5) and a renormalization is in order. Chart 4Long Term Support Should Hold Long Term Support Should Hold Long Term Support Should Hold Chart 5Unsustainable Gap Unsustainable Gap Unsustainable Gap The valuation case is equally compelling: financials are deeply undervalued and unloved compared with the tech sector (Chart 4), such that even a modest shift in sentiment would drive a large relative price swing. The macro outlook is rife with catalysts to trigger a renormalization. Our respective Cyclical Macro Indicators (CMI) signal that financials profits will best tech sector earnings in the coming quarters (top panel, Chart 6). Historically, relative performance has moved in lockstep with relative profitability. The message from our CMIs is that relative earnings will move decisively in favor of the financials sector, thereby producing positive price momentum (bottom panel, Chart 6). A simple relative demand indicator concurs with our CMIs message: bank loan growth should outpace tech capital expenditures in the back half of the year. The middle panel of Chart 6 shows our recently published bank loans and leases regression model compared with our U.S. Capex Indicator (a good proxy for tech spending) and the message is to expect a catchup phase in relative share prices. If our thesis proves accurate, then relative demand will soon show up in relative top line figures. On that front, our forward looking relative sales per share models argue that the budding recovery in relative revenue is sustainable (Chart 7). Relative pricing power dynamics provide another source of support, both in terms of sales and operating profit margins. Firming financials pricing power is the mirror image of chronically deflating tech selling prices (Chart 7). Keep in mind that overall mild price inflation is a boon for financials because it will keep monetary conditions from becoming overly tight, which would undermine credit quality and availability. Using the nonfarm business sector's implicit price deflator as a proxy for overall inflation, the (third panel, Chart 7) shows that relative share prices move in lockstep with overall corporate sector prices. In terms of economic undercurrents, if geopolitical risks remain muted and financial conditions reasonably accommodative, then a further boost in economic and investor sentiment is likely. History shows that the financials/tech share price ratio has benefited when risk premia recede. The same relationship is also evident in the positive correlation with our U.S. sentiment indicator and real 10-year bond yield (Chart 8), and inverse correlation with corporate bond spreads (not shown). Chart 6Heed The Relative##br## CMI Signal Heed The Relative CMI Signal Heed The Relative CMI Signal Chart 7Financials Have##br## The Upper Hand Financials Have The Upper Hand Financials Have The Upper Hand Chart 8Improving Economy = ##br##Go Long Financials/Short Tech Improving Economy = Go Long Financials/Short Tech Improving Economy = Go Long Financials/Short Tech Finally, recent positive bank sector news suggests that financials have the upper hand in this share price ratio. Banks passed the Fed's stringent stress test with flying colors and should become more shareholder friendly, i.e. boost dividend payouts and reinstate/augment share retirement. In addition, even a modest watering down of Dodd-Frank will also lift the appeal of banks and financials at the expense of tech stocks in the coming quarters. Adding it up, we recommend swapping consumer staples with financials in our pair trade versus the tech sector. Relative profit fundamentals suggest that this relative share price ratio will soon spring into action. Bottom Line: Switch consumer staples out and sub financials in the pair trade versus tech stocks. We are also removing the S&P consumer staples index from our high-conviction overweight list for a modest gain of 0.1% since the early-January inclusion. The latter move makes room for an upgrade to high-conviction of a transportation sub-group that has caught fire since our recent upgrade to overweight. Air Freight Stocks Achieve Liftoff! We raised the S&P air freight & logistics group to overweight two months ago, reflecting a lack of recognition in either valuations or earnings estimates that a global trade revival was unfolding and washed out technical conditions. Since then, this transportation sub-group has regained its footing, and firming profit fundamentals now embolden us to add air freight stocks to our high-conviction overweight list. The relative share price ratio has smartly bounced off its GFC lows. Similarly, our Technical Indicator found support at one standard deviation below the historical mean, a typical launch point for playable rallies. Importantly, deeply discounted valuations remain in place, both in terms of P/S and P/E ratios (Chart 9). We expect the rebound in global growth to help unlock excellent value in air freight equities. Global trade is reviving. The synchronized DM and EM economic recovery has buoyed the global manufacturing PMI, which continues to trend well above the boom/bust line. Both global export volumes and prices are expanding. Yet buoyant global trade expectations are still not reflected in tumbling relative sales expectations (Chart 10). Chart 9Unwarranted ##br##Grounding Unwarranted Grounding Unwarranted Grounding Chart 10Buoyant Trade Growth Is Neither Reflected##br## In Collapsing Sales Expectations... Buoyant Trade Growth Is Neither Reflected In Collapsing Sales Expectations... Buoyant Trade Growth Is Neither Reflected In Collapsing Sales Expectations... Chart 11 highlights two additional Indicators to gauge the stage of the global trade recovery. Korea and Taiwan are two small open economies: exports in both countries are accelerating. Meanwhile, our Global Trade Activity Indicator, comprising the economically-sensitive Baltic Dry Index and lumber prices, is also waving a green flag. The upshot is that a number of Indicators confirm that a durable pickup in trade is underway, which should ultimately translate into a recovery in relative earnings expectations (Chart 11). Domestically, business shipments-to-inventories ratios are expanding comfortably in all three major segments: manufacturing, wholesale and retail (bottom panel, Chart 10). Anecdotally, recent news that FedEx beat both top and bottom line estimates also reinforces a firm global activity backdrop. All of this serves as reliable evidence that the budding recovery in global (and domestic) growth has morphed into a sustainable advance. The implication is that air freight pricing power has ample room to grow. Wholesale price momentum has reached a 5-year high. If our thesis plays out, more pricing power gains are in store, which will boost profit margins given the industry's impressive labor cost restraint and high operating leverage (Chart 12). Chart 11...Nor In Depressed##br## Forward EPS ...Nor In Depressed Forward EPS ...Nor In Depressed Forward EPS Chart 12Margin Expansion##br##Phase Looms Margin Expansion Phase Looms Margin Expansion Phase Looms Finally while investors are digesting the Walmart in-store pick up option and Amazon's push for its own delivery service plans, the persistent ascent in online shopping suggests that the structural increase in rapid delivery services will remain intact. Investors should expect pricing power to gravitate toward the long-term trend (bottom panel, Chart 12). Tack on the recent corrective action in the commodity pits and this group also benefits from the fall in fuel costs. Taken together, profit margins should resume expanding. In sum, appealing relative valuations along with a durable synchronized global growth rebound argue for increasing conviction in our overweight position in this transportation sub-group. Bottom Line: Stay overweight the S&P air freight & logistics group (UPS, FDX, CHRW, EXPD), and bump it to the high-conviction overweight list. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights The European Central Bank's ultra-dovish policies have depressed the value of the euro and, by extension, boosted German manufacturing. Germany has diffused its inflationary pressures by outsourcing jobs and production to central Europe. As a result of this and labor shortages, wages in central Europe are rising rapidly, and inflation is accelerating. The Polish and Czech central banks will be forced to hike rates sooner than later. Hungary's central bank will lag behind. Go long the PLN versus the IDR. Stay long the CZK versus the euro and the PLN against the HUF. Feature Inflation in central Europe is picking up and will continue to rise (Chart I-1). The main driver is surging wage growth in central Europe. Considerable acceleration in wage growth, in Poland, Hungary and the Czech Republic signifies genuine inflationary pressures that could very well spread. Based on this, our primary investment recommendation is to be long the PLN and CZK versus the euro and/or EM currencies. Labor Shortages There is a shortage of labor in the central European manufacturing economies of Poland, Hungary and the Czech Republic. This partially reflects similar trends in Germany and its increased use of outsourcing to central European countries. Escalating wage growth (Chart I-2) in central European economies denotes widening labor shortages. Chart I-1Inflation Is Rising In CE3 Inflation Is Rising In CE3 Inflation Is Rising In CE3 Chart I-2Labor Shortages = Higher Wages Labor Shortages = Higher Wages Labor Shortages = Higher Wages Indeed, our proxy for labor shortages - calculated as the number of job vacancies divided by the number of unemployed looking for a job - has surged of late across all central European countries (Chart I-3). The same measure for Germany is at a 27-year high (Chart I-3, bottom panel). Chart I-4A and Chart I-4B illustrate both components of the ratio: the number of job vacancies has skyrocketed to all-time highs and the number of unemployed people has dropped to multi-decade lows as well. Chart I-3Labor Is Scarce In CE3 And Germany Labor Is Scarce In CE3 And Germany Labor Is Scarce In CE3 And Germany Chart I-4AA Breakdown Of Labor Shortage Proxy A Breakdown Of Labor Shortage Proxy A Breakdown Of Labor Shortage Proxy Chart I-4BA Breakdown Of Labor Shortage Proxy A Breakdown Of Labor Shortage Proxy A Breakdown Of Labor Shortage Proxy Importantly, it is not the case that labor shortages are occurring because people are discouraged and giving up on their search for work. The participation rate for all these countries has risen to its highest level since data have been available. In brief, a rising share of the population in these countries is either working or actively looking for a job. (Chart I-5). Finally, their working age population is shrinking (Chart I-6), with Germany being the exception because of immigration inflows (Chart I-6, bottom panel). Chart I-5Labor Participation Rate Is ##br##High In CE3 And Germany... Labor Participation Rate Is High In CE3 And Germany... Labor Participation Rate Is High In CE3 And Germany... Chart I-6...While Working Age ##br##Population Is Declining In CE3 ...While Working Age Population Is Declining In CE3 ...While Working Age Population Is Declining In CE3 Robust labor demand has been occurring in central Europe because of the ongoing manufacturing boom in the region. Given central Europe's extensive supply chain linkages to German manufacturing, the artificial cheapness of the euro that the ECB engineered has boosted the German economy and by extension central Europe's manufacturing boom. Germany: A Cheap Currency And Export Boom The ECB's ultra-accommodative policy has suppressed the value of the euro, and caused German exports to mushroom (Chart I-7, top panel). Chart I-7ECB Policies Have Been ##br##A Boon For German Exports ECB Policies Have Been A Boon For German Exports ECB Policies Have Been A Boon For German Exports A cheap common European currency has boosted Germany's manufacturing competitiveness and has led to rising demand for German exports. An overflow of manufacturing orders in Germany in turn has led to labor shortages in central Europe via increased German outsourcing. Currency appreciation is the conventional economic adjustment in a country with a flexible exchange rate and an export boom coupled with a large current account surplus. However, this has not occurred in Germany in recent years. This is because of the ECB's ultra-easy policies. The euro has depreciated even as the German and euro area overall current account has mushroomed (Chart I-7, bottom panel). Since the currency has not been allowed to appreciate in nominal terms, the real effective exchange rate will inevitably appreciate via inflation - rising wages initially and broader inflation increases later. In our opinion, the best currency valuation measure is the real effective exchange rate based on unit labor costs. Our basis is that this measure reflects both changes in productivity and wages - i.e. it reflects genuine competitiveness. Chart I-8 demonstrates Germany's real effective exchange rate based on unit labor costs in absolute terms compared to other advanced manufacturing competitors like the U.S., Japan, Switzerland and Sweden. Based on this measure, it is clear that Germany continues to enjoy a significant comparative advantage on the manufacturing world stage among advanced manufacturing economies. It is only less competitive versus Japan. Chart I-8Germany Is Very Competitive Based On Real Effective Exchange Rates Germany Is Very Competitive Based On Real Effective Exchange Rates Germany Is Very Competitive Based On Real Effective Exchange Rates Bottom Line: The ECB's ultra-dovish policies have depressed the value of the euro and boosted German manufacturing. This has boosted central European manufacturing and demand for labor. Germany Is Passing The Inflation Baton To Central Europe Despite a historic low in the unemployment rate and ongoing labor shortages, German wages have not risen by much (Chart I-9). Our hunch is that German companies faced with some labor shortages have been increasing their use of outsourcing. Central European economy's export to Germany have boomed, especially after the euro started depreciating circa 2010 (Chart I-10). Chart I-9German Wage Inflation Is Muted German Wage Inflation Is Muted German Wage Inflation Is Muted Chart I-10Growing Dependence On ##br##Germany For CE3 Growth Growing Dependence On Germany For CE3 Growth Growing Dependence On Germany For CE3 Growth Being the lower marginal cost producer in the region, central European economies have benefited from German competitiveness and the cheap euro. Outsourcing is economically justified because German wages are still four times higher than in Poland, Hungary and the Czech Republic. (Chart I-11). Even though Germany's productivity is higher than in central Europe, manufacturing wages adjusted for productivity are still higher than in central European economies (Chart I-12). Therefore, it still makes sense for German businesses to outsource more to lower-cost producers in central Europe. Chart I-11CE3 Wage Bill Is Cheaper ##br##Than That Of Germany... CE3 Wage Bill Is Cheaper Than That Of Germany... CE3 Wage Bill Is Cheaper Than That Of Germany... Chart I-12...Even After Adjusting ##br##For Productivity ...Even After Adjusting For Productivity ...Even After Adjusting For Productivity Faced with strong orders as well as a lack of available labor, businesses in central European countries have been competing for labor by raising wages. Unlike in Germany, manufacturing and overall wages in Poland, Hungary and the Czech Republic have recently surged (Chart I-2 on page 3). Wages are rising more so in Hungary and the Czech Republic since they have smaller labor pools compared to Poland. Notably, wage growth has exceeded productivity growth, and unit labor costs have been rising rather rapidly (Chart I-13). Chart I-13Unit Labor Costs Are Rising Rapidly In CE3 Unit Labor Costs Are Rising Rapidly In CE3 Unit Labor Costs Are Rising Rapidly In CE3 Higher unit labor costs amid rising output denote genuine inflationary pressures. Producers faced with rising unit labor costs and shrinking profit margins will attempt to raise prices. Given that income and demand are strong, they will partially succeed - meaning genuine inflationary pressures in central Europe are likely to intensify. Since the beginning of the ECB's accommodative monetary policy, Germany has been able to avoid the fallout of higher wages because it has been able to outsource a portion of its production to other countries, namely central Europe. The problem is that the supply of labor in central Europe is now drying out, so its price will naturally rise. If Germany did not have the labor pool of CE3 available as a resource, German wage inflation would be significantly higher by now because companies would have been forced to employ Germans more rapidly, paying more in labor costs. Bottom Line: Germany has diffused its inflationary pressures by outsourcing jobs and production to central Europe. Overheating In Central Europe Various inflation measures are showing signs that inflation is escalating in CE3. With rising wages and unit labor costs, these trends will continue. Consequently, output gaps in central European economies are closing or have closed, warranting further increases in inflation (Chart I-14). Money and credit growth are booming, which is further facilitating the rise in inflation (Chart I-15). Finally, employment growth is very robust and retail sales are strong (Chart I-16). Chart I-14Inflation Will Remain On An Up Trend In CE3 Inflation Will Remain On An Up Trend In CE3 Inflation Will Remain On An Up Trend In CE3 Chart I-15Money & Credit Will Facilitate Path To Inflation Money & Credit Will Facilitate Path To Inflation Money & Credit Will Facilitate Path To Inflation Chart I-16Employment & Retail Sales Growth Is Robust Employment & Retail Sales Growth Is Robust Employment & Retail Sales Growth Is Robust Bottom Line: A cheap euro has supercharged German demand for central European labor at the time when the pool of available labor in CE3 is shrinking. This has generated genuine inflationary pressures in the region. Conclusions And Investment Recommendations 1. The Polish and Czech central banks will hike rates sooner than later. This will boost their currencies. The Hungarian central bank will lag and the HUF will underperform its regional peers. CE3 currencies are set to appreciate, especially the CZK and the PLN: stay long the PLN versus the HUF, and the CZK versus the euro. We recommended going long PLN/HUF and long CZK/EUR on September 28 2016 due to stronger growth and rising inflationary pressures. This week's analysis reinforces our conviction on these trades. In the face of rising inflationary pressures, the Czech National Bank (CNB) and the National Bank of Poland (NBP) will be less reluctant to tighten policy than the National Bank of Hungary (NBH) and the ECB. This will drive the PLN and CZK higher relative to the EUR and HUF. The NBH is unlikely to tighten policy while credit growth is still weak. Given strong political pressure for faster economic growth, our bias is that the NBH is more interested in ending six years of non-existent credit growth rather than containing inflation. The ECB is unlikely to tighten policy either, given the still-poor structural growth outlook among the peripheral European economies. A new currency trade: go long the PLN versus the IDR, while closing our short IDR/long HUF trade with a 9% loss. This is based on our expectations that central European currencies will appreciate versus their EM peers, and the PLN will do better than the HUF. 2. Relative growth trajectory favors Central European economies relative to other EM countries. Such economic outperformance and resulting currency appreciation will be a tailwind to CE3 equity performance versus EM in common currency terms. Continue overweighting CE3 equity markets within the EM benchmark. We recommended equity traders go long CE3 banks / short euro area banks on April 6, 2016. This position has not worked out due to a significant rally in euro area banks since Brexit. However, euro area banks remain less profitable and overleveraged compared to their central European counterparts. As such they will likely underperform in the coming months. 3. In fixed income, we have the following positions: Overweight Hungarian sovereign credit within an EM sovereign credit portfolio. Long Polish and Hungarian 5-year local currency bonds / short South African and Turkish domestic bonds. A new trade: Receive 1-year Hungarian swap rates / Pay 10-year swap rates. As structural inflationary pressures become rampant in the Hungarian economy, the market will start pricing in rate hikes further down the curve, and the yield curve will consequently steepen (Chart I-17). Polish and Czech bonds offer better value relative to bunds as investors stand to gain from currency appreciation as well as an attractive spread. (Chart I-18). Chart I-17Bet On Yield Curve ##br##Steepening In Hungary Bet On Yield Curve Steepening In Hungary Bet On Yield Curve Steepening In Hungary Chart I-18Polish & Czech Bond Offer Value ##br##Relative To German Bunds Polish & Czech Bond Offer Value Relative To German Bunds Polish & Czech Bond Offer Value Relative To German Bunds Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The Fed Is Right: Wage growth and inflation increase as growth rebounds in the second half of the year. Treasury yields move higher, the yield curve steepens and TIPS breakevens widen. This is the most likely scenario. The Fed Capitulates: Inflation fails to rebound but the Fed responds by signaling a shallower rate hike path. Increased inflation compensation offsets lower real yields, leaving long-maturity nominal yields unchanged. Meanwhile, wider TIPS breakevens cause the yield curve to steepen. This is the second most likely scenario. Policy Mistake: Inflation fails to rebound and the Fed continues to tighten. Nominal yields move lower and tighter TIPS breakevens cause the yield curve to flatten. This is the least likely scenario. Feature Chart 1Pricing A Policy Mistake Pricing A Policy Mistake Pricing A Policy Mistake Rather than go out of her way to assure markets that the Fed will respond to recent weakness in core inflation, Janet Yellen insisted at last week's post-FOMC press conference that low inflation will prove transitory. The Fed decided to plough ahead with its second rate hike of 2017, while maintaining its median projection for one more before the year is out. The Treasury market remains skeptical. Long-maturity nominal yields continued to decline following the FOMC meeting while short-maturity yields increased (Chart 1). The resultant curve flattening - the 2/10 Treasury slope is back down to 84 basis points - signals that the market is pricing-in an overly aggressive pace of Fed tightening. Consistent with this message, the drop in long-dated yields continues to be concentrated in the inflation component while real yields - which are linked to the expected pace of Fed rate hikes - remain firm (Chart 1, bottom panel). We were surprised by Yellen's reluctance to throw the market a bone, but we actually agree with her assessment of the fundamentals underpinning inflation. Our base case scenario is that inflation will soon resume its gradual uptrend, causing the Treasury curve to bear-steepen and TIPS breakevens to widen. Whether or not this base case scenario plays out, it is clear that the next few inflation prints and how the Fed responds to them will dictate the path for Treasury yields between now and the end of the year. We see three possible scenarios, and this week we examine each in turn, in order of most likely to least likely. Specifically, we would characterize Scenario 1 as our base case scenario, Scenario 2 as unlikely and Scenario 3 as a remote tail risk. Scenario 1: The Fed is Right The Fed is taking a gamble betting against the markets, but as we have argued in the past several reports,1 we think this gamble will soon pay off. In fact, it is quite likely that weak core inflation during the past three months is nothing more than a lagged response to last year's deceleration in economic growth. A deceleration that has already reversed. The year-over-year change in core CPI tends to lag year-over-year GDP growth by about 18 months. Meanwhile, GDP growth has already rebounded and leading indicators such as financial conditions, the BCA Beige Book Monitor and the BCA Composite New Orders Indicator, all point to a further acceleration (Chart 2). More importantly, it would be very unusual for core inflation to trend lower while the unemployment rate is falling and wage growth is increasing (Chart 3). This Phillips Curve relationship between the labor market and prices is the basis for the Fed's belief that inflation will resume its uptrend, and it has worked quite well since 1995.2 Chart 2Inflation Set To Rebound Inflation Set To Rebound Inflation Set To Rebound Chart 3Fundamentals Suggest Inflation Will Rise Fundamentals Suggest Inflation Will Rise Fundamentals Suggest Inflation Will Rise Further, our U.S. Investment Strategy3 service has calculated that it does not take much growth for the unemployment rate to continue its descent (Chart 4). Even a monthly increase of 130k in nonfarm payrolls is sufficient to bring the unemployment rate down, assuming the labor force participation rate stays flat. Monthly payroll gains are already averaging 162k so far this year, and our model suggests that number is poised to accelerate (Chart 5). Chart 4The Unemployment Rate Under Various Monthly Job Count Scenarios ##br##The Unemployment Rate Will Keep Falling The Unemployment Rate Under Various Monthly Job Count Scenarios The Unemployment Rate Will Keep Falling The Unemployment Rate Under Various Monthly Job Count Scenarios The Unemployment Rate Will Keep Falling Chart 5BCA Employment##br## Model BCA Employment Model BCA Employment Model What Could Cause Inflation To Fall? A Rising Participation Rate. While labor market fundamentals support gradually rising inflation, it follows that inflation would likely fall if the unemployment rate were to increase. This is not a likely scenario, but it could occur if there is either a severe slowdown in payroll growth, or a surge of re-entrants into the labor market, leading to an increase in the labor force participation rate. The labor force participation rate fell from 65.9% at the end of 2007 to 62.8% in June 2014. As of today it stands at 62.7%, not far off its mid-2014 level (Chart 6). A paper published by the White House's Council of Economic Advisors (CEA) in July 20144 attributed 1.6% of the decline since 2007 to the ageing of the population, another 0.5% of the decline to normal cyclical factors and left the remaining 1% of the drop unexplained. The demographic effect is not about to reverse. Also, normal cyclical variation in the participation rate is linked to changes in the unemployment rate itself (Chart 6, panel 2). With the unemployment rate already low, it is likely that any normal cyclical decline in the participation rate has already been unwound. It is the remaining 1% residual decline in the participation rate that is tougher to pin down. The CEA offers two possible explanations for that residual 1% drop. The first is that it is the result of the downtrend in the prime age (25-54) participation rate that pre-dated the Great Recession (Chart 7). Prior to the recession, this downtrend had been partially offset by increasing participation among those aged 55+, but that latter trend has leveled off since 2010. If the 1% residual is the result of this longer-run trend in prime age participation, a trend possibly driven by technological advancement and the outsourcing of jobs overseas, then it is unlikely to reverse. Chart 6Can The Part Rate ##br##Bounce Back? Can The Part Rate Bounce Back? Can The Part Rate Bounce Back? Chart 7Secular Downtrend In Prime-Age ##br##Participation Secular Downtrend In Prime-Age Participation Secular Downtrend In Prime-Age Participation The second possible explanation is that the extra 1% is accounted for by the large increase in long-term unemployment that followed the Great Recession (Chart 6, bottom 2 panels). There is an observable correlation between the participation rate and the average duration of unemployment. If this correlation holds, and the duration of unemployment falls back to pre-crisis levels, then the participation rate could increase in the near term. However, there is also a school of thought that says the longer a person is out of the labor force the less likely it is they will ever return.5 If this turns out to be an accurate description of the dynamic between long-term unemployment and the participation rate, then it suggests that the permanent damage from the Great Recession has already been done. Even if the average duration of unemployment falls from current levels, its correlation with the participation rate would likely break down. If we assume that the participation rate rises 0.5% during the next year, then it would take payroll gains of more than 200k per month to keep the unemployment rate flat. That is too high a hurdle. While a much higher participation rate is not our base case, mathematically it is possible to envision a scenario where increasing participation causes the unemployment rate to rise, keeping a lid on wage growth and inflation in the process. Bottom Line: Overall, we agree with the Fed that wage growth and inflation will increase as growth rebounds in the second half of the year. This will very likely cause Treasury yields to move higher, the yield curve to steepen and TIPS breakevens to widen. Indications that the average duration of unemployment is rapidly falling and/or that the labor force participation rate is rising could lead us to change our view. Scenario 2: The Fed Capitulates Chart 8A Dovish Fed Can Boost Breakevens A Dovish Fed Can Boost Breakevens A Dovish Fed Can Boost Breakevens Now let's imagine that U.S. growth remains steady, the labor market continues to tighten, yet core PCE inflation is still close to 1.5% by the time the Fed meets in September. In this scenario we would expect the Fed to send a much more dovish message to markets than it did last week. Specifically, we would expect the Fed to lower its forecasted rate hike path, signaling that no further rate hikes are likely in 2017. What sort of impact would this have on the yield curve? Long-maturity real yields, which are highly correlated with rate hike expectations, would almost certainly fall. However, if the Fed sends a sufficiently aggressive signal that it is willing to take action to support inflation, then it is conceivable that the long-maturity compensation for inflation protection could rise, offsetting some of the decline in real yields. In last week's report we noted how this exact scenario played out in 2011/12.6 Regression analysis shows that the 10-year real yield has historically moved about half as much as our 24-month Fed Funds Discounter (Chart 8), with the exception of the period surrounding the 2013 taper tantrum. If we assume the historical beta of 0.5 holds, then even if the market starts to discount no Fed rate hikes during the next two years and our discounter falls from its current level of 42 bps to zero, the 10-year real yield would have only 21 bps of downside. The current 10-year TIPS breakeven inflation rate is 1.67%, and would only need to return to 1.88% to completely offset the decline in real yields from the Fed being completely priced out. This does not seem like a high bar (Chart 8, top panel). Bottom Line: If core PCE inflation remains close to 1.5% by the time the Fed meets in September, then we would expect the Fed to respond more aggressively by signaling a shallower path of rate hikes. In this scenario it is likely that wider TIPS breakevens would offset the impact from lower real yields, leaving nominal Treasury yields close to unchanged. Scenario 3: A Policy Mistake A monetary policy mistake in its strongest form would be tightening so aggressively that the slope of the yield curve flattens all the way to zero before inflation has reached the Fed's target. In prior cycles we are used to seeing much higher inflation when the slope of the 2/10 curve is as flat as it is today (Chart 9), which suggests that the market is already starting to discount a premature Fed tightening. If core inflation remains low between now and the September FOMC meeting, and the Fed continues to write-off low inflation as transitory, signaling its intention to stick to its current projected rate hike path, then the market would go further to price-in a policy mistake scenario. The yield curve would flatten and long-maturity nominal yields would fall, led by tighter TIPS breakevens. We still view this as the least likely scenario. The Fed should be concerned about inflation expectations becoming un-anchored to the downside. As we showed in last week's report,7 it is well documented that when inflation expectations become unmoored, the relationship between prices and the labor market is significantly weakened. Further, the longer that actual inflation deviates from target the more likely it becomes that inflation expectations will become un-anchored to the downside. In last week's press conference Janet Yellen said: It is true that some household surveys of inflation expectations have moved down, but overall I wouldn't say that we've seen a broad undermining of inflation expectations.8 That claim is undoubtedly open for interpretation (Chart 10), but the important point is that the longer inflation stays below target, the more likely a "broad undermining of inflation expectations" becomes. We expect the Fed will heed this message from the markets, but after last week's meeting we cannot completely rule out a policy mistake. Chart 9Curve Is Too Flat Versus Inflation Curve Is Too Flat Versus Inflation Curve Is Too Flat Versus Inflation Chart 10Still Well Anchored? Still Well Anchored? Still Well Anchored? Bottom Line: If inflation stays low between now and September, but the Fed sticks to its current forward rate guidance, then the market will price-in more of a policy mistake scenario. Nominal yields will fall, led by tighter TIPS breakevens, and the yield curve will flatten. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Reports, "Two Challenges For U.S. Policymakers", dated May 23, 207, "The Fed Doctrine", dated May 30, 2017 and "Low Inflation And Rising Debt", dated June 13, 2017, all available at usbs.bcaresearch.com 2 The post-1995 environment has been characterized by stable inflation expectations. It is well documented that the relationship between labor markets and inflation is much weaker when inflation expectations become un-anchored. We discuss this risk in Scenario #3. 3 Please see U.S. Investment Strategy Weekly Report, "Balancing Act", dated June 12, 2017, available at usis.bcaresearch.com 4 https://scholar.harvard.edu/files/stock/files/labor_force_participation.pdf 5 http://www.nber.org/reporter/2015number3/2015number3.pdf 6 Please see U.S. Bond Strategy Weekly Report, "Low Inflation And Rising Debt", dated June 13, 2017, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "Low Inflation And Rising Debt", dated June 13, 2017, available at usbs.bcaresearch.com 8 https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20170614.pdf Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Rising equity prices, low and falling bond yields and stable credit spreads are all consistent with today's low growth and inflation backdrop, where the Fed can take its time raising rates. The FOMC is looking through the inflation shortfall for now and is sticking with its rate hike plan. Lower oil prices are the key driver of plunging market-based inflation expectations. We expect the Fed to begin to trim its balance sheet later this year, and be a modest negative for Treasury prices. The latest readings on the health of household balance sheet from the Fed's flow of funds accounts reinforce our view that the consumer sector will provide solid support for the U.S. economy through 2017; the student loan debt situation is not a source of financial systemic risk. Feature We first outlined our view that U.S. assets were in a policy sweet spot back in September 2016, noting that the monetary policy sweet spot won't end for risk assets until interest rates climb above the equilibrium rate. Nine months later, policy remains in the sweet spot, thanks to a beneficial combination of moderate economic growth, healthy corporate profit growth, stable margins and low inflation. Last week's CPI report was disconcerting, but did reinforce the notion that the Fed can take its time. Thus, when investors ask: "How can equity prices and bond prices both be moving higher?" Our answer is: "Because we are still in the sweet spot." Low And Slow Wins The Day Investors are wondering how the equity market can hold up given that the bond market and the dollar appear to be signaling sluggish economic growth. We look at it another way. Rising equity prices, low and falling bond yields and stable credit spreads are all consistent with today's low growth and inflation backdrop, where the Fed can take its time raising rates. The FOMC reaffirmed its intended path for rates at last week's meeting (see below). If the Fed's modest forecasts for growth and inflation are met, the central bank will raise rates gradually and begin to shrink its balance sheet. The implication for investors is that the recent outperformance of stocks over bonds accompanied by positive correlations between the two can persist for some time. Lessons from the 1950s and 1990s are helpful in illustrating this point. During the 1950s (Chart 1A, the Fed was gradually raising rates, but inflation and long rates remained low. Even as rates edged higher, stocks outperformed bonds, despite a booming economy that was near full employment. In the 1990s, long bond yields fell even as equity prices surged. Inflation was well contained for most of that decade (Chart 1B). Chart 1ABond Yields, Stocks, Inflation And The Fed In The 1950s... Bond Yields, Stocks, Inflation And The Fed In The 1950s... Bond Yields, Stocks, Inflation And The Fed In The 1950s... Chart 1B...And In The 1990s ...And In The 1990s ...And In The 1990s At what point will bond market become a problem for stocks? Charts 2 and 3 show that low inflation and low rates are both critical to keeping stock and bond yields positively correlated. The 4.25% level on the 10-year Treasury is a critical level to watch based on the historical relationship between Treasury yields and stock-bond correlations. However, the reason for rising bond yields is as important as the level of yields. An increase in long-dated Treasury yields associated with a pickup in real growth is less of a threat to equities than a rise in yields due to an uptick in inflation, because the latter invites a more aggressive Fed tightening cycle. Chart 2 Chart 3 Chart 3 shows that core inflation around or below 2% supports a positive correlation between stock and bond yields. As inflation begins to move from 2 to 3%, the relationship fluctuates, and above 3% there are very few periods of positive correlation. All signs point to a depressed inflation environment over the next year, which is one of the keys to keeping bond yields and stock prices positively correlated. We expect core CPI to move back up to 2% in the medium term, and the Fed agrees. The central bank's latest forecast puts inflation at just 2% for the next two years and in the long run. Bottom Line: Stocks can handle rising bond yields as long as higher yields are driven by better growth and not inflation. With inflation low and bonds yields at 2.15%, we are a long way from where bond yields become a problem for the stock market. FOMC: Sticking With The Roadmap For Now It was a wild ride in the Treasury market last week as bonds first rallied hard on the heels of some data releases, before selling off after the FOMC failed to deliver a fully "dovish hike". May retail sales were decent below the surface. The "control group" measure that feeds into the GDP figures was flat in May, but was revised up to a 0.6% gain in April (Chart 4). The result was a solid 4.3% annualized gain over the past three months. This suggests that, although not booming, consumer spending growth is solid in the second quarter. U.S. household balance sheets are in solid shape, as we highlight below. The FOMC was probably not swayed by this report. The CPI report was another story (Chart 5). The energy component pulled down the headline rate as expected, but the softening of inflation is widespread in the index. The annualized 3-month rate of change in the core rate fell virtually to zero in May. Disinflation can be seen in areas that have little to do with the output gap, such as shelter and medical care. But it is also showing up in other services, a segment of the CPI that is most highly correlated with wage growth and labor market pressure. The sudden broad-based change in direction is difficult to explain and, at a minimum, presents a challenge to the view that the U.S. economy is approaching its non-inflationary limits. Chart 4Consumer Spending##BR##Remains Solid Consumer Spending Remains Solid Consumer Spending Remains Solid Chart 5Disinflation In Core Services##BR##Is A Challenge To Fed's View Disinflation In Core Services Is A Challenge to Fed's View Disinflation In Core Services Is A Challenge to Fed's View Bonds rallied heading into the FOMC meeting on the view that the Fed would deliver a rate hike as promised, but would revise down the "dot plot" or, at a minimum, would play up concerns about the inflation undershoot. In the event, the Fed did neither. Chart 6Labor Market Continues To Tighten Labor Market Continues To Tighten Labor Market Continues To Tighten The statement acknowledged the disappointing inflation readings, but also revealed a determination to normalize interest rates in the face of a tight labor market. In the press conference, Chair Yellen downplayed the inflation shortfall, pointing to some one-off factors. She stressed that the FOMC makes policy for the "medium term," and should not over-react to short-term wiggles in the data. Given the tight labor market, the Fed Chair argued that the conditions are in place for inflation to move higher. Indeed, the median FOMC forecast for headline and core inflation was revised down for this year only; the outlook for 2018 and 2019 was left unchanged at 2%. Growth was revised up a little for 2017. We agree with the FOMC that the labor market is tight enough to gradually push up inflation. The underlying trend in wage growth has accelerated from 1.2% in 2010 to 2.4% today according to our wage tracker, in line with the narrowing of the unemployment gap over the period (Chart 6). The FOMC trimmed its estimate of the full-employment level of unemployment by 0.1 percentage points to 4.6%, but it revised down its forecast for the actual unemployment rate by a larger 0.3 percentage points over the next two years. This means that the projected amount of excess labor demand is now greater than in the March projection. By itself, this should make the FOMC more predisposed to tightening, especially since financial conditions have been easing. That said, the May CPI report was admittedly disconcerting due to the broad-based nature of the disinflationary pulse. This is contrary to Chair Yellen's assertion that the inflation disappointment reflects one-off factors. The May CPI report could be a head-fake, related to normal randomness in the data. But it is not clear why there would be a sudden and widespread moderation of inflation. Inflation Expectations Plunge A large portion of the decline in long-term Treasury yields since March reflected a decline in inflation expectations. The 10-year CPI swap rate has dropped by 35 basis points over the period. BCA's fixed-income strategists point out that the decline in long-term inflation expectations has been widespread across the major countries, irrespective of whether or not actual inflation is trending up or down.1 Given all these diverging signals within the national inflation data, it is odd that there has been such a uniform decline in inflation expectations across the major bond markets. That leads us to look to the oil price decline as the main driver. Weaker energy prices have been part of a broader move lower in commodity prices that is likely related to less reflationary monetary and fiscal policies out of the world's biggest commodity consumer, China. However, our commodity strategists have noted that export and import volumes in the emerging economies accelerated sharply in the first quarter of 2017. Given that there is a strong correlation between trade volumes and oil demand in the emerging markets, this bodes well for a rebound in global oil demand. Combined with the "OPEC 2.0" production cuts, the demand-supply balance in world oil markets is likely to turn positive in the months ahead, which will allow oil prices to return to a range close to $60/bbl by year-end. A move in oil prices back to that level would help arrest the downturn in overall commodity price indices, and stabilize goods CPI inflation in the developed economies in the latter half of 2017. This should also boost global inflation expectations and bond yields, especially since inflation expectations have fallen too far relative to underlying non-energy inflation pressures. This forecast also applies to the U.S. bond market, although one cannot blame the deceleration in inflation entirely on energy in this case. We expect inflation to move higher in line with the tight labor market, but we may have to change our view if service sector inflation continues to move lower in the next few of months. Balance Sheet News Chart 7Main Risk To Bond Yields Is To The Upside Main Risk To Bond Yields Is To The Upside Main Risk To Bond Yields Is To The Upside The Fed also provided some details on plans to shrink the balance sheet in terms of the size of the monthly "run off". If the economy evolves as the Fed expects, the balance sheet will start to shrink later this year. Reducing the Fed's balance sheet will be negative for Treasury prices as we argued in the May 22, 2017 Weekly Report, but the impact of this adjustment on its own will be modest. As the FOMC dials back monetary stimulus it will be concerned with overall monetary conditions, including short-term rates, long-term rates and the dollar. If long-term rates and/or the dollar rise too quickly, policymakers will moderate the pace of rate hikes and use forward guidance to talk down the long end of the curve so as to avoid allowing financial conditions get too tight, too quickly (i.e. the term premium would rise, but would be partly offset by a lower expected path for the fed funds rate). Thus, the path of short-term rates is dependent on the dollar and the reaction of the long end of the curve. The bottom line is that the FOMC is looking-through the inflation shortfall for now and is sticking with its rate hike plan. The evolution of inflation in the coming months will obviously be key. Nonetheless, given that only one more rate hike is expected over the next year, inflation expectations are back to U.S. pre-election levels, and that the 10-year U.S. term premium is well below zero again, it appears that the main risk for bond yields is to the upside (Chart 7). The equity market should benefit in the short-term to the extent that market expectations for a flatter rate hike cycle are driven by lower inflation expectations, rather than a slower growth outlook. If we are correct that inflation expectations will bounce later this year, the associated bond sell-off may present a small headwind for stocks. Nonetheless, we do not believe this will derail the rally in risk assets until inflation has reached the Fed's 2% target, and bond yields and the dollar are significantly higher. The Consumer Comeback Continues The latest readings on the health of household balance sheet from the Fed's flow of funds accounts reinforce our view that the consumer sector will provide solid support for the U.S. economy through 2017 and beyond. Household net worth continues to rise and is well above average at this point in a long expansion (Chart 8). While the total wealth effect for consumer spending is lagging behind prior cycles, it remains supportive. Debt to income ratios are at multi-decade lows. The result of the ongoing balance sheet repair is that FICO scores have hit an all time high (Chart 8, panel 4). The most recent Fed Senior Loan Officer's Survey also suggests that the banking sector is willing to lend to households and that consumers themselves are open to borrowing, although household demand for loans has weakened in recent quarters (Chart 9). Chart 8Support For Consumer Remains In Place Support For Consumer Remains In Place Support For Consumer Remains In Place Chart 9Senior Loan Officers Survey Still Supportive Senior Loan Officers Survey Still Supportive Senior Loan Officers Survey Still Supportive Consumer spending intentions also remain in an uptrend, and while consumers do not always do what they say, the 10-year high readings on "plans to buy" a house and a car are telling. (Chart 10, panels 1 and 2). Overall measures of consumer confidence also remain at 16 year highs (Chart 10, panel 3). Chart 10Consumers Are In A Good Mood Consumers Are in A Good Mood Consumers Are in A Good Mood The sturdy labor market, modest wage growth, and low inflation are all factors that support a solid pace of real income growth, adding another support to the spending backdrop (Chart 10, panel 4). Rising rates do not pose a threat to spending for two main reasons, at least in the early stages of the Fed tightening cycle. First, we expect Fed rate hikes to be gradual this year and next, putting only modest upward pressure on longer-dated Treasury yields that anchor consumer loan rates for mortgages, autos, and personal loans. Our colleagues in The Bank Credit Analyst concluded that household interest payment burdens will rise only modestly, and from a low level, in the next couple of years even if borrowing rates increase immediately by 100bps for today's levels. According to their analysis, it would require a much more significant shock, i.e. 300bps or greater, to move interest payments as a share of GDP back toward historical averages.2 We continue to receive many questions from clients on the risks posed by the rise in student debt levels. The Bank Credit Analyst publication covered the topic in a comprehensive report back in November 2016.3 The key takeaway from that report for investors was that student debt is a modest drag for economic growth, but is not a source of risk for U.S. government finances and does not represent the next subprime crisis. More than half a year later, our conclusions remain the same, though the concern among investors has not abated. A recent report4 by the Federal Reserve Bank of New York provides some data on student loans through Q1 2017. More specifically, the report noted that student debt levels continued to rise in Q4 2016 and Q1 2017, and that student loan delinquencies remain high by historical standards but moved sideways in recent years. We will continue to monitor the student loan and all other forms of consumer indebtedness as we assess the risks in the U.S. economy. However, the elevated level of student loan delinquencies does not change our overall assessment of the impact of student loans on the economy and the financial system. Student loans are only a mild economic headwind, and do not represent a source of financial systemic risk. Bottom Line: The consumer - a key driver of the U.S. economy and corporate earnings - will provide a solid backdrop for the economy through 2017 and beyond. This climate will allow the Fed to raise rates one more time this year and begin to pare its balance sheet. The solid underpinnings for the consumer will sustain corporate earnings growth and, ultimately, higher stock prices. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report "Alternative Facts In The Bond Market," dated June 13, 2017, available at gfis.bcaresearch.com. 2 Please see The Bank Credit Analyst Special Report "Global Debt Titanic Collides With Fed Iceberg?," dated February 2017, available at bca.bcaresearch.com. 3 Please see The Bank Credit Analyst Special Report "Student Loan Blues: Can't Replay What I Borrowed," dated October 2016, available at bca.bcaresearch.com. 4 Please see "Quarterly Report On Household Debt And Credit", dated May 2017, available at https://www.newyorkfed.org/medialibrary/interactives/householdcredit/data/pdf/HHDC_2017Q1.pdf